Krugman has made such a strategic error in his advocacy for monetary inflation that even his teammates had to rebuke him. But first some context: “Potential GDP” is a mainstream economics concept referring to the maximum sustainable level of (real) GDP. In the standard New Keynesian paradigm, if actual (real) GDP is above potential, you get accelerating price and wage inflation. Printing more money doesn’t do anything, except cause prices to rise more quickly. On the other hand, if actual GDP is below potential, then there is “slack” in the economy; boosting aggregate demand (through monetary and/or fiscal stimulus) will put people back to work and increase real output, without causing a significant rise in prices.
(#1)==> Now, over the last several years, various opponents of further Fed stimulus have been arguing that there is “structural” unemployment in the economy; further rounds of QE won’t lower the unemployment rate, since (say) there is a growing mismatch between idle workers’ skills and the type of job openings in the new global economy. Not surprisingly, Krugman has dismissed such pontifications as “humbug”–as recently as this August. Since there was no structural change to speak of, it proved that Krugman has been right all along in recommending more aggressive stimulus.
(#2)==> More generally, Brad DeLong and Paul Krugman have both argued that potential GDP today, is not significantly lower than what it would have been, had the Great Recession never struck. Readers may remember that in late August I had the temerity to question DeLong’s reasoning at the time. In response, Krugman sided with DeLong–agreeing that potential GDP today was not much lower than it would have been on the 2007 trajectory–and pointed out that the CBO took into account the lower pace of investment since 2008 (the specific issue I had raised). In the comments at Daniel Kuehn’s blog, DeLong called me a “clown” and said I needed to quit my job as an economist, since even rudimentary calculations showed that potential GDP right now was about 1% lower than its 2007 trajectory. DeLong further explained that if potential GDP today were, say, 5% lower, then that would indeed be something. (I tried to defend my honor by saying that the CBO showed potential GDP was about 3.6% below trend, but that’s just the sort of stupid thing a clown would say, isn’t it?)
Since potential GDP was not materially lower than the pre-recession trajectory, Krugman and DeLong were once again vindicated: We should heed their advice for more aggressive monetary and fiscal stimulus.
(#3)==> Last week, while attending an IMF research conference, Krugman wrote an op ed in which he discussed the “blockbuster paper of the conference” (his actual description of it). Here’s some of what Krugman had to say about that blockbuster paper:
[T]he authors — one of whom is the Federal Reserve Board’s director of research and statistics, so we’re not talking about obscure academics — put a number to these effects, and it’s terrifying. They suggest that economic weakness has already reduced America’s economic potential by around 7 percent, which means that it makes us poorer to the tune of more than $1 trillion a year. And we’re not talking about just one year’s losses, we’re talking about long-term damage: $1 trillion a year for multiple years.
That estimate is the end product of some complex data-crunching, and you can quibble with the details. Hey, maybe we’re only losing $800 billion a year. [Bold added.]
The part I put in bold was to emphasize (a) their estimate is for the drop in potential GDP that has already occurred, and (b) Krugman quibbled with their estimate and thought hey, maybe it’s only a 5.6% drop in potential GDP. (If a 7% drop is $1 trillion in output, then a 5.6% drop is $800 billion in output.)
Naturally, Krugman concluded that since the economic slump has already eroded potential GDP by anywhere from 5.6% to 7%, it’s evidence that we need to increase public (government) spending.
(Also, for those purists keeping score, I note that 5.6%, let alone 7%, are greater than DeLong’s threshold of 5%. But again, this is a clownish point, so I’ll move on.)
(#4)==> At that same IMF conference, Christina Romer and others apparently pointed out to Krugman that he had stepped in it, and just conceded the whole case to the austerians. Krugman realized the potential problem, and so clarified: We don’t know if that blockbuster paper is right in claiming that the drop in potential GDP is here already; for all we know, the damage has yet to be done. So by all means, put the pedal to the medal: We need more aggressive monetary and fiscal stimulus.
(#5)==> And so we see that whether potential GDP is relatively on trajectory, materially below, or on the verge of falling, the conclusion is always the same: It is evidence that we need aggressive monetary and fiscal stimulus. Also, be sure to watch out for ideologues like me, who invent rationales for my preferred policy prescription, no matter what the data say. You need to stick with objective scientists like DeLong and Krugman, who follow the evidence no matter where it may lead.