Bubble, Bubble, Conceptual Trouble, by Paul Krugman, in NY Times: We’re living in the aftermath of a major financial crisis. Reinhart-Rogoff warned in advance that recovery was likely to be slow; so, with less historical detail, did I. And so it has proved.
But based on the discussion I’ve heard, both on the blogs and in forums like that House of Commons debate Monday, there’s a lot of confusion even among economists about what the pattern of slow recovery from financial crisis is really telling us. Basically, there seems to be a confusion between saying that something is usual and saying that it is necessary. Those aren’t the same thing.
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.
What this means in turn is that conventional monetary policy, which normally bears most of the burden of economic stabilization, is no longer up to the job.
Now, there are other policy options. You could use discretionary fiscal policy, a k a stimulus, to boost demand; you could use unconventional monetary policy to depress interest rate spreads and/or raise expected inflation, helping get past the zero lower bound problem. Historically, however, countries tend not to do these things, or not to do them on a sufficient scale. Why? Politics. Intellectual confusion. Inertia. Misplaced fears.
Basically, it takes much more clarity and unity to pursue either discretionary fiscal expansion or unconventional monetary policy than it does to cut the Fed funds rate, and few countries manage to display that kind of clarity and unity. And that, in turn, is why it took a war to end the Great Depression; there’s nothing special about military spending from an economic point of view, but as a political matter Hitler managed to override the usual objections to stimulus.
Which brings me to the conceptual confusions.
First, I get a lot of complaints that people like me are being inconsistent: we say that financial crises are usually followed by prolonged slumps, yet we also want to End This Depression Now! and claim that it could be done very quickly. But there’s no inconsistency: 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.
Second, there’s a lot of confusion about the difference between demand and supply. 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. But this says nothing about whether other people can spend more, so that the economy doesn’t suffer from inadequate overall spending. Larry Summers used to like to say that you don’t have to refill a flat tire through the hole; indeed. Yes, highly indebted households in the US will have to spend less in future; but the government can spend more, we can have lower trade deficits, and in general there’s no reason why aggregate demand needs to be low despite the past excesses of some players.
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.
Back to the main point: yes, the aftermath of crises is usually a bad time. But that’s because the policy response to crises is usually lousy. We are repeating that story — but we shouldn’t.