Paul Krugman is really smart

Clearly. My salary doesn’t depend on not understanding Keynes and the wonders of fiscal policy. I choose to think this is just a really complex issue and only Nobel Laureates (or some Nobel Laureates) can understand it.

In Krugman’s book, he tells the story of the Capitol Hill babysitting co-op. Co-op members can do three things with their time: babysit others’ children and build up their savings of the IOU coupons they earned, spend coupons and go out for the evening, or sit at home with the kids.

Also, they can borrow coupons, paying interest in the form of more coupons paid back than borrowed, from the co-op authority. This allows the authority to cool off an over-babysat economy by increasing the number coupons that would have to be paid back by those that borrowed them. This means babysitting today is worth less than babysitting in the future so people are more likely to have their kids babysat today. Likewise, a depressed, underproducing economy could be encouraged by decreasing the number of coupons that borrowers would have to pay back.

A liquidity trap comes when the co-op authority reduces the “interest rate” such that one coupon borrowed is paid back with one coupon but the economy is still depressed.

The solution is inflation. Make the coupons people are holding worth less over time so they become less likely to horde them. Penalize liquidity preference.

Thus have inflationary monetary policy.

But then Krugman has another thus. Thus, he says, have the government produce large amounts of deficit spending.

I don’t get it — maybe I need to be on someone else’s payroll or win a Nobel prize. Yes I know about Keynesian crosses, but the government’s borrowed money, besides the usual crowding out by its effects on interest rates, has to be paid back. In anticipation for when those debts come due, people save more today so they can pay those future taxes; they horde babysitting coupons. In that case, we’re back to where we started. The reason for hording has changed, but the hording remains.

But forget Keynes and hocus pocus theory. The data are pretty inconclusive about fiscal stimulus ((My nomination for best footnote of the year is the third one in the Mountford paper Mankiw cites. One finding of that paper is that consumption doesn’t change much, and so neither does welfare, when there are increases in government spending even if its deficit spending. The footnote says this can be true because of increasing returns, the interaction of sticky prices with “non-Ricardian” agents or with imperfect intersectoral capital mobility.)). Although, Krugman might argue the papers Mankiw cites look at the wrong data, i.e. they look at the U.S. in non-depression times.

I don’t think appeals to the precautionary principle get us anywhere. Yeah, fiscal stimulus might help, but it might hurt too. Creating frictions in the labor market (by increasing unemployed workers’ reservation wages, thus increasing the time it takes them to find jobs) and otherwise slowing down the adjustment of factors of production (by subsidizing dying industries or funding make-work programs) in a time when adjustment is necessary will only prolong the pain.

2 thoughts on “Paul Krugman is really smart”

  1. No. Americans have been saving less than 1% of their incomes during the housing bubble (below the usual 2-3%). I want Krugman et al to ‘splain themselves.

    I don’t believe in conspiracy theories, but I’m wondering if someone wants a little more government spending and are finding reasons for it.

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