Friday, May 3, 2013

The usual rules of economics

Krugman continues to defend his activist policies on the basis of the 'liquidity trap.' Beyond the usual confusion criticized several times here, he says that: "some of the usual rules of economics are in abeyance as long as the trap lasts. Budget deficits, for example, don’t drive up interest rates; printing money isn’t inflationary; slashing government spending has really destructive effects on incomes and employment." So according to him usually you have crowding out (higher interest rates with higher deficits), inflation is demand driven and caused by money printing (exogenous money), and cutting spending has no effect on employment (expansionary contractions).

None of this holds in normal times either, and he should know better. The evidence for the effects of budget deficits on interest rates, even in normal times, is not particularly favorable to the crowding out argument. The effects of a higher deficit-to-GDP ratio on long-term interest rates tends to be small, when it's statistically significant. And arguably even that small effect might be due to reverse causality, that is, the higher interest rate causes higher financial spending and higher deficits.

The same problems of causality plague the relationship between money and inflation too. And it has been accepted by almost everybody that central banks, always and not just in liquidity traps, control the rate of interest, not money supply. Unless you really believe that the economy in normal times is at full employment. If unemployment is the normal situation, then that would mean that the Fed sets the rate of interest, money supply is endogenous, and inflation, if it does exist, is cost driven. And if you really think that the 1970s inflation in the US was casued by money printing rather than the oil shocks and wage resistance, then it's hard to take you seriously.

Finally, wait, does he seriously think that, in non-liquidity trap periods, if you cut spending, then income and unemployment don't increase? I guess Okun's Law only works during liquidity traps. Oh well; and he is on our side. As they say, with friends like this...

2 comments:

  1. If reverse causality characterizes, which it does, monetary relations, Wicksell's conventional analysis of monetary policy is therefore somewhat strange...

    ReplyDelete
  2. He's making sure that in retirement he has a way back into the "VSP" club...

    ReplyDelete

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