I first have to acknowledge that I have been a Krugman fan way before he became a post-Keynesian pinup. His Geography and Trade is one of my favourite textbooks on regional economic dynamics. And not just because it is short 🙂
His latest book is a polemic against recessionary policies that exacerbate income inequality within and between nations. The main thesis and his analysis of the predicament of the EU and US economies is that they are in a self-inflicted liquidity trap. In simple terms this means that there is not enough demand from private households for whom the crisis has increased uncertainty. Financial institutions seek to reduce risk and therefore will not offer cheap money to business while the ‘independent’ central banks have no scope to reduce interest rates with rates at historical lows. He concludes that the least painful policy is for states to increase their debt instead of reducing it by increasing aggregate demand through infrastructure and similar growth oriented projects. In sort he goes against the grain of the dominant neo-liberal rhetoric that sees a reduced role for the state and which informs the dominant trend among central banks to keep inflation rates below 2%. He suggests this fixation with low inflation to be partially responsible for our present predicament. Low interest rates benefit the creditors as their debt assets do not loose value. For those with long term debt, like a mortgage a higher inflation reduces its relative value. He suggests a target inflation closer to 4% for attaining economic growth.
So what, you might say? Well, first is the strength of his argument on its own merits. I find it compelling. Then there is the fact that Krugman has been found to be the most accurate pundit over an 18 month period (accurate 15 out of 17times) from a group of 26 notable policy commentators. The academic study in question found that 3 out of 5 of these people are not better than random and 1 in 5 are actually worse! Among other intriguing findings is that those that have law degrees are worse at predicting and that there are no topic experts. I am always suspect of those claiming expertise and have considered the issue of an objective measure of expertise with my PEST study to which I should one day properly return.
But back to the crisis and Paul Krugman. His awards and Nobel prize aside, his prognostication accuracy and reasoned argument notwithstanding is there merit to his claim? There are those like Steve Keen that fundamentally disagree. He claims that Krugman does not understand the role of banks in lending. In short, new debt does not imply that a saver lends to a debtor (a system in balance) but implies banks create debt without at the same time reducing consumption by savers. I am not aware of a direct response by Krugman but one could think of a couple of problems with this thesis. The focus on private debt as the main determinant of aggregate consumption or the neo-liberal assumption that banks operate unregulated and banks operations should not really be constrained. One can read banking accords of the past as blatant exercises of power over public policy that precipitated the current crisis.
My own reflection is that there is definitely a case for increasing aggregate demand through ‘public works’ at a time of deflationary pressure. At the same time I am concerned that the higher the level of aggregate public and private debt the more opportunities for profit that exist for banks. Financial intermediaries will exert a higher tax on economic activity. Since they know they bear no real risk of failure (public finances will always bail them out) they are not concerned about global level sovereign defaults. Their share of the pie is what matters and this has and will be increasing. Another concern is the “perennial growth” mind-set among prominent economists. I see no serious concern on the long-term sustainability of economic models when discussing long-term target growth rates. At what point will OECD economies reach optimal efficiency? At what point increases in growth can only be sustainable with beggar-thy neighbour policies? and so on. Finally, I am concerned that these models ignore the elephant in the room. Sorry, the panda in the room. What will China, India and Brazil do if we apply inflationary policies?
I retain a ‘buy’ advise on Krugman. I like his analysis, clarity and view on ethical economic policy. I will keep reading him.