Home » Economics » Benn Steil: Why Is Paul Krugman Still Calling For Fiscal Stimulus?

Click on image to purchase

Olduvai III: Catacylsm
Click on image to purchase

Post categories

Benn Steil: Why Is Paul Krugman Still Calling For Fiscal Stimulus?

Nobel economist and New York Times columnist Paul Krugman is fond of mocking his critics for being ideologues rather than economists. In contrast, Krugman’s own policy prescriptions, he assures us, are based wholly on soundeconomic science.

Case in point is the theory of liquidity traps, which goes back to Keynes. An economy is said to be in a liquidity trap when the central bank is powerless to stimulate economic growth because the public demand for liquidity has become limitless. This could happen when interest rates have been driven down to zero, a situation in which people may prefer holding cash to consuming or investing.

Krugman has argued that the rules of the policy game are different in a liquidity trap. In normal times, when short-term interest rates are positive, governments can and should rely on monetary policy – cutting rates – to stimulate economic activity if output is running below capacity. There is no need for extra government spending to substitute for deficient private demand – what we call fiscal stimulus. The private sector can do the job on its own with an appropriate level of interest rates. But if rates are at zero, and need to go lower, the central bank is out of ammunition. The government must step in with higher spending, even if it means running large budget deficits.

While in no way disproving the theory, recent years have shown, however, to Krugman’s admitted surprise, that the so-called zero lower bound on rates is not, in fact, a lower bound. Central banks in Europe and Japan have experimented with negative rates and have found that they have thus far not driven banks to hoard cash in vaults (as a means to avoid paying the central bank to hold their balances). So the lower bound is actually somewhere below zero.

…click on the above link to read the rest of the article…

Olduvai IV: Courage
In progress...

Olduvai II: Exodus
Click on image to purchase