The State of the World

There is some stuff in this Krugman blog post that is worth discussing. It's hard to get past his usual self-aggrandizement (I am a remarkably prescient forecaster; I am an island of clarity in an ocean of confusion; blah blah blah), but I'll try. We need to be tolerant, even when it's hard.

Here's what Krugman thinks is the key effect of the financial crisis:

Here’s how I interpret what we see in the historical data: financial crises leave an overhang of private-sector problems, principally excessive debt on the part of some subset of economic agents — households, in the case of the United States. Because these agents are either forced or strongly induced to slash spending, the “natural” rate of interest, the interest rate consistent with full employment, falls sharply — and in the case of a severe crisis, falls well below zero.

He's got the sign wrong. Suppose that for various reasons debt constraints bind more severely. That's in Eggertsson-Krugman for example. They just impose debt limits exogenously, but you could do something more sophisticated and tie the debt limits to the value of collateral, or what a would-be borrower stands to lose from default. In any case, what you get is more severe credit frictions, which make safe assets - government debt and safe private liabilities - more valuable. Why? These assets are now more useful at the margin in financial trade and as collateral. The safe market rate of interest is now too low, relative to where it should, or could, be. The "natural rate of interest" has not fallen. For more detail, see this post, point #1.

Krugman thinks economists and policymakers (past and present) are subject to "conceptual confusion." According to him, there are three facets to this:

1. Krugman is worried that people think he is being inconsistent (see my previous post for example). How can the Reinhart-Rogoff regularity (extended recovery after a financial crisis) be a regularity, and also represent an opportunity for Keynesian policy? Here's the heart of Krugman's argument:

...there are simple policy actions that could quickly end this depression now, there were simple policy actions that could have quickly ended depressions past. The problem is that now and then policy makers tend not to take these actions — which is why some of us write books.

A simple and quick solution is at hand. Easy. To buy this argument, you have to think that Krugman is really really smart, and the remainder of the human race is really really stupid. There are plenty of economists - with and without Nobel prizes - who don't think the solutions are easy.

2. Demand/supply and bubbles:

Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much — and we can’t expect those people to return to past spending habits.

What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

But the bubble component of housing prices after, say, 2000, does not appear to have been entirely a good thing, as it was built on false pretenses. Various kinds of deception resulted in housing prices - and prices of mortgage-related assets - that, by anyone's measure, exceeded what was socially optimal. As a result, I think we can make the case that pre-2008 real GDP in the US was higher than it would have been otherwise. Further, the housing-market and mortgage-market boom could have masked underlying changes taking place in US labor markets - for example David Autor's "hollowing out" phenomenon. One could argue that there was a cumulative effect in terms of the labor market adjustments needed, and that these adjustments took place during the recent recession, and are still taking place. See for example this paper by Jaimovich and Siu. That's why all the long-term unemployed. So that's not some confusion. People are talking about alternative ideas that have some legs, and may have quantitative significance. Why dismiss them?

3. Sectoral shifts:

One last point: we still keep hearing the “structural” argument, that we have to expect prolonged high unemployment because it takes time to turn construction workers into manufacturing workers or whatever. One answer is that this portrait of the economy is factually wrong: job losses have not been concentrated in a few sectors or professions, they have been broadly spread across the economy. But there’s also a conceptual answer: if shifting workers across sectors requires mass unemployment, how come the bubble years — when we were moving out of manufacturing into housing — weren’t high-unemployment years? Why does moving into the bubble sectors mean more jobs, but moving out into other sectors mean fewer jobs? I’ve never heard a coherent answer.

Answer: If you're not listening, you can't hear. There is plenty of unusual behavior in the recent labor market data: (i) the jobless recoveries that Krugman highlights here; (ii) the large drop in employment relative to output in the recent recession; (iii) the abnormally large fraction of long-term unemployed. One element of unusual behavior is the failure of residential construction to lead the recovery. David Autor and others (as mentioned above) have highlighted the recent shift out of middle-skill occupations. There is plenty here for any labor economist or macroeconomist to sink their teeth into. How do you tie together the financial crisis, the shifts in employment across sectors, and the changes in the skill mix? It's well-known that sectoral changes have macroeconomic consequences - economists have been discussing this at least since the early 1980s.

So, there is a lot going on. If we want to think of our current predicament as an aggregate demand management problem, we're missing all or most of what is important. It's certainly not simple, but it's a lot more interesting than an IS-LM model.