In the 1990s and early 2000s Paul Krugman basically employed a classical approach to policy analysis, with opportunity costs playing a central role. (Note that this should not be confused with New Classical claims of the non-importance of demand shocks, a view Krugman quite sensibly avoided.)

In recent years he’s argued from more of a traditional Keynesian perspective, with the concept of the liquidity trap almost always lurking somewhere in the background. Here’s an example:

The way to deal with secular stagnation, if we believe in our models, is to raise the long-run neutral interest rate above zero. If we can do this via structural reform and/or self-financing infrastructure investment, fine. If not, raise the inflation target.

And how do we get to the higher target inflation rate, when monetary policy is having trouble getting traction? Fiscal policy! If you’re really worried about secular stagnation, you should advocate a combination of a raised inflation target and a burst of fiscal stimulus to help the central bank get there.

I don’t agree that we need to raise the inflation target, but I do agree that it would work. Indeed despite the fact that I am opposed to raising the inflation target, I so dislike current Fed policy that I would consider a 3% inflation target to be the “lesser of evils.”

Another example of this liquidity trap economics occurred in a March 11 post, which I discuss over at TheMoneyIllusion. So the liquidity trap has become a central organizing principle of his recent policy analysis.

But here’s the problem. Most experts, and also the financial markets, expect the US to escape the liquidity trap within a few months. That would almost instantly make Krugman’s policy analysis look obsolete. Will he then stop making arguments that rely on the zero interest rate lower bound? (Now assumed to be more like a negative 1% interest rate lower bound.)

I believe Krugman will not abandon the Keynesian framework that he has recently invested so much effort in promoting. And my supporting evidence comes from the eurozone, which was not at the zero bound until quite recently. And yet Krugman applied zero bound arguments to the eurozone in the 2009-12 period, despite interest rates being above zero, and indeed even rising in 2011.

What would be Krugman’s counterargument to the points I’m raising? Probably this, which immediately precedes the previously quoted passage:

But the assumption here is that the neutral rate will eventually rise, so that monetary policy can take over the job of achieving full employment. What if we have doubts about whether that will ever happen?

Well, that’s the secular stagnation question. In fact, I’d define secular stagnation as a situation in which the neutral interest rate is normally, persistently below zero. And this raises a puzzle: If we worry about secular stagnation, should we then say that St. Augustine no longer applies, because better days are never coming?


Here Krugman doesn’t discuss the actual policy rate, but rather the Wicksellian equilibrium rate, which is the interest rate necessary to generate macroeconomic equilibrium. Even when the Fed raises interest rates to 0.5%, or 1.0%, Krugman may continue to argue that the economy is so depressed that even a cut in rates to 0% would not do the job, and hence fiscal stimulus is needed. But I see several problems with this argument:

1. If that were true, then the interest rate increases expected later this year should drive us into a double-dip recession. Now that might happen, and did happen when the ECB raised rates in 2011, but as far as I can see the markets don’t currently expect this outcome.

2. Recent data suggesting the actual lower bound is closer to minus 1% doesn’t completely undercut the Keynesian argument, but it weakens it a bit. And it weakens the argument even more if interest rates rise to 1% or more. Then they would be at least 2% above the actual lower bound—pretty far from a liquidity trap.

3. However there is one problem that seems far more important that all the rest. And to understand this problem it will be helpful to back up and explain how my views have differed from Krugman’s over the past 6 years. I’ve argued that monetary policy is still highly effective at the zero bound, which is of course the standard textbook view, or at least was until 2008. The Fed can do other things to boost aggregate demand; so fiscal stimulus is not needed.

Krugman had one advantage in this debate; most people (wrongly) envision monetary stimulus in terms of rate cuts. So they were skeptical of my claim that monetary policy was still highly effective, and indeed the preferred policy tool. But once rates rise above zero, Krugman will lose that advantage. When he calls for fiscal stimulus in a positive rate environment, people will ask why not try monetary stimulus first? Even worse, if you respond that the Fed won’t do that because they are inflation hawks, your fiscal stimulus arguments collapse like a house of cards. After all, if the Fed is opposed to higher inflation, then they will simply negate the inflationary effects of more fiscal stimulus.

So I’m afraid the sell by date of Krugmanomics in the US is very short, perhaps 6 months. Then the debate will move on to other topics.

Suppose I’m wrong and rates don’t rise later this year? And indeed, this is a possibility that I think is quite plausible, maybe a 30% chance. Would Krugman have been correct?

I would still disagree with his advocacy of fiscal stimulus, as I prefer unconventional monetary stimulus. However I would agree that his argument would be more persuasive in the zero rate forever environment than in a positive rate scenario. The best example of a zero rate forever country is Japan, and yet even they are moving strongly in a market monetarist direction, with tight fiscal combined with monetary stimulus. So far all they have to show for it is the ending of 15 years of deflation, the lowest unemployment rate in decades, and a doubling of the stock market. In other words, all the Very Serious People say it’s been a complete failure. (Oddly, the limited success of Abenomics is one area where Krugman and I agree. Although he favors fiscal stimulus, he also likes monetary stimulus.)

PS. Just to be clear I don’t think Abenomics has been completely successful. As I’ve predicted all along, they are likely to fall short of their 2% inflation target unless they do much more, and of course I don’t think inflation targeting is a good idea in the first place.