Scott Sumner  

A little bit pregnant

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Paul Krugman has a new post of mercantilism:


Neil Irwin has a good think piece on Trumpism and the trade deficit; but as Dean Baker rightly suggests, it arguably suffers a bit from being a discussion of the effects of trade deficits in normal times. And these times aren't normal.

In normal times, the counterpart of a trade deficit is capital inflows, which reduce interest rates, and there's no reason to believe that trade deficits reduce employment on net, even if they do redistribute it. But we are still living in a world awash with excess savings and inadequate demand, where interest rates can't fall (or at any rate not much) because they're already near zero. That is, we're in a liquidity trap.


Actually we are not in a liquidity trap, and it's not even debatable. Just as a woman cannot be a little bit pregnant, you are either in a liquidity trap or you are not. In the case of the US in 2016, we are not in a liquidity trap. Hence liquidity trap theories do not apply. Krugman's post is completely wrong, because it's entirely built on the incorrect assumption that we are in a liquidity trap.

When Krugman uses the liquidity trap excuse to justify an otherwise counterproductive policy (such as mercantilism, fiscal stimulus, or artificially higher wages) the term has a very specific meaning. It does not mean "interest rates close to zero." It means interest rates higher than the central bank would prefer. The Fed raised rates in December, and will probably raise them again in June. Interest rates are relatively low, but they are obviously not lowerhigher than the Fed wishes. So Krugman is simply wrong.

To the casual reader this Krugman post may seem like more of the same, but it is actually another step away from the neoliberal analysis that he produced in the 1990s. The first step was when Krugman claimed that fiscal stimulus and mercantilism are only justified when interest rates are at zero. I disagree with that view, but it's a defensible argument. Now he claims that these policies merely require that interest rates be relatively low. That's not even a defensible argument. If rates are low but non-zero, then the central bank has NGDP right where they want it. Right now it's in the central bank's power to raise NGDP growth as high as they like. If we fall back to the zero bound, it would be 100% the fault of the central bank, no one else. Unfortunately, it seems likely that we will fall back to the zero bound in the very next recession. We don't need fiscal stimulus or mercantilism; we need to fix the monetary regime.

There are many other problems with the analysis. Krugman links to a Dean Baker post that suggests the current "secular stagnation" is mainly caused by the trade deficit. But secular stagnation is occurring all over the developed world, including those countries with trade surpluses. Indeed the US is doing better than most other developed countries. The one country that avoided a global recession in 2008-09 was Australia, which has an even bigger deficit, as a share of GDP. Japan has a big surplus. Whatever you think of trade deficits, there is little evidence that trade deficits lead to slower economic growth.

PS. Krugman's post cannot be saved by pointing to the global economy, which does have many countries at the zero bound. The global economy has no overall current account deficit.

PPS. In this post I've assumed that zero interest is the lower bound. If the actual lower bound is a minus 0.75% interest rate, then Krugman's argument is even weaker.

PPPS. The current account deficit in America is almost identical to 30 years ago, as a share of GDP. Trust me, it has nothing to do with "secular stagnation."

HT: Benn Steil




COMMENTS (20 to date)
marcus nunes writes:

Coincidentally, but much shorter!
https://thefaintofheart.wordpress.com/2016/03/29/in-an-lt-world-murder-is-ok/

ThaomasH writes:

I think you ought to clarify your liquidity trap definition to "interest rates higher than the central bank would prefer" to include "and would therefore not offset additional demand coming from X."

It may indeed be true that the Fed would offset additional demand coming from say a big increase in net exports -- I think that would be a mistake, but it could well be their policy. That wold make Krugman strictly speaking wrong; we are not in a SS liquidity trap. What he ought to say is that we OUGHT TO BE in a SS liquidity trap rather than that we ARE in a SS liquidity trap because the Fed OUGHT NOT to have the reaction function he (and I think you, too) thinks it does.

So, big picture, Krugman is right about these not being "normal" times that generate the standard change-in-net-exports-do-not-affect-aggregate-demand result.

Maybe "sticky prices" explanations of AD recessions need to be supplemented with "sticky interest rates;" central banks do not allow interest rates to be whatever they would have to be in order to maintain NGDP growth.

Lawrence D'anna writes:

Has Krugman actually changed his mind from what he believed about economics in the 90s? Or is he just acting like a Lawyer now, advocating zealously for a position using any argument he thinks might be persuasive, whether or not he actually believes it?

Scott Sumner writes:

Thaomas, You said:

"What he ought to say is that we OUGHT TO BE in a SS liquidity trap rather than that we ARE in a SS liquidity trap because the Fed OUGHT NOT to have the reaction function he (and I think you, too) thinks it does."

Just to be clear, I do think monetary offset is appropriate. If a central bank is doing its job they will offset the demand side effects of other policies.

You said:

"So, big picture, Krugman is right about these not being "normal" times that generate the standard change-in-net-exports-do-not-affect-aggregate-demand result."

No, these are normal times. Interest rates are positive, unemployment is 4.9%, and the Fed both would and should offset changes in AD coming from other sources.

You said:

"Maybe "sticky prices" explanations of AD recessions need to be supplemented with "sticky interest rates;" central banks do not allow interest rates to be whatever they would have to be in order to maintain NGDP growth."

I don't follow this. I thought you were saying interest rates were not sticky enough, that the Fed should not be raising rates.

Daublin writes:

Lawrence, Krugman from the 90s is unrecognizable compared to today. Go read some of it--it's positive, refreshing, and cogent. You would never believe it's the same guy.

For more than a decade, now, he just bashes Republicans. It's very hateful, and the economists who don their asbestos and try to read through his missives anyway are widely declaring that he's not consistent in any sense: not with himself nowadays, not with himself in the 90s, and not with the rest of the field.

He definitely hates Republicans, though.

jj writes:

Scott,

Who is Krugman referring to in this sentence? My impression is that we have the opposite of excess savings.

"But we are still living in a world awash with excess savings and inadequate demand"

Ryan writes:

"It does not mean "interest rates close to zero." It means interest rates higher than the central bank would prefer. The Fed raised rates in December, and will probably raise them again in June. Interest rates are relatively low, but they are obviously not lower than the Fed wishes. So Krugman is simply wrong."

Is the italicized above a typo? It seems inconsistent with the penultimate sentence. Is it instead that a liquidity trap means interest rates lower than the central bank would prefer?

ThaomasH writes:

Scott,

I guess we have a disagreement about monetary policy that I was not aware of. I thought that you would agree that monetary policy did not and still has not done enough to to keep ngdp (or even the price level) and expectations thereof on their pre-crisis trends. Interest rates on a broad spectrum of assets (maybe we could include the exchange rate, too) were and still are "too sticky" (downward) to keep/get ngdp back on track. Krugman seems to think that the Fed ought not offset and increase in net exports. In that sense Krugman does not think we are in "normal" times and that "mercantilism" makes some sense.

Scott Sumner writes:

jj, He means that people want to save more than they want to invest, at zero interest rates.

Ryan, Actually there was a typo later in the paragraph. I fixed it.

Ryan writes:

Scott,

Ah, OK, that makes sense now. Thank you!

Kevin Erdmann writes:

This pairs well with your post at TMI. These things are all related, but the causal factor is the constraint on housing in top cities. This constraint is a competitive moat around firms that utilize highly skilled and networked labor. These firms earn economic rents from both domestic and foreign consumers. The former leading to domestic stagnation. The latter to persistent capital inflows which are funded with imports. Firms do still deploy capital to be competitive, as they always have. But now, it is deployed through high wages, which are then funneled to the owners of the binding constraint - urban housing. This is why housing capital is high, corporate investment appears to be low, market value appears high relative to book value, profit margins are high, and yet income to capital (except for housing) is relatively normal. And it's why wage inequality seems to come mostly between firms, not within them.
I think if we let workers migrate to high income cities, real incomes would rise, home prices would fall, and the trade deficit would shrink. The blockage of this migration is the thing that is different now, and it is the cause of stagnation.

Andrew_FL writes:

@Daublin- Normally I would agree with you, I've called Krugman a partisan hack for years now. But in this particular instance he seems to be kissing up to someone nominally running as a Republican. Weird.

Daniel Kuehn writes:

Well a liquidity trap is any flat region of the liquidity preference schedule. ZLB is just a special case where that holds mechanically because everything starts to look like cash. I don't know what the central bank's preferences are supposed to have to do with it.

Andrew_FL writes:

@Andrew_FL-Just to be clear, I feel that, given the support he's espoused for Trump, nominally a Republican, I think I was unfair to Krugman all these years. Which is weird for me to say, given that I disagree with Trump on these issues, but I have to admit my uncharitable mental model failed to predict the way Krugman would react to the most likely Republican nominee.

Scott Sumner writes:

Thaomas, I do not think the Fed is currently constrained by the zero bound from doing the right policy. In other words, if the current instrument setting is not optimal, and it may be a bit too tight (as you believe), the optimal instrument setting is likely a feasible number, say 0.25%, or 0.0%. In that case Krugman's argument does not hold.

Kevin, I'm not sure I follow that. Wouldn't more internal migration lead to more housing construction in the US, and a bigger trade deficit?

Daniel, Krugman's argument depends on there being no monetary offset, so the central bank's intentions have everything to do with the question. And if the Fed is raising rates, then we are obviously not on the flat portion of the liquidity preference curve.

Floccina writes:

Funny, but Krugman and Trump seem to align on economic policy.

Kevin Erdmann writes:

We don't need a trade deficit to fund home construction. It is the lack of urban home construction that leads to both housing "bubbles" and the trade deficit.

If you're GM in 1950, you create a competitive moat by building more and better metal stamping machines. You design better machines, earn market power, and over time, competitive pressures bring the aggregate return on those machines down to a fairly stable long term range.

But, what if we pass a law that you're not allowed to improve or expand those machines any more? Now, there would be stagnation. We would be buying the same cars over time, without the cost and quality improvements that those new machines were creating. But, capital investments at the corporations would still remain the same. Corporations would just be bidding up the price of the machines that do exist instead of building new machines.

Today, as you point out, the economy has shifted so that much of the new valuable production comes from highly networked and skilled labor. To create value, these workers need to locate in highly dense urban cores. But, we have made a rule - no new housing in those areas. So, there is a fairly hard cap on the expansion of these value creators, just as there would have been a cap on GM making better cars without new machines.

But, instead of corporations bidding up the prices of the machines in order to claim the profits they produce, in the current context workers have to bid up the price of houses where they can access dense high-skilled innovative networks. This leads to migration because, on the margin highly skilled workers are trying to claim more of that housing, and low income households are forced to move out of New England and California as that happens, which creates a tremendous amount of economic stress.

And, what happens is that, as with our hypothetical GM, there is still the same amount of capital investment, but now it happens off the books of the corporations. Now, that capital investment happens through the highly skilled workers. The corporations just sort of lease the capital by paying higher wages to the workers, which are funneled to real estate owners through rent.

The reason market cap looks higher than tangible book value is because the assets that create a competitive moat around these firms are not on their books, they are just imputed through the bloated wages of their workers. The reason we have stagnation is because the competitive moat is coming from bidding up a fixed stock of assets instead of investing in new assets. The reason we have a foreign capital surplus is because the economic rents captured by this are claimed both from domestic consumers and foreign consumers, allowing US firms to earn excess profits on foreign sales, so that we out-earn foreign savers every year, even though we don't save as much as they do. They must counter this transfer of rents by continually reinvesting their normal profits in capital that earns lower returns than our protected firms do.

This is why income inequality is mostly between firms, not within them, and why it is almost totally claimed by high income labor (and real estate owners), because they are most able to leverage their ability to capture the economic rents of closed access to those labor markets by reducing their housing consumption and keeping some of those bloated wages for themselves. The relative income levels of the housing constrained cities over the last 20 years are extreme and unprecedented.

It's why operating profits as a share of GDI aren't particularly high - because the workers and landlords claim at least as much of the rents as the firms do. It's why total corporate profits / GDP seem high, because much of those profits are excess rents earned abroad.

James Alexander writes:

Quite remarkable for PK to claim the world is awash with savings and in a liquidity trap in the same paragraph.

More like we are awash with liquidity but not being encouraged to use it as our big western central banks tighten or threaten to tighten any time their projection of two year out inflation approaches their ceiling of 2%. They are in almost total control via their projections and their target of a ceiling.

The only time they lose control is when reality falsifies their projections. But they bounce back, time and time again.

James Alexander writes:

Quite remarkable for PK to claim the world is awash with savings and in a liquidity trap in the same paragraph.

More like we are awash with liquidity but not being encouraged to use it as our big western central banks tighten or threaten to tighten any time their projection of two year out inflation approaches their ceiling of 2%. They are in almost total control via their projections and their target of a ceiling.

The only time they lose control is when reality falsifies their projections. But they bounce back, time and time again.

James Alexander writes:

Quite remarkable for PK to claim the world is awash with savings and in a liquidity trap in the same paragraph.

More like we are awash with liquidity but not being encouraged to use it as our big western central banks tighten or threaten to tighten any time their projection of two year out inflation approaches their ceiling of 2%. They are in almost total control via their projections and their target of a ceiling.

The only time they lose control is when reality falsifies their projections. But they bounce back, time and time again.

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