The Train Has Already Left The Station: A Reply To Paul Krugman

by: David Beckworth
Paul Krugman says now is not the time to cut government spending. Why? Because the Fed is out of ammunition and cannot possibly provide any offset to the fiscal drag such spending cuts would make:

Today, by contrast, we’re still living in the aftermath of the worst financial crisis since the Great Depression, and the Fed, in its effort to fight the slump, has already cut interest rates as far as it can — basically to zero. So the Fed can’t blunt the job-destroying effects of spending cuts, which would hit with full force.

The point, again, is that now is very much not the time to act; fiscal austerity should wait until the economy has recovered, and the Fed can once again cushion the impact.

There are two big problems with this analysis. First, fiscal retrenchment has already started and has been happening since mid-2010. The fiscal austerity train has already left the station and shocker of shockers, it has not caused the cataclysmic collapse in aggregate demand that Paul Krugman fears. Here is a figure from a earlier post that shows NGDP growth has been relatively stable despite the reduction in total government expenditures:

The same story emerges if one looks at the shrinking budget deficit. Note also that short-term interest rates have been near 0% since early 2009. So somehow, the Fed has been able to keep NGDP growth stable despite (1) a fiscal contraction and (2) the zero lower bound on short-term interest rates. According to Paul Krugman, this is not possible.

The second problem, then, with Krugman's analysis is his claim that the Fed is out of ammunition at the zero lower bound. He, of all people, should know this is not the case given his seminal work on Japan. He should also know this given all the exchanges he has had with Scott Sumner and me over the past few years. But just to be thorough, let me spell it out once again why the Fed is far from powerless.
To begin, consider how the public would respond if the Fed suddenly announced it was raising its asset purchase by 20% per month until some NGDP level target was hit. That would be the monetary policy equivalent of shock and awe, and should catalyze the mother of all portfolio rebalancings. Households and firms would start spending their built up stock of money assets on other riskier assets (like stocks and physical capital), as well as goods and services in expectation of higher nominal income and temporarily higher inflation. Asset prices would increase, household balance sheets would be repaired, and real debt burdens reduced. This would reinforce the recovery in NGDP growth.
The key to this working is permanently raising the expected size of the monetary base. When this happens, expected nominal incomes will go up and lead to the responses outlined above. Thus, even though open market operations at the zero lower bound might be trading near substitutes now -- monetary base for Treasuries earning 0% -- the belief that they won't stay near substitutes in the future (because of the permanent increase of the monetary base) will trigger the portfolio rebalancing that will lead to higher nominal spending.
Under QE1 and QE2, this did not happen precisely because the public did not expect the increase in the monetary base to be permanent, a point noted by Michael Woodford. But it has happened before. Back in 1933, FDR effectively took the reigns of monetary policy from the Fed and credibly committed to a higher monetary base level by devaluing the dollar. As consequence, the U.S. saw one of its sharpest recoveries that year. The same can happen now by adopting an aggressive, but well anchored, nominal GDP level target.