What the neo-Keynesians have right and what they have very wrong

In Economy on August 15, 2011 at 9:33 pm

Sunday on Fareed Zakaria GPS, Ken Rogoff and Paul Krugman engaged in a healthy debate over what needs to be done to keep the economy from double-dipping into another recession or re-contracting into another financial crisis. Naturally, Paul Krugman took the straight-forward neo-Keynesian approach stating a mix of inflation and government spending would solve all of our problems and he could not understand why everyone did not agree with him. Rogoff, who sees himself as more of an economic policy driver than an ideological economist, at least he suggests that  in his own writing, tends to see the economy in a more complex and nuanced way than Krugman.

For all of their simplicity, neo-Keynesians are generally right about two things, (1) inflation would reduce the real debt of the U.S. government and (2) government spending through deficits would decrease unemployment. There are three important questions to ask when considering these policy options, however.

  1. What is the marginal inflationary effect of reducing interest rates and engaging in expansive monetary policy at a given time?
  2. What is the marginal employment effect of additional deficit spending versus future tax, future debt repayment, and future deficit spending needs?
  3. What will the economy look like in three years in different scenarios?

In my opinion, the answers to these questions regarding Dr. Krugman’s scenario highlight the policy conundrum in which our present financial contraction exists. Furthermore, they illustrate the lack of simplicity for effective, preferable economic policy decisions.

Regarding question 1, we are experiencing, in part at least, depleted ability to react to money creation and debt problems through money supply because of extended low interest rates during a boom period. I am not completely adopting some sort of Austrian School argument but I think it is fair to say that low interest rates going into the recession reduced the effectiveness of reducing interest rates after it started.

Question 2 can be answered in a similar way to question 1. Ideally, the government could help the private sector move through its deleveraging process during a financial contraction. However, the marginal impact of increased deficits on a medium to high indebted public sector appear to be more substantial than the positive relief offered by the government relieving the private sector. Furthermore an important question exists about the preferableness of what government spends these marginal deficit dollars on to an overall deleveraged economy. Not to say at all that deficit spending is not preferable in a recession, but it does seem reasonable that certain deficit spending might be less desirable that reduced debts. I would argue that a large reason this scenario happened connects back to the Bush tax cuts, which eroded the surpluses of the 1990s. If in 2007 we had had a surplus, or at least a nearly balanced budget, we (1) would have had a very very small overall debt burden going into the recession – assuming it still happened and (2) would have had more policy options to quickly deal with the recession at home and abroad.

Question 3 connects closely to question 2 but is definitely distinct. Ken Rogoff made this point in his debate with Paul Krugman. Is it economically advantageous for the United States to employee people temporarily in jobs of yesteryear? Infrastructure investment, even through deficit spending, makes a lot of sense. However, we must be cautious when employing large amounts of the work force through short-term deficit spending. Are we risking a problem of a different sort in a couple of years? How do we end the stimulus?

At the end of the day, I still think there is some validity to immediate deficit spending and keeping interest rates low. However, we have to start developing ways to transition out of this phase. To borrow from the Powell Doctrine of war, do we have an exit strategy?

  1. Isn’t it possible that the Bush Tax Cuts served the purpose of stifling the contraction already being felt in 2001 and grew worse after 9/11?

    • I would agree except they weren’t implemented that quick and that wasn’t the reason they were proposed. They were actually intended to erode the surplus. There was a fear that we would get rid of the debt to quickly and alter the markets. So they wanted to end the surpluses.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: