In which I get to disagree with Krugman — slightly

I don’t mostly disagree with this post.

Still, I have been looking for a way to distance myself from Krugman’s take for quite a while now, just to prove I can have my own thoughts too. So any port in a storm. I have found something about which to quibble!

Krugman returns to the (weak) case for fiscal stimulus in the current environment and makes three claims that I think are both correct and dominantly important.

  • The time for fiscal stimulus is when there is high unemployment and (more to the point) liquidity trap conditions.
  • Those conditions do not hold now.
  • There is a political force working on people’s interpretation of fiscal policy, but it is not weighing on us.  As economic conditions change the appropriate policy changes. That the GOP’s timing is off by exactly half a cycle is their fault, not ours. Krugman follows up to detail that aspect in this post.

But but but, I think I have caught Paul Krugman understating his case. He says that the case for fiscal stimulus has not fully disappeared but has become more “subtle” and now involves mostly a precautionary motive.  To wit, fiscal policy managers should give the economy a bit of a lift as a precaution against the demand recovery aborting in the next couple years, before (I guess) inflation expectations have renormalized?

But there are also three problems with that argument, I think:

  • The Fed is tightening and will adjust the pace of its tightening in response to any deviations of demand from baseline. This is just another way of repeating Krugman’s point that we are out of liquidity trap. Accordingly, any fiscal stimulus now will be systematically offset by the Fed. Krugman’s precautionary warning needs to be directed at the Fed, not Treasury. I doubt he would disagree with me on this, so I honestly find his point confusing in this regard. Maybe I am missing something. For now, I am taking this chance to disagree!!
  • Precautionary macroeconomic policy management from the GOP? The same GOP who insisted on tightening the budget into liquidity trap, complained that weak-tea unconventional monetary policy would be hyper inflationary, and thought defaulting on the debt might work? That GOP?  LOLOLOLOLOL.
  • More seriously, Krugman’s argument implicitly assumes that fiscal policy in period A has no effect on either fiscal policy or the effect of fiscal policy in period B. In fact, a larger deficit delivered during economic expansion would make fiscal stimulus during recession, when it will be more needed, both less effective if delivered and less likely to be delivered.  So the precautionary incentive reinforces the case for not delivering fiscal stimulus now.

Oh, it’s on. Paul Krugman is wrong. I am saying that. Even in his follow-up post, he is understating the issue when he shows that the interest rate responds to fiscal policy. It does not just respond. To a first approximation, it fully offsets.

This is not well demonstrated in a two-period IS/LM framework IMHO. Maybe it would look somewhat like the output targeting case explain on page 3 here, except the output target is a medium-term construct imposed by full employment, rather than the Fed’s reaction function. I would leave that to others. I don’t think my point is complicated enough really to need an a diagram. I don’t have many of those, preferring what Noah Smith calls the literary approach — and not flatteringly. *

Hopefully, I don’t suffer the fate that invariably befalls Brad Delong when he disagrees with Krugman.  On this issue I am to the right of  hawkish side of Krugman, max distance from Delong.

* I actually agree with Noah on that point, and take the side of the mathematicians in this debate. So I do not plead sour grapes, but just know my place.  I would no more slag math than join Skidelsky in assuming it plural. Diagrams beat words and math beats all.

Monica Crowley weighs in

Crazily, former Fox analyst and new Trumpista Monica Crowley has weighed in on this issue too.  I had no idea she was Paleo Keynesian on this, but let me just say I mostly agree. This description of the environment that we have just exited seems really well put:

Now, suppose you’re considering the effects of policies that will, other things equal, raise or lower aggregate demand — that is, shift the IS curve. In normal circumstances, where the IS curve intersects an upward-sloping LM, such shifts have limited effects on output and employment, because they’re offset by changes in interest rates: fiscal expansion leads to crowding out, austerity to crowding in, and multipliers are low.

In the aftermath of the financial crisis, however, we spent an extended period at the ZLB, as shown by the “2010” IS curve. In those conditions, shifts in the IS curve don’t move interest rates, there is no crowding out (actually crowding in because increased sales lead to higher investment), and multipliers are large.

In that kind of world, prudence is folly and virtue is vice. Almost anything that leads to higher spending is a good thing; we were in coalmines and aliens territory.