Krugman’s blog, 11/2/15

There were three posts yesterday.  The first was “Liquidity Traps, Temporary and Permanent:”

Larry Summers reacts to an offhand post of mine, seeking to draw a distinction between our views. I actually don’t think our views differ significantly now, but he’s right that what he has been saying differs from the approach I took way back in 1998. And I’ve bothacknowledged that and admitted that the approach I took then seems inadequate now:

Back in 1998, when I tried to think through the logic of the liquidity trap, I used a strategic simplification: I envisaged an economy in which the current level of the Wicksellian natural rate of interest was negative, but that rate would return to a normal, positive level at some future date. This assumption provided a neat way to deal with the intuition that increasing the money supply must eventually raise prices by the same proportional amount; it was easy to show that this proposition applied only if the money increase was perceived as permanent, so that the liquidity trap became an expectations problem.

The approach also suggested that monetary policy would be effective if it had the right kind of credibility – that if the central bank could “credibly promise to be irresponsible,” it could gain traction even in a liquidity trap.

But what is this future period of Wicksellian normality of which we speak?

Japan now looks like an economy in which a negative natural rate is a more or less permanent condition. So, increasingly, does Europe. And the US may be in the same boat, if only because persistent weakness abroad will lead to a strong dollar, and we will end up importing demand weakness.

And if we are in a world of secular stagnation — of more or less permanent negative natural rates — policy becomes even harder.

Yesterday’s second post was “Flexible Illusions:”

Wolfgang Munchau declares that the euro was a mistake, and pinpoints a key illusion. Advocates

knew that, to withstand the rigours of a fixed-exchange system that resembles nothing so much as the gold standard, countries would have to adjust to economic shocks through shifts in wages and prices — a course, they believed, that the euro’s members would be forced to take.

That is, they believed that reforms could create enough flexibility to mainly neutralize Milton Friedman’s warning that in the face of negative shocks, countries with fixed exchange rates would suffer large costs:

If the external changes are deep-seated and persistent, the unemployment produces steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course.

But I never believed this would work, and based my skepticism on some real evidence. During the runup to Maastricht, there were a number of studies of the US — a currency union that functions reasonably well. Was that because the US, with its weak unions and competitive labor markets, had more wage and price flexibility than other nations? Not according to Blanchard and Katz, who found that wages played hardly any role in US regional adjustments to shocks, that it was all about labor mobility. So the idea that Europe would find itself able to achieve a kind of flexibility found nowhere in the world — not even the brutal, markets-rule American economy — was just implausible.

What none of us thought about at the time was the further problem of the interaction of deflation and debt — the way attempts to adjust through falling wages would worsen debt problems. But even given what we knew a quarter-century ago, the problems with the euro were obvious.

The last post yesterday was “My Head Talks:”

I’ve done very little TV lately; I will, however, be on Chris Hayes tonight at 8.



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