Paul Krugman on the Year of Inflation Infamy

The inflation caused by supply chain disruptions should fall within a few months, but tight labor markets might keep prices uncomfortably high for a while longer.

Paul Krugman joins David on Macro Musings to discuss the great inflation surge of 2021 and its implications for policy. Specifically, David and Paul discuss the state of public opinion surrounding inflation, whether the level of aggregate demand or its composition is the more important driver, what the state of the economy would be if the Fed had more aggressively countered inflation, whether the Fed squeeze is the appropriate response, and much more.

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 back to the show.

Paul Krugman: Hi there. Good to be on.

Beckworth: Yeah. It's great to have you on. In preparing for today's show, I went back and looked at our previous conversation which was in 2017, and looking back now much simpler times, we were worried about liquidity traps, the unanemic recovery, safe asset shortage. We even talked about Isaac Asimov back then.

Beckworth: So much simpler times. And what was interesting back then, I think one of the key pieces of our conversation was this question that was looming, was there sufficient or adequate aggregate demand back then? Was policy doing enough fiscal and monetary to speed up the recovery against the full employment? And from that perspective if we flip it to today, the question is the opposite, is there too much aggregate demand? And I never thought we'd be in this place where we're having to answer and wrestle with this question.

Evaluating the Inflation Concerns

Krugman: Yeah. It is not someplace in a way it's the political economy of this has been just wild. Not at all what I would've feared, what I would've expected. Of course that's my guess is that two or three years from now, we'll be having the same discussion we were having in 2017. This is not a permanent state of affairs, but for now, at least, yeah, we are worrying about overheating, which is kind of a welcome change in some ways although problematic in others.

Beckworth: Yeah. Absolutely. And I agree with you. I think the same structural forces that were with us before the pandemic that led to low interest rates, low inflation will be back on the other side. So agree with you on that point there. The other thing that's really interesting about this day and age is just how quickly... You alluded this in your article that we're going to base our conversation off today, but how quickly inflation has become such an important issue.

Beckworth: I mean, as you mentioned in your piece in The New York Times, that inflation just a few months ago wasn't this poignant of an issue, but now it's front and central. It has arguably caused the big power pivot. Any thoughts on how rapidly public opinion has changed on this. And moreover it has political implications too. Right? So any thoughts on just that part of it?

Krugman: Well, I mean, part of it is, I mean, some of this, maybe most of it is actually spontaneous public opinion. Although we always want to bear in mind that public views on inflation are not, people don't know what the CPI is or what's happening to it. It's a few visible things and it's overwhelmingly, it's the price of gasoline. So gas prices went up a lot and people say, "Oh my God, gas prices are up."

Krugman: And we might be surprised, wholesale gas prices are down about 40 cents from their peak now and prices at the pump will presumably follow in a few weeks. And I wouldn't be surprised if inflation suddenly becomes a whole lot less salient. But there was also, it was clearly as you remember very well, 10 years ago, there was enormous fear over inflation when there was really nothing on which to base it, except again, a blip and gasoline prices. There's a segment of journalism, some of it's political, some of it is generational that's always prime. There's a part of elite opinion for whom it is always 1979. And they had their moments, 2021 was their chance finally to relive the glory days of their youth.

Beckworth: Oh, that's interesting. So maybe a few decades from now, if we have something like this again, and that generational element's not there, it'll be interesting to see what the policy response is. Plus we've been through this and if we get to the other side successfully, maybe it'll be more humility in interpreting the implications for the broader economy.

Krugman: Yeah. I'm spending a lot of time, a little bit in the longer piece that I wrote and some more coming and shortly after having this conversation on the '40s, the postwar inflation, which was actually two years of quite high inflation, but then ended and went down the memory hole, nobody talks about the inflation rate in 1947. And it's possible that a few years from now the inflation of 2021 will also have kind of been regarded ex-post as a flash in the pan, although I guess we're forbidden to use the word, but as having been transitory. So-

Beckworth: That's a good point.

Krugman: ... I've been looking for synonyms and there are some ones I words, I didn't know, but fugacious turns out to be a synonym for. Maybe in the end we'll regard this as a fugacious inflation.

Beckworth: Now that's interesting point because if we look back to 2008, which you do in your article and we'll come to your article in just a minute, but in 2008, I mean, many at the FOMC were also screaming high inflation because the commodity prices and that ended pretty quickly. And we seem to have forgotten that as well. We don't see many people looking to that as baseline or a reference point in this conversation.

Krugman: Yeah. Partly of course, I think there's a fallacy of misplaced concreteness. 2008 was all about commodity prices. And this one is not all about commodity prices about things that in a lot of ways are behaving like commodity prices. I mean, I'm told by some old Fed hands that back once upon a time when they were deciding on a definition of core inflation, they actually did consider including used car prices and chose not to. But if they had the discourse these past few months would've looked a little bit different.

Beckworth: Right. And going back to your point about this inflation experience going down the memory hole, a part of me has always wondered if we're just hardwired to think in terms of growth rates versus levels. And let me give you an illustration of this. And you know this period real well because your work has been done on it.

Beckworth: But the Great Depression, coming out of the Great Depression, the sharpest part, 1929, 1933, and then right after that, I believe 1936, the Fed began to worry about inflation, even though there was still in terms of levels of big gap between where the price level had been and where it was, there'd been some inflation. And I just wondered, do we have a hard time processing levels versus growth rates on this issue?

Krugman: Probably. There's a lot of, I remember when gas was, actually I should know this, tells you that I don't drive all that much, but people remember gas prices last summer, the summer before last, when they were really depressed because of the pandemic, and where we are right now is, well, gas prices are up actually oil prices and wholesale gas prices, not yet retail, are at their levels of 2018. If the price of the pump ends up being the same as it was in 2018, will people still be saying, "Oh, look at gas is so expensive, because it's up over the past year" or will they say, "Well, it's kind of normal." I don't really know the answer to that, but I do wonder.

Beckworth: Yeah, very fascinating. Well, let's go to your article. It's titled, “The Year of Inflation Infamy,” and I like that. It's very serious. I'm calling this a great inflation surge of 2021 since economists like to put great before things, but great title.

Krugman: By the way I stole, it's an old article by Bill Nordhaus, about the 1952 inflation.

Beckworth: Okay.

Krugman: So borrowed the title pretty much from him.

Beckworth: Okay. That makes sense. Well, you begin your article by talking about the history and you really alluded to one experience in 1948, but walk us through some of the past experiences as a way to maybe help us better understand what we're going through now.

Krugman: Yeah. So there are really. There have been roughly speaking, three eras of inflation shocks since World War II. There's the immediate post war ones, both the '46, '48 and then Korean War, which were just simple, too much money chasing too few goods. A surge in demand coupled in the '40s one with an economy that was still adjusting to the dislocations of the war. So some obvious parallels with now. Those were came on fast, they were remarkably high.

Krugman: I mean, 20% inflation that's peak in that '40s inflation, but they went away quickly and left very little scar. Then there was the '70s, really starts in the '60s, but we most identify with the '70s, that was the one that got seared into our collective and selective memory of inflation that just wouldn't go away and stay at high, even when unemployment was high and all of that, which is the model that a lot of people are still working with. And then we had spikes and inflation that were mostly commodity prices associated with the Kuwait War, associated with that 2008 shock and a slightly smaller one as the economy was coming out of the Great Recession which overall transitory by any standard. So in a way I like to, as I say in the article, there are three different kinds of inflation.

Krugman: It's not just too much money chasing too few goods, that was the story in 1947, but the inflation of the '70s although it may have started that way was all about leapfrogging, wage and price setting. It was all about embedded expectations of inflation that kept it going. And then there are these commodity price shocks that produce spikes in inflation, but are the kind of thing you want to just ride through.

Beckworth: Yeah. And in your article you mentioned, we can learn a little bit from each of these different experiences, because what we're going through now is really unique. It's a combination of many of the things we solving. So once you lead us off by talking about what is unique about this period and what's not unique about it.

Krugman: Okay. So we're actually having. I mean, we certainly have had a period of pretty strong demand. I mean that was the political miracle of 2020-2021, was that we actually did provide a lot of fiscal support to the economy and a monetary support also. We have pretty close to a financial meltdown in March, 2020, but the Fed... three trillions of dollars at it and it went way fast.

Krugman: But we also had an astonishingly generous relief package in 2020, and then another one in early 2021, all of which has led to real personal incomes have stayed high despite the shutdown of a lot of the economy and a lot of demand sustained by that. So we have had probably some demand, just plain excess spending inflation. And that's where a lot of import issues come up in how big a factor is all of that.

Krugman: Then we've also had the sort of idiosyncratic shocks except this time, it is oil among other things and it is food among other things, but then there's the weird stuff. There's the used car shortage, there's the hotel rooms and rental cars. Conceptually those are similar to those blips that we had in the long period of inflation was actually pretty stable. And then there's the last bit, the self-sustaining inflation driven inflation.

Krugman: So far I don't actually see any of that. And of course we don't have very good ways of measuring it, but for what it's worth, you just cannot see any hint in of the data and even in the anecdote that anybody is saying, 'Well, I'm going to offer my workers a 10% wage because I figure all my competitors are going to be raising their wages by 10% over the course of the next year." There's no sign that, that kind of '70s type inflation is happening at least so far.

Beckworth: Yeah. It's striking to look at the bond market for example. They would quickly incorporate any concerns about inflation being unanchored. And right before we recorded this, I checked a 10 year treasury yield was a 1.39%. It's shocking.

Krugman: Noted. I have to say that I am wary about the bond market because the bond market doesn't set wages prices. And in a way we had this concept called the expected rated inflation, which is really doesn't exist. There's are what bond traders think inflation's going to be. There's what consumers, not even sure the consumers really even have such a thing, but there's a defacto kind of notion of what inflation might be that's built into the behavior, and there's people setting wages and prices. And there's no arbitrage mechanism that forces all of these views to be the same. But still the bond market is people putting their money on the line and the bond market doesn't think that the '70s are coming back. Inflation maybe say maybe a generational thing. Right? I mean, if you ask-

Beckworth: That's a good point.

Krugman: If you are bond traders, they're all about 29 years old. So maybe they.... That's very different.

Beckworth: They're widely optimistic. Okay. That could do one hot take. So on the wage price, biral prospects, couple observations, one and I got this from Mark Zandi. He notes that the Atlanta wage growth tracker, which is pretty neat tool that accounts for changes in composition who has the jobs. But if you look at it by income levels, I believe they list it by quintiles, almost all of the rapid wage growth we've seen at the lowest levels. And it's hard, yes. It's hard for me to see that being sustained. I mean, once this financial cushion from the Federal Government runs out, once we're on the other side of the pandemic, they might have a permanent level increase in their wage, but it's hard to see sustained wage growth at that level. Is that a reasonable assumption?

Krugman: I think that's right. I mean the wage growth. I mean the thing that gives me a bit of pause, I'm not worried at all about used car prices. I think that's clearly not something that's going to last. Wages is something that is traditionally kind of sticky and inertial, but what we're seeing doesn't look like that kind of wage growth, it looks like there is a shortage of workers, especially low paid workers, especially workers in unpleasant jobs who for the time being have the luxury of saying no partly because of the financial cushion and maybe because they had a bit of a moment of revelation saying, "Boy, I really hated my job." But it doesn't look sustainable. And it's also worth pointing out by the way that the bottom, I think it's quartile whatever, the bottom quartile of workers is a lot of workers, but not a lot of labor costs because they're so poorly paid. So the actual cost push effect of rapid wage gains down at that end of scale is not that large.

Beckworth: Yeah. The other observation about a wage price spiral is, and I'm even wrong here, but it's hard for me to envision it, this spontaneously occurring on its own. It's usually indulgent. You think of a really extreme case where you have hyperinflation, there's a reason why the wage price spiral occurs, right? The government is running fiscal policy really strong. So is it possible for a wage price spiral to emerge in the absence of really, really big fiscal packages?

Krugman: Well, we don't have a lot of experience and actually there's even summit depending on how seriously you take some of the academic research. Meaning there's, the Nakamura, Steinsson stuff on the reverse. The wage price downward spiral of the 1980s in which they argue there really was kind of that it had less to do with high unemployment and more to do with just people perceiving a regime change, which I find fascinating, but don't quite believe, but still could be true and it's certainly careful research. So it's possible, but there's nothing. The wage price spiral that we had in the '70s that took a long time. It took years and years of irresponsible policy to get time point.

Beckworth: Right.

Krugman: And even if you think that we overdid fiscal stimulus this year, and even if you think that the economy is running too hot right now, it takes the idea that really maybe six months of alarmingly high inflation prince is going to feed a decades long wage price spiral, I mean, we understand everything perfectly, but it's not what I would've expect given history.

Beckworth: Yeah. I definitely need some perspective. I mean the great inflation was from 1965 to the early '80s, almost 15, 16 years. So you're at a six month period compared to that long run puts things in perspective. The other I mention on this wage price spiral is again, what do we have to help generate this? What we see currently, and that is these big packages last few years, right? We had the stimulus checks, we got the unemployment insurance that may have contributed to this. And moving forward, even with President Biden's infrastructure bill, and if Build Back Better does become law at some point, many people look at that and say, that's going to create inflation. But from where I stand, that's really a small, small percentage GDP moving forward so it should be inconsequential one way or the other, is that right?

Krugman: That's right. Yeah. People have people who should know better simply don't have a sense of the scale of the U.S. economy. I mean, we're a, what is it? Something like a $23 trillion annual economy. You have a Build Back Better if it happens is going to spend something like 160 billion in the first year partially paid for with higher taxes, which will depress demand. So the net stimulus is a fraction of a percent of GDP. That's just not going to.

Krugman: I mean, I think the habit of voting many budget measures as 10 year totals is really doing a lot of damage here because you say, "Oh, well, American Rescue Plan was 1.9 trillion and Build Back Better is 1.75 trillion, but yeah. But one was immediate outlays and the other over a decade. And again, this is a CBO estimate of cumulative GDP over the next decade is 288 trillion. So that gives you some perspective there.

Is it the Level of Aggregate Demand, or Composition?

Beckworth: I want to go back to this point about demand or aggregate demand and the level of it. And many people like your friend, Larry Summers was arguing in early 2021, we were just putting too much aggregate demand out there. And my reply would be to that point is that, if you look at the level of aggregate demand, and you mentioned this in your article as well, it's really where it would've been had there been no pandemic. So we're really right on trend. So you can imagine a world where there was no pandemic, we continue to grow long like we did prior to the pandemic and inflation probably would still be low at the same size of the economy, same level of aggregate demand. So is it really the level of aggregate demand or is it the composition of the demand that's driving this inflation?

Krugman: Okay. Let's just say, I think it's mostly composition, but it is worth saying that it looks as if aggregate supply, even leaving aside those sort of bottleneck issues is somewhat lower than we thought it was going to be because of the great resignation. Because number of people in the labor force still, is below where we thought it was going to be. And fair number of people retired, having lost their job they figured no point in going back to work because I'm already not that far from retirement. And some people still staying out because of, they figure they can for the time being. So aggregate supply to potential GDP is probably a percentage point. We can play with those numbers, but it's a potential GDP is probably a bit lower than we thought it was going to be. But mostly, yeah. Mostly this inflation is overwhelmingly concentrated in durable goods.

Krugman: Aside from the commodities, and that's not because overall consumer spending is extremely high, it's because the, I keep on trying to find a less lead, clear metaphor, but anyway, it's people couldn't go to the gym so they bought Pelotons and that compositional effect is dominating. I mean, at the peak durable goods consumption was 34% above pre-pandemic levels, that's not-

Beckworth: Staggering.

Krugman: That's not the stimulus package doing it, but that's people buying stuff because they couldn't do anything else.

Beckworth: Right. So you could imagine a world where we have the pandemic and we didn't get the generous Federal support. People still would've pulled back from services just because it fears of the COVID virus and bought these physical goods because that's just the way it had to be.

Krugman: Yeah. I mean, if durable goods consumption had been up by 29% instead of 34%, we would still have a whole lot of supply chain problems.

Beckworth: Right. So this, I think should make us optimistic about this next year and the possibility getting past it. Because I know you've seen this stated too, but if you look at the PCE measure of durable goods, they've been on a 25 year deflationary run. I mean they literally prices have been getting cheaper year after, year after year, maybe we can thank global capitalism for that. But it seems to me that the sudden spike we've seen in the price, it's not sustainable given all those global pressures that first created the deflation.

Krugman: Yeah. A lot of durable goods part of it is just IT, but just in general. Yeah. Goods tended to get not just relatively, but absolutely cheaper over time. And then we have this sudden shortage, difficulties in delivering stuff, but that's among other things, that's the kind of thing we expect markets to fix.

Beckworth: Right.

Krugman: Right. There are really strong incentives and it's happened. It takes time. But the big retailers say that have adequate inventory for the holiday season. The shipping rates have peaked seem to be coming down. Lot of straws in the wind suggesting that a year from now, it will not look at all the way it does right now.

Beckworth: Yeah. What's it's interesting is that many of the people who are big supporters of markets, myself included, but many of my market loving friends are losing their religion on this point I think. They're losing their faith that the markets can solve this issue. At least they've lost sight of that one dimension, which has been interesting to observe. The other thing about durable goods, I guess I would make before we move on is, there's only so many durable goods we can buy. Right. I mean, I can only put so many TVs, exercise equipment couches in my house, at some point I am physically constrained.

Krugman: Well, I'm always suspicious of arguments like that. I mean, it's true, and there's some hints of that out there, but you always want to bear in mind that there are particularly lower income people may not have bought all the stuff that they might have wanted to and we are seeing much bigger wage gains at the bottom. So maybe you may have as big a TV as you could possibly want, but maybe somebody at the 25th percentile of the wage distribution doesn't. So I'm not sure about that one. It's possible, but what I think may happening is that people who are compensating for pandemic restrictions by buying stuff are now getting sick of the stuff they bought.

Beckworth: Yeah.

Krugman: Apparently if you want to buy a used Peloton on Craigslist, it's getting quite cheap.

Beckworth: Very fascinating. I want to provide one decomposition of the CPI number, because it came in really hot, as you know. And you mentioned your article, 6.8% in November, PPI came in almost double digit, but let's look at the CPI and there's an analyst from Moody's name, Ryan Sweet. And he did a decomposition of that number.

Beckworth: And I think it's very instructive to take a look at it. He shows 2.5 percentage points of that 0.8 was energy related and we know that's coming down. He also calculated 1.8% in supply chain constrained industries. And everything we've talked about here, but if you go 6.8 minus 2.5, minus 1.8, the CPI would be at two and a half percent, which is about where you would want the CPI in a relative to the PC. It's always a little bit above a PC target. So it just seems very obvious to me, and again, maybe I'm being wildly optimistic here, but that we are headed in the right direction. All the forces are there.

Krugman: Well, yeah. I mean, I've been looking at people who've been using a consistent set of categories. Now, core inflation was supposed to do that, but it's not because of the peculiar components. But the CEA is doing a consistent measure that tries to exclude pandemic related stuff. Matt Klein has a substack and he's been doing that. And they're all kind of suggesting that there's a lot less happening to underlying inflation than the headline numbers.

Krugman: Now there are some other stuff in there. And actually, I hate the fact that I'm being forced to pay attention to all this high frequency, informal data, not really my specialty, but the rents, Zillow and places like that are showing much bigger rent increases than the CPI is, but that's because the CPI is the rents that people are actually paying whereas these eight rental companies are the rents on newly rented apartments. And so there's probably a fair bit of rent, which is a big component of price measures. There's probably a fair bit of rent inflation still in the pipeline. So I wouldn't be. You don't want to assume that we're going to see instant gratification.

Beckworth: Right.

Krugman: I don't think we're seeing. But on the other hand, look underneath the hood and it does not look like, we don't really have a 7% inflation economy out there.

Beckworth: Yeah. Most of the projections I've seen by different firms I looked closely this including Moody, it says, it's going to come down gradually. It's not going to be suddenly we're at 2%. And Mark Zandi actually spoke to this point about housing. Housing is the big thing that's still going to linger with us as you mentioned. But he says, look, what that's going to do is it's going, maybe take the PCE from 1.6, 1.7 closer to two, will be closer to target. That's his sense of its importance. Is it won't push us way above two, but get us closer to two, given the other disinflationary forces we might see.

Krugman: Yeah. I mean, I wouldn't be shocked if we have a PCE that's still above three by the end of next year. How bad is that? Especially if there's pretty good indications that it is on its way down. And of course that 2% target itself is a pretty weird animal.

Beckworth: Right.

Krugman: Once you start to look into the history of it, it's pretty strange. I mean, of course we could be wrong, but at the moment it just does look like, again, it does not look like 1979.

How Much Should the Fed Squeeze?

Beckworth: Yeah. Well, that's a nice segue into the next part of this conversation and that relates to your article. How hard should the Fed move? How much should it squeeze? And I want to see what your take is of why the three rate hikes this last meeting, December FOMC, why the talk of tapering faster, they even mentioned shrinking the balance sheet that's being discussed now at the FOMC. What does that accomplish in your mind given everything we just talked about that? A lot of this inflation will work itself out. Is this all about preventing the inflationary expectations from taking off? Do you think that's where it is?

Krugman: Yeah. I mean, the taper is. There is a really good question, why is the Fed still buying long term assets? There's a question about why ever do it. I'm not sure. I've never been persuaded that QE actually does anything except signaling. But in any case, I think it makes perfect sense to bring that to an end quickly. The rest I think is, really, these are small numbers. I mean, if it's three normal rate hikes 75 basis points is not... I remember Paul Volcker, this is not the Fed hitting the economy over the head with a sledge hammer. This is, I'm mixing metaphors here, but this is a very gentle tap on the brakes whose purpose is arguably mainly psychological. It's a way of saying again, I'm showing my age, but the elder Bush used to read his stage directions, message I care, message we care, we're aware.

Krugman: We know that inflation is worrying people. So, we're doing this to signal that, yeah, we're aware. We haven't committed ourselves actually, and it’s quite possible that it won't happen, but it's a reasonable thing to say, "Look, if anybody is thinking that this is going to be the Arthur Burns’s Fed, and we're just going to reduce the economy regardless and let inflation run wild – no, we are not those guys.” Not a bad strategy, especially since the concrete impact of the rate hikes that are so far on the table is really just not going to be very big.

We know that inflation is worrying people. So, we're doing this to signal that, yeah, we're aware. We haven't committed ourselves actually, and it’s quite possible that it won't happen, but it's a reasonable thing to say, 'Look, if anybody is thinking that this is going to be the Arthur Burns’s Fed, and we're just going to reduce the economy regardless and let inflation run wild – no, we are not those guys.'

Beckworth: Yeah. That's seems to be the correct take in my view as well. The Fed wants to guarantee that it doesn't add any fuel to the fire. It's going to keep long run expectations anchor than they are. I mean, long run inflation expectations for at least forecasters and markets tell us that. I know households have seen a little bit of an increase, but I think that's the key is it's not so much that they're responding to the actual inflation we're seeing, but it's more about preventing future unhinging and anchoring of inflation.

Krugman: Yeah. It's really notable. Also, if we look at the latest set of forecasts that they do not expect to be causing a recession, that unemployment will continue to fall. So their view is very much that we are tapping on the breaks, but not really in a way that's going to bring this recovery to an end.

Beckworth: Yeah. They have unemployment fall to three and a half percent next year, which is pretty remarkable along with 2.6% PCE inflation. So if that's the world we end up in the next year, then hats off to the Federal Reserve for navigating this storm with amazing deftness. Let's talk about that. So, one of the things is that inflation – what motivated your article – this conversation that inflation has become kind of enemy number one, like Jay Powell had alluded to in his press conference, and it's affecting President Biden's poll numbers, it's affecting a lot of conversations. But I think it's useful to do the counterfactual and say, "Okay, what if we hadn't had the support that we had? What if we had acted on these inflationary concerns very, very aggressively, where would we be?” And we didn't do that and as a result, again, we're back to the dollar size of the economy. We've had a rapid recovery in the labor markets, there's still room to go, but maybe walk us through what you think, the proper counter factual is here.

What if… the US Had More Aggressively Countered Inflation?

Krugman: Okay. I think you want to make a difference between what we did last year and what we did this year. Last year, if we hadn't done what we did, if we hadn't had the really big, the combination of unemployment benefits, business lending checks, although I actually think that the checks were in some ways the least important part, but if we hadn't provided all that economic support, we could have had utter catastrophe.

Krugman: You were taking 20 million jobs lost, business grinding to a halt. If we hadn't largely held people financially harmless, we really could have had an economic implosion on top of everything else. So that was absolutely critical and hard to say anything negative from it. Now we did have a big package early this year. And it's funny, I wouldn't make the case that that package was enormously important in our current economic recovery for the same reason I don't think it was very inflationary. Because I think that was actually a pretty low multiplier fiscal package. There was a lot of aid to state and local governments, but which has mostly not been spent, there were the $1,400 checks, which to an important extent were not spent at least not right away, state and local stock will be spent over time, but that's good, there'll be investment in the end. And there were unemployment benefits which helped a lot.

Krugman: But the main thing that the package did was it actually drastically reduced child poverty, which is a really, not just really good thing in itself, humanitarian, but also as an investment in the future. But I don't think that the macro side of the ARP was all that large. And it's actually kind of, if you look at the debate that Summers and I were having early on, he was saying, this is going to be a huge multiplier. It's going to cause enormous expansion and demand and that's going to cause inflation. And I said, "No, I don't think it'll have much of a multiplier." And the funny thing was, it didn't have much of a multiplier, but we got the inflation anyway, because of these other factors.

Beckworth: That's interesting.

Krugman: I would not give the ARP most of the credit for the really good job numbers, although I think in general, lots of fiscal support was critical in getting us through all of this,. But I'm not sure that the counterfactual. Yeah. I think that the counterfactual, if we hadn't had that package is that we would have a little bit less job creation which would be a bad thing and we'd have a lot more individual financial misery, which would be a really bad thing.

I wouldn't make the case that that package was enormously important in our current economic recovery for the same reason I don't think it was very inflationary. Because I think that was actually a pretty low multiplier fiscal package...But the main thing that the package did was it actually drastically reduced child poverty, which is a really, not just really good thing in itself, humanitarian, but also as an investment in the future.

Beckworth: Okay. Going back to Larry Summers. So you guys have extensive conversations, I was watching one that Markus Brunnermeier hosted. So we got the inflation he said we're going to get, but we got it for different reasons than he said we would get it. Okay.

Krugman: Yeah. And I have to say, look, in the distant past, I've been on the receiving end of the same thing. I mean, lots of people thought I predicted the Asian financial crisis when in fact I predicted problems for Asia that were quite different from the ones that actually happened, that stopped me from getting a lot of undeserved credits. So, all right, it happens.

Beckworth: Yeah. Well, that's been my sense too, is that not so much him, but some others out there who've been very vocal about this are saying, "see, I told you so," and it's not clear to me that they told us so in this particular context.

Krugman: Yeah. And if we're going to be serious about doing economics, we need to be it. Yeah. We do point predictions, but lots of stuff can happen. And we want to ask about, well, but the mechanism did things actually happen the way you said they would. And even if the number, the headline number looks like what you were talking about, if it didn't happen for the reason you said it was, then that needs to be admitted.

Beckworth: Right. We all make conditional forecasts and we need to admit as much when things change. All right. So taking this counterfactual conversation to the next step. Again, going back to 2020, not just 2021, but the world could have been a much worse place. Like you said, widespread bankruptcy, the mother of all financial crisis, keeping nominal income stable, I think was very important to accomplishing that outcome. But what's striking about it, and you mentioned this at the beginning of the show is that it was even possible that there was a political support for it. And I wanted just kind of go back and look at this from the context of the work that you did in 1998, your paper calling, I think for something similar in spirit to what we saw. So maybe remind us of your 1998 paper and does it fit what we saw in 2020?

Krugman: Okay. Now there are different pieces. And then in a way my 1998 paper was really, didn't talk much about fiscal policy, which I now have changed my views on that a little bit, mostly out of political economy reasons, right. I thought that I was all for very aggressive monetary policy and raising inflation targets and eventually I still think that the logic of that was right, but the politics of it turned out to be much harder than I realized and fiscal policy turns out to be much more doable than I realized, although still problematic.

Krugman: But there were a couple of big messages from the '98 paper, which was, I do think the best thing I ever wrote. One of them was that when interest rates are very low, do not worry about the money supply, do not worry about inflationary impacts from monetary expansion. Also I really do not worry about the central bank's balance sheet because the money multiplier is a really useless concept once you're in a situation like that, where banks will mostly just add monetary base to their reserves.

Krugman: And the kind of implied point was in a very low interest rate world. Also, don't worry much about public debt and that's something first that I got into a lot more after the 2008 crisis. And we somehow ended up taking on those lessons. The Fed was uninhibited about going ahead and vastly expanding its balance sheet to save the financial markets. The Federal Government was remarkably willing to spend a lot of money on helping people in a time of need without worrying about what the debt number looked like. So we got this hugely aggressive and relative considering the scale of the climate is hugely successful policy response.

Beckworth: Yeah. Now I know some will push back against this interpretation, they'll say, "Well, but David, this is a supply shock recession." But one takeaway away, one lesson I've learned from the past two years is that it's really hard to disentangle a pure supply shock from the other side of the economy. And there were a number of papers that were done and I've been running, and even Michael Woodford had a paper out on how, when you have something big like this, that has these ripple effects that ultimately generate distinct and separate, aggregate demand shortfalls as well. So it is important for the government to provide some support.

Krugman: If the government hadn't been in there providing support, first of all, if the Fed hadn't been in there, we were really on the edge of a sort of souped up version of what happened after we even fell with COVID. Suddenly nobody knew which businesses were solvent. Nobody knew and financial markets froze up. We could have had a financial multiplier effect in which a supply shock turned into a catastrophic demand shock.

Krugman: And then a lot of people suddenly lost all of their normal income, their marked income, and if they had been forced to slash their consumption, we would've had a conventional demand shock on top of that. This could easily have propagated into something much worse. So, yeah. We did the right thing. And on the whole, when all is said and done that we did not have the people selling apples on street corners despite this massive dislocation, and that was good policy.

Beckworth: Yeah. And again, that's the kind of the counterfactual I want more people to think about is where we could have been compared to where we are and the trade offs involved in that. But it is remarkable to me though, that this willingness to do what was done and again, going forward we don't expect it to be repeated every year, but just during this crisis, it was done and in a way that's long run sustainable. Stepping back, you have your work, you have your colleagues at Princeton, my colleague now, Scott Sumner wrote a paper titled, The Princeton School of Macroeconomics, which was you, Ben Bernanke, Michael Woodford, Lars Benson, I guess Scotty Hubbard, somebody thrown in there as well. And he makes the point that everything you guys wrote about finally came to fruition 20 years later when the Fed adopted this new framework, as well as the response we saw from the Federal Government, is that you think a reasonable interpretation of history.

If the government hadn't been in there providing support, first of all, if the Fed hadn't been in there...We could have had a financial multiplier effect in which a supply shock turned into a catastrophic demand shock. And then a lot of people suddenly lost all of their normal income, their marked income, and if they had been forced to slash their consumption, we would've had a conventional demand shock on top of that. This could easily have propagated into something much worse. So, yeah. We did the right thing.

Krugman: Yeah. I mean, in slightly different mechanisms. I mean, the Fed actually is serious and they read stuff and they talk to academic economists and they do a lot of research on their own. So the Fed was clearly, they learned a lot from all of this stuff. The Federal Government response was a little funnier because there is part of the political system does listen. I mean, if you actually ask about some members of Congress and the Senate really do, are in touch with, and are communicating with, and have paid attention to this, but it's only half the political spectrum. And if we ask the question, how was it that with the Republican president, we managed to get this massive fiscal response. And I think the answer is that actually half the political spectrum was simply clueless.

Krugman: They had absolutely no idea how to deal with this. This was not part of their mental universe. The idea crises that just came from nowhere were not something they were sort of like, "Now what?" And on the other side, you did have people, I mean, we asked how do we get those generous unemployment benefits, his largely Senator Ron Wyden, who definitely is in touch with this stuff. And it was basically the one side had reasonably clear ideas that were directly or indirectly influenced by academic research. And the other side was just sort of, help somebody give us some, the old British show, Yes Minister, as the, we must do something. This is something, therefore we must do it. That's kind of what happened in 2000. And it worked out fine, but I don't expect it to be a, that's not a mechanism you want to count on it in the future.

Beckworth: Yeah. So that's one of the things I wonder about is moving forward, will we be able to replicate what we did in 2020? And when I say replicate, what we did, I want to think this more generally, I would call this policy mix a form of level targeting. So fiscal and monetary work together to keep the level of the economy on its trajectory. Do you think going forward, this is something we will continue to do, will we look from this lesson? Will it be internalized? Will it be able to be replicated, I guess, in future crisis?

Have Policymakers Internalized the Economic Lessons from COVID-19?

Krugman: Well, it's going to depend a lot on who's in charge, obviously. And that's going to vary, I mean, it's not just the United States. I actually think that Europe as moved substantially in this direction. We actually have the European Central Bank now talks like the Fed. It's a very different from the way it used to be. The Bank of England despite they just had high rates, but they are also written in the same universe.

Krugman: Some overseas governments depends a lot, but even the Germans are sounding almost reasonable these days. Here, you tell me, who is going to be running things in the United States in 2025. And I mean, as it turns out that Steve Mnuchin was a pretty reasonable guy on macro policy, which I don't think would've been anybody's forecast, but it's also unlikely if it's the Republican administration, that will get anybody that reasonable at treasury. So we don't really want to talk about politics here, but it depends a lot. But if-

Beckworth: Yeah. For sure.

Krugman: If we're going to have a Powell or a Powell / Brainard Fed a few years from now, or people like that, and if we're going to have people like Janet Yellen running treasury and making policy, then yeah, we will get this. I mean, we have at this point a country of economic policy makers who have moved a long way from the kind of hard line inflation is always. Get price stability and everything else will fall in place, view of the world.

Beckworth: Yeah. I'm hopeful too that instead we'll have, you know where I'm going to go with this. We have a world full of young, up and coming policy makers who want to see nominal GDP stability going forward. Some policy mix that will lead to that outcome. Let me go back to an observation you raised at the beginning of the show is when you're the end of the program. And that is, you mentioned, you thought we might be back or will be back in kind of a secular stagnation world once we get to the other side of the pandemic, did I hear that correctly? Is that your-

Krugman: Yes.

Beckworth: So why do you say that? What gives you reason to believe that will be the case?

Krugman: Okay. There's some conflicting as always there's academic research that can disagree, but I think secular stagnation is mainly a demographic story.

Beckworth: Okay.

Krugman: That when all of a sudden down low fertility rates in the advanced world, and actually now in China as well, which mean stagnant or falling age population just create a world of weak investment demand. And there's a reason that Japan in the '90s was a dress rehearsal for all the rest of us, because they entered this world of demographic slow down before the rest of us. And then there's an uncertainty factor which is technology, and you can hope that we will have faster technological progress than we've had in recent years. And that it'll be the kind of technological progress that drives investment demand. But I would say that, that's possible and certainly not something to count on.

Japan is already at age dependency ratios that we won't be at for decades, we don't think. And if there was going to be an inflationary surge as retirees start spending down their children's inheritance, it hasn't happened there yet. So I don't see it. Thing is I think that part of the problem here, I think people think too much in terms of consumers spending and saving, which is not irrelevant, but the really big mover here is investment. And if your working age population is shrinking, then you don't need to build a lot of houses, you don't need to build a lot of office buildings. So that's where the main action is. And I think the demography is still the huge driver here.

Krugman: So most these demography I just, and if anything, the demographic thing has gotten, I'm about to say worse, but there's nothing necessarily wrong with having zero population growth provided that you have policies that let you maintain full employment despite it, but we are looking at a fertility is still going down, immigration is down. So all of the things that boosted us out of the possibility of secular stagnation in the past, all have gone away. All of the things that made Alvin Hansen wrong in 1938, he was basically talking demography and he was wrong largely because of the baby boom. Well, now we're in the world that Alvin Hansen envisions 85 years ago. And I think that's what has to be baseline case.

Beckworth: So Paul, you're expecting a world where return to low rates, which I think also means continued demand for safe assets like U.S. government debt. And again, looking into Japan. Japan has a really large amount of debt of GDP yet they still have low inflation, they have demographics. The one pushback that I get, I share this few too about demographics is, comes from the kind of the Charles Goodheart view that demographics actually are going to push inflation in the other direction. But to me, the best evidence against that is Japan. It would've happened in Japan already if that were the case.

Krugman: Yeah. I mean, Japan is already at age dependency ratios that we won't be at for decades, we don't think. And if there was going to be an inflationary surge as retirees start spending down their children's inheritance, it hasn't happened there yet. So I don't see it. Thing is I think that part of the problem here, I think people think too much in terms of consumers spending and saving, which is not irrelevant, but the really big mover here is investment. And if your working age population is shrinking, then you don't need to build a lot of houses, you don't need to build a lot of office buildings. So that's where the main action is. And I think the demography is still the huge driver here.

Beckworth: Yeah. It seems like it is. I mean, if China is having the same challenge that we've had and we are having the same challenge that Japan has had, this will be with us for some time. Well, with that our time is up. Our guest today has been Paul Krugman. Paul, thank you for coming back on the show.

Krugman: Thank you. Take care.

Photo by Daniel Slim via Getty Images

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.