"In a liquidity trap, saving is a personal virtue but a social vice", Paul Krugman 2013
Paul Krugman is annoyed with Summers for taking his ideas of a permanent liquidity trap to market (in this case the intelligentsia at the IMF). I think he will be alright in the end though. What consequently could have gone into the ether as a relatively innocuous speech has fast developed into a new economic manifest spear headed, as it were, by Krugman. The gist of the message is the notion of a permanent slump as argued here in a NYT oped. The best quote to capture this "new" idea is the following from Krugman;
Larry’s formulation of our current economic situation is the same as my own. Although he doesn’t use the words “liquidity trap”, he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.
And as he also notes, in this situation the normal rules of economic policy don’t apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression. And so on down the line.
Allow me initially to dispense with the deeply partisan argument hidden in all this. The Austrians and blood letters are evil, austerity and prudence are folly and rapidly rising debt as a proportion of national income is not a problem (on the contrary, it is needed!). This is all a boring and predictable part of the argument, but there are aspects of this new "meme" which are really, really important to consider. I take three points from this discussion which closely links to my own work.
- Demographics are pushing OECD economies into a collective liquidity trap - Ageing populations are pulling us towards a negative natural level of interest. This suggests that liquidity traps and ZIRP are now the new normal. Trend growth and interest rates fall with population ageing and when working age population growth turns deeply negative so does trend growth and the natural rate of interest.
- Global paradox of thrift - If more and more economies are now faced with a negative natural rate of interest it means that (desired) savings will exceed investment even with ZIRP. This has crucial implications for global capital flows. You only need rudimentary algebra to see this in the context of basic national accounting. If S>I it can only mean that the current account is positive in an open economy and this is difficult to prescribe a universal growth strategy since you need someone to run the deficits.
- The economy needs persistent asset bubbles to sustain full employment - This is Krugman's defense for ultra loose monetary policy (in the US) and I think it is a poor one. If the liquidity trap is the new normal it also stands to reason that the extraordinarily loose monetary policy normally associated with a such a situation becomes endemic and structural. Asset prices buoyed by easy money from the Fed simply becomes a necessity to close the output gap. As I argue below I think this is a tenous argument at best.
If Krugman is annoyed with Summers then I am annoyed with both of them. First of all, they are putting their weights behind ideas that Edward and I have been arguing for a while now (5 years to be exact). This is a small part of my nuisance though. Professional jealousy is not my forte. I am interested in ideas, particularly good ones, and the ideas being crystallised here by Krugman and Summers are really important ones.
What annoys me more is that I am not sure this applies to the US economy at all. We should note here that US working age population is set to be positive for many decades still while it is now negative as far as the eye can see in Japan and Europe. Why haven't someone in the ECB thought up these ideas I ask?!
As such I think this is a very poor argument for continuing loose Fed policy. It should be clear by now that QE has substantial negative externalities one of which is of course the emergence of asset price bubbles which inevitably burst. The financial market can be an evil mistress and it is often the very people the Fed is supposed to create jobs for that lose out spectacularly when parabolic upward moves in equities turn into gut wrenching declines. In addition and while I must admit I can only point to anecdotal evidence I think that the aggressive QE has damaging income redistributive effects and essentially that it fosters income inequality.
On the other hand I think the realisation that more and more economies are now being stuck at the zero lower bound and what it means for desired savings is absolutely crucial. This means that desired savings in the OECD is now structurally above investment demand which puts tremendous pressure on the equilibrium game that is ultimately global capital flows.
I think this is the critical research paradigm that must be taken from this discussion and not whether aggressive monetary policy in the US is appropriate. I actually think it might not be and in any case I think the real examples of this important new theoretical postulate should be found outside the US.