Krugman v. Keynes

Paul Krugman takes Ned Phelps to task for mischaracterizing what Keynesians think:

Phelps:

Keynesian economics, which had been nearly forgotten inside the macro field, has found new voices from outside. They take the position that fiscal “stimulus” of all kinds is effective against slumps of all causes.

Krugman:

Nobody, and I mean nobody, holds that alleged position. The position held by Keynesians — by the way, if Keynesian economics has been “nearly forgotten inside the macro field”, someone should tell Greg Mankiw that he’s an unperson — is that fiscal stimulus is necessary only under certain special conditions. Namely, when you’re up against the zero lower bound, and conventional monetary policy is useless, fiscal stimulus may be your best option.

And we are at the zero lower bound right now, for the first time in 70 years. That’s why fiscal stimulus is on the agenda — not because Keynesians believe that deficit spending is always and everywhere the best policy.

Phelps' argument is nonsense. But Krugman's "defense" of fiscal policy is pretty pathetic. I think it's probably true that many people like Krugman who consider themselves Keynesians do believe that fiscal policy is only useful at the zero bound. But this is a pretty constipated version of Keynesianism. Keynes himself thought fiscal policy was an important policy tool in general, not just at the zero bound. His macroeconomic policy program during WWII was heavy on the fiscal policy.

I think if the profession put its minds to it, we could make a good argument for using fiscal policy on a more regular basis.

- Monetary policy affects some sectors of the economy (housing, small business) more heavily than others - why should those sectors be the ones to bear the burden of stabilization?

- We probably need to use monetary policy to prick asset market bubbles from time to time, but why sacrifice the productive sectors of the economy for the sake of financial stability; why not when faced with bubbles that need pricking execute an increase in interest rates coupled with fiscal expansion?

Fiscal policy is fraught with practical difficulties - delays in passing the necessary legislation, capture by parochial interests, complications posed by environmental and labor regulations, etc. But if we spent half the effort ironing out those infrastructural details as we have greasing the skids for monetary policy (I'm thinking of the ingenious ways that the Fed has come up with to issue and withdraw reserves and manage interest rates), fiscal policy would be a much more powerful tool.

More on the problems with macroeconomics

Since Paul Krugman's NY Times piece dissecting what went wrong with the macroeconomics profession, some misinformation has bounced around the blogosphere about the role of rational expectations in all this. Justin Fox, for example, argues:

3) Macroeconomists actually have been making progress over the past couple of decades:

But the standard policy prescription of economists in the rational expectations tradition is that government shouldn't try to do anything about macroeconomic fluctuations. While I think that may be the right course (albeit one that is never really followed) in reaction to a garden-variety recession, I'm not so sure in the case of a potential global depression caused by a huge financial shock. And here's the thing: As best I can tell, modern macro models of almost all stripes don't really take the financial sector and its influence into account. Which is why Krugman and many others find themselves grasping back to Keynes.

Fox's first point is wrong, his second point is right. Back in the 1970s proponents of rational expectations were arguing that policymakers should do nothing about the business cycle. There are still those who peddle that line. But the mainstream of macroeconomic theory, New Keynesian economics, has incorporated rational expecations into models with sticky prices, with the implication that activist monetary policy can help stabilize the economy. This type of model, epitomized by the work of Michael Woodford, has been tremendously influential. It has informed the Fed's policy of "flexible inflation targeting," it justifies the use of various versions of the Taylor rule.

The problem is not in the use of rational expectations, it is in the modeling of the financial system. While there are plenty of models out there that incorporate "financial frictions" into New Keynesian models, the linearity of the models seems to be a fatal flaw. Linearity means that if a financial collapse can cause a recession and deflation, then a boom can cause an equivalent expansion and inflation. Then the proper response to an asset bubble is to lean against the wind only when the effects are visible on GDP and inflation. This reasoning underlies the Fed's policy of not trying to prick asset bubbles (Bernanke and Gertler established this as the conventional wisdom in a couple of papers a decade ago). Unfortunately, it appears that the real world is nonlinear. Asset bubbles may have modest macroeconomic effects on the upside but devastating effects on the downside.

Don't blame rational expectations for this particular shortcoming of macroeconomics - blame the propensity of macroeconomists to favor linear over nonlinear models (I'm looking at you, Blanchard and Khan!).