Paul Krugman, fiscal policy and the Federal Reserve
I've been quoting Paul Krugman a lot lately. Because he's a good economist and has been calling the economic trends during this depression well. One would hope that the fact that he received the Nobel Prize in economics would in itself indicate that he's a good economist. But then, the Nobel Committee has been known to hand out the Peace Prize to recipients whose appropriateness has been highly questionable. In Krugman's case, though, it holds true.
... let's start with the state of monetary policy orthodoxy circa 1997 or so. By that time, most macroeconomists had come to believe that central banks could and should bear the whole burden of stabilizing the economy. No need for active fiscal policy (although maybe let the automatic stabilizers stay in place), just let Uncle Alan do his thing, and we'll have acceptable stability. I shared this view.
But then some of us started to notice Japan, which had cut rates to near zero and was still sliding into deflation. Could this really be the hoary old liquidity trap come back to haunt us again? [my emphasis]
The late John Kenneth Galbraith in Economics of Innocent Fraud (2004), the last book published during his lifetime, wrote of his skepticism of the usefulness of Federal Reserve actions in dealing with recessions. He first describes the conventional theory, some portion of which Krugman apparently shared in the 1990s:
The false and favorable reputation of the Federal Reserve has a strong foundation: There is the power and prestige of banks and bankers and the magic accorded to money. These stand behind and support the Federal Reserve and its member - that is, belonging - banks. If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will then produce goods and services, buy the plant and machinery they can now afford and from which they can now make money, and consumption paid for by cheaper loans will expand. The economy will respond, the recession will end. If then there is a boom and threat of inflation, a higher cost of borrowing initiated also by the Federal Reserve and imposed on its lending to member banks will raise interest rates. This will restrain business investment and consumer borrowing, counter the excess of optimism, level off prices and thus insure against inflation.
His description highlights the problem that such a theory faces in the case where interest rates are stuck at or near zero, at the "zero lower bound," as the economists say, which is the situation in which the US economy finds itself now. If the interest rates can't go any lower, the strategy of lowering interest rates doesn't mean much. Even at rates near zero, further lowering is like the proverbial pushing on a string.
But Galbraith argued that even in a normal recession, i.e., not one like the Great Depression or the current depression, that this didn't really work:
The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low. As this is written, in 2003, during a recession, the lending rate of the Federal Reserve has been reduced roughly a dozen times in the recent past. These reductions have been strongly approved as the wise and effective response to the recession, so acknowledged in both popular and learned comment. How good this simple, painless design, free from politics and in the hands of responsible and respected professional and public figures free from political taint. No disagreeable debate, no pointless controversy. Also, and uncelebrated, no economic effect.
Here Galbraith shows himself a true disciple of Thorstein Veblen to the very end in his piercing use of irony:
The belief that anything as complex, as diverse and by its nature personally as important as money can be guided by well-discussed but painless decisions emanating from a pleasant, unobtrusive building in the nation's capital belongs not to the real world but to that of hope and imagination. Here our most implausible and most cherished escape from reality. No one should deny those participating their innocently acquired prestige, their sense of personal competence, their largely innocent enjoyment of what in economic effect is a well-established fraud. Perhaps we should let their ineffective role be accepted and forgiven.
I'll venture here to say that Galbraith was painting with a broad brush, though he was accurately describing the faith in the mystical power of the Federal Reserve via its marvelous magical manipulation of interest rates. The Federal Reserve has other roles, such as being a key regulator of banks. Its pitiful performance in its regulatory role under the (once-) revered Alan Greenspan, for his part a disciple of Ayn Rand, is a big part of the story of the financial collapse of 2008 and the recession of which it was a part. The Fed could have taken measures to restrain the mortgage fraud. It could have forced the banks to hold more realistic capital reserves. I don't believe Galbraith intended to argue that the Fed was powerless in all respects, but rather that the notion that it could manage recessions through manipulating interest rates was pure illusion. As the quotes above indicate, he knew very well that such an opinion was scandalously divergent from conventional wisdom. (Galbraith was proud to claim the distinction of having introduced the phrase "conventional wisdom" into common usage via his 1958 classic The Affluent Society.
As the title of Krugman's post indicates, it touches on some technical issues in economics. He also explains how real scientific research works in this passage on why he modified his views on the "liquidity trap":
Many economists just dismissed the Japanese example, asserting either that it reflected very special circumstances — zombie banks! — or that the Bank of Japan just wasn’t trying hard enough. I guess I was the first to suggest that Japan actually showed that the liquidity trap was not a myth, after all. The way I got to that conclusion, by the way, was as follows: I set out to prove, using a model with all the eyes dotted and teas crossed, that monetary expansion would always work even at a zero interest rate. But the model said just the opposite. And so I was forced to acknowledge that the liquidity trap was real, and to think through the implications, which I did in this 1998 paper (pdf).
The paper is called "It's Baaack: Japan's Slump and the Return of the Liquidity Trap."