Krugman’s Inflation Target

The Keynesian blogosphere is up in arms at Ben Bernanke’s response to Krugman’s view that he should pursue a higher inflation target as a debt erasure mechanism.

According to Chairman Bernanke:

We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

Krugman responded:

This is not at all the tone of Bernanke’s Japan analysis; remember, Japan had nowhere near as high unemployment as we do, and his analysis back then was not simply focused on ending deflation.

Disappointing stuff.

The basic Keynesian logic is as follows:

The economy is performing far below its potential, due to an ongoing slump in aggregate demand caused by a contraction of confidence. Simply, there is plenty of money, but far too many people are risk averse and thus are not spending (and thus creating economic activity) but instead just holding onto their money. The Fed should ease some more, so as to create inflation that turns holding cash into a risk, and so encourage investment and consumption. What’s more, residual debt overhang is a burden on the economy, and additional inflation would decrease the relative value of  debts, giving some relief to debtors.

Matthew O’Brien presented this chart to make the case that output is far below its potential:


I am deeply sceptical that GDP is a sufficient measure of output, and I am even more sceptical that the algorithmic jiggerypokery involved in calculating what the Federal Reserve calls “Potential Nominal GDP” has anything whatever to do with the economy’s real potential output. But I will accept that — based on the heightened unemployment, as well as industrial output being roughly where it was ten years ago — that potential output is far below where it could be, and that the total debt overhang at above 300% of GDP is excessive.

The presupposition I really have a problem with, though, is the notion that this is a problem with hoarding:

Simply, the United States is a consumption-driven economy. And that isn’t so much of a fact as it is a problem. More and more money is going toward consumption, and less and less is going toward investment in companies, in ideas and in businesses. Exemplifying this, less and less money — even in spite of the Fed’s “pro-risk” policies (QE, QE2, ZIRP, etc) is going into domestic equities:

The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows. And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.

Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?

As Zero Hedge noted:

In the period 2009-2011, America’s largest multinational companies: those who benefit the most from the public sector increasing its debt/GDP to the most since WWII, or just over 100% and rapidly rising, and thus those who should return the favor by hiring American workers, have instead hired three times as many foreigners as they have hired US workers.

So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.

Then there is the notion that inflation will effect debt erasure. This chart tends to suggest that at least for government debt it may not make much difference:

There’s no real correlation between government debt erasure and high inflation.

Paul Donovan of UBS explains:

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis.

Consumer debt may also not experience significant erasure.

From Naked Capitalism:

Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

The deeper reality though, is that even if my concerns are unfounded and Krugman is correct, and that a higher inflation target would achieve precisely what Krugman desires, I don’t think it would solve the broader problems in the economy.

As I wrote in November:

The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).

In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, but with the huge underlying challenges like the ones we face, a transitory money-printing-driven spike will in no way be enough to address the structural and systemic problems, which most likely will soon rear their ugly heads again, triggering yet more monetary and financial woe.

On the other hand, it would be interesting to see Bernanke go the whole hog and adopt a fully-blown Krugmanite monetary policy, just to see Krugman’s ideas get blown out of the water by the cold, dark hand of falsification.

Of course, there was an opportunity to achieve debt erasure in 2008, when the world faced a default cascade and a credit collapse. Had economists and planners let the system liquidate, a huge portion of bad debt and bad companies and systems would have been erased, and — after a period of pain — we might well be well into a new phase of organic self-sustaining growth. But we live in a different world; where zombie systems, companies and their assets are preserved by government bailouts and interference, and very serious people like Paul Krugman earnestly push dubious solutions to problems that their very interventionist worldview created.

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50 thoughts on “Krugman’s Inflation Target

    • Krugman uses the term “very serious people” himself to attack those he disagrees with who manifest a seriousness and a certainty that their ideas do not necessarily merit. I thought he would appreciate it.

      From Paul Krugman:

      I use the phrase “Very Serious People” a lot; it seems to me to capture the way respectable opinion keeps demanding utterly foolish policies.

      I will be using it a lot too, from now on.

  1. There is not “plenty of money,” the soaring private debt during the past decades shows that. There is insufficient demand to drive the economy bcause there needs to be a redistribution of the wealth into the hands of people who will spend it. Orothdox economists don’t like to talk about such things because they are not concerned with tthe general welfare. Hence these silly debates.

    • Well there was enough money to sustain the economy before the bubble burst, and people became risk averse and “demand” fell.

      Money velocity is at an all time low:

      Standard Keynesian interpretation is that more money introduced into the system means lower real interest rates, means less people will hoard cash.

      Krugman has written plenty on income inequality (I have written plenty too), but on this particular issue, he’s talking about inflation to reduce the debt overhand.

      I agree with the demand-siders that income inequality is a problem, and insufficient demand stems from the poor and middle not having much to spend.

      I differ from the demand-siders in terms of how to fix it.

      By the way, regarding your work, I guess Mitt Romney’s rise is the epitome of managerialism infecting government, right?

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  3. OMG,

    First things first, I just read two Paul Krugman books in the last week. There were many odd views and opinions in the two books, but a couple in particular, stuck out to me.

    First, Krugman feels that a recession is caused by people not spending enough. No joke, ALL RECESSIONS are caused by people hoarding money. His solution is, if necessary, is to FORCE PEOPLE TO SPEND using the tool of forced inflation. Again, not joking. If this solution sounds like hyperinflation, its becasue it is, but Krugman doesn’t or can’t see this because……he doesn’t understand finance.

    Yes, Paul Krugman, Nobel Prize Winner, doesn’t understand the basics of finance. Things such as savings=investment or that individuals and firms seek to maximize profits are, and I quote “Wildly Irrational.” Another thing that he seems to be unable to grasp (As Steve Keen recently pointed out) is credit. The role that credit plays in our society (including pulling aggregate demand forward) is completely lost to him. To Krugman, the only rational people in this world happen seem to be Ivy League educated economists.

    In the first book, “Peddling Prosperity”, written in 1993, Krugman attacks supply-side economists and laments the fact that after 12 years of Republicans in the White House, all we got was $3 Trillion in debt. Yes, Krugman points out in 1993, that much of the 1980′s growth, was do to debt. Again, not joking.

    A large portion of this book focuses on what he calls “The return of Keynesian economics.”
    Of course, with the use of hindsight, we can see the outcome of his correct forecast.

    The last thing to point, a key theme throughout both his books, are his lies of omission. Its not what he says, its what he leaves out. He attacks Laffer and Friedman, but never mentions Von Mises. He is correct about 95% of opinions and so bothches the last 5% of economics, that it spoils most of his arguments.

    Paul Krugman is a dangerous person. He is one of those people we have all met, that despite overwhelming evidence to the contrary , will never admit that he is wrong. That he has a bully pulpit, both as a teacher and NY Times Columnists, scares me to death.

    • Excellent points.

      It was, of course, entertaining to watch Krugman get roughed up by Steve Keen, a true follower of John Maynard Keynes and Hyman Minsky (as opposed to most “Keynesians” today who are really followers of… Paul Krugman).

      More than anyone else, he reminds me of Floyd Mayweather Jr, the boxer. That is, the picks his fights very, very, very carefully, which meant it was surprising to see him tangle with Keen, who is possibly the greatest demand-side economist in the world. Usually he does not seem to bother tangling with anyone unconventional or outside-the-box (he’d rather debate Tyler Cowen than Tyler Durden, mainly because he would win the first debate, and lose the second, etc).

      The key difference between me and Krugman is that while I accept some of the demand-side logic (i.e. that recessions happen because people stop spending) I don’t limit my enquiries to that. I ask why they stopped spending. That means that instead of advocating any old inflationism (Krugman’s one size fits everything solution) I often end up advocating getting government out of the way, because it is often the case that something the government did (usually some form of malinvestment) led to the situation that caused the recession. But really, recessions happen for all numbers of reasons, and anyone who tells you he has it down to one reason for all recessions is a crank.

      It is also interesting to note why Krugman wanted to go into economics; he was inspired by Asimov’s Foundation novels to want to be a Psychohistorian, i.e. a very extreme form of central planner.

      From Wiki:

      Psychohistory depends on the idea that, while one cannot foresee the actions of a particular individual, the laws of statistics as applied to large groups of people could predict the general flow of future events. Asimov used the analogy of a gas: an observer has great difficulty in predicting the motion of a single molecule in a gas, but can predict the mass action of the gas to a high level of accuracy. (Physicists know this as the Kinetic theory.) Asimov applied this concept to the population of his fictional Galactic Empire, which numbered a quintillion. The character responsible for the science’s creation, Hari Seldon, established two axioms:

      that the population whose behaviour was modeled should be sufficiently large
      that the population should remain in ignorance of the results of the application of psychohistorical analyses

      I was also inspired by Psychohistory in Asimov; but in exactly the opposite direction. For where he saw beauty, I saw terror.

      That this man is considered to be one of our top public intellectuals is just sad and embarrassing. At least on the other side we have some relatively interesting figures like Taleb, a man who would fit happily besides Nietzsche and Kierkegaard, or Xenophon and Heraclitus, or Lao Tzu and Confucius. Krugman is a peculiarly modern thinker; I cannot see many historical parallels for his centralism (centralism itself is a modern peculiarity originating in Marxism), but his doctrinaire views surely carry Marxian and Calvinist echoes.

  4. Also,

    “Algorithmic jiggerypokery” funny to economic dorks such as myself.

    I after all did read TWO books written by Paul Krugman in one week, a personal torture method I do not wish to repeat. But, one must know thy enemies…

    • That’s what I like about the people on this site. We are mostly the kind of people who will spend a lot of time reading the views of those we disagree with…

      • I don’t know who wiped out my entire family of Great Grandparents in WW2 Ukraine so I read Marx and Hitler’s ideologies to understand the Politics that lead to war.

        I can’t stand Nazis (Superiority complex) nor Marxists (Control Feaks)

        One must know thy enemy. At least I learnt that lesson from Hitler. He hated Marxists with a passion. Probably because he was bullied on a building site when he refused to join the sites Political Party (Communist Party)

        • It is strange to think that the various forms of libertarian conservatism which were once the political mainstream in America are now considered the extreme end of the spectrum, while the various forms of statism which were once manifested most conspicuously in Nationalism and Marxism are now closer to the political mainstream…

          To vote for Alexander Hamilton, you can vote for either of the two “mainstream” parties. To vote for Jefferson you have to vote for Paul or other libertarians.

  5. Mainstream economists are given a platform precisely because they are court intellectuals, they determene the truth and decide who is on the right or wrong side. This process is dialectical and framed in this way by Power…they want to take us down a particular road, they give us two apparent alternatives and we choose one…the one they wanted us to take in the first place.

  6. The solution is, and I have written to the Australian Treasurer with this solution ( no response to date), is a Government issued Visa Debit Card. The Govt can preload it with digital cash, whenever there is a decline in aggregate demand. Because the demand comes from the consumer, the supply will be efficient and what has highest utility. This is akin to a helicopter of cash, but what is required during a deflationery recession. Governments can hoard cash via taxation in surplus years, curtailing inflation, and release cash during deflationery times. During boom times Government public works are curtailed, freeing up labour and capital for other sectors of the economy (e.g. Mining Investment Boom) and during a deflationery recession and a reduction in private sector investment implement infrastructure projects. The infrastructure projects keep skilled workers busy and up to date with skills and allow apprentices to train.

    It is the ultimate statist intervention, and the Visa Debit Cards would be a problem in regards to who gets what, but if it was loaded like a lottery ticket, then this would solve squabbling.

    I am convinced Statists are here to stay, Keynesians rule the Political system, so Keynesian principles have to be implemented witha modern twist. As long as Budget Deficits are managed, the system could work.

    • Buddy this is an extremely interesting topic (although your comment would be downvoted to hell on ZH); if we are going to do Keynesianism at all, we should do it in a way which is minimally damaging/dangerous. I tend to agree that if we must do helicopter drops, we should do them to wherever the most potential productivity is, and I believe this is to the middle class, not to Wall Street, and of course helicopter drops should come from saved capital from the fat years if at all possible, rather than borrowing (because we never really know when rates will spike and rolled debt will become expensive). Eventually, maybe later this year or next (perhaps after the election) I will write a Keynesian Damage Limitation article.

      • ZH readers would not understand it anyway. Bitchez would be the most common word in the collective thought bubble.

      • I think the concept of psychohistory is valid, in that Statists could “herd” the public mood in certain direction, abolishing doom and manic periods. I know they try to do this with monetary policy but I think Fiscal Policy is more directive and efficient; provided the public sector tenders for the Government Infrastructure project. This will avoid cost blow outs.

        The first thing I would do is abolish legislation that hinders innovation and risk taking. This will reduce the Government department responsible and be a boost to the budget. I think Nationalisation of key infrastructure & mineral resources with a Corporate KPI Management system. Effectively the Nation owns assets and the best Managers run it. Profits would no longer go offshore. Resources would be managed to extract the best prices for the long term wealth of the Nation.

        • Herding is very popular with centralists, but it most often leads to unintended consequences and blowback. Reality is still fundamentally unpredictable.

      • Helicopter drops in th form of bank bailouts and ZIRP, only cause income redistribution from the lower -middle class to the 1%. For example who can get a low interest loan to buy distressed property when you lose your job? The 1% buy up distressed assets causing a price floor to form, well above the afordability of the low – middle class. My form of a helicopter drop (Preloaded Visa Debit Cards) will give an opportunity for all. At least goods and services will be demanded based on maximum utility, not commodity or asset speculation.

  7. If I may apply a little psychohistory, a foresee Krugman at the helm of the Fed, monetizing US debt. It’s a win-win situation for both the Fed and the Treasury. Krugman will in good faith apply policies for the betterment of the US, while the Treasury and some politicians will be happy to have him there destroying the US dollar.

      • And this will work all the more better considering that a lot of treasuries were op-twisted to 10 years or more.

        I meant that the average duration of US debt was probably extended as a result of the operation. On the other hand, you would probably have wanted the others to hold those long dated bonds (not yourself).

        • There is some case to be made for putting Krugman in charge of the Fed, so he can destroy the U.S. dollar as quickly as he feels the need to, thus destroying his own credibility and effectively abolishing the Fed (or, as I diplomatically put it in the article so as his ideas can be tested and either confirmed or falsified). That’s probably the fastest way, in reality, to a new and better paradigm.

  8. Question to our readers: Does the Krugman Camp ridicule our camp like we ridicule their camp?

    Are we not getting it? Or they actually insane?

  9. Interesting, a guy calling himself Frank Beard I think making comments over at the Max Keiser website gave a good solution if I remember it right.

    Every year everyone pays on their debt
    The gov collects and gives everyone in the society all the money that was paid down that year. This continues until all debt is paid. This means bailout money does not just go to insiders while the rest of us bail them out…but we all get bailed out and money circulates through out.

    Or we could have debt Jubilees.

  10. Aziz,

    Nice post. I see a lot of conflicting views in economics, and I think Henry Hazlitt sums it well in his book Economics in one lesson:

    ECONOMICS is haunted by more fallacies than any other study known to man. This is no accident. The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousandfold by a factor that is insignificant in, say, physics, mathematics or medicine— the special pleading of selfish interests .

  11. From Steve Keen’s Debt Watch. I totally agree with Minsky’s view.
    http://www.debtdeflation.com/blogs/2012/04/16/inet-presentation-minskian-perspective-on-instability-in-financial-markets/?cp=2

    “Minsky on Debt-driven booms and busts”:

    Minsky’s analysis of a financial cycle begins at a time when the economy is doing well, but firms are conservative in their portfolio management, and this conservatism is shared by banks. The cause of this high and universally practiced risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings, and many banks had to write off bad debts. Because of this recent experience, both sides of the borrowing relationship prefer extremely conservative estimates of prospective cash flows: their risk premiums are very high.

    However, the combination of a growing economy and conservatively financed investments means that most projects succeed. Two things gradually become evident to managers and bankers: “Existing debts are easily validated and units that were heavily in debt prospered: it pays to lever” (Minsky 1982, p. 65). As a result, both managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows, so that with these rising expectations go rising investment and asset prices. The general decline in risk aversion thus sets off both growth in investment and exponential growth in the price level of assets, which is the foundation of both the boom and its eventual collapse.

    More external finance is needed to fund the increased level of investment and the speculative purchase of assets, and these external funds are forthcoming because the banking sector shares the increased optimism of investors. The accepted debt to equity ratio rises, liquidity decreases, and the growth of credit accelerates.

    This marks the beginning of what Minsky calls “the euphoric economy” (Minsky 1982, pp. 120-124), where both lenders and borrowers believe that the future is assured, and therefore that most investments will succeed. Asset prices are revalued upward and financial institutions now accept liability structures for both themselves and their customers “that, in a more sober expectational climate, they would have rejected” (Minsky 1982, p. 123). The liquidity of firms is simultaneously reduced by the rise in debt to equity ratios, making firms more susceptible to increased interest rates. The general decrease in liquidity and the rise in interest paid on highly liquid instruments triggers a market-based increase in the interest rate, even without any attempt by monetary authorities to control the boom. However, the increased cost of credit does little to temper the boom, since anticipated yields from speculative investments normally far exceed prevailing interest rates, leading to a decline in the elasticity of demand for credit with respect to interest rates.

    The condition of euphoria also permits the development of an important actor in Minsky’s drama, the Ponzi financier (Minsky 1982, pp. 70, 115). These capitalists profit by trading assets on a rising market, and incur significant debt in the process. The servicing costs for Ponzi debtors exceed the cash flows of the businesses they own, but the capital appreciation they anticipate far exceeds the interest bill. They therefore play an important role in pushing up the market interest rate, and an equally important role in increasing the fragility of the system to a reversal in the growth of asset values.

    Rising interest rates and increasing debt to equity ratios eventually affect the viability of many business activities, reducing the interest rate cover, turning projects that were originally conservatively funded into speculative ones, and making ones that were speculative “Ponzi.” Such businesses will find themselves having to sell assets to finance their debt servicing—and this entry of new sellers into the market for assets pricks the exponential growth of asset prices. With the price boom checked, Ponzi financiers now find themselves with assets that can no longer be traded at a profit, and levels of debt that cannot be serviced from the cash flows of the businesses they now control. Banks that financed these assets purchases now find that their leading customers can no longer pay their debts—and this realization leads initially to a further bank-driven increase in interest rates. Liquidity is suddenly much more highly prized; holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded and the euphoria becomes a panic, the boom becomes a slump.

    As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them—with those cash flows depending upon both the level of investment and the rate of inflation.

    The level of investment has collapsed in the aftermath of the boom, leaving only two forces that can bring asset prices and cash flows back into harmony: asset price deflation, or current price inflation. This dilemma is the foundation of Minsky’s iconoclastic perception of the role of inflation, and his explanation for the stagflation of the 1970s and early 1980s.”

    • I agree that most cycles (if there can be found any) are a result of the coming and going of various generations of people (and their fading memories). But otherwise, as James Grant said, I believe economists should rid themselves of the Atlas complex and leave businesses to think, live and die for themselves.

      • Minsky and Keen are true Keynesians, unlike fake Krugman who is a Hicksian/Walrasian. I respect them a lot.

        Of course, Minsky’s theories are demand-side reiterations of earlier Hayekian explanations.

        As for Andrei’s point, well, the trouble with business today is many businesses are always looking to hand out money to economists, and take subsidies from government. They have become part of the government-military-industrial-financial-subsidy-lobbying-academic complex; the establishment. They are happy to see figures like Krugman advocating more redistribution via QE from the middle class to the elites.

        • A post/article would be interesting to explain your views on what true Keynesianism is, and how different people are more deserving of respect than others according to their adherence to true/fake Keynesianism.

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