Keynesian monetary policy needs bubbles to 'work'

By , Guest blogger

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    Paul Krugman on 'Meet the Press' on March 6, 2005 before he won the Nobel economics prize.
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If someone told you that he planned to buy a lot of fat food because he thinks they taste so good and he wants to experience those positive taste sensations, yet he wasn't going to actually eat them because he wants to avoid the weight gains associated with it, wouldn't you believe that he was delusional?

Yet an equivalent delusion can be found in Paul Krugman's writings about monetary policy and asset bubbles. In his latest post, he comments on his old call for bubbles. Let's start by reiterating what Krugman wrote then.

"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

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Krugman now claims that he wasn't advocating a bubble, he was simply neutrally stating the alleged fact that in order to end the recession, a new bubble was needed.

"If you read it in context, you’ll see that I wasn’t calling for a bubble — I was talking about the limits to the Fed’s powers, saying that the only way Greenspan could achieve recovery would be if he were able to create a new bubble, which is NOT the same thing as saying that this was a good idea. Of course, I know that this explanation won’t keep the haters from pulling up the same quote out of context, over and over."

I have read that whole article repeatedly, yet I can't find anything in the rest of it (you can try to find it yourself here) which provides a different context from what is in the above 2002 paragraph. Still, his explanation might have been plausible if Krugman had been a well-known "liquidationist" Austrian. But of course, we all know he isn't, and we all know that he instead advocates the use of government actions to close the "output gap" as soon as possible, at basically all costs. Indeed, in the next paragraph in his latest post, he writes this:

"But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance. You can disagree if you like, but that doesn’t make me someone who deliberately sought a bubble."

So let's restate what Krugman argued:

1) He argued that the only way to end the recession or in other words to "not sacrifice output and employment" was to create a bubble.

2) He argues that he believed and still believe that it would be wrong to "not sacrifice output and employment".

3) Yet he still claims that he didn't endorse a bubble.

You simply can't believe in all of these things at once. You can believe in 1) and 3) at the same time if you at the same time didn't believe in 2), and you can believe in 1) and 2) at the same time as long as you don't endorse 3) and you can believe in 2) and 3) at the same time as long as you don't endorse 1). But you simply can't believe that in the absence of a bubble we would "sacrifice output and employment", argue that it is wrong to "sacrifice output and employment" and still argue that you're not for a bubble.

But aside from Krugman specifically wrote about bubbles in 2002, his current argument that you can use interest rate policy to revive an economy without creating bubbles reveals a lack of understanding (or perhaps honesty) about how a Keynesian monetary policy temporarily boosts an economy.

By lowering interest rates, a Keynesian central banker wants people to borrow money and start spending. If they don't do that for whatever reason, then monetary policy will have no effect on the economy. Thus, a necessary (but not sufficient) condition for Keynesian monetary policy to work is if it causes credit expansion (or possibly lower savings). Yet an expansion based on central bank inflation is an expansion based on an unsustainable factor, meaning in short that it is creating a bubble in the parts of the economy where the newly created money is spent. Thus, in order to work Keynesian monetary policy needs bubbles (not necessarily big ones, but it needs to be some form of bubble(s)).

Suppose then however, we got Krugman's current stated wish of "better regulation to curb bubbles". Assuming they were effective, this means that monetary policy would also become less effective, meaning that the regulations would "sacrifice output and employment".

There is really no escape: either you get a bubble type boom with a temporary boost to some forms of output and employment-or you don't get it. If you get it, it might shorten a recession but create a bubble which will create future problems. If you don't get it you will avoid bubbles, but you won't get the temporary boom in some sectors that Keynesian monetary policy is aimed at achieving. The view of Krugman and other Keynesian that we need Keynesian monetary policy to create a temporary boom and regulation to prevent bubbles is as confused like the view of the guy that bought fat food to enjoy the taste sensations they create while refusing to actually eat it because he doesn't want to gain weight.

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