SA contributor Ian Bezek argues that New York Times columnist and economist Paul Krugman is inconsistent. We simply think he's catching words. This is unfortunate, as in the post-financial crisis Krugman's predictions have a stellar track record.
First off, Krugman is known for being an advocate of deficit spending. What's less appreciated is that this enthusiasm isn't universal. It's conditional on the state of the economy.
In short, the bigger the slump, the stronger the case for deficit spending. The slump caused by the financial crisis was lending itself particularly well to deficit spending. Not only because the slump was particularly deep (the economy plunged by an annualized 9% for a couple of quarters), but also because of the nature of the slump.
Basically, the slump destroyed a large swath of household wealth, some $9 trillion was wiped off of the value of housing, doing great damage to household balance sheets.
In order to repair the damage to those balance sheets, households started to save more and spend less, which in large part is what is responsible for the economic collapse.
Here one can see this in action, the private sector moved from a financial deficit to a huge financial surplus, that is, savings exceeded investment by a large margin. Note also how unemployment almost perfectly correlates with this movement.
The increases supply of savings collapsed interest rates to basically zero. This had the notable side effect that it rendered monetary policy much less effective. Basically, households were in the business of paying off debts in order to repair their balance sheets, they were not in the mood to borrow more, despite zero interest rates.
In this particular set of circumstances, Krugman made a series of highly counterintuitive predictions:
- A large expansion of central bank balance sheets will not lead to accelerating inflation (let alone hyperinflation, as many predicted in 2009).
- Even very large public deficits and debts will not lead to higher interest rates.
- Monetary policy becomes near powerless, fiscal policy becomes very powerful.
All these predictions have panned out. Krugman based this not only on his knowledge of the 1930s and the work of Keynes, but he was also one of few who had studied the same phenomenon in the Japan of the 1990s, updating the Keynesian liquidity trap with modern economic modeling.
Even the IMF had to admit it was wrong on the effectiveness of fiscal policy, and issue a mea culpa for the damage austerity has done in parts of the eurozone. Fiscal multipliers, under these conditions (large output gaps, zero interest rates) are much bigger than normal.
This isn't hard to grasp. If monetary policy is basically powerless and households are deleveraging to repair balance sheets and the private sector is moving into a large financial surplus (see graph above), something has to counterbalance that to avoid a downward spiral.
The disastrous experience of some eurozone countries with austerity testifies to this. We might also have forgotten how common in the aftermath of the financial crisis predictions were like:
- The US with it's large public deficit, will become like Greece and experience a fiscal crisis, a bond crash, etc.
- The money printing by the Fed will lead to dollar 'debasement' runaway inflation, a dollar and bond market crash, or even an economic collapse, etc.
None of this has panned out. What happened was that household balance sheets gradually improved, they stopped deleveraging, and things gradually turned to normal.
Hence less need for fiscal stimulus.
This need becomes less the closer the economy gets to full employment. Nobody knows exactly when that is, but the rising wages and interest rates of late are a pretty good indicator we're getting quite close.
Now, it is indeed true, as Bezek has it, that Krugman still argued for some deficit spending fairly recently, for two reasons:
- Precautionary, to avoid the economy falling back.
- Infrastructure. The US economy simply has a large backlog in infrastructure spending and maintenance, and we should take advantage of the still very low interest rates to finance that.
Since that, economic growth has accelerated to over 3% and interest rates have risen, indicating the economy is even more robust which weakens the precautionary motive, but there is still a case for infrastructure spending. Here is Krugman himself:
Wages are finally rising, quit rates are back to pre-crisis levels, so we seem to be fairly close to full employment, and the Fed is raising rates. So it now looks like the "2017" IS curve in the figure. We're just barely over the border into normality, which is why I think the Fed should hold and we could still use some fiscal stimulus for insurance, and very low rates still make the case for lots of infrastructure spending. But it's not the same as it was.
That doesn't seem all that inconsistent to us. In fact, it seems very consistent with his underlying economic model (which perhaps not everybody is familiar with), which dictates that you embark on deficit spending when the economy needs it, when there is a big slump and monetary policy is out of commission. Not when the economy is approaching full employment.
Speaking about inconsistency, let us turn this around. How many of those who now criticize Krugman for his supposed flip-flop where real deficit hawks in 2009-2015, when the rationale for fiscal stimulus was as compelling as it has ever been but are now suddenly turning into deficit doves and are rejoicing in the coming Trump reflation?
Who is actually inconsistent here?
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