"Was Krugman right in 2002?
To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
As everyone knows by now the once kooky and discredited Austrian business cycle model has now become conventional wisdom. Easy money creates bubbles, which inevitably cause depressions when they pop. It’s Greenspan’s fault. Paul and I are still not on board the Vienna express, but we are in an awkward position. (Thank God I didn’t have a blog in 2002!)
Here’s what I think is a defensible view of what Paul might have meant. (Notice I use first names in the times I agree with him.) The words are mine, not Paul’s:
“Business investment is tanking. A sharp fall in overall investment can often lead to a depression. The Fed should reduce interest rates to maintain adequate NGDP growth. Because tech is so overbuilt, the lower interest rates may not be enough to bring business investment back to normal levels, instead other types of investment and consumer durables will have to pick up the slack. We can expect the housing sector to expand if rates are cut sharply. In the classical model we would then be moving along the investment PPF from less business investment to more housing investment, instead of moving far inside the PPF (as in the 1930s) with less overall investment as the economy tanks. Let’s hope bankers lend money to people who are likely to repay their loans, so that the bankers do not lose hundreds of billions of dollars, and their jobs. Monetary policy has no choice but to proceed on the assumption that we should stabilize the overall macroeconomy, and let the private sector decide where to allocate resources. I am not asking the Fed to target housing, merely predicting it will expand if we have the appropriate level of AD.”
Would that statement have been defensible? I think so, even today. But if he wrote that poorly no one would read his blog. Short, provocative, counter-intuitive statements are more fun, but can come back to bite you.
[PS, I hope no one will tell me that bankers didn't lose money. They did.]
Update: Off topic, but since I am praising Paul Krugman, I don’t recall seeing a better post exposing the problem with the Republican Party than this."
20. June 2009 at 09:43
Don, You and I are really on the same wavelength. Did you see Tyler Cowen’s analogy where he discusses a banana subsidy? He assumes the banana subsidy caused people to build their roofs out of bananas. Then it rains hard and all the roofs collapse. Then people blame the government. Perhaps the banana subsidy contributed indirectly to the problem, but isn’t the main problem that people stupidly built their roofs out of bananas? The equivalent concept here is sub-prime lending, which reached pretty absurd levels regardless of interest rates.
I also have a bias toward public policies that promote saving (to offset most of our public policies, whhich discourage saving.) So I like ideas such as minimum down payments for loans made by any federally insured banks.
Nick, If it was hindsight, then I might agree with you. But it depends how deterministic you want to get. Are we allowed to “do over” the Fed’s interest rate decision of September 16, 2008? My view on blowing more bubbles has always been the following, whenever it comes up in discussion:
Let’s not try to go back to the bubble days of 2006, let’s use monetary policy to get back to mid-2008, when housing was already deeply depressed, the rest of the economy was ok, and unemployment was in the mid-5s. I don’t think that’s an unreasonable way of thinking about the optimal monetary policy’s impact on the economy. And I don’t view mid-2008 as a bubble economy. Yes, housing was stronger than today, but I think we have now overshot the goal (on the downside.)
Current, There is no way to know the equilibrium real rate, and the government shouldn’t even try to figure it out. Target NGDP and let the markets set rates. BTW, many economists think the equilibrium real rate is something like negative 5 or 6%. I think those estimates are meaningless, because they assume the economy is expected to stay weak. With appropriate monetary policy the economy would be expected to recover quickly, and thus the equilibrium real rate would rise sharply.
Joe, Starting with your last point. I agree that Krugman wasn’t advocating a housing bubble, but he was advocating a monetary policy that he expected to produce a housing bubble—I don’t think there is any dispute about that. And I agree with him in a sense, although I don’t like the term ‘bubble’ because it means different things to different people. I will make 4 observations about monetary policy:
1. Low rates were appropriate in 2002. If rates had been higher in 2002, then they would have been much lower in 2006. Why? Because if rates had been higher in 2002, the recession might have been a depression, leading to low rates in 2006.
2. The housing boom was partly caused by weak business investment (which is the real reason rates were low in 2002, not the Fed as many assume), and partly by high savings rates in Asia. I have no idea the relative importance of these two factors in the early period. But once business investment recovered in 2006, then high Asian savings rates became relatively more important.
3. Monetary policy was a bit too expansionary in 2004-06, but not because of the housing bubble, rather because NGDP was growing too fast. The housing bubble was a side effect.
4. The housing bubble did not cause our current crisis, tight money in late 2008 did.
Jon, Doesn’t the natural rate reflect both saving and investment schedules? How can it just reflect one side of the market?