Posted by: Dirk | May 23, 2009

Is Paul Krugman always right?

So asks Brad DeLong and provides the answer – yes. Niall Ferguson, historian and economist (The Ascent of Money), is the last victim to fall over a lack of knowledge of Keynes:

There is a clear contradiction between these two policies, and we are trying to have it both ways. You cannot be a Keynesian and a monetarist simultaneously, at least I cannot see how you can, because if the aim of the monetarist policy is to keep interest rates down to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up…. [T]here is going to be… a very painful tug-of-war between our monetary policy and our fiscal policy…

This was criticized by Paul Krugman, and rightly so. Keynesian policy today does not drive up the interest rate because loan demand from the private sector has fallen. Only if the fiscal stimulus is too big, interest rates might be driven up. But then, some government investments can be temporarily put on hold. Anyway, we are far away from full employment, so inflation and higher interest rates are definitely not a worry.

A related point that I would like to see discussed is the question whether you can save the banks AND expand government spending. Until now, countries like the US, Germany, China and Japan can have both at the same time. However, in countries like Iceland, Ireland, Spain and the UK the situation is different. Faced with constraints, the governments have either no extra cash to spend at all (Ireland, Iceland) or have only limited funds at their disposal (Spain, the UK).

So, how do we save the economy? Please tick one (and only one) choice:

(A) Increase government spending by transferring money from banks to the government.

(B) Save the banks by providing extra capital to the financial sector.

Faced with this question, we have a trade-off. It’s either saving banks or extra government spending. Both are worthy ends in themselves, so let’s take a look at second round effects.

Increasing government spending (no nationalization, just an increase of spending) will increase demands and profits of firms. This will help them to refinance or use the retained earnings to invest. The effect on the economy should be positive.

Saving banks will probably have no second round effects. People will still be afraid of losing their money. There will not be any extra investments by firms since banks are reluctant to lend, since they will have to repay their debts in the near future. Banks are highly leveraged, they need to get smaller to decrease the risk of a bank run. If they don’t, they will be dependent on international financial markets to refinance. These markets are almost shut down, compared to 2 years ago. Only central banks offer new financing, but this cannot be the long-run idea of running a bank.

So, I wonder whether Paul Krugman is right when he proposes more aggressive government intervention in the financial sector. Much depends on details. If he proposes a smaller financial sector and less government intervention there leaving more space for fiscal stimulus, OK. If he proposes that the government forces the banks to spend their excess reserves, that would be a different thing.

We would have a situation where Krugman might – and this is a big might indeed, since nobody knows what Krugman suggested to Obama – differ from Keynes: while the latter believes that the government should spend the money and take responsibility, Krugman might prefer banks to spend the money. In theory, both suggestions could work. But I believe that if we as a society have to force us to invest money, it should be decided by government, not by banks. A government that wastes the money I can vote out of office, but we have seen how hard it is to deal with banks that are too big too fail. See Japan’s experience since 1990 as a reference (this links to a series of Paul Krugman, and I don’t care whether he is really alway, always right as long as he is a very, very good economist. And nobody should doubt that he is.)


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