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The Way Out of the Slump

Paul Krugman and Robin Wells:

The Way Out of the Slump: Most of the time, we count on central banks to engineer economic recovery following a slump... cut the short-term interest rates it controls; market-determined longer-term rates fall in sympathy; and the private sector responds by borrowing and spending more.

The sheer severity of the slump after the 2008 housing bust means, however, that this normal response falls far short of what’s needed.... [C]onventional monetary policy is up against the “zero lower bound”: it can do no more.... What’s left?

One answer is fiscal policy: the government can step in to spend when the private sector will not. We’ve already argued—in the first part of this review—that a rise in government deficits played a key role in preventing the crisis of 2008 from turning into a full replay of the Great Depression. Why not use more deficit spending to push for a full recovery?

That’s a question that deserves more serious consideration than it has received so far. Leave aside the political considerations: if you believe that deficit spending is an effective way to reduce unemployment—as, for example, Roubini and Mihm clearly do—why not advocate going all the way and spending enough to restore full employment?

Yet that is a recommendation few economists have been willing to make.... [I]n December 2008 Larry Summers... explicitly rejected the idea that the stimulus should be large enough to restore full employment... too much spending might create worries about the US government’s long-run fiscal position, and thus lead to a sharp rise in US borrowing costs....

Richard Koo... will have none of that.... Koo argues that today, with the world as a whole in balance-sheet recession, the governments of major economies need precisely to run large fiscal deficits, and to continue doing so until the private sector is ready to spend again. Only then, with the economy no longer dependent on government support, would it be appropriate to shift to deficit reduction. But can governments really continue to borrow and spend? Yes, says Koo: like the world Keynes saw in the 1930s, today’s world is awash in savings with nowhere to go.... This is, needless to say, a view very much at odds with the current conventional wisdom—but these days the conventional wisdom is looking very foolish. Ever since the crisis began, establishment figures have warned that the bond markets are about to lose faith in nations with big budget deficits; yet interest rates keep falling rather than rising....

In our view, Koo makes a persuasive case. Unfortunately, it’s not a case currently making any headway in American politics.... So are there any alternative policies that might at least help promote recovery?

If there are any options left, they probably involve actions by central banks.... What could the Fed do? It can’t push short-term interest rates on government debt lower. But it could try to reduce other interest rates. Interest rates on long-term government debt normally contain a premium demanded by investors in return for locking up their funds; the Fed could reduce this premium, and hence long-term rates, by buying long-term government debt directly. Interest rates on private debt normally involve an additional premium, because of the possibility of default; again, the Fed could reduce this premium by buying such debt directly.... The Fed could also try to change expectations by announcing its intention to keep short-term interest rates low for a long time....

All three of the books reviewed here, however, end up arguing against the use of unconventional monetary policy. This isn’t surprising in the case of Rajan, who doesn’t seem concerned at all about promoting recovery. It’s more surprising in the cases of Roubini-Mihm and Koo.... In the case of Roubini and Mihm, rejection of unconventional monetary policy seems of a piece with their unwillingness to follow the logic of their own Keynesianism.... Koo... adopts what seem to us to be contradictory positions... monetary expansion and an attempt to raise expectations of future inflation are ineffective in an economy with balance-sheet problems... [and] quantitative easing would threaten to create widespread inflation. We’re not sure how he can believe both things....

So what would we recommend doing? Practically everything that might stimulate the economy. If more spending on infrastructure is politically impossible, at least make the case for it and pound its opponents for their obstructionism. (It’s worth noting that President Obama’s recent proposal for a national infrastructure bank is very similar to a proposal that has been endorsed by none other than the bitterly anti-Obama Chamber of Commerce.) Targeted, temporary tax cuts—like the temporary incentives for business investment also recently proposed by the Obama administration—aren’t our preferred policy, but they would be better than nothing. And monetary expansion should be pursued through every route possible—yes, it’s uncertain how effective any given measure would be, but that’s no reason not to try.

We should also consider policies that enable borrowers to reduce the burden of their debt, such as allowing mortgages to be covered by personal bankruptcy procedures or, as Bill Gross of the bond fund Pimco has proposed, allowing Fannie Mae and Freddie Mac to engage in mortgage refinancing. (Although Obama’s program for modifying mortgage obligations was a step in that direction, it has largely failed as a result of overly complex rules and stonewalling by lenders—a result of its cautious construction. Indeed, it has made many borrowers worse off)...

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