Paul Krugman posts on Paul Volcker, who he considers a “hard-money guy”. Personally, I thought the following was a gem:
I haven’t had an opportunity to ask him, but my guess is that he’s suspicious of quantitative easing, and would be more likely to side with the Fed’s inflation hawks than with those of us who think the Fed should expand its balance sheet, target higher inflation, and in general do whatever it takes to bootstrap ourselves out of the liquidity trap.
Given all of the debate on liquidity traps held here, I thought it would be valuable to refine my understanding of the concept. It seems to me that Paul Krugman has become another Keynesian completely detached from reality. John Maynard Keynes operated, to some extent or another, under a Wicksellian framework of capital. Keynes had some understanding of capital theory. He simply did not ascribe to the theory of roundaboutness, later extended by Böhm-Bawerk, and did not make the same logical deductions that Friedrich Hayek did (although, to be fair, Hayek was aided by the fact that he had read Mises). Nevertheless, Keynes at least had some understanding of capital theory. Since then, Keynesian theory has completely detached itself from capital theory, and it has come to a point where they have so muddled basic economic principles that they have even begun to contradict themselves.
A liquidity trap is where interest rates have fallen to their lower bound, meaning that further quantitative easing will not allow for a further drop in interest rates. Usually, this bound is at 0%, but with the “advent” (not really, they have existed since the beginning of central banking and inflation) of negative interest rates who knows where the lower bound is. Who is John Galt? (Sorry, I’ve been reading Atlas Shrugged.) The reason why it is considered a liquidity trap is because no further amount of liquidity will stimulate lending and private investment. So, if Krugman thinks that further quantitative easing can stimulate the economy, we’re not in a liquidity trap!
Apart from proving that Paul Krugman really has no idea what he’s talking about, it also goes to show that Keynesian theory is a bunch of hooey.
The best part of that blog post was a reader’s comment. Check it out:
We have a desperate need for inflation. Why does no one know this? We have been creating more and more poor people every year. Poor people do not buy cars, TVs, homes or college educations for their children. Note Bob Herbert’s column in Suday’s Times. Ninety one million Americans make less than twenty two thousand dollars a year. Since 2000, we have added five million people to the number of poor.
Why does no one know that we need to get money to the sixty percent of Americans that have earned less income in real terms for the past ten years. A recorery requires an increase in demand. We will spin our wheels until a correction is made in the distribution of income in this country.
I have a feeling that the majority of Americans would agree with this poster. There is a need for demand, which is effectively consumption, and you buy things with money. Therefore, it follows that if you need to buy, you need money. I am willing to make the assumption that these same people agree that much money, or hyperinflation, is a problem. There is a disconnect somewhere there. I have a very bad feeling about the near future…
You think the majority of Americans agree with that poster?!?!? How do you come to that conclusion? Americans have been moritified by the 1970s, and as a result have an extremely unbalanced view of inflation. Granted, that poster makes a lot of really naive points. I’m not saying I agree with him. But I think Americans generally would agree with him even less. I’m able to wince when I read what he writes, but nevertheless nod my head not because I think inflation is great – but because I recognize that it’s not the boogey-man that people think it is, particularly at times like this. Anyway, I think that’s a very different position from his, but that is neither here nor there. I’m not sure what you’re implying about Americans in general, though – my impression is they’re unnecessarily terrified of any inflation.
I’m chewing on the rest of your post – very interesting. You know I’ve been mulling over these issues too. I would say we should be a little easier on Keynes. His chapter on the interest rate makes it very clear that he understands the time structure of production, but that he is engaging in a simplified version for the purpose of discussion. This is clear in subsequent work by Hicks, Klein, etc as well. The criticism of Keynes by guys like Thomas Woods on this issue are completely disingenuous. Keynes’s views on the insensitivity of investment to the interest rate I think are also relevant to considering the extent to which he understood and agreed with this question of “round-aboutness”. I find that Austrians commonly come across someone (like Keynes) who differs on some particulars of a very obvious general point (like round-aboutness and investment demand), and in response they claim that either he doesn’t understand it or completely disagrees with it. I don’t think that’s true at all. The idea of “round-aboutness” is a very pedestrian insight (as is the insight that artificial credit expansion can lead to painful busts). Just because someone like Keynes doesn’t put the degree of emphasis on it, or lays claim to it the way that the Austrians do doesn’t mean that he doesn’t understand or accept the point. Furthermore, Keynes did cite Böhm-Bawerk and Mises, so I think it’s safe to assume he was familiar with them.
I think your definition of a liquidity trap is a little strange. Your point seems to be that if there’s a policy that can get us out of a liquidity trap than it’s not a liquidity trap. I don’t think that’s quite right. A liquidity trap, in my view, is simply a binding price floor on the interest rate such that adjustment must occur through an adjustment of quantity rather than price (ie – through a decline in output rather than a further decline in the interest rate). There are lots of interest rates out there, the price floor can be more or less binding, and we can ameliorate the extent to which an adjustment needs to take place through a decline in output. For all of these reasons it’s not really meaningful to claim that if we can think up a policy to help alleviate the liquidity trap, then it’s not a liquidity trap.
But you do allude to a very important weakness in Krugman’s argument that has lead me to second guess the liquidity trap logic as well. Ironically, I think it’s a shockingly non-Keynesian perspective for him to take. The idea is that the Fed buys up bonds by creating new liabilities on it’s balance sheet, which should cause inflation and lower long term interest rates. The problem is, liquidity is the last thing you want in a liquidity trap. By buying up the bonds, existing investment demand is satisfied with newly created money, so you have less demand for funds and more funds available (created by the Fed), both of which should make the liquidity trap worse. I suppose the idea is that the newly created money makes people less concerned about cautionary savings, which should get production back on track.
I guess.
I don’t fully understand the logic, but I think there’s enough that we don’t know about the technique that we should be cautious. Bernanke has been cautious about jumping into outright money creation (I’m assuming that the liquidity programs for financial institutions last year aren’t intended to be permanent money creation – which I think is a safe assumption, as they are already being rolled back), but he hasn’t been overly conservative either – he’s responded vigorously to the crisis and the interventions have largely worked. The credit markets weren’t functioning last year – because of his intervention they’re functioning now. What we are left with right now is depressed aggregate demand, and that is the job of Congress to solve, not the central bank (and like I said – this is a very Keynesian point, so of all people Krugman should be more receptive to it).
So I’m coming at it from a slightly different angle than you, and probably a more charitable angle – but I agree that quantitative easing is a dicey proposition, AND that there are some major inconsistencies (or at least potential inconsistencies) that people aren’t fully addressing.
Daniel,
In regards to Krugman and his comment on the liquidity trap, I think I more or less agree with you. I didn’t mean to imply that a liquidity trap is not “solvable”, at least according to Keynesian theory. I re-read my post and notice that I didn’t say anything about government spending. I agree that had Krugman said that what we needed was another stimulus, and not quantitative easing, then Krugman would have been consistent with Keynesian theory. It’s just clear that greater quantitative easing will not solve a liquidity trap, when working within a Keynesian framework (it seems akin to building a bank’s excess reserves, which is really a useless measure by any standard).
Regarding inflation, I am afraid I will have to disagree with you. That commenter was not the only the only to suggest some policies. Ben Bernanke himself hailed the printing press as a fountain of wealth (although he has inflated the money supply quite a bit, I have a feeling that he has not done so further out of fears for his own job and because he is not the only person in the Federal Reserve pulling strings), and I’m sure you have read Krugman’s blog posts where he suggests that Spain should inflate themselves out of debt (by reverting back to the peseta). There are a great deal of inflationist. It has no longer just become an intellectual outcry against “inflation hawks”, but full own proponents of money creation as a source of wealth. This is obviously (well, I think it’s obvious) all malarkey.
On your points on Austrian capital theory as “pedestrian”, well obviously that’s quite insulting, but alas it’s not really worth arguing over. We’ve already been there, and obvious neither of us budge, so there’s no use in continuing. On the topic of whether or not Bernanke’s policies have worked thus far, I am sure you can make that correlation, but all I am willing to say is that correlation is not causation. Just to clarify, I agree more or less that Bernanke avoided further liquidations. But where you think that is permanent, I obviously think that is only postponing the worse to come. We will see who is right, anyways, in the future (except if there a huge gap between recessions, were obviously I could make my case theoretically, but empirically you could suggest otherwise; this brings me back to my old post on the problem of positive economics and empiricism). Just to finish off, from my reading of The General Theory, Keynes certainly was not as smart as other economists, and so I feel that a lot of Austrian criticism towards Keynes is justified.
But, I digress.
Let me take back “pedestrian”, because I’m sure I honestly don’t understand all of Austrian capital theory.
And allow me to rephrase this way: basic Austrian insights into things like round-aboutness, the term structure of investment, the role that interest rates play in coordinating investment over time, etc. – are all very common and pedestrian insights. I do not mean to insult the Austrian school by saying that – I simply mean to point out that these sorts of things are very broadly recognized. I don’t mean to insult the Austrian school precisely because I don’t think these insights are unique to the Austrian school (and that lack of uniqueness is sort of the definition of “pedestrian”, isn’t it?). So it’s frustrating to hear people like Robert Murphy or Tom Woods take these basic, so called “Austrian” insights and claim that non-Austrians don’t understand or agree with them.
That was more my point – and I’ll gladly retract criticism of the rest of Austrian capital theory, which I know you’ve put a lot of time and effort into understanding.
And I should say – that rephrasing goes for ABCT too. I know ABCT is a substantial theoretical edifice, and I think it deserves respect. But the basic ABCT insight – that excessive credit creation causes booms which make busts inevitable – is pedestrian and it’s not unique to Austrians. So again, without criticizing the broader corpus of ABCT, this version of ABCT that gets peddled as a unique insight by pop-Austrians is actually very broadly recognized and agreed upon. As I’ve said elsewhere, my feeling on ABCT isn’t that it’s wrong – my feeling is that it is a necessary but not sufficient explanation for the business cycle.
I forgot to mention something about the topic of Keynes citing Mises and Böhm-Bawerk. Keynes’ lack of comprehension when reading German is well cited, and he admitted this himself. Keynes was simply not really influenced by Mises or Böhm-Bawerk because of this language barrier. It is one of the reasons why his criticism of Hayek’s Prices and Production was so poor, and one of the reasons why he brought Sraffa on board to write a criticism of his own (which was also rather poor, and was more of a criticism of Hayek’s writing style; although, I don’t think he was as insulting as Austrians believe Sraffa to have been). So, I don’t think it’s fair to claim that Keynes had an understanding of Austrian capital theory.
I’ve always been amazed at how much mileage people have gotten out of that 1930 quote of his. It’s possible he didn’t understand it – I find it a little hard to believe. And even if he didn’t, citing a self-deprecating remark where he didn’t even admit to not understanding the language (only having trouble with understanding newer ideas in it) hardly proves that he didn’t.
Keynes read and reviewed Mises over two decades before the General Theory came out, and he had the intervening time to chew on it more and pick up on things he might have missed.
You need to consider the possibility that you think his criticism of Hayek was poor because you agree with Hayek, rather than hanging so much on a single self-deprecating quote. I think the Austrian critiques of Keynes are very poor, but I don’t go around blaming that on the fact that English was Hayek’s second language. I’m assuming the critiques are poor because Hayek starts from some very different premises.
Hey Jonathan,
Good to see your still very active with your blog. I wanted to forward a link to you about Krugman.
http://www.newyorker.com/reporting/2010/03/01/100301fa_fact_macfarquhar
I just don’t understand this guy? Every time I hear something from him I try to follow his logic and it seems so far from generally accepted principles of economics.
I understand the world of macroeconomics is a bit ambiguous compared to micro but I feel like he has really let the political animal inside take over his brain.
Maybe this article will shed some light onto Krugman the man vs Krugman the economist. (Oh wait, they are one in the same)