ZLB, R.I.P.

Even if one is not a fan of President-elect Trump, one must be impressed how he managed to shift expectations to end secular stagnation. With the Zero Lower Bound (ZLB) now dead as a door-nail, it is going to be difficult for mainstream economists to make it look like Dynamic Stochastic General Equilibrium (DSGE) models have something useful to tell us about the real world.

This article first discusses some of the academic theoretical issues around the ZLB, and then jumps to the latest economic squabbling based on Paul Krugman's recent comments.

Rogoff Scoffs at the ZLB

Professor Ken Rogoff was a discussant on a ZLB paper at the ASSA conference in Chicago. His comments are described by Professor J.W. Mason in this article.

I will refer the reader to J.W. Mason's article to see his transcription of Rogoff's comments. I just wanted to highlight Mason's remarks at the end of his article.

One way of looking at this is that the ZLB is a device to allow economists like Krugman and Gourinchas and Rey — who whatever their scholarly training, are aware of the concrete reality around them — to make Keynesian arguments without forfeiting their academic respectability. You can understand why someone like Rogoff sees that as cheating. We’ve spent decades teaching that the fundamental constraint on the economy is the real endowment of resources and technology; that saving boosts growth; that trade is always win-win; that money and finance matter only in the short run (and the short run is tolerably short). The practical problem of negative policy rates doesn’t let you forget all of that.
Which, if you turn it around, perhaps reflects well on the ZLB crowd. Maybe they want to forget all that? Maybe, you could say, they take the zero lower bound seriously because they don’t take it literally. That is, they treat it as a hard constraint precisely because they are aware that it is only a stand-in for a deeper reality.

If I wanted to be charitable, I think this is the nicest interpretation of what has been going on in DSGE macro. DSGE macro is an intellectual failure, but we can pretend to get useful results if we stick in silly things like an assumption that the policy rate being allegedly stuck at 0% forever completely changes how the economy functions.

Paul Krugman Triggered Me!

 Paul Krugman wrote a recent New York Times op-ed -- "Deficits Matter Again" -- which has raised a lot of eyebrows amongst supporters of Modern Monetary Theory (MMT), or post-Keynesians more generally. I will discuss my take on his comments further below; the summary is that I think his comments are defensible from a mainstream economics viewpoint, but his hand-waving explanation of the dynamics is either terribly written or outright incorrect.

My gut feeling is that he phrased his article in such a way so as to deliberately drive post-Keynesians crazy. I may be just taking the bait, but I just wanted to throw in some comments.

• The article "Paul Krugman's ideas are part of the problem" by Professor Bill Mitchell gives an in depth take down of Krugman's analysis. For those of you who are not familiar with him, Bill Mitchell is one of the "founders" of MMT (my phrasing), and he covers the various theoretical objections. I generally agree with him, but I do not want to repeat what he writes there.
• Jared Bernstein wrote another interesting article -- "Paul Krugman Goes All 'Crowd Out' On us -- Is He Right?"

On the other side, there this article by Gerard MacDonell -- "What did Krugman Know, and When Did He Know It?" In it, he discusses the political context of Krugman's article; in earlier article, Gerard made the same point about "full employment" that Krugman did. As I discussed in an article I published in December, Gerard is using "full employment" in a way that many (wide definition) Keynesians (such as Bill Mitchell) would object to. Although I would phrase things differently, my reading of the current cyclical conditions may not be fundamentally that different than his.

Crowding Out - Sigh

The most objectionable passage (for post-Keynesians) in Krugman's article was the following paragraph.

No, they’re going to blow up the deficit mainly by cutting taxes on the wealthy. And that won’t do anything significant to boost the economy or create jobs. In fact, by crowding out investment it will somewhat reduce long-term economic growth. [emphasis mine] Meanwhile, it will make the rich richer, even as cuts in social spending make the poor poorer and undermine security for the middle class. But that, of course, is the intention.

The highlighted sentence looks to have been engineered to put post-Keynesians in a frenzy -- or it may have been the result of an economically illiterate editor at the New York Times. It is largely irrelevant to Krugman's big idea -- that the Republicans are being hypocritical about their deficit fears.

The phrase "crowding out" is by itself fairly meaningless; historically it was associated with the Loanable Funds fallacy. Is Paul Krugman reverting back to loanable funds thinking?

Perhaps he is, but we should have no reason to care what his particular thought processes are. He is a standard bearer for mainstream economics, and we should look at what that theory says.

If we take the pretensions of mainstream economics at face value, we should be discussing this topic as follows.

• We start out with the current policy stance as the base line. The economy is at an "equilibrium state," characterised by various levels of interest rates, investment, consumption, and so forth.
• We can then imagine the policy stance changing (courtesy of President-elect Trump), and the economy snaps to a new "equilibrium" state, with new levels of interest rates and so forth.
• Paul Krugman's argues that the new equilibrium features higher interest rates, higher consumption, and somehow (?) lower investment.

I can see how one could attempt to describe this process as tax cuts "crowding out" private investment; no appeal to "loanable funds" is required. The problem with the logic is that there is no reason to believe that investment will be lower in the second equilibrium. We commonly hear about excess capacity in practically every sector of the economy; increased demand could easily bring forth greater supply.

Even if we put that debate aside, I am not particularly impressed with the argument.

Firstly, if a tax cut does not do "anything significant to boost the economy," why should we object? The objective of taxation is to regulate demand (to preserve the value of the currency); why not keep taxes at the lowest possible rate to achieve that objective? Presumably, the tax cuts are part of the starve the beast" political strategy, which Jared Bernstein discusses in his article. This would obviously be of concern to Democrats, but the strategy of invoking bond market vigilantes to counter it has been a strategy with a multi-decade record of failure.

Secondly, why should we care if interest rates are higher (unless one is a leveraged long)? We move away from the dreaded ZLB, and we reduce the pressure on the retirement savings complex, which is a key point of weakness for the middle class. Unless one believes in dubious theories about "fiscal space," the objective of policy should be to raise interest rates.

I would note that I have no fear whatsoever about the inflation outlook. A large rise in inflation would be the risk of a massive shift in fiscal policy. However, I have serious doubts that policy settings would ever be changed that radically, no matter how exuberant the Republicans get. Core inflation has been anchored for decades, and a few timid tax cuts are not going to change the situation.

Concluding Remarks

Secular stagnation and the ZLB are dead. DSGE macro will need a new gimmick in order to pretend to be relevant. On the policy front, we really need to wait to see actual policy shifts in order to be able to have an idea whether they matter.

Appendix: The Politics of Deficit Phobia

In Gerard's article, he made some comments about a blogger friend who I assume is myself. He objected to my amusement at "Democratic-leaning" economists switching their tunes on fiscal policy once Trump was elected (similar to how some Republican leaders have suddenly become much less worried about government debt post-election).

I generally avoid writing about politics, but I do not claim to have "non-partisan objectivity." Partly my reasoning is commercial: I am writing primers about bond market economics, and see little reason to pointlessly anger potential readers. However, it reflects the fact that I am one of the few Canadian Prairie Populists outside of an old folks' home.

I doubt that many of my readers are aware of the Prairie Populist world view, but it safe to say that both Hillary Clinton and Donald Trump are not exactly the types of politicians that are approved of. Correspondingly, my comments about their partisans should not be expected to have an approving tone.

(c) Brian Romanchuk 2017