17 Nov 2008

Paul Krugman Makes Sure We Understand How Crazy He Is

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It is really amazing to see how glib Paul Krugman can be about his insane recommendations. (HT2MR) I can’t take this apart right now; it surely deserves its own Mises.org article. For now, let us just read it and “enjoy”:

It’s a curious thing that even now, when we are clearly in a liquidity trap, we still have a lot of economists denying that such a thing is possible. The argument seems to go like this: creating inflation is easy — birds do it, bees do it, Zimbabwe does it. So it can’t really be a problem for competent countries like Japan or the United States.

This misses a key point that I and others tried to make for Japan in the 90s and are trying to make again now: creating inflation is easy if you’re an irresponsible country. It may not be easy at all if you aren’t.

A decade ago, when I tried to make sense of Japan’s predicament, I used a simple, unrealistic model to ask what we really know about the relationship between the money supply and the price level. We normally say that an increase in the money supply, other things equal, leads to an equal proportional increase in the price level: double M and you double the CPI. But that’s not actually right. What a model with all the i’s dotted and t’s crossed actually says is that the CPI doubles if you double the current money supply and all future expected money supplies.

And how do you do that? No matter how much Japan increases the monetary base now, expectations of future money supplies won’t move if people believe that the Bank of Japan will move to stabilize the price level as soon as the economy recovers. And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.

Zimbabwe wouldn’t have this problem: people believe that any money it prints will stay in circulation. But the likes of Japan, or the United States, print money for policy purposes, not to pay their bills. And that, perversely, is what makes them vulnerable to a liquidity trap. Back in 1998 I argued that the Bank of Japan needed to find a way to “credibly promise to be irresponsible.” That didn’t go down too well, but it was what sober, careful economic analysis prescribed.

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

BTW, if you are a supergeek, here is Krugman’s more formal exposition on the liquidity trap. I have to read this in preparation for an article on all this stuff. (I can hear Drago saying to Rocky, “I must break you.”)

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