Paul Krugman on Liquidity Traps, the Great Recession, and Isaac Asimov

Economies may need to accept higher inflation in order to escape a liquidity trap, no matter how unpopular the policy might become.

Paul Krugman is a Nobel Laureate in economics, a columnist at The New York Times, and a Distinguished Professor of Economics at the Graduate Center of the City University of New York. He joins Macro Musings to discuss his work on liquidity traps, Japan’s Lost Decade, and lessons from the Great Recession. Paul also explains how Isaac Asimov’s science fiction inspired him to become an economist.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

David Beckworth: Paul, welcome to the show.

Paul Krugman:  Hi there.

Beckworth: Oh, it's a real treat to have you on. We have followed your work for many years. And I want to begin with a question that I asked all my guests. How did you get into economics?

Krugman: I have a cute story, possibly too cute. As a teenager, I was a great fan of science fiction and especially Isaac Asimov. And I loved the foundation novels, which if you've ever read old science fiction…

Beckworth: Mm-hmm (affirmative).

Krugman: The conceit of the of those novels is the galactic civilization is falling. But there are these social scientists who have a mathematical theory of social behavior, who use their social science to limit the length of the coming dark age and restore civilization. So I want to be one of those guys. That was how I got to economics.

Krugman: I thought I was going to do history. So in college, I discovered I wanted more why as opposed to what. I wanted more of a structure on it. And so, the combination of my childhood, that the seeds of being an Isaac Asimov character and my desire for something that was a little bit more disciplined or a little more analytical than history got me into the field.

Beckworth: It's interesting, you came into it with an appreciation of history, science fiction, social science perspective, trying to understand humanity. A lot of people that they come in from the math perspective. They're engineering students or they love math and they come into it. And I wonder if having your perspective has made you more able to answer all these different questions you've answered or to have the ability to think of the questions in the first place.

Krugman: I really have no idea. And somewhere long way back, someone, one of my colleagues said that the optimal amount of math to know in economics is the amount that you happen to know. Anybody who knows more is just too techie and has no idea about humanity. And anyone who knows… So everybody has their point of view. I think it does.

Krugman: I've probably been more in touch with what are the issues that are going to matter to people or what's interesting out there. I guess I should also say I have two great mentors. And the second of them, which was really Dornbusch, when I was trying to decide on a thesis topic, he had great advice, which is, for the next few months, don't any technical papers, don't read any analysts.

Krugman: Go out there, read newspaper articles, read history, yet find out what's interesting in world, then you can come back to your technique. And I think that's a good advice. Even if you do come at it from an engineering background, that's how you should do it.

Beckworth: Yes. Now, looking back at your career as a print for the show was reminded of all the different areas you've touched upon. So you've done seminal work, the new trade theory, the economic geography, international finance, you created the first generation currency crisis models, liquidity traps.

Beckworth: Then also, you came across to work in the optimal currency area. And again, just wondering, is there a secret source to being able to come up with all these different areas, these topics, these questions? What advice would you give to a buddy in young macro economist on how to uncover such interesting topics?

Krugman: I would say, again, be engaged with the world. Try now. It's a little bit slightly awkward because there is this thing about getting tenure and getting papers published in flagship journals. But at any rate, at a certain point, you really want to be reading, paying attention to real world issues, to history, get some sense of, what is on people's minds?

Krugman: What is it that people are talking about? But you have this feeling that they're not talking about it from the right angle, that they're not looking at. Just get a sense of what matters. And above all, don't spend a lot of time doing minor extensions of someone else's work. Find out a genuinely interesting topic that is going to stand independent of the technique, independent of the citation list.

Beckworth: Very interesting. Well, let's move to a paper that you did in 1998, was on Japan and it's titled, *It's Back, Japan Slump and the Return of a Liquidity Trap.* And this article is seminal to and that created a whole literature on the zero lower bound, what to do there. And I want to first ask as we get into it, what got you interested in this topic? Why Japan? What motivated you to go down that path?

Japan and Liquidity Traps

Krugman: Now, there's a little intersection here between the various kinds of things I've done in my life here. I had already begun some popular right. I obviously wasn't ready for the times yet, but I was writing articles for foreign affairs and work for Slate. And one of the disputes I got into a book, I don't know how many people even remember it now, but there was a book by William Greider, *One World Ready or Not: The Manic Logic of Global Capitalism.*

Krugman: But one of the core arguments was that we're getting too efficient. We can produce more. There's not going to be enough jobs. It doesn't sound as outlandish now as it did then, but it was a very much of the automation, will destroy jobs, there's just never going to be enough work for people. And I wrote a pretty hostile review saying, look, when you're talking about a persistent shortfall of aggregate demand and that has nothing to do with productivity.

Krugman: And then we know how to create aggregate demand. Alan Greenspan can always create as much aggregate demand as you want. And then a little bit after having written that review, I started to pay some attention to Japan. And I say, hey, you know what? They have zero interest rates. They don't seem to have enough aggregate demand. What is going on there? And I knew about the basic, you're primitive, if you like, ISLM although I tend to think ISLM and is a lot less primitive than people imagine it is.

Krugman: But anyway, a very simple traditional macro says that you can in fact have a situation where my trade policy becomes completely ineffective when interest rates hit zero. And I said, well, okay, but those are ad hoc models. They have to be not there. There's something missing. There must be the case that if you just print enough money, it will in fact increase spending. And so I sat down to write down a minimalist little, all of my I's dotted and T's crossed model to show that.

Krugman: And what the model ended up saying was actually no, doesn't necessarily work at all. So it was this kind of transition from a largely US domestic dispute about economics to taking a look at what was going on in another country cause I was always interested in cross-country macroeconomics, to say, okay, how do we think this through? And out comes this paper, which was I thought was regulatory to me, partly because it was one of those cases, we're actually doing the math that changed my mind-

Beckworth: Mm-hmm (affirmative).

Krugman: - which is not actually, it's fairly rare. And also because once I start to look at it, I took a look at Japan and I said, Japan, people look at Japan. They talk about all the differences suddenly. The culture is different. They look at all of these things and they end the mistakes they make, which they obviously do, and said, well, of course, this is all about the problems of the Japanese.

Krugman: And I said, fundamentally, this is a big stable country that is run by people who are maybe not ideal, but are not complete idiots. If it can happen to them, it can happen to us.

Beckworth: So was this a eureka moment when you did the model? You're like, wow, that there is something here.

Krugman: Yeah, it actually was. There've been maybe half a dozen times in my life when I did some analytics, spend some hours scrolling things on yellow legal pads and out pop something that usually, when those moments work, well, your eureka moment means for me is, I find something that, first of all, was not at all what I was expecting. And secondly, as soon as I've said it to myself, I say, Oh, that's obvious, why didn't I see that before? And that was definitely the case here.

Beckworth: Very interesting. I'm going to read an excerpt from this paper, the 1998 Brookings paper that’s been influential and then ask you to comment on it. This comes from the introduction, the first page or two into it. And it goes as follows: “The central new conclusion of this analysis is that a liquidity trap fundamentally involves a credibility problem.

Beckworth: But it is the inverse or opposite of the usual one in which a simple bank has difficulty convincing private agents over commitment to price stability. In a liquidity trap, the problem is that the markets believe the central bank will target price stability given the chance, and hence that any current monetary expansion is merely transitory. The traditional view that monetary policy is ineffective in a liquidity trap and that fiscal expansion is the only way out, must therefore be qualified.

Beckworth: Monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible to seek a higher future price level.” And that last line there, of course, you're famous for credibly promise to be irresponsible. So explains to the listeners, what does that mean in practical terms for monetary policy, for fiscal policy, for a deep, deep recession?

Liquidity Traps and Central Bank Credibility

Krugman: Well, what it means in practical terms is actually turned out to be the hard part. So, I mean, let's start with where I came from. My entry into this whole subject was saying, hey, we know about monetary neutrality. We know that if you double the money supply, you must double the price level. That can not be true.

Krugman: And that has led many people, including people who really should know better or should have known better a few years after that paper to say that I just cannot believe that the monetary policy can be ineffective. But what pops out once you actually do that for monetary temporal rational behavior model, which is not something I necessarily believe is the right way to go, but it's something that you wanted to do, just to be clear about it is that there is a hidden clause there.

Krugman: If you doubled the money supply, but you double not just the current money supply, but all expected future money supplies, yes, then the price level has to double. But given that that's not actually how we do monetary policy, central banks, if they target monetary aggregate, it's at all they do it on a temporary basis. They're not telling you what it will be forever and ever.

Beckworth: Mm-hmm (affirmative).

Krugman: And that they usually lose interest rates. The actual monetary policy in a situation like Japan's does not look like that credible commitment to have that more money in circulation forever. So the logic was clear. The logic says that if everybody is forward-looking and understands everything, then the old monetary neutrality proposition does hold, but it holds only if you are making this credible commitment that monetary expansion is forever.

Krugman: Now, turning that into something practical is, it turns out I think harder than I realized at the time when I wrote the paper, because you not only have to convince the central bank that they need to do something that's very different from their normal operating procedure, not only convince a central bank that price stability has become their enemy, not their friend.

Krugman: Yeah. So the central bank, it's not just enough to convince the central bank that it needs to do this, which it turns out that in itself as extremely hard. So far, I would say not one central bank has been convinced, fully convinced of the validity of this analysis. But you also have to convince all of the relevant agents that the central bank will do things that are different-

Beckworth: Mm-hmm (affirmative).

Krugman: - that a preference. So it's not enough to get Governor Kuroda to change the Bank of Japan's spots, which he's done to some extent, though I think not enough. You also have to convince asset markets that the Bank of Japan has changed, which to some extent has been achieved. But beyond that, you have to convince wage and price setters that everything has changed.

Krugman: So it needs to be a complete shift of mindset on the part of a large set of uncoordinated agents to make this policy work. If you're starting, if you're trying to bootstrap, if you can come in with to what might have been a liquidity trap with 6% inflation, then no problem. Everybody is expecting that.

Krugman: But if you're starting with minus 1% inflation and you're trying to use credible promises to be irresponsible to get up to 4% inflation, then it's a much harder task. And that's what I think I've learned since that paper is a much trickier business than it seemed at the time.

Beckworth: Nice. I completely agree. I think the last eight years have shown us that right with the Fed, the ECB, the Bank of Japan, but one thing they seem to do really well is, maintain low inflation. But in terms of generating robust growth, they really struggled with that. And it speaks to the results you have in your paper, this distinction between a permanent injection versus a temporary one.

Beckworth: And this is inability to do reflation, to restore the price level to a higher point. Let me ask one clarifying question, it's not that there has to be a permanently higher inflation rate, there just has to be a temporary bout of inflation. Is that right to return to the price level path?

Krugman: Well, it really depends on... One way to say this whole problem is that a liquidity trap happens when the natural real rate of interest-

Beckworth: Mm-hmm (affirmative).

Krugman: - rate of interest consistent with full employment has for whatever reason become negative. And if that's a temporary phenomenon, then if you can get a bout of inflation so that over some period of time, you can have zero nominal rates, but substantially negative real rates, then that's it. That's a one time story.

Krugman: If however, you're going to have a very persistent period of decades, it's maybe generations long when the natural real rate of interest is negative, no, then you need a permanently higher inflation rate. And so, a secular stagnation story-

Beckworth: Mm-hmm (affirmative).

Krugman: - that is now very much back in the discussion is one which says, look, an economy that is prone to secular stagnation needs a higher underlying inflation rate in order to be able to keep real interest rates low enough to not keep hitting the zero lower bound.

Krugman: So it actually depends a lot on what you think the underlying causes of the economy's weakness are. And what's a little bit funny actually, again, they're are taped up, they are on the Japan taper, although I did it for analytical reasons. And I've thought of it as being a temporary phenomenon.

Beckworth: Mm-hmm (affirmative).

Krugman: I mean, one a one period phenomenon, though I left length of the period unspecified. If you actually think about what might be driving Japan's persistent problems, the things that immediately pops into your head is demography and at now quite rapidly shrinking working age population, and there's no sign of an end to that anywhere, which means that actually, Japan probably doesn't need a temporary period of higher inflation, it probably needs higher inflation as far as the eye can see.

Beckworth: Yeah. I think there's also party up a political economy story there, as well as what you've just mentioned, the structural one in that a large part of the population is aging, as you mentioned. They also hold a lot of the government debt.

Beckworth: And I suspect they would be very reluctant to see higher inflation erode the fixed income, the fixed nominal income that they're getting from those debt securities. So I wonder, even with Kuroda and Abenomics and all these promises of 2% inflation, if they really can even do it politically, given the political influence of this large, old demographic part of the population.

Krugman: That may be true, although I wonder, if as best I can make out, nobody ever wants. No large part of the body politic ever wants inflation. Maybe, just possibly, a farmer is voting for William Jennings Bryan. But on the whole people, there's a psychological thing. Everybody thinks that they earn their wage increase and that inflation snatched it away. So I think it's even aside from these who are they? Who holds nominal assets issues?

Beckworth: Mm-hmm (affirmative).

Krugman: That's just a very difficult thing. Now, it doesn't seem to me, as best I can tell, the Kuroda as if we're talking about reality in Japan, that he's having a political problem with the 2% inflation target. He's having a very hard time achieving it because probably 2% is not enough even if believed to produce a sufficiently negative real interest rate to get Japan into an inflationary cycle.

Beckworth: Yeah. So that the challenge I guess, that you've just pointed out and I think it's a real one is, there needs to be a tolerance by the body politic for some reflation. And maybe it's a longer period of secular stagnation, as you mentioned.

Beckworth: But even in a simple case, just the ability to tolerate a year or two of maybe above 2%, 3%, 4% inflation, which if you go back a decade or two, wasn't a big deal. Even after Paul Volcker, we had inflation running maybe 4%. And so, I guess the question is, how do you do that? How do you change the perception of the public, the tolerance of a public to have more flexibility towards inflation?

How to Alter Public Perception of Inflation

Krugman: That's very tricky. But I would actually talk less about the public, although there is an issue, but the immediate barricade, the problem we have with any change in the inflation targets right now is actually the elite, not the public. It's actually the policy elite to a large extent.

Krugman: You try and get any significant group of central bankers, is particularly if they're actually in office, as opposed to those sitting at a think tank, because sometimes afterwards, they too say that maybe the 2% inflation target is not high enough. They're very, very reluctant to accept that. And that's an interesting story in itself. I don't think there's a whole lot to do with crude interest group politics.

Krugman: I think it has a lot to do with the question of, what is perceived as respectable? Through almost confluence of accidental events, 2% inflation became an accepted responsible thing to do. Once upon a time, it would have been zero, but 2% became acceptable. But now, if you say, well, whatever it was that made us think that 2% was good enough is probably not true anymore.

Krugman: Why not four? You meet a blank wall of we can't do that. That would be irresponsible that would destroy our credibility, which in some ways, the other point is that we want to destroy our credibility, but that's not what they want to do. So it's I don't think we're even at the point of asking the voters, would you be willing to accept higher inflation in return for full employment?

Krugman: First question is just, how do we get any significant number of central bankers and finance ministers to say, look, the rules of thumb, we had a responsible policy that seemed to make sense in the year 2000 don't seem to make sense since you're in 2017.

Beckworth: Yeah, that is a tough issue. And I want to be clear, it's at least as you can do this in a predictable, systematic manner. It's not like you want to reintroduce 1970s inflation rate. I think that maybe part of the fear too is it's willy nilly high inflation. It's a systematic, rules-based, it's predictable amount of just a higher tolerance of inflation. Now, I want to go back to this idea that maybe we have secular stagnation. And I want to throw a question out and see what you think about it or a possibility.

Beckworth: And that is, what if we had responded more aggressively in 2009? So you pick the policy, but more rapid aggregate demand response, temporary overshoot of inflation, would we even be in a secular stagnation environment? So there's some kin of the potential GDP has declined because of the sustained demand shortfall, could we've avoided that? And if so, wouldn't that say, all we really needed was a temporary overshoot, 2009, 2010, maybe, we would have avoided a lot of these tough questions?

Krugman: Yeah. To which course, the answer is that we don't know.

Beckworth: Sure.

Krugman: What I believe depends on what I had for breakfast. I think you can make the case several different ways.

Beckworth: Mm-hmm (affirmative).

Krugman: If you won an argument that says the secular stagnation is a building problem, that it was not contingent on mishandling the Great Recession, you can point to what appears to have been an ongoing decline in real interest rates for several decades before you can point out... So you can make the argument which Larry Summers has popularized. I actually I am seriously pissed and not at him, but at myself because I made similar arguments, but incoherently.

Krugman: And Larry was the one who got it really clear and justifiably gets the credit very well. But you can look back. If you look back at the period from really from 1990 onwards, you can say, look, we only seemed to be anywhere close to full employment during major asset bubbles and then slow card difficult, slow jobless recoveries in between, which would make a case that said, look, we were drifting towards secular stagnation long before the Great Recession, that it was just masked by the real estate, commercial real estate boom with the late 80s and the Internet bubble and then the housing bubble.

Krugman: And sooner or later, we were going to find ourselves confronting this. On the other hand, the evidence for sustained effects of demand shortfalls on potential output is pretty strong. I mean, it's actually shocking. The data really wants to tell you that having a severe recession does not mean that you never do get back on to the previous trend. We don't quite know why, but the data do want to tell you that story.

Krugman: So you can make the argument that we'd be much stronger potential output, much stronger investment demand if we had a more aggressive response. So I don't know which is the right track. I think we'll have to take seriously the possibility that this is a long-term problem. You can base policy on the certainty that we are in a secular stagnation world, but we may well be even if we do a big reflation in the short-run, which but in any case, we should be doing that whether you think that's right.

Krugman: Whatever you think is the long-term duration of the problem, we should be doing a big push to get inflation up. So not only up to 2% everywhere, which really basically still isn't, but at the very least, be some overshoot. And I would argue that we actually should be raising the target as well.

Beckworth: Yeah. I'm definitely very sympathetic to the idea of temporary overshooting. And that's why I'm a big advocate, as you probably know, of level targeting price level or nominal GDP level targeting because it allows for that catch up. I guess the question is, as you point out is, is this a secular stagnation environment? Then that may not be enough.

Beckworth: But I want to believe any help. Let's take these insights and apply them to the responses that were actually done after 2008, the QE programs in particular. So the Fed began QE1, the QE2, QE3, the ECB Bank of Japan followed suit. And what's interesting about your 1998 paper and then the ones that followed, Michael Woodford got a Morgenson's paper, also Brookings paper I believe 2003, and then a host of others have come along is, they all stress this point that if it's not a permanent monetary base injection, it's really not going to have any effect.

Beckworth: And then, in fact, there's a term that the irrelevance results of your paper and the Eggertsson-Woodford paper right, that QE will be irrelevant. Now, I want to be clear. I think QE did have some effect maybe with the tinkering on the margins as credit spreads were affected. I think it had some effect, but it definitely did not live up to the hope and that the building I think that the Federal Reserve put out for it and in the hope that many of us had for it.

Beckworth: So my question is why? Why did Fed officials, why did ECB and Bank of Japan officials ignore this large literature? I mean, starting with your '98 paper and beyond, why was it ignored? And then I asked that because your colleague, former colleague Ben Bernanke, he understood it before the Fed, and he had a speech at Japan where he spoke to the importance of a permanent money supply injection, price level targeting. Even afterwards, he spoke to that same principle. But why is it that central banks tend to revert to QE, which in the literature, very clearly says will be irrelevant?

Ignoring the QE Warning Signs

Krugman: First of all, you want to be QE1 in the US-

Beckworth: Mm-hmm (affirmative).

Krugman: - which was taking place at a time of really disrupted credit markets. It was essentially the Fed stepping in to provide credit that the private sector was not going to provide. I don't think if really any question that that was effective. And I would say that the debt in Europe, the Draghi, whatever it takes, policy, OMT, outright monetary transactions, although they never actually did any of them. But the announcement that they would was in some ways similar.

Krugman: You had a panic in the market. You have private market participants not prepared to step up. And so central bank policy made a lot of difference, even though interest rates on safe assets were zero. So there are some things that we might call QE or we might call macro policy that even a skeptic. I would say, look, those those really made the difference.

Krugman: And in particular, that Draghi intervention was almost miraculous in its effects for a while anyway. Now, there is a there is an argument that says that if you buy longer-term assets, different-term assets, you do get some traction. The real world is not just money and bonds. And that's that's all there is. There's money in their bonds, a different duration. And there's other kinds of assets.

Krugman: And we would expect some imperfect substitutability in there. And it's that Bernanke at least has read his Tobin from the 60s and early 70s, which way too few people have. And so he was always thinking in terms of Tobin style operations that go beyond the classic open market operations. Now, the question, and there's a very distinct shift in what Bernanke himself said between that '99 paper on Japan and the 2004, I think Brookings paper responding to zero lower bound in which he became convinced or at least began saying that the unconventional asset purchases are really all we're going to need.

Krugman: And the Asian question is, what persuaded him of that? And I always thought that the quantitative evidence being presented was not very compelling, particularly if you thought about the scale of the shocks that might come along. And I have no inside information. But my sense is that, and I think I've said this, I don't think I'm inventing a new insult, I think to a certain set, he was assimilated by the Borg that the central banks really, really don't like the idea of changing their mission, which is to stabilize inflation at a low level.

Krugman: They really don't like the... And they have set back policy by decades with that credibly promise to be a responsible remark. It's just isn't the role that they have been acculturated to play, so they're very much looking for other kinds of policy that let them skirt that dangerous territory. Probably want to add political pressure from outside. The fact of the matter is that certainly, if you look at what the Bernanke Fed had to face from Congress, it was under constant accusations of debasing the currency and so on, even when all they were doing was unconventional asset purchases.

Krugman: If they said, oh, by the way, we really need to promise a period of accelerated inflation, then just imagine what kind of political heat they would have faced. It might be even if we'd been able to intellectually persuade the Fed that they needed to do something different, that they would have been cut off at the knees by members of Congress.

Beckworth: So what would you recommend if you could be the benevolent economic dictator? What type of rule or a policy would you have the Federal Reserve follow, going forward? Or let's step back, starting 2008, you could step in and literally be the dictator and change course for the ship, what would you do?

Krugman: So the first thing that we haven't mentioned and if it does, it is important now is fiscal policy. And when I wrote back in '98, I was skeptical about fiscal policy. I said, personally don't need it. Credible, incredibly irresponsible trade policy. It will do the job. And I was worried about debt. What I've learned since then is that it's much, much harder both to change behavior of the central bank and to change the expectations of all of the relevant market players.

Krugman: And one thing about fiscal policy is that it doesn't require those expectations of changes. In fact, on the contrary, if people believe that a big fiscal expansion is temporary, especially if it takes the form of actual purchases of goods and services, it's more effective if people think it's temporary and they don't think it's going to reduce their future tax bills so that in the face of something like 2008, there's a really strong case for fiscal policy as a relatively surefire way of pumping up demand.

Krugman: And so if I had on politically untrammeled ability to set policies right then and so 2008, it's clear that the sky is in fact falling and that this is really bad. And it was also immediately clear, I thought, that the inflation target that had been set based upon basically that we all somehow picked up from New Zealand in 1995 that the inflation target was too low.

Krugman: So what I would probably have done is say, hey, we actually need a 4% inflation target and we're going to do a huge infrastructure plus program to make sure that there's enough spending, enough aggregate demand to get up to 4%. And the Fed is going to accommodate that. And then we can revert to policy as normal, but at a higher baseline inflation rate. That's probably how I would have, in my ideal world, that's how we would have responded to the whole problem.

Beckworth: So this to be clear, you'd have had fiscal policy more aggressively used, it would have closed the output gap and pushed inflation back to its target and then things would have been more smoothly carried out at that point.

Krugman: Yeah. And I would say that there are a couple of reasons to think that in addition to having gotten us up to a higher inflation rate. And and have possibly bypassed that negative long-run impact on potential output that we're worried about. Also, a period of up some inflation would have eroded the overhang of household debt.

Krugman: So one of the things that we think was helping to drag the economy down would have been help. That's like a miniaturized version of what we think happened to World War II. Why did the wartime boom not only produce a wartime boom, but produce an economy that did not slide back into the Great Depression afterwards? And there are a couple of... We can think of about several reasons, but probably all of those same reasons would have applied in this case as well.

Beckworth: So I know we've had this exchange before in the blog. So I want to bring it up here and this is, would you be concerned at all about the Fed getting antsy and wanting to start raising rates if fiscal policy was really productive, if you were able to accomplish this and snuff out the success you could have with fiscal policy?

Higher Interest Rates vs. Productive Fiscal Policy

Krugman: Oh, sure. This is the problem one has with all of these things. If you're worried about the Fed wanting to be too conventional, then that's going to undermine all of these policies. Now, as it turns out under their Bernanke's Fed, and given the extremely limited range of fiscal policy that we were able to pursue, none of this happened.

Krugman: There was no hint that the Fed was getting ready to raise rates wildly while the Obama stimulus was in effect. So we didn't get there. And yeah, it would have been an interesting question if you want to say, look, I call for a fiscal expansion that each has 4% of GDP, not two, which is what actually happened with the ARA and that lasts for four years, not 18 months and all of that, could we have counted upon the Fed to play its necessary accommodative role?

Krugman: And the answer is, well, we're already in a fantasy world where I'm imagining that austerity isn't happening. Why not imagine the Fed is going to go along with it too?

Beckworth: Well, here's why I ask. And this, as well as anyone, the Fed's preferred measure of inflation, the PCE to flatter, the core measure has averaged 1.5% since the bottoming out in June, 2009. The headline measure, which is 1.4. So that's a long time. That's eight years now. And it makes one begin to wonder if that's something systematic the Fed wants. It likes opportunistic disinflation.

Beckworth: And again, I'm speculating here, but I'll look around the world and I see the same tendency in Europe and Japan. And you almost want to put the I do. And I like to point the finger at inflation targeting has been so successful. Central banks are conservative, as you mentioned, is hard to do anything else. And I wonder if fiscal policy had been tried, even though Bernanke explicitly said he wanted more fiscal policy. In practice, would he have gotten the inflation high as soon as inflation started to get close to 2%?

Krugman: I don't think the Fed actually wanted sub target inflation. I think that's been a little too conspiratorial. It's true, I think the Fed really does behave as if two is not a target, but it's stealing. Although it's not that they have a hidden preference or lower inflation exactly, but they clearly get much more upset at 2.5 than they do at 1.5. And that's I guess and in some sense operationally that turns into what looks a whole lot like a preference for or low inflation.

Beckworth: Yeah.

Krugman: And they also have a... I think just there... Now, how can I say this? I think that the impression I always get is that there is a lot of people on the FOMC. I think less so on the staff, but a lot people in the FOMC, they want to go back to being what to normality. And they all want to be Paul Volcker in 1981, heroically standing against the inflation.

Krugman: And that's how they see themselves. That's the image of what they're supposed to be doing. And they just at the first hint that they can stop playing this opposite role of trying to push inflation up and of trying to support the economy. They seize on it. And so we've seen, now repeatedly among central banks, we've seen the Bank of Japan has had a couple of abortive attempts to move off zero. We've seen the ECB abortively move off zero, raise rates-

Beckworth: Mm-hmm (affirmative).

Krugman: - incredibly in '08. And then again and against what 2011?

Beckworth: Yeah. Twice.

Krugman: And the Fed's behavior in the last year or so has been more muted, but it seems to me that some of the same psychology is at work. The case for raising rates right now is, it's not terrible. It's not as absurdist as the case was in 2011 at the ECB, but it's certainly a weak case and the extent of unanimity of around the desire to start normalizing rates is really quite strange.

Krugman: By the way, what makes it particularly strange is that, and I've written about this too, is that if you look at the people, the people on the outside, the people saying don't raise rates till you see the whites of inflation's high. So people like me and Larry are basically students of the same people who are inside the Fed saying, now is the time to start raising rates. So there's something institutional about the incentives. And I don't have a really great way to solve that problem.

Beckworth: Yeah. And I don't mean to sound as conspiracy-minded, I'm just saying it seems the revealed preference is what you mentioned, that 2% it's more of a ceiling than a target. And maybe another way of framing this, maybe the Fed is still fighting the last war. They're still thinking about how bad things could get if they repeat the 1970s.

Beckworth: And there's interesting paper, it was done recently that looked at, if FOMC officials had lived through high bouts of inflation, if so, they tended to be much more of an inflation hawk. So younger FOMC members like today, we have Neel Kashkari there in a coach with a coat up. These individuals didn't experience or maybe appreciate the pain of the 1970s because they were younger and they're more open-minded, less worried about repeating that mistake.

Krugman: There some of that, although the funny thing about the fighting the last war analogy is that we are now talking where this the 70s is a long time ago. I make this distinction among business cycles, that we have had now three postmodern recessions.

Beckworth: Mm-hmm (affirmative).

Krugman: They brought on, not by the Fed having to squeeze to fight inflation, but were brought on by private sector overreach. So 1991 and 2001, and then the Great Recession were all situations where the problem was not... There was never an inflation problem, the problem was always one of, how do you deal with a bubble that burst?

Krugman: To go back to the kinds of environment that these people are thinking of, you need to go back to the 1970s. So it's not like French generals in World War II are trying to refight World War I, it's more like French generals in World War II trying to refight the Franco-Prussian War.

Beckworth: Great analogy. It's a great point. It's a long time ago, but if Janet Yellen was asked at one of those FOMC pressers if the Fed would overshoot or consciously overshoot, engineer and overshoot so that they would begin to hit 2% on average, she just said no. So we have a symmetric target. We're not going to do that because we don't want to repeat the mistakes of the 1970s machine vote, the 1970s...

Krugman: It's really remarkable and it's remarkable because even in the 70s, there's a myth, which was that it was just like there was a moment of inattention. Then the next thing you knew, inflation was running wild. It took a lot more to get inflation up to those levels. It took a combination of oil shocks at the Arthur Burns, reelect Richard Nixon and inflation, there's a whole lot of things. It's not that easy to take a 21st century economy and replicate stagflation.

Beckworth: Let me go back to fiscal policy for a minute here and let me tell you how I've grown to appreciate it more over the past eight years. And it's almost more of a monetarist's perspective. And then it goes as follows: Money, as we have learned from Gary Gordon and others like him, is now much broader, has been much broader than the standard textbook M2 definition of money.

Beckworth: So M2 with the retail money assets, money that you and I would use small businesses. But we learned from the run on the shadow banking system that there's institutional money assets as well. Again, Gary Gordon has done a good job documenting this. And those things completely collapse. A lot of the privately produced mortgage-backed securities, some of the stuff was junk, some of it was legitimate, but it disappeared and that part of the broad money supply property measure simply vanished.

Beckworth: Now, part of it is also treasury bills. Treasury bills are an important part of that. And if you look at a measure of the money supply, so there's been one institution that actually tracks M4, which is M2 plus these institutional money assets. It actually it collapses. And to the extent, treasury bills could have filled that gap, but I can see the argument for fiscal policy stabilizing the broad money supply here.

Beckworth: But I think that's a probably a subtle point that many people don't appreciate. I mean, really, it speaks more generally to the safe assets' shortage problem that Treasury bills are more than just something that's used by government funds operation. That's an important part of finance for many institutional investors.

The Safe Asset Shortage Problem

Krugman: Yeah. So I've never fully made up my mind how seriously I take the safe asset shortage issue.

Beckworth: Mm-hmm (affirmative).

Krugman: But it's certainly, there's a reasonable case to be made for it. And we had a yeah, we had an era when the private sector was creating a bunch of what looked to people like safe assets and turned out not to be remotely safe assets. So what you're left with is government securities.

Krugman: And that's a pretty good case for not instead of being worried about the debts all the time as being excessive, we might want to worry a little bit about there just not being enough stuff out there to get people to the safe assets they need to do business. And yeah, it's always remember that there was that very, very old book on British history, 1066 of all that.

Krugman: And it had one little section on public finance, believe it or not. And by the way, if you think about long-term British history since the chorionic wars, much of that time, there was a huge government debt out there. And it said something about the debt, which must never be paid off on account of political economy.

Beckworth: Interesting.

Krugman: There's a little bit of wisdom there actually somehow. All those councils that essentially were used to fight Napoleon were probably a more important part of the 19th century British economy than we realize.

Beckworth: And likewise, treasuries today fill that role.

Krugman: Exactly.

Beckworth: Well, let me ask this at the time we have left, so I'm someone who's a big fan on nominal GDP level target as you know, I think it could be implemented in a rules-based approach, make a predictable, systematic kind of what the Fed is doing now with inflation targeting. I would like to see them move towards a nominal GDP level targets. I want to get your take on it. I know you've had mixed views in the past. Where do you stand today?

Krugman: I still have mixed views partly just because I don't think we have a very good handle on the long-term future rate of growth of potential GDP.

Beckworth: Mm-hmm (affirmative).

Krugman: I can tell you a story where potential GDP growth, looking forward from here is maybe one because well, actually, Robert Gordon is right. And all of the good ideas have already been exploited. And working age population growth is pretty much ending.

Krugman: And I can tell you a story which says that nominal debts are the real potential GDP growth is for us because the self-driving cars are going to start doing everything for us and robots are going to take over large numbers of service jobs and then Skynet kills us all. But there seems to me that there is a plausible range of several percentage points-

Beckworth: Mm-hmm (affirmative).

Krugman: - about potential real GDP. And if you have a fixed nominal GDP target, that means this your implied inflation target is several percentage points wide. And that seems to me to be highly questionable because even with my higher inflation targeting point of view, the theory has to be some cost to having to change prices a lot.

Krugman: So if we turns out that we've got a 5% nominal GDP target and we only have potential growth, well, I guess four is a number I said is okay, but maybe we think the potential is four or is two and we think the inflation target should be a four, and so we set six and then that might end up being a rather higher rate of inflation than we intended, or it might be that it's actually at an excessively low rate of inflation because now, there are counterarguments.

Krugman: I understand that some nominal GDP is a simpler thing than an inflation target and has some virtue of providing an automatic catch up. I don't find it hugely persuasive, but I don't find it hugely awful either.

Beckworth: All right. Well, let's say great in the time we have left, because we're coming to the end, to some points you just raised and that is the future here. Smart cars, robots, Terminators. What is your outlook for the US economy? Do you see us getting past this rough past secular stagnation if it's actually there? Does the future look bright? Are we going to have a great future of smart machines, high productivity, rapid growth? What are your thoughts?

The Krugman Outlook for the US Economy

Krugman: This short. Again, this is one of those where the clear answer is, I don't know. Nobody knows. Now, let me give you the two sides of this. On the one side, I'm pretty I'm pretty convinced that if we look at technological change over the past 20 years, it's actually been pretty significant disappointment, maybe even more than 20 years.

Krugman: And it's part of that where the flying cars, but just in general, you ask, how much has the way that we live, the way that we work really changed? And it's a lot less than people like to imagine. I have this weird, you always look for some motivated thing. If you look at old Dilbert comic strips-

Beckworth: Mm-hmm (affirmative).

Krugman: - and that's been around since the... I think since the early 90s. And so there's depictions of office life and what people are doing in offices in the early 1990s. And it does not look all that old fashioned. We really don't. Most people work in offices these days and they work here, we're better network. But the changes that have not been huge.

Krugman: And there's an argument that says that's Bob Gordon is right, that there is a there is no technological transformation happening on the scale that used to happen. On the other hand, we are seeing certain kinds of things, particularly it seems to me in the last six or seven years, things that were supposed to be fundamentally impossible, hard problems have suddenly become not at all impossible, that the big data machine learning is bringing some really dramatic changes, so far, in stuff that is fairly trivial.

Krugman: So suddenly, translation software actually produces stuff that no longer has me giggling all the way. Speech recognition has gotten reasonably good and all of that. That by itself doesn't matter all that much, but it suggests that a whole lot of the things that we thought up as requiring common sense, requiring human ability to deal with unpredictable environment might not be actually that hard to solve.

Krugman: So I can tell you a story I'm wondering a little bit about self-driving cars in cities, but as an economy in which long distance trucking is quite quickly taken over by robot trucks, that can stop at depots on the edges of major cities where a human steps in to help on the last few miles, that could happen fast. And that right away, that's millions of workers. That's a large productivity change. So I can tell you a story either way. I guess, I don't know. Surprisingly, I don't even have a clear lean either way.

Beckworth: Interesting.

Krugman: Yeah.

Beckworth: So you're agnostic on the future in terms of whether growth picks up or not.

Krugman: That's right. Yeah. And then of course, the chances of catastrophe of one sort or another, not a political protest, but the other kinds of things that President Trump and President Le Pen can do together can be pretty amazing.

Beckworth: So I guess assuming that the Trump administration does not blow up the world, I like to be optimistic and hope for the best, but those are real questions I think that you raise to be fair.

Krugman: And let me say, by the way, that one thing that does, my colleague, Branko Milanovic now at the Stone Center of CUNY

Beckworth: Mm-hmm (affirmative).

Krugman: - his famous elephant graph, which shows that if you look across the world as a whole, what you really have is huge income growth at middle incomes. That's a very encouraging thing. And these are a really large part of humanity has been making rapid progress and it's spreading.

Krugman: More people, everyone talks about China as they should, but if you take a look at what has happened in places like Bangladesh, which are still desperately poor, but not in the same way they used to be, that can make you feel pretty optimistic about humanity.

Beckworth: All right. Well, on that positive note, we are out of time. Our guest today has been Paul Krugman. Paul, thank you for being on the show.

Krugman: Well, thank you. That was fun.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.