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Home Publications Blogs Beat the Press What Krugman Said, With a Not So Small Addendum

What Krugman Said, With a Not So Small Addendum

Saturday, 20 October 2012 09:35

In his latest blogpost Paul Krugman makes the point that the recoveries from financial crises have in general been slow and difficult, but that they need not be. The point is that this downturn is not like the severe downturns in the 74-75 or 81-82, because they were both driven by the Fed raising interest rates to combat inflation. That left the obvious corrective step of lowering interest rates, which in both cases prompted a swift recovery.

That option does not exist today because this downturn was brought about a collapsed housing bubble, not the Fed raising interest rates. Okay, I just gave my addendum to the Krugman story. Yes, we did have a financial crisis in the fall of 2008. This crisis did hasten the pace of the downturn, but it was and is not the story of the recession. We would be in pretty much the same place today even if the financial crisis had not happened.

It is difficult to see any obvious way in which the current state of the financial system is seriously impeding recovery at this point. Unlike Japan, mid and large size firms in the United States have direct access to capital markets and are now able to borrow at record low interest rates. While some potential homebuyers are finding it more difficult to get mortgages than in the mid-90s (that's the relevant comparison, not the nuttiness of the bubble years), the impact of restoring 90s era credit conditions for homeowners on the housing market would be trivial, especially if it went with mid-90s interest rates. In short, the problems of the economy are not directly related to the financial crisis.

Nor are they directly related to indebtedness. The ratio of current consumption to disposable income is still high by historical standards, not low. While the consumption share of disposable income is not at the peak of the stock bubble of the housing bubble, when the saving rate was near zero, it remains far above the average for the 60s, 70s, the 80s or even the 90s. There is simply no reason to expect consumption to return to bubble levels when the bubble wealth that drove it has disappeared.


Source: Bureau of Economic Analysis.

This gets to the more fundamental story of a recession driven by a collapsed housing bubble. We were able to reach near full employment at the peak of the bubble as a result of demand created by an extraordinary construction boom and consumption boom. The overbuilding of the bubble years led housing construction to fall well below trend levels. With the excess supply now being eroded by a growing population, housing construction will return to trend levels, but not the levels of the bubble years. This leaves a gap in demand of roughly 2 percentage points of GDP or $300 billion. 

Consumption has already returned to a reasonable, if not excessive, share of disposable income. Are most households saving enough for retirement? The answer is almost certainly not, especially given the stated desire of the leadership of both parties to cut Social Security and Medicare benefits. This means that we have zero reason for expecting the consumption share of disposable income to go still higher, absent the return of another bubble.

The difference between a saving rate of 5 percent of disposable income and 0 is $500 billion in annual demand. Added to the $300 billion of missing demand from the residential construction sector, we need $800 billion or 5.4 percentage points of GDP, in additional demand from other sectors of the economy.

While the Romney crew might sing the praises of the job creators, only in Republican fantasy land could this demand possibly come from investment. There continues to be substantial excess supply in most categories of non-residential real estate, which leaves investment in equipment and software as the only source for additional demand any time soon. This sector of the economy has averaged less than 8 percent of GDP through the last four decades. It would take a real wild investment boom to see this share rise enough to fill the gap created by the collapse of the bubble, especially considering the large amounts of excess capacity in many sectors of the economy.

This leaves government and net exports. That is why those of us who believe in national income accounting and arithmetic praise the budget deficits every day of the week. In the short-term there is no alternative way to drive demand. The folks pushing for lower budget deficits are calling for less growth and more unemployment.

In the longer term we will need more net exports, which will only be brought about by a lower dollar. The trade agreement story pushed by both President Obama and Governor Romney is just silliness for children and economic reporters. These deals will not reduce the trade deficit and quite likely will increase it.

Anyhow, that is the quick story on the recession. My difference with Krugman is that it is the story of a collapsed bubble, not a financial crisis. (I recall in 2009 hearing folks like Stiglitz praise the well-regulated Spanish financial system and how this had allowed Spain to avoid a financial crisis. Well, maybe that wasn't quite right.) Furthermore, deleveraging will not get us back to full employment. We will need more fiscal stimulus or a lower dollar. Alternatively, we can go the German route of using work sharing to sustain full employment even in an economy that is operating below its potential.

Comments (28)Add Comment
Small Addendum to Dr. Baker's Addendum: Expiration of payroll tax cut may lower savings
written by Robert Salzberg, October 20, 2012 11:46
I agree with everything in Dr. Dean Baker's post except:

"This means that we have zero reason for expecting the consumption share of disposable income to go still higher, absent the return of another bubble."

The consensus opinion is that the 2% payroll tax cut will be allowed to expire, reducing disposable income by around 125 billion dollars. With millions of working Americans on tight budgets, a 2% pay cut will likely have a modest effect on lowering their savings rate.

Unless working Americans cut their savings rate in half or cut their spending by 2%, we'll have both less spending and less savings due to expiration of the payroll tax cut.
written by fuller schmidt, October 20, 2012 11:53
A graph of the spread between the work-sharing German economy and the US's no work-sharing would seem to be an interesting tale to watch unfold.
Addendum to my previous comment
written by Robert Salzberg, October 20, 2012 11:57
I realize that Dr. Baker's analysis was in the context of ways in which we could increase demand and that the expiration of the payroll tax cut will cut both demand and savings.

I think my point makes Dr. Baker's argument stronger because with even less disposable income, the confidence fairy will be pushing on an even limper rope.

At last...
written by Roger Vance, October 20, 2012 12:03
This post finally exposes a tacit disharmony between the writings of Baker and Krugman, two economists who agree on so much and whose popular writings I admire, learn from, and follow daily. The basic cause of the current downturn is a fundamental issue that must inform meaningful policy corrections. I hope to read more about this from both sides.
written by JSeydl, October 20, 2012 12:05
I agree and would add that the longer the demand gap isn't filled by more government spending and a speedier reduction in the value of the dollar, the worse off the next generation will be. All of the recent college grads who graduated into this mess will have not acquired the skills they need to be successful later in life, which will lower potential GDP in the long run. So the case for doing nothing is probably just as irresponsible as the case for hoping for another consumption/investment boom.
Let's Get Serious
written by duckmonkey, October 20, 2012 1:34
The survival of the human species is at risk. Baker needs to stop diddling around with arguments like this one with Krugman and address the far more serious question of what to do about global warming. Baker (and Krugman’s) general advice on matters economic: crank up production with Keynesian-style stimulus. Foreseeable result: End of humankind. I realize Baker advocates channeling more money into “clean” energy, but that’s about as far as he’s gone. Given the rapidly closing window to act on global warming, I urge him and the other brainy folks at CEPR to take a much more comprehensive look at this issue – immediately. Once they’ve done that, THEN they can go back to nitpicking about Krugman and beating up on Brooks and Friedman.
can the dollar go lower?
written by Brian Dell, October 20, 2012 1:39
re lowering the dollar, the OECD comparative price levels for August indicate that the US is already the the lower 40% of OECD in terms of its currency-adjusted price level. The US is close to even with the PIGS (Portugal, Italy, Greece, Spain) and the lower ones are eastern Europe (Czech/Slovak/Hungary/Poland/Estonia) plus Korea, Chile, Mexico, and Turkey. Can the US drop into this group? I would think that if there was an easy way for a rich country to do this the Japanese would have figured it out long ago.
endogenous growth
written by Brian Dell, October 20, 2012 1:53
How about an endogenous growth strategy? If expected returns on physical investment are low how about doubling down on strategies that would increase output per unit of additional investment?
the inflation contest...
written by pete, October 20, 2012 2:23
Brian Dell kind of nails it. The Euro is at 1.30. It was 1 12 year ago. Thats a 30% dollar devaluation. How much lower should it go? Oh wait, that's the solution for Europe too! Oops, are there first mover advantages here? Trying to out inflate another country is really a dangerous game, with likely unintended consequences. The goal is to drive down our real wages through a drop in the dollar (inflation). Real wages are already too low, have not changed in what, 40 years. A lot of these macroeconomists are extremely antilabor. They want GDP growth but care little about the distribution.
written by Donald Pretari, October 20, 2012 2:37
I'm going to pitch my own view of the Housing Bubble...which is confined to me. When I bought my house in CA in 1991 it was near the bottom of a Housing Bubble. Then all the talk was about Demography. I sold my house in 2008. During this Bubble all the talk was about Retirement. People believed that SS wouldn't be enough for them...and they were having trouble Saving. So they tried to substitute a Mortgage for Rent. They were told that it they didn't buy now they would never be able to because House Prices were never going down. This created the kind of Anxiety that Fraud...Collusion..etc. thrive on. That Anxiety needs to be addressed. I too believe attacking Medical Costs is the Main Solution to this problem.
written by uncle bruno, October 20, 2012 3:16
Or we could repeal Taft Hartley and allow workers to share in productivity gains.
external devaluation agenda is internal devaluation agenda but more hidden
written by Brian Dell, October 20, 2012 4:18
Well, pete, when I earlier asked what a lower dollar would do for ordinary people at the cashier's till, Dean was of the view that the higher nominal wages resulting from greater exports would benefit most of the country.

I continue to wonder, though, if the benefit flowing to the businesses who enjoy greater sales to overseas customers will trickle down to people on a hourly wage, never mind the 36% and rising who are not in the labor force. And the hair salon across the street isn't going to see more sales from a lower dollar (aside from a foreign tourist or two) such that there would be no trickle down to the staff even if the owner was inclined to flow that through.
A Matter of Definitions
written by ellen1910, October 20, 2012 4:23

A "financial crisis" is a second order result of a "credit bubble" the former occurring when lenders suddenly realize they've been unknowingly promoting a Ponzi scheme -- that is, much of their recent extension of credit will never be repaid.

Lenders become cautious; credit becomes tight; demand falls; recession/depression follows.

Still, economists must distinguish recessions caused by actions of the central bank from those caused by actions of bankers. And accurately defining/identifying a "financial crisis" is the best way of doing that. Pace DB.

Thank you
written by GP, October 20, 2012 5:33
Thank you to this post, Dr. Baker, it is extremely lucid and helpful.
$50,000 Prize for best solution to Robo-calls
written by AndrewDover, October 20, 2012 7:33
Dean has mentioned the use of Prizes as a way to develop intellectual property. I saw the following challenge:

"The Federal Trade Commission (FTC) is challenging innovators to create solutions that will block illegal robocalls. These solutions should block robocalls on landlines and mobile phones and can operate on a proprietary or non-proprietary device or platform. Entries can be proposed technical solutions or functional solutions and proofs of concept.

The vast majority of telephone calls that deliver a prerecorded message trying to sell something to the recipient are illegal.? As technology has advanced over the years, so have the number of illegal robocalls.

The winning solution will win $50,000 in cash, as well as opportunities for promotion, exposure, and recognition by the FTC."

It seems to me the simple way to handle this problem is a 2 cent tax on each telephone call. Perhaps there are other ways?


(Sorry to be offtopic)
Don't forget the effect of programs like Cap-and-Trade, putting line-workers out of work
written by Rachel, October 20, 2012 10:14

We're so busy making the lower-income people do the hurting while the Top 5% claims credit for the "self-sacrifice." And then we're surprised, and grope for explanations, when the life of the lower classes gets worse.
written by Lee A. Arnold, October 21, 2012 1:12
Does the savings rate include payments of mortgage principal?
Retired Economist
written by R Baesemann, October 21, 2012 2:06
I have said this on the Krugman blog, and I wish I were wrong. Please prove me wrong and I will be happy as a clam. If I am right, I think we should all promote Neo-Keynesian stimulus packages for years to come.

The banks have traditionally makrketed money. When they needed to they have gone to considerable lengths to promote borrowing. Ot they have purchased Brazillian Bonds etc. They agressively marketed loans to Agribusiness at one point. For four years we have languised in a liquidity trap, and banks have not marketed money, they have hoarded it. Is this not true? if it is true, how does their failure to market ther product square with your ideas. Is the financial stress index based on balancesheet data that is realistic. The short sellers who sank Lehman flagrantly claimed that the big banks balance sheets were fraudulent. The made a lot of money by destroying Lehman, and by all accounts Goldman Sachs et al. were next. CDSs covering 68 trillion dollars in potential losses were outstaning in early 2008. That number is now down to 13 trillion dollars. Somehow, this seems to show that serious people still doubt the banks numbers and think the Financial Stress Test data is based on mark to market funny money.
High dollar unemployment
written by anon, October 21, 2012 2:40

The high dollar makes American workers less competitive with foreign workers so that we export jobs.

The trade deficit can lead to higher budget deficits and since deficit hawks run Washington we may face higher unemployment and increased threats to Social Security and Medicare.

There is also the question of sustainability of the trade deficit if China reverses its high savings policy.

I don't think workers will get higher wages with no jobs or high unemployment.

(Alternatively the trade deficit may increase private debt levels which can create instability (I think) and a higher frequency of economic crises.)

(So the the high dollar may cause higher unemployment unless we're prepared to run higher deficits.)
Capital Costs
written by chris herbert, October 21, 2012 7:41
Wages are stagnant but not profits, hence the accumulation of capital at the top. We need a distribution fairy to come along and adjust the amount of capital being hoovered off the system by fewer and fewer wealthier folks. Shareholders and executives are demanding greater and greater shares of capital. In effect they are raising the cost of capital, said cost reducing its availability for use elsewhere--like for capital investment. Low tax rates for capital gains and dividend incomes discourage capital investment and retained earnings. It's not that labor is too expensive, it isn't. It's that ownership has become too expensive.
Krugman & the Dollar
written by RL, October 21, 2012 8:59
I've been reading Krugman's blog for a long time now, and it seems that he rarely, if ever, mentions the value of the dollar as a means of decreasing the trade deficit and increasing employment.

At the very least, there is a major difference in the amount of emphasis and importance that Dean and Krugman put on the value of the dollar. Whether it signals active disagreement between the two I really don't know since Krugman has written so little on the matter. For that matter, virtually no one else seems to write much about the value of the dollar as a possible solution to the trade deficit. I'd love to see a spirited debate on this matter, but it doesn't seem to be forthcoming. Dean's arguments seem convincing to me, but I've never seen a reasoned argument from the other side, only dismissive comments about inflation or the dangers of competitive devaluation. These sort of tossed-off arguments seem weak to me since they fail to address most important fact involved in the matter: the U.S. has had, and continues to have, colossal and unsustainable trade deficits.
written by Chris M., October 21, 2012 9:20
I agree the housing bubble collapse was the primary cause of the deep recession and slow recovery. Not only did the bubble collapse destroy wealth, but it caused the financial crisis - which only made matters worse. On the other hand, Wall Street certainly contributed to the housing bubble. Had Wall Street and the banks been more cautious and less greedy, there would have been a much smaller housing bubble and a much smaller financial crisis.
written by skeptonomist, October 21, 2012 9:57
The mortgage situation is a financial matter, and that should have been cleared up long ago, one way or another. Some measures were proposed and even authorized, but the money was not spent. There is still uncertainty about the effects of the remaining foreclosures. Had the big banks been taken over as Dean recommended things probably would have gone very differently with respect to mortgage relief. Those banks and their executives are still around to impede all kinds of reform. This was an important difference between Baker and Krugman (as well as many others who went with the herd), although unfortunately neither had much influence at the time and the bailout was arranged by Paulson, Bernanke and Geithner.
written by JSeydl, October 21, 2012 10:09
RL nailed it. I've been commenting on Krugman's blog tirelessly, trying to get him to talk about the dollar and the trade deficit, yet he has remained silent. Given that his rebuttal to Dean's original argument didn't even really make any sense -- no, we're not talking about just semantics -- it doesn't seem like he's going to talk about the dollar anytime soon.
brian dell...unfortunately wages lag prices in keynesian model
written by pete, October 21, 2012 2:10
Issue in U.S. is wages are too high to support additional output at current output prices. Lower dollar=increased demand for exports, which puts upward pressure on prices, so firms can hire more workers at the same wage (especially with 20% real unemployment), maybe wage increases will follow, but probably at quite a lag, likely not until the unemployment falls to 6% or so. I.e., inflation lowers real wages...real wages have stagnated since the early 70s, when the inflation rate doubled from a post war average of 2% to 4%. Capital has done fine.
written by urban legend, October 21, 2012 9:52
What is the evidence that the dollar is higher than it should be? It has dropped dramatically since about 2002, with no apparent positive impact on the trade balance. I have been asking Dean to address this disconnect with what looks like the evidence to me, but so far no response. I would be happy to be proved wrong. On the other hand, emphasizing a lower dollar puts our fate in the hands of other countries, who may or may not respond to our moves to protect their exports and their industries against more imports. That seems to make a lower dollar an iffy proposition at best.
The trade deficit is the evidence the dollar is too high
written by Dean, October 22, 2012 8:02
Urban Legend,

sorry if you didn't think I had responded to your question before, but i thought I had written this one a few thousand times. The value of the dollar is what equilibrates trade in a system of floating exchange rates. If we have a large trade deficit, then it implies the value of the dollar is too high.

It's sort of like having a huge surplus of wheat on the market. The way you get rid of the surplus is by lowering the price of wheat. That's the story.

It also fits the data. We first got large trade deficits in the mid-80s when the dollar soared against other currencies. The deficits fell sharply later in the decade when the Plaza Accords brought down the value of the dollar against the currencies of most of our major trading partners.

The trade deficit exploded again following the East Asian financial crisis when the dollar again soared in value. The decline in the dollar since 2002 has helped to reduce the deficit some -- it had risen to 6.0 percent of GDP and no doubt would have gone considerably higher without the drop -- but we still have a long way to go to get near balanced trade.
written by urban legend, October 22, 2012 11:28
I understand the logic of it, but to say the dollar is too high because there is a trade deficit seems like a tautology. The dollar has dropped a lot since 2002 against other currencies, and yet the trade imbalance has become worse. This suggests to me there are other factors at work besides the value of the currency. How about the possibility that it's gotten worse because we have nothing to sell (as manufacturing has collapsed in the GW Bush era)? Do our trade deals (and trade policy) actually operate to favor imports over exports?

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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.