Saturday, June 12, 2010

What would make Krugman wrong about spending?

A few weeks ago I submitted a comment on Krugman's blog. I'm a fan, so it was intended to be a gracious question. I don't believe it ever appeared, but I suspect a technical problem more than rejection (lots of seriously obnoxious comments get routinely posted).

I asked Professor Krugman to invent a rational reason for reducing government spending and/or increasing interest rates.

Ok, so that is a bit of weird request. Krugman, after all, has been shredding the feeble arguments of economists (Sachs, etc) calling for deficit management in the teeth of the Great Recession and the zero-bound. He makes a persuasive case, based on the best of modern economics, that this is a time to spend for future growth.

And yet there is an emergent global consensus to reduce spending. How could that make sense?

That's the challenge. How could it make sense? Under what extraordinary conditions would it be right to be wrong?

Maybe there is no plausible rationale. Maybe it's all human nuttiness. Certainly we're prone to it. Maybe, but I've seen this sort of thing before. Sometimes mass movements are batty, but sometimes there is an emergent understanding -- even if it's only dimly sensed and not articulated. Sometimes all the raging arguments skirt that rationale -- because it's one that nobody dares express.

I wanted Paul Krugman to try to imagine what that rationale might be. Reading him today, I wonder if he's beginning to try... (Perhaps due to the influence of Brad DeLong, who I think is also trying this exercise. Emphasis mine.)
Strange Arguments For Higher Rates - Paul Krugman Blog -

... My take on the current economic situation is quite simple, and I would have thought corresponds to standard economics. Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?

The trouble is that getting that negative real rate isn’t easy, because the nominal rate can’t go below zero [jg: zero bound], and there’s no easy way to create expected inflation. If you ask what would happen if prices were completely flexible, the answer, as I figured out long ago, is that prices would fall so far now that people would expect them to rise in the future, creating expected inflation. But prices aren’t that flexible, which is why we turn to quantitative easing, fiscal policy, and more.

Surely, though, we want to get rates as close to their appropriate level as possible — which means a zero nominal rate. There’s nothing “unnatural” about it. On the contrary, the “natural rate of interest”, as Wicksell defined it, is clearly negative right now.

So why does Rajan feel that there must be something wrong with low rates (and he’s not alone)? I think his language, with its odd moral tone, is the giveaway: it’s the sense that economic policy is supposed to involve being tough on people, not giving money away cheap.

I actually understand the seductiveness of that posture; I can sort of understand how economists succumb to it. But right now, with the world desperately in need of clear thinking, is no time to give in to the subtle allure of inflicting economic pain.
Well, I didn't say he was trying hard. Maybe he's just warming up.

So I'll give it a go. Maybe Brad can refine my speculations (I think they are his as well) and then ease Paul into thinking about this differently.

If classical economics works at all, then there may not be a rational reason to worry about deficits or raise interest rates. What if, however, we're in a world where classical economics doesn't work any more? Maybe in a normal laminar flow world we can use models and make predictions that don't work in a whitewater world where crazy things are everyday events that go almost unnoticed.

Maybe we've truly moved outside the bounds where the models work -- and we're going to stay there for a while.

Just consider the short list of possible disaster we need to dodge over the next decade. Iran could nuke Israel, and the Middle East would go down forever - along with the world's oil supplies. North Korea could go bonkers tomorrow. Pakistan is always on a precipice. China's bubble is going to blow -- maybe this month, maybe this year. Maybe we've run the American economic engine too hard, too fast, too long -- and the economy is really going to melt down. Maybe 'Peak Oil' really is five years away. Maybe the Atlantic warm currents really are unstable, or that Kurzweil was right and Aaronson and I are wrong.

It's quite a list really. I don't think we'll dodge them all, not to mention those I haven't listed (terrorist bioweapons etc). I'd bet money on China's bubble blowing for example, and, despite the current price and the impact of a crashing world economy, I'm still a Peak Oiler. (Though if China really fell hard Peak Oil would move out at least 5 years.)

These aren't the sorts of things scholars and leaders can come out and talk about. Obama can't go on Fox News and say -- "We need to keep our powder dry because we expect unemployment and US based terrorism to get worse, then China's economy will crater and we're going to have fight a really big war in Pakistan and we need to get ready for $8/gallon gasoline and ..."

Yeah, you see what I mean. That would not fly.

Let's assume that there's a lot of bad news ahead. News every bit as bad as the collapse of the US real estate market. If we assume that kind of trouble lies ahead, does it make sense to prepare for the worst now? Is that what people are unconsciously reacting to?

Update 6/14/2010: Here's a better example of why Krugman might be wrong. It's not a matter of economics, it's a matter of craziness. The US has lots of money, and lots of powerful whackos. (I do love the word "whacko" by the way -- it doesn't have the association with either mental illness or cognitive disability. Whackos are perfectly smart people with extraordinarily poor judgment.)

Update 6/15/2010: Another example. There are a lot of poorly understood constraint and linkages in our new financial world. It's somewhat remote from the world of actual work, and it demonstrates hysteresis -- it doesn't adjust quickly. What works in the world of logical economics may not work in this world. Also, my comment on Krugmans June 14 post has still not been published - there are only 19 comments posted. I don' think I've been blacklisted, but I do think it's pointless to comment on his blog.

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