Delong on Krugman

Frankly, I’m confused by this Krugman post so after I’m done writing this, I’m going down to The Avid Reader to pick up Krugman’s latest book. I suspect he lays out this argument more fully there.

Delong reviewed the original version (written in the late 90s) and had this to say about Krugman’s policy advice:

The core of Krugman’s book is made up of analyses of the two greatest economic disasters of the 1990s: the lost decade of economic growth in Japan, and the waves of currency crises and depression that have rolled around the world … These are the parts of the book I love.

Krugman’s analysis of how the Japanese economy entered its present period of stagnation is lucid, clear, and accurate. The collapse of the financial bubble of the 1980s depressed consumption and investment spending…

The answer to what you should do in order to recover from such a state of depressed aggregate demand is “everything.” You should have the government run a substantial deficit … You should have the central bank push the interest rate it charges close to zero (to make it very easy and cheap to borrow money). And if that isn’t enough you should–as Krugman advocates–try to deliberately engineer moderate inflation. If demand is depressed because people think investing in corporations is too risky, change their minds by making the alternative to investment spending–hoarding your money in cash–risky too by having a share of its real puchasing power eaten away every year by inflation.

So far Japan has changed its fiscal policy to run big deficits (but, as any student of the Great Depression would suspect, they haven’t been big enough). Japan has lowered its short-term safe nominal interest rates to within kissing distance of zero. But these haven’t done enough good. And so Krugman thinks it is time for the deliberate engineering of inflation to extract Japan from what economists call its “liquidity trap.”

But at this point Krugman doesn’t have all the answers. For while the fact of regular, moderate inflation would certainly boost aggregate demand for products made in Japan, the expectation of inflation would cause an adverse shift in aggregate supply: firms and workers would demand higher prices and wages in anticipation of the inflation they expected would occur, and this increase in costs would diminish how much real production and employment would be generated by any particular level of aggregate demand.

Would the benefits on the demand side from the fact of regular moderate inflation outweigh the costs on the supply side of a general expectation that Japan is about to resort to deliberate inflationary finance? …

And there is another problem. Suppose that investors do not see the fact of inflation–suppose that Japan does not adopt inflationary finance–but that a drumbeat of advocates claiming that inflation is necessary causes firms and workers to mark up prices and wages. Then we have the supply-side costs but not the demand-side benefits, and so we are worse off than before. Something like this happened to the Popular Front government of Leon Blum in France in the late 1930s.

Thus senior officials of the U.S. government have a problem… Quiet whispers … will not … have much influence on what policy actually is. Loud shouts through public megaphones … run the risk of triggering adverse shifts in aggregate supply.

“Keynesian” policies (like those advocated by Krugman) are most successful when they are enthusiastically adopted by were not generally anticipated, much less effective when they are both adopted but also anticipated, and positively destructive when they are anticipated but not actually adopted and implemented.

Delong’s worry about Krugman’s policy prescriptions is that expectation of inflationary policy will induce higher wages and thus depress supply. He’s guessing that in the case of Japan this effect would have been smaller than than the increase in demand. On net, his guess is that output would have risen under a Krugman policy regime.

So, assuming we take as given Krugman’s contentions that our present circumstances are very similar to Japan’s experiences in the early 90s, the salient questions are: how similar are Krugman’s policy prescriptions today to what he was advocating, and Delong was criticizing, for Japan? How salient are Delong’s criticisms? Did Japan follow Krugman’s advice and how did that work out for them?

UPDATE: I don’t see a discussion of wages or employment in Krugman’s book. He seems to be claiming in his post that deflation (along with sticky nominal wages), increased union power and minimum wage laws don’t increase real wages or at least they didn’t during the Depression. Why is he going on about nominal wages? Nominal wage supports don’t have cause unemployment, but they do when combined with deflationary monetary policy.

I’m missing something.

The Keynes chapter Krugman cites has a basic general equilibrium argument against the standard supply/demand story:

For the demand schedules for particular industries can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of the aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption reduces the argument to an ignoratio elenchi. For, whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate effective demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money-wages will or will not be accompanied by the same aggregate effective demand

Keynes spends the rest of the chapter arguing adjusting real wages (or keeping them stable) is easier/better/preferable for unstated reasons via monetary policy rather than “fixed money wage” policy… whatever the hell that would be.

In other words, I haven’t a clue as to why Krugman thought this chapter was relevant.

Did I mention I’m missing something?

BTW, Krugman’s book wasn’t nothing special. Its a decent rehash of recent mania/panic/crash history; it could have been a chapter or two in an updated version of Kindleberger’s book. I did learn Krugman thinks fiscal stimulus is a good idea right now. He doesn’t say why. I also learned he thinks the real problem with the financial crisis is in the shadow banking sector (banks without the columns and marble) and he thinks increased credit in the traditional banking sector is a sign businesses are leaving shadow banking. Somehow this means we need to bail out the shadow banks.

If you ask me, increased demand for traditional banking is a sign that the financial turmoil will have limited impact on the real economy, i.e. epsilon is small to use notsneaky’s notation. Yes, there is a 1930’s style bank run going down in the shadow banking sector, but unlike the 30’s we have a whole legit banking sector (not to mention the Fed’s direct participation in the commercial paper market) as backup.