Many of Paul Krugman’s essays deal with the need to combat economic recession by basing public policy on sound economic ideas. Here is where the zombie ideas that “should have been killed by contrary evidence” do the most mischief. Occasionally his arguments get a little technical, but overall he does a good job of explaining his ideas in pretty plain English, and he puts warning labels on his more “wonkish” essays. One essay—his discussion of the determinants of interest rates—sent me scurrying to his macroeconomics textbook for a more thorough explanation.
Interest rates and monetary policy
The most technical essay in the collection describes the “IS-LM” economic model, where IS stands for the relationship between investment and savings, and LM stands for the relationship between liquidity preference and money supply. It is a macroeconomic model describing relationships among some of the most important variables in the economy.
In Krugman’s formulation, the IS-LM model is a way of reconciling two different views of how interest rates are determined. Interest rates are, of course, crucial to the workings of a capitalist economy because interest is the price of financial capital. Businesses pay interest when they borrow money to finance business expansion, and so do consumers when they finance major expenditures. Both views of interest rates rest on the laws of supply and demand as applied to money. We start with the idea that the price of anything varies directly with the quantity demanded and inversely with the quantity demanded. Low prices increase the quantity demanded and discourage the quantity supplied, while high prices do the opposite. In theory, the price mechanism brings supply and demand into balance, making transactions acceptable to both parties.
How does this apply to the interest rate, which is the price of money? The two approaches focus on different forms of money. The first view of how interest rates are determined is the “loanable funds” approach. It says that interest rates are determined by the supply of savings and the demand to use those savings for investment spending. The interest rate has to balance the desire of savers to earn a high return against the desire of borrowers to obtain funds at a reasonable cost. In this context, think of the borrower as a company borrowing to finance business expansion.
The second view of how interest rates are determined is the “liquidity preference” approach. It focuses on the supply and demand of “money”, meaning liquid forms of money like the cash in your wallet or your checking account, which is earning little or no interest. Here we have something of a riddle. How can the interest rate be the price of money for money that earns no interest? In this case, the interest rate is the opportunity cost of money, the price you pay for keeping money in cash instead of loaning it out at interest. The higher the interest rate, the higher the cost of liquidity and the lower the demand for liquidity. In this approach, the supply of money is a simpler concept, since it is just the money placed in circulation by the central bank, which controls the national money supply. The balancing of supply and demand in the money market is not just a matter of reconciling the wishes of buyers and sellers, or of lenders and borrowers. It is a matter of reconciling the conflicting desires of anyone with income—the desire for both money to spend and money to lend. Too much liquidity and spending, and interest rates must rise to attract more money into lending. When the desire to save and lend is very high, interest rates can fall, bringing down the opportunity cost of liquidity.
Can the two approaches be reconciled? Yes, because interest rates balance supply and demand in both the loanable funds market and the money market, the two being interconnected. Suppose the Federal Reserve deliberately increases the money supply—we won’t worry about exactly how—in order to stimulate the economy. That lowers interest rates, encouraging businesses to borrow for expansion. That in turn increases production and national income, which increases the supply of loanable funds when people save some of the increased income. Krugman’s Macroeconomics (with co-author Robin Wells) says, “As a result, the new equilibrium rate in the loanable funds market matches the new equilibrium interest rate in the money market….” The two approaches are focusing on different sides of one adjustment process.
To return to Arguing with Zombies, The IS-LM model synthesizes both approaches by relating both markets to the Gross Domestic Product. The balancing of investment and savings in the loanable funds market implies a negative (inverse) relationship between interest rates and GDP. Low interest rates encourage businesses to borrow for investment, and investment spending contributes to GDP. This can also be looked at the other way around, since high GDP means high incomes, and high incomes provide the supply of savings for investment, which holds interest rates down. This negative relationship between interest rate and GDP is described by the downwardly-sloping IS curve on a graph plotting interest rate on the vertical axis and GDP on the horizontal axis.
However, the balancing of supply and demand in the money market implies a positive (direct) relationship between interest rate and GDP. A growing economy with higher GDP increases the demand for money to spend rather than save, especially if wages and prices are rising. That tends to push interest rates up. That is represented graphically by an upwardly-sloping LM curve, based on the dynamics of liquidity preference and money supply. Put the IS and LM curves on the same graph, and “the point where the curves cross determines both G.D.P. and the interest rate, and at that point both loanable funds and liquidity preferences are valid.”
The IS-LM model is useful for understanding the effects of monetary policy. If the Federal Reserve increases the money supply, that tends to reduce interest rates, stimulating the economy by encouraging borrowing for investment. As long as prices are “sticky”—that is, they react slowly to the increased spending—the IS effect can predominate, and the economy can move to a new equilibrium at higher GDP. But when and if prices rise, the increasing demand for money may force interest rates back up (and eventually GDP back down). Monetary policy can have a stimulating effect, but mostly in the short run.
The analysis does get very technical, but it’s important because it supports some of Krugman’s main conclusions. One is that more than one relatively stable point of equilibrium is possible. Another is that a particular equilibrium does not always represent the most desirable state of affairs, such as full employment with inflation under control. Nations can and do make political choices that affect economic outcomes, for better or for worse. An economy can remain in a less than ideal state for a long time, if the wrong political choices are made.
When an economy is in recession, most economists support an expansionary monetary policy, and some advocate it to the exclusion of fiscal policy (deficit spending by government). However, Krugman emphasizes the limitations of monetary policy in his many discussions of the 2007-2009 recession and the economy’s long recovery. For one thing, the benefits of monetary policy tend to be short-term, easily undone by longer-term rebalancing, as described above. And monetary policy becomes ineffective or even counterproductive once interest rates fall to near zero, as they did during the 1930s, after the 2008 financial crisis, and again in 2020. Then the economy may fall into a “liquidity trap,” where people are hoarding cash because they have no financial incentive to lend. If things reach that point, it’s a sign that economic demand is really depressed. Companies are reluctant to borrow for expansion not because interest rates are too high, but because they don’t see a good market for more of their product. What the economy needs is not looser monetary policy, but aggressive fiscal policy—especially more government spending.
Many people, including many political leaders, make the mistake of describing an economy as if it were an individual household, always benefiting from spending no more than it receives in income. Statements like, “People are having to tighten their belts, so the government should tighten its belt too” epitomize that kind of thinking. But in the economy as a whole, everyone cannot run a budget surplus at once; my surplus is someone else’s deficit, and my spending provides someone else’s income. If everyone tries to cut spending at the same time, they just reduce overall production and income. Government is a big player in the economy, and it can help the economy by increasing spending when others are cutting theirs.
Economists have found relationships between GDP, unemployment, and government fiscal policy. Okun’s law states that unemployment varies inversely with GDP. A reasonable rule of thumb is that GDP must go up at least 2% to reduce unemployment by 1%. In our $21 trillion economy—I am updating the number from Krugman’s book—that would mean increasing GDP by $420 billion for each 1% desired drop in unemployment. Fortunately, government spending has a multiplier effect, which Mark Zandi has estimated at 1.5. That means that a mere $280 billion increase in spending should increase GDP by $420 billion and reduce unemployment by 1%.
What about tax cuts? Estimates of their stimulus effects vary, but most estimates put the multiplier at no more than 1.0. In general, a tax cut will stimulate the economy less than a spending increase of the same size, especially if it puts more money into the hands of people who are sitting on cash already. Krugman argues that the Obama stimulus package was less effective than it could have been because it relied too much on tax cuts in order to win conservative votes. It was an economic success anyway, reversing the downslide and saving millions of jobs. Yet Republicans turned it into a political liability for Democrats by declaring it a failure and blaming it for the sluggishness of the economic recovery. That set the stage for Donald Trump, who described the economy as a disaster and proposed even more tax cuts as the solution.
As I noted in the last post, Krugman calls the Trump tax cuts “the biggest tax scam in history.” He says that the “core of the bill is a huge redistribution of income from lower- and middle-income families to corporations and business owners.” He sees it as a continuation of standard Republican policy of cutting taxes mainly for the rich, and then using the fear of excessive government debt as an excuse to cut spending on the social safety net. But more to the point of fiscal policy, he describes the Trump tax cut as a “fizzle” because it didn’t produce the promised boom in investment. Corporations did not use very much of their tax cut to add jobs and productive capacity. What was holding them back was not a shortage of capital, but a lack of market demand for their products.
Krugman wrote the essays in this book before President Biden proposed his $1.9 trillion Covid Relief plan. He has written about it elsewhere, however, such as here. If the estimate based on Okun’s law is at all correct, and it takes only a $280 billion stimulus to reduce unemployment by 1%, we can understand why some economists regard $1.9 trillion as stimulus overkill. Unemployment is currently around 6%, and economists doubt that we can get it down below a “natural” level of 4 or 5% without risking runaway inflation. Krugman acknowledges the “good-faith criticism coming from people who actually have some idea what they are talking about, as opposed to the cynical, know-nothing obstructionism that has become the Republican norm.” Nevertheless, he defends the plan, for two reasons. First, he compares it to fighting a war, when a country just has to spend what it takes now, and worry about the costs later. World War II spending brought us high taxes and inflation, but it also won the war, ended the Depression, and sparked the postwar economic boom. Second, he thinks that the plan’s price tag may exaggerate its actual stimulus, since a lot of the cash benefits will probably be saved by households and state or local governments rather than spent or invested.
The price of debt
How much of a problem are budget deficits and the rising national debt for the future economy? Krugman steers a middle course between minimizing and exaggerating their effects. He reserves some of his harshest criticism for politicians who do both, minimizing their own deficits and attacking those incurred by the other party.
First, the good news. The rate of interest on government debt is normally lower than the growth rate of the economy. That means that even if debt is rising in absolute dollar terms, it can shrink as a percentage of GDP. If the government runs a deficit when interest rates are especially low, and if deficit spending stimulates economic growth, the country can come out ahead. This is exactly what happened to the debt accumulated by the end of World War II. “When and how did we pay it off? The answer is that we never did. Yet…despite rising dollar debt, by 1970 growth and inflation had reduced the debt to an easily handled share of G.D.P.” Krugman calls this “melting the snowball.”
Some economists warn that deficit spending can undermine growth by raising consumption but lowering investment. All that government borrowing siphons off resources that could have been used for private investment. But that argument is least relevant in times of recession, when companies aren’t investing enough anyway, and a boost in consumption is what the economy needs to get it moving. When the economy is running at full capacity, government has to be more careful about borrowing too much.
Krugman acknowledges that debt can become too large under unusual circumstances. He uses an example where the national debt is 300 percent of GDP, and the interest rate is 1.5 percent above the economic growth rate. Then in order to keep the debt-to-GDP ratio from spiraling out of control, the government would have to run an annual surplus of at least 4.5 percent of GDP. That would require politically difficult tax increases or benefit cuts. Right now the debt-to-GDP ratio is about 130% of GDP. Reinhart and Rogoff argued that anything over 90% is a big problem, but other economists have been unable to verify that conclusion.
Finally, Krugman distinguishes among different kinds of expenditures proposed by progressives. First are expenditures that can truly be regarded as public investments, such as infrastructure improvements. He is least worried about paying for them because they should boost future productivity enough to pay for themselves in economic growth and higher tax revenues. “If you can raise funds cheaply and apply them to high-return projects, you should go ahead and borrow.” His second category includes projects where “the sums are small enough that the revenue involved could be raised by fairly narrow-gauge taxes,” like the taxes imposed to pay for Obamacare. These too are easily justified as fiscally responsible. His third category is a “major system overhaul,” such as replacing all private health insurance with Medicare. That type of expenditure could not be undertaken without convincing the public that the gains in universal access and efficiency are worth the additional taxes.
Notice that Biden’s infrastructure proposal, although very costly, falls into Krugman’s first category, the kind of expenditure we shouldn’t worry about paying for. But Biden does propose to pay for it, by reversing some of the tax cuts on corporations and the wealthy. No doubt, opponents will try to argue that such tax increases hurt the economy more than infrastructure spending helps it, but they will not have the evidence on their side. Krugman is especially upset that we have let infrastructure spending fall to historically low levels, when it is one of the best investments a society can make.