What If Paul Krugman Is Right? Part ll

by: Shareholders Unite

In the first part we have discussed two fundamental views of the economy. The 'freshwater' economist argue that the economy is essentially self-stabilizing and full-employment equilibrium will return. 'Saltwater' economist like Krugman argue that the economy can stay in a prolonged slump.

If the likes of Krugman are right, this is bad news for investors because corporate earnings growth will be much lower and some kind of policy intervention might be necessary to restore the economy (we'll look into that in another post).

In this article, we'll describe two phenomena that have marked the US economies for quite some time:

  • Record low interest rates in the face of record public deficits and debts
  • Record debt monetization without setting off accelerating inflation.

We argue that it is difficult not to credit Krugman for having foreseen these developments in the midst of rather widespread alarm and it does provide considerable support for his view of the economy, as these are developments that have quite vexed his opponents.

Interest rates, public deficits and debt

If there is one thing that has freshwater economists in a bind, it is the persistence of record low interest rates on US public debt when that debt (and deficits) has reached unprecedented levels. Here is Eugene Fama:

bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

Krugman berates Fama (and John Cochrane, who made a similar point) for mistaking accounting identities for behavioral relationships. According to Krugman, what equates savings and investments is GDP as well as interest rates.

In a deeply depressed economy there are plenty of idle resources (unemployed and/or discouraged workers, underutilized plant, etc.) and there is a world savings glut. Increasing resource utilization through some kind of stimulus will increase incomes and GDP, which increases savings as well (part of the additional income is saved).

A simple Keynesian IS-LM analysis has no trouble explaining this but it apparently escapes the likes of Fama and Chchrane.

Krugman had a similar, rather famous bout with Niall Ferguson. The latter argued (in 2009!):

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every U.S. undergraduate) could such a tidal wave of debt issuance exert 'no upward pressure on interest rates.' [Slate]

He even went as far as declaring victory:

I am saddened by Krugman’s resort to ad hominem attacks, couched in the language of the playground. I presume it is because he knows, but bitterly resents, that I won the argument we had back in April about the future path of long-term interest rates. [Timesonline]

Once again, the fact that not only interest rates, but also incomes and GDP can equate savings and investments seems to completely escape Ferguson as well, especially in a climate where interest rates can hardly fall much further and there is a large output gap (the difference between what an economy can produces if it uses all readily available resources and what it actually produces).

What's more, we're now two years further, and we have the distinct impression Ferguson was a little early in declaring victory. A similar fate has befallen the Wall Street editorial page, which has predicted rising interest rates every now and then, only for these not to materialize, as Krugman has noted on his blog more than once. He summarized that in with the following figure:

(Click to enlarge)

Click to enlarge

And Krugman has no problem explaining the low interest rates (neither in the US or the UK, both countries have, unlike the euro zone countries, a lender of last resort):

British rates are low for the same reason US rates are low — not as a reward for fiscal virtue, but because everyone now expects the economy to stay depressed, and policy rates near zero, for years to come.

The other side of the insufficient demand by which the crisis is characterized (see part I) is a (world) savings glut, which also explains the low interest rates:

I thought it might be useful to re-explain why our current predicament can be thought of as a global excess of desired savings — which means that fiscal deficits won’t drive up interest rates unless they also expand the economy.


Many people are alarmed about 'money creation' (in fact, what they refer to is base money creation, bank reserves, through various operations of the Fed like QE, quantitative easing). Not Krugman, according to him, as long as we're in a liquidity trap, there really isn't any danger of hyperinflation:

I really, really don’t understand people who deny that we’re in a liquidity trap. As I’ve tried to explain in various ways, the hallmark of such a trap is that at the margin people hold money not for its moneyness but simply as a store of value, and that therefore conventional monetary policy — which involves swapping money for non-money assets like Treasury bills — has no effect, because it’s just replacing one zero-interest asset with another.

His study of the similar Japanese situation in the 1990s enabled him to meter out some history lessons. Here is Alan Melzer:

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

Krugman can reply with a simple figure:

In the US, all that 'newly created money' just sits there, as bank reserves:

Compare Krugman with the editorial page of the Wall Street Journal, here is Bruce Barlett:

In an editorial on Feb. 29, 2008, The Journal said it was certain that higher inflation was on the way, calling it the “Bernanke reinflation.” An editorial on June 9, 2008, warned that easy money and Keynesian stimulus “is taking us down the road to stagflation.” On Feb. 6, 2009, the Journal editorial writer George Melloan said the inevitable result of economic stimulus would be inflation. On June 10, 2009, the economist Arthur Laffer wrote on the Journal editorial page that the increase in the Fed’s monetary base was “a surefire recipe for inflation and higher interest rates.”

David Frum (former assistant to President George W Bush), famously asked the following question:

Imagine, if you will, someone who read only the Wall Street Journal editorial page between 2000 and 2011, and someone in the same period who read only the collected columns of Paul Krugman. Which reader would have been better informed about the realities of the current economic crisis? The answer, I think, should give us pause. Can it be that our enemies were right?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.