Sunday, April 3, 2011

And to depart from Krugman...

One of the things Krugman wrote in his post on my 1920-21 paper was "All of the unorthodox policy recommendations and conclusions are contingent on the economy being in a liquidity trap, in which short-run nominal interest rates are up against the zero lower bound and can’t go lower", but I'm not sure I entirely agree with this or at least I think we should be careful about claims like this.

Is there no room left for functional finance? Krugman's point here is one that I fundamentally accept - monetary policy is generally the policy lever you want to use to induce investment, and fiscal policy only becomes viable in situations where interest rate adjustment becomes trickier. But I'm not sure it follows from that that fiscal policy is off the table until a liquidity trap rolls along. The thing is, fiscal policy can be - because of the nature of the state - extremely inefficient or welfare reducing. That's why Keynesians prefer monetary policy when it will do the job, because monetary policy leaves the task of resource allocation to entrepreneurs and investors. But to say that monetary policy is highly preferable for these public choice theory sorts of reasons is not the same as saying that fiscal policy is ineffective or off the table. It seems to me the macroeconomics of fiscal policy ought to work just as well in a liquidity trap as out of a liquidity trap, although we need to be cognizant of the microeconomic liabilities of fiscal policy in all cases.

Why is this important? Because there are a lot of important things for the state to do. Education, research investment, renewable energy, and intensive space exploration and colonization are four quite important public tasks that I think we've had mixed results on but could use more of as a matter of microeconomic efficiency (correcting well known market failures). Integrating these microeconomic imperatives for the state into a broader macroeconomic policy seems like common sense to me, which is why it's important to note that although monetary policy can be relied on exclusively in most circumstances, there's nothing stopping us from using fiscal policy outside of a liquidity trap, as long as we pay attention to the public choice concerns and the debt load. I think of it this way - monetary policy and fiscal policy are both effective in all departures from full employment. Monetary policy starts to lose some of its effectiveness in a liquidity trap, and so fiscal policy needs to be leaned on more heavily in those periods than outside of those periods.


  1. Daaaaaaamn, Daniel.

    I go to the Chinese border for three days at 14,000 feet above sea level without internet access, and on the day I come back, I find you are already being cited by Paul Krugman on his blog.

    This is incredible, because you are now probably better known by the top honchos of the American economics scene than some of the PhD professors at the university at which you have been selected!

    And slow blogging? I see half a dozen new posts in the three days that I was not there.

  2. Blogger.Com has been so cruel to me! Comments never get through.

  3. Comment rescued!

    Thanks :)

    I know, I know... it was really slow while I was writing the report, and like I said of course I cry wolf on this... I really do need to pull back when school starts, though.


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