Evaluating Krugman's Axis of Depression

In Paul Krugman's Axis of Depression article in the November 19th, 2010 edition of the NY Times, he creates an allegory on George Bush's famous reference of the Axis of Evil, which represented Iran, North Korea, and Iraq in the early part of 2000.  While Bush was concerned about terroristic activities from Iran, North Korea and a Saddam-led Iraq, Krugman is worried that China, Germany, and the Republican Party are favoring policies that will send us to economic calamity.  Recently, we learned that the U.S. Federal Reserve Open Market Committee (Fed) led by Bernanke decided to implement a second round of quantitative easing aimed at stimulating economic activity by driving down interest rates.  In this editorial, Krugman not only agrees with the Fed's moves, but is adamant that government should play a much larger role in sustaining and growing this recovery.

This debate is actually an age-old argument on the proper role of a central bank in running an economy.  In the Principles of Macroeconomics and Mankiw's Five Debates over Macroeconomic Policy, there are two schools of thought.  On one hand, you have monetarists, such as John Taylor, who believes the primary goal of the Fed is to maintain price stability.  Then you have other economists such as Krugman, who favor the Fed playing a more active role in steering the economy where they increase money supply to increase employment.  While this act might improve the labor market, it should be noted that it can lead to higher inflation.

When the Fed plays an activist role in managing the economy, they must recognize that the two goals of low inflation and unemployment often conflict with each other.  In Principles of Economics and Mankiw's Ten Principles of Economics, there is Principle #10 stating that society faces a short-run trade-off between inflation and employment.  This means that the Fed can increase money supply, which floods additional reserves to financial institutions, and eventually leads to more lending and investment activities. Jobs typically follow higher investment spending, so unemployment should fall.  However the downside to this strategy is that more money in consumer pockets can lead to excessive spending.  While that sounds good, the problem occurs when businesses are not able to meet the rise in consumer demand for goods and must respond by raising prices to ensure their goods remain stocked.  This can result in higher inflation and that spooks investors and consumers alike.

Krugman's central argument is that the current economic environment calls for a more aggressive response to improving the labor market and not be as concerned about inflation because it is already so low.  Economists often remark how monetary policy is an art where we carefully have to guide through the ebbs and flows caused by market forces.  The general rule is that you increase money supply when inflationary risks are lower than unemployment risk.  Conversely, you decrease money supply when inflationary risks are higher than unemployment risk.  As I remark in my November 18th, 2010 blog entry, current inflation rates are near historical lows and there's even concern that deflation could be an issue.  Therefore, this is strong evidence to support Krugman's reasoning for quantitative easing and boosting money supply.

On the other hand, it should be acknowledged that inflation often takes on disguised forms and can strike with immediacy and great force.  While Krugman states that inflation remains low, he neglects to mention that the market also prices bonds based on inflation expectations.  Based on past history, bond investors are wary about extended efforts in keeping interest rates low and money supply high.  As pointed out in this November 15th, 2010 WSJ Real Time Economics blog, we can look back to the 1960s where the Fed was too aggressive in keeping interest rates low by buying short-term bonds over an extended period.  You can see the what happened to inflation based on their actions as shown in this graph of core inflation rates from 1965 to 1984 from the Federal Reserve Bank of Cleveland.  The measure of core inflation was initially low in 1965, but quickly exploded in the mid-1966 and continued its rise for over a decade.  (Note:  There was a brief respite in the early 1970s, but that was due to flawed price controls implemented by President Richard Nixon, which only led to hyperinflation a couple of years later.)  Only the vigilant actions of former Fed Chairman Paul Volcker was able to stave off inflation around 1983.  Therefore, the Fed must tread carefully with monetary policy because an incorrect move can damage an economy for a long period of time.

Another ancillary benefit to the quantitative easing is its potential impact on U.S. exports and jobs that can be created from it.  One of the effects of increasing money supply is that it will devalue the U.S. currency.  This is beneficial because a cheaper dollar can make our U.S. goods less expensive to foreign goods, which is one of the reasons why Krugman casts a dismissive eye to complaints from China and Germany.  In fact, both of these countries passed the U.S. in overall exports.  In particular, China was able to do this by tying its currency rate to the U.S. dollar at artificially low exchange rates, while Germany capitalized on a unified currency (Euro) that enabled them to attract investment away from its European breathren.  Both would see their position weaken with a cheaper U.S. dollar, so Krugman discounts their criticism as being self-serving.

Krugman's angst with Republicans is their preoccupation with limiting government's role during an economic downturn.  Their concerted efforts in watering down last year's stimulus legislation, along with reluctance in passing an infrastructure bill, can also stall economic activity.  As we have seen with the impotence of monetary policy so far, one could assert that the U.S. is in a liquidity trap where the private sector is either unwilling or unable to create jobs.  In those instances, government can intervene by boosting spending on highways, investment in alternative energy, and serve as a stopgap for state finances that continue to deteriorate.  While not being specific, the Republican Party believes that government excess can be cut.  While their proposals could lead to lower deficits, one cannot forget that lower government spending will lead to economic declines in the short run.  Local businesses would be affected if welfare spending and extended unemployment benefits are cut.  Areas that depend on military bases could be greatly affected if those bases close due to cuts in national defense. 

In fact, one look at history can see the danger in addressing the budget deficit immediately.  When looking at historical data on U.S. budget deficits from the U.S. Census, one can see the potential harm.  Specifically, you can look at 1937 and 1938 where the budget deficit was significantly curtailed from $4.3 billion in 1936 to $2.2 billion in 1937 and a paltry $89 million in 1938.  During this time period, Democrat President Franklin D. Roosevelt was concerned about budget deficits and immediately reacted by drastically cutting government expenditures from $8.2 billion in 1936 to $6.8 billion in 1938 and the results were staggering as shown in this table of Real GDP growth rates from the Bureau of Economic Analysis.  Economic growth rates went from an explosive 13% in 1936 to a demoralizing -3.4% in 1938.  This is indicative of why Krugman is concerned about the Republican priority of slashing government spending.

In summary, the U.S. recovery is still fragile and I believe the actions from both the Fed and Congress will influence the direction of future economic growth.  It is my belief that Bernanke anticipates gridlock from a divided Congress, so that is why the Fed decided to organize a second round of quantitative easing because they want to avoid a deflationary environment that could occur if our recovery stalls.  Despite this risk of deflation, I do not think quantitative easing is the right method now.  As inferred by even Krugman, the effect of quantitive easing will probably be minimal anyway.  However, the risks of retalitory currency manipulation, along with heightening inflation risks in the future, outweigh the benefits of this monetary policy response.

A more appropriate course of action would be Congress quickly passing legislation aimed at additional public investment and reforming the tax code.  Industrial policy aimed at investments of transportation systems and alternative energy projects are essential to maintaining our competitive edge globally.  While I understand that these investments are costly and could crowd out private investment in the future, I think this could be balanced by imposing deficit-cutting methods that will start to take effect three or four years down the road.  As for the tax code, I do believe that it needs to be modified to boost revenues and better align incentives.  This can be done by slowly limiting deductions for both individuals and businesses over time.  By broadening the tax base, we can increase revenues through these efforts and then make it politically more viable by cutting marginal income tax rates for everyone, along with lowering the corporate, capital gains, and dividend tax rates. 

Lastly, we also need to address the strain of entitlement spending and national defense.  As the baby boomers retire, Social Security, Medicare, and Medicaid spending will skyrocket, so politicians will soon not be able to ignore it.  Then combine that with a volatile world where nuclear proliferation and terrorism threaten our security, there will be increased pressure to raise defense spending.  All of these forces are leading the U.S. to an unsustainable fiscal state soon.  Therefore, politicians will need to be frank with the public and outline priorities that will require sacrifice by all of us.