constrained optimization, where the constraint comes from the power of bad ideas.

[phantom power]

We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do?

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.

OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.

That’s why, at this point, I’m turning to what I understand perfectly well to be a third-best solution: subsidizing jobs and promoting work-sharing.

Call it constrained optimization, where the constraint comes from the power of bad ideas.

http://krugman.blogs.nytimes.com/2009/11/13/its-the-stupidity-economy/

[DJ13]

1. Is advocating for the creation of inflation really a good idea

when the level of real unemployment is near 20%, with wages already declining?

[econoclast]

2. I guess Krugman forgot his earlier columns

Krugman intrigues me. He'll sat whatever bolsters his own political preferences.  

So while Krugman is sanguine about defecits today, he wasn't always. Guess when he wrote the following for the NYTimes? If he was scared stiff then with ten-year defecits projected to be 1.8 trillion dollars and 4% of GDP, why is he not peeing down his leg now? Maybe he is one of the wishful-thinking economists who tell their readers "this time it's different"?

Here is an exerpt from some vintage Krugman .....

A Fiscal Train Wreck
By PAUL KRUGMAN

... it's time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits. 


So what?  ... we're looking at a fiscal crisis that will drive interest rates sky-high.

A leading economist recently summed up one reason why: "When the government reduces saving by running a budget deficit, the interest rate rises."


But what's really scary ? what makes a fixed-rate mortgage seem like such a good idea ? is the looming threat to the federal government's solvency.

That may sound alarmist: right now the deficit, while huge in absolute terms, is only 2 ? make that 3, O.K., maybe 4 ? percent of G.D.P. But that misses the point. "Think of the federal government as a gigantic insurance company (with a sideline business in national defense and homeland security), which does its accounting on a cash basis, only counting premiums and payouts as they go in and out the door. An insurance company with cash accounting . . . is an accident waiting to happen." So says the Treasury under secretary;  his point is that because of the future liabilities of Social Security and Medicare, the true budget picture is much worse than the conventional deficit numbers suggest.

How will the train wreck play itself out?  ... my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.

And as that temptation becomes obvious, interest rates will soar. It won't happen right away. With the economy stalling and the stock market plunging, short-term rates are probably headed down, not up, in the next few months, and mortgage rates may not have hit bottom yet. But unless we slide into Japanese-style deflation, there are much higher interest rates in our future.

[phantom power]

3. When he wrote the article you are citing...

were we in a liquidity trap? What was the prime rate?

[econoclast]

5. Liquidity trap?

When the doctor says "take this medication and you'll get better". And you take the meds but don't get better. The doctor has two choices. Admit he was wrong or come up with a theory about why the 'correct' perscription didn't cure you.

When Keynesians find that their prescriptions failed to have the desired result they bust out The Liquidity Trap.

Liquidity Trap is Keynesian-speak for "our ideas failed but we can't bring ourselves to admit we are wrong"

Witness Japan. They have run the entire Keynesian playbook for over a decade. They poured more concrete for infrastructure than anyone else on the planet as part on various stimulus plans. Interest rates near zero. But I guess they have been in a Liquidity Trap for 15 years.

[phantom power]

7. The reason I bring it up is...

You are saying Krugman is being inconsistent: "Look here he was being a deficit hawk, but now he's arguing for deficit spending." But he's saying that conditions are no longer the same. When economic times are basically good, and you have positive interest rates that you can lower as an economic lever, then you should be avoiding deficit spending and lower interest rates, if you are looking for a stimulus. Today, we have a situation where economic times are desperate, and interest rates can't be lowered any further. So if you want economic stimulus (and we need it badly), deficit spending for the purpose of curbing unemployment is a reasonable option.

I don't think that's inconsistent. Conditions change, and his suggested responses change. Now -- whether or not you think he's right is another entirely separate question.

[econoclast]

8. Conditions have changed

The crucial condition that has changed - for Krugman- is the party in the White House. Back when he wrote Fiscal Train Wreck, there was a Republican at the helm. And one that Krugman despised. So Krugman was all over the defecit spending like stink on a monkey. And rightly so.

But now, with his guy driving, Krugman just can't bring himself to the same criticism. Are the giant defecits better now because interest rates are very low? Isn't that the same logic employed by the hundreds of thousands who took out giant mortgages at minute interest rates? How did that work out?

I think it is important to read Krugman with a jaundiced eye. He is a political pundit who employs an economist's vocabulary. He'll say whatever bolsters his political viewpoint. And if that means tossing his previous economics under the bus ... So be it.

[phantom power]

9. If you were Economist God-Emperor for a day...

what would your (I assume non-Keynesian) economic recovery plan look like?

[pokercat999]

4. I think you are correct about future higher interest rates

and the return of inflation. But first, I think we are going to experience a few years of deflation and interest rates remaining very low, maybe not as long as the Japanese two lost decades, but for at least 2-3 years, we will all be Japanese.

[econoclast]

6. Just to be clear...

The prediction about higher interest rates is Krugman's from his old Fiscal Train Wreck column. Important to get the footnote right.

I share your assessment though.