Fiscal Stimulus: Completing Krugman's Thought

by: Brad DeLong

Paul Krugman writes (Paradoxes Of Deleveraging And Releveraging):

Whenever the issue of fiscal stimulus comes up, you can count on someone chiming in to say, “Only a moron could believe that the answer to a problem created by too much debt is to create even more debt.” It sounds plausible — but it misses the key point: there’s a fallacy of composition here...

There is nothing wrong with what Paul says. But I think it is incomplete, and that there is a better way of getting to the right conclusion.

The problem was created by too much risky debt and not enough safe debt. The result is that right now there is an excess demand for safe assets--like U.S. government securities. Because businesses and households want to hold more safe assets at full employment than exist, they are trying to cut back on their spending on currently-produced goods and services in order to build up their stocks of safe assets.

As a group, when they try to do this they fail: building up the economy's stock of safe assets requires that somebody do something to create them. But as they try their cutbacks in spending on currently-produced goods and services produces the fall in production, income, and employment that has led us to our current situation.

The best ways to get us out of this? (a) Have the government put people to work, and (b) have the government create more safe assets--more Treasury bonds--for people to hold. The first puts people to work. The second gives businesses and households more safe assets to hold so that they will be happy with their safe asset portfolios. Thus they will then stop trying to accumulate more safe assets, they will spend their incomes, and that will put more people back to work too.

If our big problem were too much debt we would not be here, in depression. Too much debt generates inflation. The things that generate depression are shortages of financial assets, and excess demand for some class of financial assets then produces, by Walras's Law, excess supply of currently-produced goods and services. We had a "shortage of liquid cash money" recession in 1982; we had a "shortage of long-duration bonds" recession in 2002, and now we are having a "shortage of safe assets" recession.