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.
Interest rates and monetary policy
The most technical essay in the collection describes the “IS-LM” economic model, where IS stands for investment-savings and LM stands for liquidity-money. 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.
The first view of how interest rates are determined is the “loanable funds” approach. It says that interest rates are determined by the supply and demand of savings. The demand for loans by businesses and other borrowers tends to push interest rates up, just as the demand for any commodity tends to push up its price. The supply of money to lend by people with savings tends to hold interest rates down. The market strikes a balance between the two with interest as the pricing mechanism, just as buyers and sellers do when they negotiate a price.
The second view of how interest rates are determined is the “liquidity preference” approach. It takes into account another variable, the degree to which savers prefer to keep their savings in cash, despite its earning little or no interest, rather than buying interest-earning bonds. Liquidity is valuable to people who expect to spend their money in the near future. Interest rates on bonds have to be high enough to overcome this liquidity preference.
Can the two approaches be reconciled? Yes, because both the supply and demand of savings and the liquidity preference are related to the Gross Domestic Product. In theory, there is a level of GDP at which both approaches converge on the same interest rate. This is an equilibrium point where everything balances. From the standpoint of the loanable funds approach, GDP should vary inversely with interest rates. When GDP is high, so is national income, which increases the supply of savings available for investment and holds interest rates down. But from the standpoint of liquidity preference, GDP should vary directly with interest rates. A booming economy means that people are spending their money and therefore keeping a lot of it liquid rather than tying it up in long-term investments. Interest rates must be high enough to overcome that liquidity preference and reward those who do invest. There should be an equilibrium point for GDP where the inverse and direct effects offset and everything is in balance. Interest rates are both low enough to make loans affordable for borrowers and high enough to overcome the liquidity preference of lenders.
Graphically, the model is represented by two curves relating GDP and interest rates. The downwardly sloping IS curve describes the inverse relationship between GDP and interest rates. The upwardly sloping LM curve describes the direct relationship between the same two variables. “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.”
This model does not claim that the equilibrium point always represents a desirable state of affairs, such as full employment. Nations can and do make political choices that affect economic outcomes, for better or for worse. When an economy is in recession, a form of government action that most economists support is for the central bank to expand the money supply and keep interest rates low, making it easier for businesses to finance expanded production.
However, Krugman emphasizes the limitations of monetary policy in his many discussions of the 2007-2009 recession and the economy’s long recovery. Monetary policy becomes ineffective or even counterproductive once interest rates fall to near zero, as they did then and have done again recently. At that point, 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. The economy has too much idle cash that is being neither spent nor productively invested. 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 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, that 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 3 or 4%, even during an economic expansion. 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 attack deficits only when they are created by the opposing party’s administration.
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 debts 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.
To be continued