Scott Sumner  

Krugman slides deeper into old Keynesianism

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Those of us who liked the 1990s vintage Paul Krugman have been able to hold on to a few stands of hope. At least he still supports free trade. At least he only applies the old Keynesian model to the zero bound case, and still argues that monetary offset applies when rates are positive.

But as Ryan Avent recently pointed out, his support for free trade seems to be slipping. And his support for new Keynesianism when not at the zero bound was hard to reconcile with his claims that the eurozone double dip recession was caused by fiscal austerity. After all, the ECB raised rates from 1% to 1.25% in April 2011, and then to 1.5% in July 2011, pushing the eurozone into a double dip recession (according to standard new Keynesian analysis.) They weren't at the zero bound.

Mark Sadowski pointed me to a recent Krugman post that helps resolve the puzzle, albeit in a far from satisfying manner:

Is ECB policy constrained by the zero lower bound? You could argue that it isn't, since it could cut a bit further than it has but hasn't. I'd argue, however, that if nominal interest rates were much higher -- say, 4 percent -- but the overall euro macro situation were what it is, with inflation clearly below target and unemployment very high, the ECB wouldn't (and certainly shouldn't) hesitate at all about cutting rates substantially. It's only the fact that zero is already so close that makes cutting rates seem like a big deal, an admission that things are looking dangerous (which they are).
Most of the rest of the post is excellent, but this defense of old Keynesian economics when not at the zero bound just won't work. I suppose you could make the argument today, as the policy rate is only 0.25% (although I still wouldn't buy it.) But it certainly wouldn't apply to 2011, when the rates were higher and much more importantly the ECB was raising rates in an attempt to slow inflation (they succeeded, just as the 1929 Fed succeeded in popping the stock market "bubble.")

So Krugman's analysis of the ECB continues to be illogical, unless one assumes he's abandoned new Keynesianism, and has become one of those old Keynesians who think fiscal policy always drives AD, and monetary policy doesn't matter. And if he has, then he should clearly say so. Instead he seems to stealthily edge a few degrees more toward old Keynesianism each year.

Did the ECB's tight money policy of 2011 cause the double-dip recession, or didn't it? New Keynesian economics suggests it did, old Keynesianism suggests it didn't.

PS. Let me anticipate one possible criticism. The interest rate increase of 2011 was rather small. However the size of a change in interest rates tells us almost nothing about the impact of the policy. A 50 basis point rise in the target rate might depress the Wicksellian equilibrium rate by 5 or 10 times that much.

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COMMENTS (6 to date)
W. Peden writes:

It's an interesting decay of the ZLB-problem hypothesis, in that the problem is no longer expansionary monetary policy at the ZLB, but expansionary monetary policy when this is "an admission that things are looking dangerous". So the interest rate could be 17% and one could still make this argument for fiscal stimulus.

On the other hand, I don't think it's quite Old Keynesianism (or at least Neanderthal Keynesianism, to use Blinder's phrase) because Krugman's point in that paragraph is actually compatible with even an extremely interest-rate inelastic demand for money. You could have a model where a 0.25% reduction in the policy rate increases the NGDP growth rate by 10% and Krugman's claim COULD still be right.

Anyway, his 'however' is very misleading, since the claim "The ECB would cut interest rates if they were higher" is perfectly compatible with "The ECB SHOULD cut interest rates now". It's a case of Krugman trying to escape from the irrelevance of his narrative in the Euroarea context by changing the subject.

W. Peden writes:

For example, imagine I said "You could argue that we could it isn't raining, however if it were really pouring down in a monsoon-like fashion, no-one would even need to argue that it was raining." The second proposition doesn't contradict the first at all.

You could argue that the ECB wasn't constrained by the ZLB, because it wasn't.

Scott Sumner writes:

W. Peden, I must admit I have trouble following his argument. Not so much the current situation, but his view of the ECB's tight money policy of 2011.

Which is what?

J Mann writes:

Krugman's maddeningly unclear, but what I think he means is:

- When the central bank is constrained from increasing monetary stimulus, then you are effectively at the ZLB, and monetary stimulus has to lift the weight, if anyone will.

- In the US, Krugman imagines that the Fed is constrained because it's afraid of using unconventional stimulus, or because it doesn't know how much unconventional stimulus to use.

- In the ECB, Krugman imagines the bank is constrained because it's afraid to drop rates that last percent for fear of using up ammunition it might need later. (Or something).

Assuming that's what Krugman actually thinks, it's frustrating that he's not more clear, because one of the implications is that the banks should get off their rears and do more monetary stimulus. To the extent they're POLITICALLY constrained, Krugman's advocacy could do something to relax that constraint.

Jim Glass writes:

I've always been puzzled about why Krugman has been so intent on morphing himself from being the world's leading trade economist of the 1990s into being the world's leading Keynesian of the 1960s in the 2000s.

Scott Sumner writes:

J Mann, I get the part of being reluctant to cut rates that last 1/4%. But how does that explain the ECB raising rates that are already over 1%? It makes no sense, unless you assume the ECB actually was trying to prevent a rise in AD. In which case fiscal stimulus is impossible.

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