Why I Have Become a Lot More Keynesian Over the Past Three Years
Paul Krugman explains:
How The Other Half Thinks: Ezra Klein has written in, asking for a post laying out the difference between the more or less Keynesian model Brad DeLong and I work with and the models others have been using – and how their predictions differ. It’s a good request, although the truth is that the other side in this debate doesn’t necessarily agree on a single model, or even use models at all. Still, I think it is possible to describe the general views....
[T]he other side in this debate generally adheres, more or less, to something like what Keynes called the “classical theory” of employment, in which employment and output are basically determined by the supply side. Casey Mulligan has been most explicit here, coming up with increasingly, um, creative stories about how what we’re seeing is a choice by workers to work less; but the whole Kocherlakota structural unemployment thing is similar in its implications....
Once you have a more or less classical view of unemployment, you naturally have the classical theory of the interest rate, in which it’s all about supply and demand for funds, and something like a quantity theory of money, in which increases in the monetary base lead, in a fairly short time, to equal proportional rises in the price level.
This led to the prediction that large fiscal deficits would lead to soaring interest rates, and that the large rise in the monetary base due to Fed expansion would lead to high inflation.
You can see the classical theory of interest and the soaring-rate prediction clearly in Niall Ferguson’s remarks:
After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them … I predict, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates
and, of course, in many WSJ op-eds, in analyses from Morgan Stanley, and so on. Meanwhile, you can see the high-inflation prediction in pieces by Meltzer and Laffer — with the latter helpfully titled, “Get Ready for Inflation and Higher Interest Rates”.
While the other side was making these predictions, people like me were saying that classical economics was all wrong in a liquidity trap... where desired savings (at full employment) exceeded desired investment, and hence savings would expand to meet the demand, and interest rates need not rise. As for inflation, increases in the monetary base would have no effect in a liquidity trap; deflation, not inflation, was the risk.
So, how has it turned out? The 10-year bond rate is about 2.5 percent, lower than it was when Ferguson made that prediction. Inflation keeps falling. The attacks on Keynesianism now come down to “but unemployment has stayed high!”... if you took a Keynesian view seriously, it suggested even given what we knew in early 2009 that the stimulus was much too small to restore full employment....
[R]ecent events... amounted to a... clear test of Keynesian versus classical economics — and Keynesian economics won, hands down.
