Arnold Kling  

Krugman on the State of the Economy

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From his Nobel AEA meeting lecture.


It should have been easy to put the evidence of a mammoth housing bubble together with the concepts of third-generation crisis theory to see how a nasty deleveraging cycle could occur without the "original sin" of dependence on foreign-currency debt.

Sadly, almost nobody - certainly not yours truly - put the pieces together.

Thanks to Mark Thoma for the pointer.

Basically, Krugman's story is that the U.S. experienced something like a currency crisis, except that our debts are denominated in our own currency. In a classic currency crisis in another country, that country had debts denominated in dollars. It suffered increases in real debt costs as its currency depreciated, but the increase in net exports helped restore total demand.

On the other hand, the asset-price deflation that Krugman posits as being the heart of our crisis has no compensating stimulative effect. However, by the same token, it seems to me that if our currency were to depreciate, we would have the demand stimulus of greater net exports without the contractionary impact of raising the real cost of our debt. So I am not convinced that we are somehow in a worse position because we are experiencing asset-price deflation rather than a currency crisis.

Like Scott Sumner, Krugman views the main problem as deflationary expectations. I am not sure where these expectations come from. In Sumner's story, people just decide that the monetary authority is willing to see the price level drop. In Krugman's story, the process of de-leveraging in housing triggers an overall self-fulfilling drop in inflation expectations.

Krugman's forecast is for a Japan-like slump. In contrast, the Recalculation Story suggests that we could have stagflation, as the efforts to pump up demand run up against the reality that the necessary reallocation of labor takes time. My guess is that by the middle of 2012, we will see an unemployment rate of about 7 percent and an inflation rate of 5 percent. My sense is that Krugman thinks that the unemployment rate may well be higher and the inflation rate will certainly be lower.


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CATEGORIES: Macroeconomics



COMMENTS (6 to date)
jsalvatier writes:

I think Sumner and Krugman are ultimately telling the same story, the financial crisis sets raises the demand for money and the fed does not do enough to compensate which leads to deflationary expectations. The only difference is that Krugman has sometimes argued that the Fed *can't* do more to compensate, even though he doesn't seem to have a reason for believing that.

Bob Murphy writes:

My guess is that by the middle of 2012, we will see an unemployment rate of about 7 percent and an inflation rate of 5 percent. My sense is that Krugman thinks that the unemployment rate may well be higher and the inflation rate will certainly be lower.

My guess is that both of you are going to look extremely optimistic come 2012.

Greg Ransom writes:

I don't believe for a minute that Krugman at this point doesn't know of William White's BIS reports between 2003 and 2008 laying out what what was happening and what was goin to happen.

It just a lie to claim that people weren't puttin the puzzle pieces together well before the "mainstream" Ivory Tower macroeconomists had any clue what was happening.

baconbacon writes:

"My guess is that by the middle of 2012, we will see an unemployment rate of about 7 percent and an inflation rate of 5 percent."

I'm curious as to how you think the economy will manage to function with inflation at 5%? Just from a government perspective 5% inflation means 7-8% interest on top rated debt which is currently @ ~125% of gdp (federal, state and local combined) considering that debt is decreasing in term (average maturity of treasuries is approaching 4 years) the US as a country will be rolling over somewhere between 3 and 5 trillion dollars a year and trying to pay 7-8% on that and still paying 3-4% on the other 12-14 trillion(this is not accounting for any new debt being issued before then) and that is assuming that ALL state, local and federal remains prime (which it clearly isn't at the moment: see California). Best case scenario is $210 billion in interest on rolled over debt and $420 billion on old debt- with every year shifting more toward the higher interest debt.

This scenario is of course wildly optimistic since SS and medicare/medicaid payments are tied to inflation rates, most union contracts are as well (more costs for state, local and federal) putting more pressure on employers to cut payrolls and last but not least the expected 2-4 trillion in new debt to be piled on in the next 2 years.

State and local governments are not going to be able to meet their obligations in the near future- which means default- which means more costly borrowing, less borrowing and dramatic cuts in budgets, and that finally means higher (not lower) UE rates. It is extremely difficult to see a scenario in which a massive debtor has increasing inflation and decreasing UE rates (unless the latter is just people rolling off UE and out of the labor force). Perhaps briefly just before a total flight from the dollar, but as an expectation? I don't see it.

Ryan Vann writes:

Greg Ransom,

Point well made. I'm not sure if Economists troll the "nobody predicted this" bait out there to sound modest, or if some actually believe this nonsense. There are plenty of Economists that did indeed predict what we are going through. Hell, it was basically common knowledge that, at the least, the housing market was inflated and the subsequent bust would be ugly while I was getting my BS (2003-2007).

Ano writes:

In contrast, the Recalculation Story suggests that we could have stagflation, as the efforts to pump up demand run up against the reality that the necessary reallocation of labor takes time. My guess is that by the middle of 2012, we will see an unemployment rate of about 7 percent and an inflation rate of 5 percent. My sense is that Krugman thinks that the unemployment rate may well be higher and the inflation rate will certainly be lower.

I think it's really cool that Mr. Kling is willing to make a specific prediction like this. Let's set up some further discussion of this.
- If we don't have inflation above (what? 4%?) will you be forced to significantly revise the recalculation view?
- If we do have 5% inflation and unemployment below (what? 8%?), will you consider yourself proven right? Will the Krugmans of the world accept recalculation? What could they say to maintain their models in a 5% inflation 7% unemployment world?
- Can recalculation still be vindicated even if we don't have high inflation (if, say, it turns out the fiscal expansion wasn't dangerously large)?

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