The Output Gap
The Average Is Not the Typical...

Jan Hatzius and Paul Krugman


As reported by Ezra Klein:

Will America come to envy Japan's lost decade?:

Jan Haltzius started things off by questioning whether the Federal Reserve would really step up to the plate:

If we talk about what else could be done, I think the Federal Reserve could certainly do more. The question is whether what they'll do will have a substantial effect. It'll have some effect. But the numbers for the total amount of asset purchases really required to move the needle a lot is very large. There's a natural bias towards caution among monetary policymakers in this kind of environment.

So usually what happens is that you're in a liquidity trap and you're at the zero bound and you send the staffers away to try and figure out the optimal policy. They go away and model things and come back with some monstrously large number of the amount that needs to be purchased, and the policymakers say, 'Well, I'm not sure you've properly taken into account all the tail risks of this? How do you account for the tail risk that people will lose confidence?' So then the policymakers take a step back towards caution, and that's why in this kind of situation, stimulus tends to be underprovided compared to what's necessary. I think we'll do quite a lot, but it will still fall short of what we need.

Then Paul Krugman jumped in:

There's a trap, and it's the same thing that happened with fiscal stimulus. You do something in the right direction that's inadequate, and then people say, well, that didn't work, and instead of increasing the dosage and proving it right, you give the thing up altogether.

All of this is very familiar if you studied Japan in the '90s. In fact, we're doing worse than the Japanese did. Our monetary policy is a bit more aggressive, but our fiscal policy has been less aggressive. We have a larger output gap than they did, and we've had a surge in unemployment that they never had, and our political will to act has been exhausted much faster than theirs was. On the current track, we're going to look at Japan's lost decade as a success story compared to us. What we should be doing is a really big dose of stimulus on all of these fronts. Throw the kitchen sink at it. But if you ask me for ways to solve this problem that lives within the constraints of policymakers who don't want to be bold, I don't know that I have an answer for that.

Ezra Klein comments:

So the political system is biased toward caution, which isn't a particularly good bias to have amid a financial crisis that requires massive, unconventional economic policy interventions. But because the policies were too cautious, they don't solve the problem, and that discredits them, which leaves the government without tools and the economy in tatters. It's a bit like taking too few antibiotics, noticing that you're still sick, and swearing off antibiotics altogether.