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Thursday, September 23, 2010

Krugman and Wells: The Way Out of the Slump

Just a quick heads up to the second installment of the Krugman and Wells review of The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession by Richard C. Koo, Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan, and Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini and Stephen Mihm:

The Way Out of the Slump, by Paul Krugman and Robin Wells, NYRB: How can the economy recover? Of the three books under review, Raghuram Rajan’s Fault Lines says almost nothing about the question. He seems mainly concerned with preventing future bubbles, going so far as to call for an immediate rise in interest rates despite the depressed state of the economy. Nouriel Roubini and Stephen Mihm warn that recovery may be very slow—but they offer no solution, instead criticizing the solutions proposed by others. Only Richard Koo has something positive to propose—but his answer appears outside the realm of political possibility.

Most of the time, we count on central banks to engineer economic recovery following a slump, much as they did after the 2001 recession. Normally, when recession strikes, the Fed, the European Central Bank, or the Bank of England cuts the short-term interest rates it controls; market-determined longer-term rates fall in sympathy; and the private sector responds by borrowing and spending more.

The sheer severity of the slump after the 2008 housing bust means, however, that this normal response falls far short of what’s needed. One way to revive the economy is to consider the so-called Taylor rule, a rule of thumb linking Fed interest rate policy to the levels of unemployment and inflation. Applying the historical Taylor rule right now, with inflation very low and unemployment very high, would mean that the Fed’s main policy rate, the overnight rate at which banks lend reserves to each other, should currently be minus 5 or 6 percent. Obviously, that’s not possible: nobody will lend at a negative interest rate, since you can always hold cash instead. So conventional monetary policy is up against the “zero lower bound”: it can do no more. We’re in the classic Keynesian liquidity trap, in which the economy is so awash in liquidity that adding more has no effect. What’s left?

One answer is fiscal policy: the government can step in to spend when the private sector will not. We’ve already argued—in the first part of this review1—that a rise in government deficits played a key role in preventing the crisis of 2008 from turning into a full replay of the Great Depression. Why not use more deficit spending to push for a full recovery? ...[...continue reading...]...

    Posted by on Thursday, September 23, 2010 at 03:14 PM in Economics | Permalink  Comments (111)


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