Thursday, September 29, 2011

The 'Old Keynesian' deceit, the crisis & Europe

Paul Krugman, on Ireland. "And I have, of course, written repeatedly — both informally and in actual papers with diagrams and Greek letters — that in a deleveraging, liquidity-trap economy, wage reductions would reduce, not increase, employment "

Paul Krugman, on Ireland. "Look, standard Keynesian models, open-economy version, tell a very clear story about what happens when a country pegs its exchange rate at a level that leaves its industry uncompetitive. The country doesn’t stay depressed forever: high unemployment leads to actual or at least relative deflation, which gradually improves cost-competitiveness, which leads to rising net exports and gradual expansion. In the long run, full employment is restored; it’s just that in the long run we’re all, well, you get the picture"

So Professor, which is it? Does deflation reduce employment or increase employment? I know, I know. Reduce in the short run, increase in the long run. The challenge, is to tell us when the short run transforms into the long run in a deflationary economy without a change in the macroeconomic policy regime. When does the inflection point occur? What causes it?

The biggest empirical challenge to the Keynesian (ala Hicks, Tobin, Krugman) theories of the business cycle is not stagflation, as was earlier presumed. It is the paucity of the deflationary wage-price death spirals of the kind that you may expect or predict from these theories. Hyperinflations and sovereign defaults are much more common.

And if I understand my IS-LM (and I think I do), 'deleveraging' is not part of it. IS-LM is a plausible theory of the price of debt (of a very ideal, 'no credit risk' kind) , but it does not even begin to touch the level of debt, esp. risky debt. Among the many intellectual conceits of the Krugman/ De Long band in the past two years has been to casually add 'deleveraging' to the more standard terms of 'liquidity trap' and 'deflation'. I have nothing against adding to your intellectual repertoire. Indeed, it is the only way to approach anything even remotely complex. But to speak of deleveraging as if it has been part of their intellectual framework all along is just cheating.

For the past couple of years, the old macroeconomic camps and opponents have been mostly heat and very little light, with everyone either dropping their heads or dropping their pants. Initially, the finance and banking experts (Raghuram Rajan, Gary Gorton) were the ones to turn to. But now that the focus is back on the broader macroeconomy, I find it most edifying to turn to Ricardo Caballero & Ken Rogoff.

Among the bloggers, Scott Sumner remains the most consistently interesting, policy recommendation-wise. And the recently created David Glasner blog is just a goldmine. (Incidentally, has anybody else noticed that the RBI seems to be living a Sumnerian dream, by design or by default? India's annual NGDP growth for the past 4 odd years has consistently been stable in the whereabouts of 16-17%. 6% inflation, 10% growth ; 10% inflation 7% growth, etc.)

But the most radically simple and brilliant policy recommendation for 'balance-sheet-weakness-inducing-deficient-demand' type recessions has to be the modified 'helicopter drop' proposed by Steve Waldman here. He talks about the Fed, but there is nothing in that recommendation that can't be replicated elsewhere in the world. Or at least in India, should we need to.

The presumption, of course, is that there isn't a looming sovereign debt crisis. And that there is monetary independence. And enough fiscal consolidation to ensure that there is treasury's blessing for the central bank to undertake a quasi-fiscal action. Europe, therefore, is as a nice gentleman told me recently, quite 'shafted'.


W. Peden said...

I've been enjoying many of your blog posts for some time. I notice we also read many of the same economics blogs (though I hadn't read Steve Waldman- thanks!).

On deflationary debt spirals in Keynesian theory: is there a secondary source that gives a good summary of this concept's history? Or are there any primary sources that you would recommend e.g. Samuelson, Tobin etc.?

zen babu said...

Thank you for the kind words!

I don't think the core of mainstream Keynesian theory looks at debt deflation. In fact I doubt if any of the post Keynesians also look at it either, except for Steve Keen.

By the way, your link love over at The Money Illusion always leads to spikes in my blog counter!

W. Peden said...

zen babu,

I'm much too generous to keep a blog like this to myself.

I'll definitely have a look at Steve Keen at some point; thanks!