Keynes and the Current Crisis

Tim Congdon covers a lot of ground in his essay on Keynes, Krugman, and the liquidity trap. I will narrow my focus to the current crisis and the relevance of Keynes to the policies being pursued.

First, it is important to focus on an issue where there should really be no grounds for disagreement: the size of the stimulus and its expected impact. Contrary to what Congdon states in his piece, the stimulus was closer to $300 billion a year (@ 2 percent of GDP) in 2009 and 2010, not $800 billion a year. The total stimulus package came in at close to $800 billion. Nearly $100 billion involved a technical fix to the alternative minimum tax, which is done every year and has nothing to do with stimulus. Approximately $100 billion was slated to be spent after 2010 in longer term projects. This leaves $600 billion, or roughly $300 billion to be spent in both calendar years, 2009 and 2010.

The expected impact of the stimulus can be determined by reading what the Obama administration was saying about it at the time. The projections in the paper by Christina Romer and Jared Bernstein, which outlined the original proposal, showed that they expected it to create just 3.7 million jobs. The package that they got through Congress was smaller and less oriented toward spending than their original proposal, so the number of jobs projected would have to be adjusted downward accordingly.

Finally, there is reason to believe that we did get roughly the number of jobs projected. James Feyrer and Bruce Sacerdote found in-state job multipliers that were comparable, albeit slightly smaller, than the national multipliers assumed by Romer and Bernstein. This is very positive from the standpoint of the success of the stimulus, since national multipliers will always be higher than in-state multipliers Many of the jobs created by spending in the state of Delaware will be in New Jersey or Pennsylvania, so if anything the Feyrer and Sacerdote paper suggests that the impact of the stimulus might have been somewhat larger than had been expected.

The big failing of the Obama administration was not in their stimulus package, but rather in their projections for the economy. Their baseline assumed that unemployment would peak at around 9 percent in the absence of the stimulus. Unemployment had already crossed this level at 9.4 percent in May, just as the first stimulus dollars were going out the door, and we were still losing more than 400,000 jobs a month. The administration had badly underestimated the severity of the downturn. In effect, they had gotten a stimulus package through Congress that was designed to create 3 million jobs in an economy that needed 10–12 million jobs.

Turning to Congdon’s theoretical points, he has seriously misrepresented my friend Paul Krugman’s position. Krugman has argued that conventional monetary policy, in the form of reducing the federal funds rate, has reached its limits. That seems uncontroversial; the federal funds rate is at zero and can’t go negative. However he has repeatedly pushed for the use of unorthodox forms of monetary policy, most notably targeting higher rates of inflation.

Krugman first wrote about the idea of targeting a higher rate of inflation in 1998, in reference to the slump in Japan. He has repeated this suggestion in reference to the current situation numerous times, both in his column and blog and in academic work.

The logic is straightforward. In the current downturn we would like to see much lower real interest rates. This is true for both the short-term rate, which is already at its nominal floor, and also the longer term rates that are more important for investment decisions. The latter are largely subject to the sort of liquidity trap conditions that Keynes described and Congdon references. The nominal long-term rate is unlikely to fall further because bondholders do not want to take the risk of capital losses.

In a situation where nominal interest rates have hit a floor, the only way that the Fed can reduce the real interest rate is if can credibly commit itself to sustaining a higher inflation rate. In addition to encouraging investment by lowering real interest rates, a higher inflation rate would also have the effect of reducing the debt burden that is weighing down tens of millions of households. That should have the effect of boosting consumption since heavily indebted households are likely to have a higher propensity to consume out of wealth than those who own the debt.

So contrary to Congdon’s contention, Krugman has been a vocal advocate of monetary policy. Of course this is a different monetary policy that Congdon’s suggestion that the Fed target M3. The level of M3 is not directly a policy variable under the control of the Fed. At a time when banks hold excess reserves of more than $1.6 trillion, it might be very difficult for the Fed to easily reach any target for either M2 or M3. And, since there are well-known definitional problems with both aggregates (which caused Milton Friedman to abandon his commitment to monetary targeting toward the end of his life), I am inclined to agree with Krugman’s policy over Congdon’s.

Of course, unlike Congdon, Krugman has also argued for fiscal policy, in addition to pushing for a lower valued dollar to boost net exports. The logic is that the government should be doing everything in its power at this point to restore the economy to full employment.

Many of the workers and their families who are suffering through spells of long-term unemployment are not going to recover from this trauma. The prospects for being rehired after an extended period of unemployment are poor, and the likelihood of finding a job that pays close to the same as the prior job after an unemployment spell of one to two years is extremely low.

Families who have seen their primary breadwinner laid off will be struggling to make ends meet, especially if the period of unemployment exceeds the period of benefit duration, which is increasingly common. Many will risk losing their home or apartment. Long spells of unemployment are often associated with family breakups and create an unstable environment for children in school.

The unemployed workers are not the ones whose mismanagement led to this economic crisis. Those in positions of authority have the responsibility to protect them from a disaster that is not their fault. In this context, Krugman and other Keynesians have argued for both fiscal and monetary policy to get the economy back toward full employment as quickly as possible. It is hard to see an economically or morally justifiable alternative position.

Also from This Issue

Lead Essay

  • Dangerous Waffle about “the” Liquidity Trap by Tim Congdon

    Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Response Essays

  • Keynes, Friedman, and Higgs by Donald J. Boudreaux

    Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

  • Tim Congdon on Liquidity Traps vs. Portfolio Rebalancing by Robert Hetzel

    Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.

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