With my kids getting older, I no longer get much chance to play "What's wrong with this picture?" This is the game you'll occasionally find on a children's menu that's based on a picture with, say, a guy holding an upside-down umbrella while pulling a child on a leash and pushing a dog in a stroller.
A new opportunity arose, though, with Larry Summers' recent speech at the IMF and Paul Krugman's follow-up blogging. Their messages are slightly different, but I'll combine them as if they came from the same person, whom I'll call SK. And then I'll try to figure out what's wrong with their "picture," which SK might describe like this:
The fact that CPI inflation was subdued in the last decade tells us there's something missing in our understanding of the housing bubble. Without inflation, there couldn't have been excess demand or irresponsible monetary policy. But how is this reconciled with the recovery's inadequacy? If demand was normal and policy responsible, why is the economy in such bad shape? [Dramatic pause.] Well, maybe, the "natural" real interest rate is about -2 or -3%! And because the zero lower bound prevents us from achieving this rate, we need even more stimulus (of all types) than we thought. Essentially, we need to manufacture bubbles to achieve full employment equilibrium.
With this new line of reasoning, SK have completely outdone themselves, but not in a good way. Think Jamie Dimon's infamous "that's why I'm richer than you" quip. Or, Bill Dudley's memorable "but the price of iPads is falling" excuse for increases in basic living costs. (Dudley needed to be reminded that you can't eat an iPad.) Dimon and Dudley managed to encapsulate in single sentences much of what's wrong with their institutions. Yet, they showed baffling ignorance of faults that are clear to the rest of us.
Being academic economists, SK haven't managed to reduce their Dimon/Dudley moment to a one-liner. But in the argument above, they've collected in a single place a remarkable number of the flaws in their approach. I'll take a crack at listing them below, or at least a few of the more obvious ones. Here are five possible problems with SK's "picture":
#1: Low inflation does not equal reasonable demand and responsible policies
As we discussed here, the Fed misinterpreted the consequences of disinflation throughout the boom. Greenspan and Company lowered interest rates when inflation threatened to fall below their target of 1 to 2%, and this only worsened the malinvestment that continues to hold back the economy today. But inflation was subdued because a certain country lifted hundreds of millions of people out of poverty by building new factories and paying wages of a few dollars a day. And this country then loaned us the proceeds from its cheap exports, adding to our credit boom.
In other words, the Fed's interpretation of inflation was more flawed than usual, even backwards. Disinflation was explained by cheap imported goods, which meant abundant foreign capital, which meant a larger credit boom, which meant too much demand. Contrary to SK's narrative, policymakers made huge errors by not only failing to recognize that this dynamic is unsustainable, but by encouraging it with cheap money.
#2: The Phillips curve? Really?
In addition to applying the faulty logic of the Fed's inflation target, SK revert to early Keynesian misconceptions. They rely on the idea that inflation becomes a problem if and only if stimulus continues beyond full employment (and even in the short-term). This Phillips curve thinking was discredited in the 1970s. We saw then that high inflation can coexist with high unemployment and weak demand. We saw more recently that low inflation can coexist with low unemployment and excessive demand. In either case, inflation is clearly more complicated than SK believe it to be.
#3: Mandating Keynesian planners to achieve "equilibrium" is just asking for trouble
As part of their embrace of the Phillips curve in the 1960s, Keynesians estimated that the unemployment rate could be pushed as low as 4% without triggering inflation, and set out to do just that. In other words, 4% was said to be a "full employment equilibrium." But this notion of equilibrium is deeply flawed, as is the Keynesians' confidence in achieving such a target. Their first instance of active policymaking - in the Kennedy and Johnson administrations - led eventually to the Great Inflation that was said to be impossible, while we're still waiting on that 4%. Since the Great Inflation, Keynesians redesigned their theoretical models in a number of different ways, but none of the new models explain the economy's true behavior.
A fundamental problem with the Keynesian approach is this: The benefits of policy stimulus are invariably followed by costs that the models fail to capture and planners fail to consider. In the world of Keynesian theory, for example, an economy can cruise along at its full potential without ever suffering the consequences of a reversal of past stimulus. In the reality of a modern credit-based economy, on the other hand, good times lead to imbalances that accumulate like dead wood in a dry forest, which then ignites after stimulus turns to restraint. And not only have Keynesian policies repeatedly fostered such instability, but there's an enormous pile of dead wood at the Treasury Department (public debt) that's yet to catch fire.
There are many other dimensions to this topic, but I'll leave it alone for now to address other specifics in SK's hypothesis. I do recommend reading Arnold Kling's "PSST" theory, though, which is a quicker and more current counter-argument to Keynesian equilibrium concepts than, say, the two volumes and 1095 pages of Joseph Schumpeter's Business Cycles.
#4: Your father's natural interest rate doesn't fit the SK narrative
While there are different notions of "natural interest rates" embedded in specific Keynesian models, Krugman claims that his use of the term matches Knut Wicksell's classic definition from 1898. Wicksell's natural rate arises from the preferences of private borrowers and lenders in the absence of central bank interventions, or even money, for that matter. In other words, it's a purely market-driven rate for private, not public borrowers. Although Wicksell theorizes that several different formulations equate to the same figure (for example, his natural rate is also the marginal return on capital), none of these could plausibly be said to have been negative through the last cycle, as SK speculate.
Worse still, Wicksell held that prices are neither rising nor falling at the natural rate, implying that SK's logic is upside-down. Under Wicksellian thinking, positive inflation suggests that natural real rates would have to be higher, not lower, than observed market rates, in order to come closer to his stable price criterion.
#5: Umm, bubbles are really not a sensible route to full employment
We're clearly in Dimon/Dudley territory here, and Tyler Durden already posted the ultimate rejoinder. I'll just add an observation.
Recall that Krugman was widely lambasted for this housing bubble recommendation he offered in 2002:
[My] basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. (By "moribund," I mean that investment falls chronically short of savings at the existing interest rate, which is higher than the natural rate, and this prevents the economy from reaching full employment equilibrium.) And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
Okay, full information: That's not the exact excerpt. I added the sentence in parenthesis, just to show that Krugman's latest call for bubbles uses the same logic as the 2002 recommendation.
Now, Krugman tried with all his might to convince us after the bust that he didn't really mean what he wrote. But it's easy to see through these denials - there's no other way to interpret the 2002 article. And today, he's making virtually the same recommendation once again.
These inconsistencies beg the question: What does Krugman really want us to believe? Does he recommend bubbles for a stagnant economy, or not?
To explore possible answers, I'll turn to my usual speculation about personal incentives and motivations. As soon as I saw the renewed call for bubbles, I wondered what was behind it. At first, I saw nothing more than a redesigned argument for greater stimulus. But maybe there's more to it?
Consider that both economists take regular hits for their complicity in the mess we're in today - Krugman for his housing bubble advice and short-termism, Summers for blocking financial regulation while leading the charge against those who suggest our banks are a tad unsafe.
Consider also Krugman's observation that "[Summers] says, a bit fuzzily but bravely all the same, that even improved financial regulation is not necessarily a good thing - that it may discourage irresponsible lending and borrowing at a time when more spending of any kind is good for the economy."
Can you see where I'm going with this?
If SK convince their peers that a bubble was actually needed in 2002, while regulation would have been counterproductive, they can pull off a 180° on their legacies. Instead of being "bums who brought us the housing bust," they can be "heroes who delivered full employment despite a negative natural real interest rate." Even without broad acceptance of their new idea, they can at least rationalize past decisions in their own minds.
Now, I have no idea if this is really what's driving them. They may themselves be unaware of their motivations. But it seems reasonable to mention that their new narrative overturns past errors. You can almost imagine SK in zebra stripes, emerging from a booth review to inform the crowd there was no foul on the previous play: "Thanks to our new finding that bubbles are not only within the rules, but encouraged, Keynesians retain the ball with their field position intact."
And up in the luxury boxes, by the way, sits Jamie Dimon, as he's richer than you. His guest, Bill Dudley, quietly gnaws on an iPad.
Welcome to today's economy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)
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