Paul Krugman at the LSE

This is a reprise of a blog posted last summer following Krugman’s talk at the LSE. So much of what he talked about remains relevant today especially the challenges facing macro-economic policy-makers when deflationary and debt dangers continue to lurk.

”“The central problem of depression-prevention has been solved, for all practical purposes.” Robert Lucas, 2003

In a world of depression economics many of the standard rules of economics no longer apply. The global economy remains in the grip of a sustained downturn, the duration of which might make Japan’s “lost decade” look favourable in comparison. And macro policy-makers are grappling with an infection that has proved highly resistant to the usual doses of anti-biotic. Despite a remarkable attempt at stimulating demand – through the acceptance of large fiscal deficits and the dual attack of conventional and unconventional monetary policy – things seems to getting worse albeit more slowly.

This seemed to me to be gist of the core message from the first of the Lionel Robbins lectures delivered by the 2008 Nobel Prize Winner for Economics, Professor Paul Krugman of Princeton speaking at the LSE this evening.

Professor Krugman argued that the current nightmare is one that wasn’t meant to happen especially given the conventional wisdom regarding the effectiveness of monetary policy as a means of controlling unexpectedly large demand-side shocks.

The nightmare is evident in a collapse of world industrial output and external trade – indeed both have declined at a faster rate than in the Great Depression. And the consequence has been that some countries (and regions) that did not allow financial imbalances and bubbles to grow have been among the worst victims of the slump because of the steep decline in demand for and production of manufactured durable goods.

One of the surprising features of this downturn has been the precipitous drop in global trade – among many plausible explanations Krugman suggested three:

1. A freezing of trade credit for exporting businesses
2. The high percentage of trade now accounted for by manufactured durable products – this is where cancelled orders have been concentrated
3. The vertical dis-integration of global production – there is a misconception that iPods are all made in China. Final assembly might take place there but the broader manufacturing process including components takes place in more than a dozen countries

Two ideas make a comeback!

Two ideas that seemed to have been destined for the dusty shelves of macro-economic history are now right at the forefront of the policy debate as we search for ways out of the morass. These are the liquidity trap and the paradox of thrift.

The Liquidity Trap

Short-term policy interest rates have been driven to the floor – in the USA and the UK they are effectively at zero and will probably remain there for some time to come. But zero short-term rates have proved insufficient to boost confidence and demand – the liquidity trap effect is real and it has taken policy makers some time to realize this. In a world of desperately low consumer and business confidence (confidence seems to have become an economic variable in its own right), simply providing people or businesses with more liquidity does not encourage them to spend more. Indeed, households are raising their savings rates in very aggressive manner (the steep decline in real housing wealth and prospects of double-digit % rates of unemployment are probably enough to explain this). And businesses are reluctant to invest when expectations of demand remain weak and if they are operating in one of the vast number of industries that must adjust to a long-term excess capacity. One of the lessons from Japan’s decade of deflationary depression is that simply expanding the monetary base through ‘quantitative easing’ will probably have little effect on the general price level. Cash hoarding is becoming more common – this is great news for manufacturers of safes!

According to Krugman, macroeconomic management over the last two decades has become hugely dependent on the (imperfect) decisions of central banks. But given the size of the demand shock that has hit the world economy, they too have lost control and with it have gone one of the main lines of defence against a deep recession. The level of short-term interest rates required to achieve a full-employment equilibrium level of national income is probably somewhere between -5 to -8%! But we know that nominal interest rates cannot fall below zero – the boundary has been reached. And with it monetary policy has become impotent.

The Paradox of Thrift

If the liquidity trap is real, so too is the notion of the paradox of thrift. This is the idea that, if everyone desires to save more, they cannot all be successful in achieving this. When the global desire to save exceeds the global willingness to invest the result is a contraction in world demand and production, a fall in incomes and employment, which eventually brings savings back into balance with investment.

Business investment has fallen off a cliff because we are in a world of excess capacity. We need to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or dis-saving.

In Praise of Fiscal Deficits

Krugman argues that there has been too much hand wringing in the financial press and the financial markets about the consequences of a short-term rise in government borrowing. There are long-term budget issues that must be addressed, but in an economic depression, fiscal deficits crowd-in rather than crowd-out private sector investment – a typically Keynesian argument to make!

We have seen a spectacular fall in private sector borrowing – government deficits provide a counter-weight to this. And the fact that real interest rates on ten-year government bonds remain at historically low levels suggests that there isn’t an immediate funding crisis for western Governments who have chosen to use a fiscal stimulus as a counter-cyclical policy. Much of the funding for the borrowing – at least in the short term – will come from the rising savings of the private sector of rich advanced nations. The USA and the UK will not be overly dependent on the inflow of funds from emerging economies such as China.

Krugman’s view is that economists, governments and central bankers lost sight of the real risks that are always to be found in economic activity. And those risks – including the susceptibility of economies to supply and demand-side shocks – need to be given greater prominence in the way in which economics is taught and practiced in the years to come.

The second of Krugman’s lectures can be found here on the LSE web site

The third of Krugman’s lectures can be found here on the LSE web site

Paul Krugman’s newly revised book “The Return of Depression Economics” is available widely including from Amazon UK

The slides from his first Robbins Lecture are available here

His New York Times articles can be found here