My (very short) take on this: I do believe that Krugman has a point, a very good one, when claiming that standard textbook analysis is (almost) all you need to understand the current crisis, and to implement the correct policy solutions.
The point is what we define as “textbook analysis”. Krugman refers to IS-LM models. But these, that starting in the 1980s virtually disappeared from graduate curricula because supposedly too simplistic, not grounded on optimization, not intertemporal, and so on and so forth.
I personally was exposed to these ideas in my undergraduate studies in Italy, and I still teach them (besides using them to discuss the crisis with my students). But they were nowhere to be found during my graduate studies at Columbia (certainly not a freshwater school). None of the macro I studied in graduate school (Real Business Cycle models, or their fixed-price variant proposed by New Keynesians) as interesting as it was intellectually, could give me insight on the crisis. I simply do not need to use it.
The IS-LM model with minor amendments (most notably properly accounting for expectations to deal among other things with liquidity traps) remains a powerful tool to understand current phenomena. The problem is that it is not mainstream at all. What bothers me in Krugman’s post is the word “standard”, not “textbook analysis”.
Last Thursday the ECB cut rates, somewhat unexpectedly. This shows that it takes the risk of deflation very seriously. Good news, I’d say. But unfortunately, press conferences follow ECB Council meetings. And I say unfortunately, because Mr Draghi words often fail to match his actions. Here is what he said on Thursday (I could not resist adding some bold here and there):
If you look at the euro area from a distance, you see that the fundamentals in this area are probably the strongest in the world. This is the area that has the lowest budget deficit in the world. Our aggregate public deficit is actually a small surplus. We have a small primary surplus of 0.7%, compared with, I think, a deficit of 6 or 7% deficit in US, – 6 I think – and 8 % in Japan. This is the area with the highest current account surplus. And it is also the area, as we said before, with one of the lowest – if not the lowest – inflation rate.
Fascinating. Truly fascinating. I will pass on the fact that one of the strong “fundamentals” Mr Draghi quotes, low inflation, is actually the main source of worry for economists and policymakers worldwide, including the ECB, that had to rush into a rate cut that was not planned at least until December! I will also pass on his praise of high current account surpluses while the Commission itself is considering opening an infraction procedure against Germany, for perpetuating an important source of imbalances within the eurozone and worldwide.
No, what I find more shocking is the list of fundamentals Draghi gives: public debt and deficit; inflation; current account balance. Now, it dates back a little, but I remember all of those, in Econ 101, to be defined as instruments of economic policy, supposed to serve the final objectives of growth and employment. It is true that we do rather well in what Draghi calls fundamentals, but I continue preferring to call instruments. Look at this table:
I have reported, for ease of comparison, data from the IMF World Economic Outlook (October 2013), therefore they are not the latest (quarterly or monthly) data. Also, I have highlighted in red the worst performer, and in green the best. And boy, Draghi is right! (Notice incidentally that eurozone inflation was 2.5 percent on average in 2012. With the latest data at 0.7 percent, this suggests that we are running, not walking, towards deflation.)
But if we look at the supposed objectives of economic policy (how would Draghi call these?), the picture changes, quite a bit:
No other major advanced economy is doing nearly as badly as the eurozone in terms of unemployment and GDP. But according to the ECB President we have “the strongest fundamentals in the world”. Does this means that Draghi did not take Econ 101? No, I know for sure that he did take it, and he actually had excellent mentors. To understand Draghi’s claim, it may be useful to read his whole sentence. After arguing that the eurozone has strong fundamentals he goes on:
This does not translate automatically into a galloping recovery. But, actually, it gives you the fundamentals upon which you can pursue the right economic policies. Structural reforms are the necessary and sufficient condition for this to happen. In the absence of that, unfortunately, we are going to stay here for quite a long time.
Here is the answer. The only and one answer. Focusing on instruments instead of targets is the strategy of those who do not believe that a role exists for active economic policies. It is a pity that one of these guys is heading the second most important central bank of the world. And it is paradoxically reassuring that the situation is currently so bad that he is forced to abandon his creed and implement active monetary policies.
Advice for the next episodes: praise Mario Draghi actions, and avoid reading the transcripts of his press conferences.
Two articles on today’s Financial Times puzzle me. The first (Weidmann warns of currency war risk) offers yet another example of how economic analysis sometimes leaves the way to ideological beliefs. The Bundesbank’s president argues (as he already did in the past) that giving up inflation targeting hampers central bank independence. How? Why? He does not bother explaining.
What I think he has in mind is that once the objective of the central bank goes beyond strict inflation targeting, monetary policy needs an arbitrage between often conflicting objectives (typically unemployment and inflation). It is the essence of the dual mandate. This of course moves monetary policy out of the realm of technocratic choice, and makes it a political institution (Stephen King explains it nicely). I would argue that this is normal once we abandon the ideal-type of frictionless neoclassical economics, and we accept that we may have a tradeoff between inflation and unemployment. But this is not the issue here. The issue, and the puzzle, is why transforming the choice from technocratic to political, should necessarily lead to giving up independence. Read more
The upcoming Italian elections triggered an interesting debate on the choices ahead, and on the role of technocratic governments. A few days ago the Italian journalist Barbara Spinelli published on the daily La Repubblica a masterly analysis (in Italian) of the difficulties faced by a political sphere that seems incapable, or unwilling, to reclaim from technocrats the task of governing, by which I mean the right/duty to choose between policies with different economic and social consequences.
To an economist, Spinelli’s analysis is a source of further thoughts on the role of choice in economic theory and policy, with important consequences not only for Italy but also for the path that the European construction will walk in the coming years.