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Home Publications Blogs Beat the Press Cheap Thoughts on the Self-Correcting Economy: Konczal vs. Krugman

Cheap Thoughts on the Self-Correcting Economy: Konczal vs. Krugman

Sunday, 08 September 2013 10:09

My friends Mike Konczal and Paul Krugman are duking it out over views about a self-correcting economy in blog posts today. It's actually not much of a fight, but there are a couple of points worth adding.

First, Krugman repeats his often stated view that this time is different, that the downturn in 2007-2009 is not self-correcting because the Fed was up against the zero lower bound. The story is that other central banks also faced the same situation. This meant there was no choice but to turn to fiscal policy to provide the necessary lift to get the economy back to full employment.

There is a small problem with this "this time is different" argument. The Fed didn't quite lower interest rates to zero in the 2001 downturn, but it got pretty damn close. Because the bounce back from recession was so weak (the economy didn't start adding jobs again until September of 2003, almost two years after the end of the recession) it lowered the federal funds rate to 1.0 percent in the summer of 2002 and kept it there for two years. 

Okay, math geeks everywhere are jumping up and down right now pointing out that 1.0 percent is not zero. This is true, but the ECB had kept its overnight rate at 1.0 percent until well into 2012. This didn't keep economists from saying that it was up against the zero lower bound. While lowering the rate to its current 0.5 percent undoubtedly gives some positive boost to the euro zone economy, and lowering it further to zero would help even more, no one seriously believes that the drop from 1.0 percent to zero makes all that much difference.

In other words, it is reasonable to say that the Fed was up against the zero lower bound following the 2001 recession. This means that such experiences are not quite as rare as some may believe. It also means that stimulatory fiscal policy might have been an appropriate response to that downturn, even if the Bush tax cuts and the wars in Afghanistan and Iraq may not have been the best routes for boosting the economy.

The other point has to do with the long-run question. The idea is that something changes so that even if we never have any policy response to the downturn we eventually get back to something like full employment. Mike discusses the fact that workers who go unemployed long enough can eventually become unemployable. This suggests one possible route back to full employment. We eventually make enough of our workforce unemployable so that current levels of employment are consistent with full employment. (Mike doesn't push the argument this far, but it is certainly a plausible story.)

The other route suggested by both Mike and Paul is that something eventually kicks up to boost demand. This one is a bit harder to see.

Contrary to what you read in the papers, business investment is not low as share of output. It didn't fall off that much in the downturn and has pretty much recovered back to its pre-recession levels. Nor is consumption low. In fact, the share of disposable income that is going to consumption is well above the average in the 1960s, 1970s, and 1980s. It is below the peaks of the stock and housing bubble, but unless we get another bubble, it is difficult to see why it would rise back to those levels. People need to save for retirement. If anything, current savings rates are far too low for people to be able to enjoy comfortable retirements. So there is little reason to think there will be a rebound in consumption.

Residential construction of course plummeted in the downturn following the building boom of the housing bubble years. However it has rebounded strongly in the last two years. It is now pretty much back to its normal share of output. There is no reason to think we will again get a 2002-2006 building boom unless we see another bubble. And those who think there is now a tremendous dearth of housing as a result of the recession slump have not been looking at the vacancy data.

In short, it doesn't look like the long-term holds out much hope for much of a rebound in these components of private sector spending. Net exports, the one major item that both Konczal and Krugman left out, is more promising. We continue to run a trade deficit of more than 3 percent of GDP, which would likely be over 4 percent of GDP if we were at full employment. This is sustained by developing countries buying up vast amounts of dollars to hold as reserves. This props up the dollar and allows them to keep their export markets in the United States. In effect, they are paying us to buy their stuff.

At some point developing countries will realize that they don't have to pay us to buy their stuff, they can pay their own people to buy their stuff. When they come to understand this fact, they will stop buying dollars and the dollar will fall against the currencies of our trading partners. This will make U.S. goods more competitive internationally, leading to more exports and fewer imports, and a return to full employment.

Anyway, this is the happy long-run story, but don't hold your breath on it. If you want to see people get back to work anytime soon the government is going to have to do it. And that's true no matter how much you like the private sector.


Comments (14)Add Comment
Self Correcting to What?
written by Robert Salzberg, September 08, 2013 11:03
Even assuming that a fall in the dollar returns us to full employment our wage and inequality problems would still persist. Our economy will still be a giant sucking machine that robs ordinary workers of a reasonable compensation for their labor.

Patent reform, eliminating the cap on income subject to Social Security taxes, single payer health care, a living wage, financial transactions taxes and more will be necessary to restore balance in our economy.
written by Aussie F, September 08, 2013 11:12
I suspect the government will be quite happy to let people rot. As far as the wealthy are concerned, your income is their loss, and any collateral damage to the economy in reduced demand is a price worth paying. After all, JP Morgan makes us much on the way down as the way up. Destruction is as lucrative as investment.
Is the House Dem's progressive caucus Back To Work Budget...
written by JaaaaayCeeeee, September 08, 2013 11:37

Is this the most comprehensive plan to correct our economy? (for non-economists to read).

Could it be adjusted to make transition from fossil fuels fast enough for civilization-as-we-know-it to survive?
Echoing Keynes
written by Billmon, September 08, 2013 11:51
"This suggests one possible route back to full employment. We eventually make enough of our workforce unemployable so that current levels of employment are consistent with full employment."

That was also Keynes's suggestion in the General Theory, but expressed a little differently: Aggregate income falls enough to eliminate excess savings. Result: "High unemployment equilibrium." A.k.a. secular stagnation.
Have you read any history books?, Low-rated comment [Show]
(Downwardly) flexible wages and investment, are not the answer
written by A Populist, September 08, 2013 1:42
From Dr. K's column:

"OK, even Keynes wasn’t that pessimistic: he argued that investment would eventually recover once “use, decay, and obsolescence” created a sufficient scarcity of capital."

This view that a "scarcity of capital" is the problem, does not match our conditions.

Things have changed. The limiting factor in the economy is consumption - not supply - and not investment. Sure, a small amount of investment is needed to satisfy each additional unit of consumption beyond present consumption - but that is readily forthcoming, in response to demand - not presently a limiting factor.

And, while I buy the idea that sticky wages are a real phenomenon, I don't see how flexible wages guarantees full employment (unless you assume increased exports - which, with world-wide lack of demand, we cannot all achieve simultaneously).

The idea that lower wages will (in aggregate) cause employment to increase, seems wrong - just on general principle. Isn't this a "lump of nominal demand" fallacy?

There is also a problem with the assumption that wage stickiness is the only thing which prevents the (flawed) concept of prices adjusting to match supply and demand. Let's suppose for a moment that the long term mechanism which would bring us back to full employment is downward pressure on prices, forcing lower costs, which (somehow?) balances employment. Well, why do we not see any downward pressure on profits? Shouldn't profits and rents also fall to allow supply and demand to adjust via falling prices? Do we actually see profits and rents falling? I don't think so.

In order to balance labor with labor demand, don't we need to address the long term consequences of increased efficiency requiring ever-more consumption to employ everyone? Of course increased leisure is another great option, but don't we need to acknowledge the basic nature of the problem in order to debate solutions?
written by Fred Brack, September 08, 2013 3:37
Dr. Baker,

You say, "At some point developing countries will realize that they don't have to pay us to buy their stuff, they can pay their own people to buy their stuff."

This implies that policymakers in developing countries are ignorant of this basic knowledge. Is that likely? Or is it possible that there's something going on besides ignorance. Political power of exporting sectors and the self-interest of agents in those sectors, perhaps?
The Ultimate Sacrifice for Self Correction: It's Time to Drink the Kool-Aid
written by Last Mover, September 08, 2013 3:51

Two points:

Conservative hacks will continue to credit any added economic growth to what has become a declining deficit, and continue to deny that any growth before then was due to an increasing deficit.

Point two, if the way to reduce the unemployment rate as measured, is to discourage workers from looking for work and leave the labor force, conservative hacks will latch onto this as a way to kill Obamacare as well.

Candidates for Obamacare at state exchanges will be advised that rather than sign up for socialist Obamacare that causes employers to hire less because of uncertainty and higher costs, they should drop out of health care altogether.

They should flip the bird to the individual mandate and risk a shorter life to show they are willing to die for their country rather than see the unemployment rate increase even more, especially after already leaving the labor force to advance this noble goal.

It's the only way out of an economy that will not self correct. As Dean Baker points out in relative terms, the requisite demand from the private sector is already there and is simply not enough to fill the output gap.

It's time to drink the Kool-Aid. Ask not what your country can do for you. Ask what you can do for your country. Leave the labor force and health care for a shorter, but higher quality life, knowing your exit reduced the rate of unemployment for others as the final sacrifice.
Still missing the point, Low-rated comment [Show]
The end game
written by Neanderthal protectionist, September 08, 2013 10:28
"At some point developing countries will realize that they don't have to pay us to buy their stuff, they can pay their own people to buy their stuff. When they come to understand this fact, they will stop buying dollars and the dollar will fall against the currencies of our trading partners. This will make U.S. goods more competitive internationally, leading to more exports and fewer imports, and a return to full employment."

If developing countries make this realization that they can rely on domestic demand, why would they leave their markets wide open to imports from the US?
What is the ZLB
written by Christiaan, September 09, 2013 4:32
I'm sorry, perhaps I misunderstand you. But the ZLB is not about the rate *being* (close to or even below) zero. It is about the rate *needing to be* close to or even below zero (to achieve full employment.) So the fact that the rate now is about the same as ten years ago says nothing about whether this time is different or not. You have to take into account what rate you *need* in the 2008-present situation, which is *less* than zero. Relatedly, the ECB raised the interest rate in 2010 to 1%, but the fact that they *did* (make this mistake) does not mean that the economy had left the ZLB.
written by Dean, September 09, 2013 5:21

we can argue what rate the economy needs, but if the interest rate is not at the ZLB then it is not a binding constraint. If the ZLB was a binding constraint in the euro zone when the short-term interest rate was 1.0 percent then it was also a binding constraint in the U.S. from 2002-2004.
In terms of needs, it would be worth asking what source of demand would have replaced the government deficit in those years had we not seen the tax cuts and war-related spending.
cheap imports save money
written by Dean, September 09, 2013 6:54
Neanderthal Protectionist,
presumably developing countries would import goods for the same reason that countries always do, to save money because they are cheaper than domestically produced items.
written by purple, September 11, 2013 11:23
Most developing countries hold huge US dollar reserves to prevent another IMF humiliation. Massive SWF's were not a common thing before the Asian Financial Crisis.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.