End this depression II

In Chapter Two, Depression Economics, Krugman resorts to his favorite analogy, the babysitting coop, whose travails were chronicled by a 1977 article in the Journal of Money, Credit and Banking.  This is at least the third book in which he has resorted to the analogy, this time to demonstrate that overall lack of demand can’t hurt the economy and that “your spending is my income and my spending is your income.”  But this time, he also cites the 150 babysitting couples as an example of his proposed cure for the global economy

“That’s where we come to the third lesson from the babysitting co-op: big economic problems can sometimes have simple, easy solutions. The co-op got out of its mess simply by printing up more coupons.

This raises the key question: Could we cure the global slump the same way?  Would printing more babysitting coupons, aka increasing the money supply, be all that it takes to get Americans back to work?

Well, the truth is that printing more babysitting coupons is the way we normally get out of recessions. For the last fifty years the business of ending recessions has basically been the job of the Federal Reserve, which (loosely speaking) controls the quantity of money circulating in the economy; when the economy turns down, the Fed cranks up the printing presses. And until now this has always worked. It worked spectacularly after the severe recession of 1981–82, which the Fed was able to turn within a few months into a rapid economic recovery—“morning in America.” It worked, albeit more slowly and more hesitantly, after the 1990–91 and 2001 recessions.

But it didn’t work this time around. I just said that the Fed “loosely speaking” controls the money supply; what it actually controls is the “monetary base,” the sum of currency in circulation and reserves held by banks. Well, the Fed has tripled the size of the monetary base since 2008; yet the economy remains depressed. So is my argument that we’re suffering from inadequate demand wrong?

No, it isn’t. In fact, the failure of monetary policy to resolve this crisis was predictable—and predicted. I wrote the original version of my book The Return of Depression Economics, back in 1999, mainly to warn Americans that Japan had already found itself in a position where printing money couldn’t revive its depressed economy, and that the same thing could happen to us. Back then a number of other economists shared my worries. Among them was none other than Ben Bernanke, now the Fed chairman.

So what did happen to us? We found ourselves in the unhappy condition known as a “liquidity trap.””

Krugman’s first claim is harmless enough.  Obviously, an overall lack of demand can hurt the economy, those who erroneously insist that supply is always capable of creating demand notwithstanding.  His second claim is partially true, but incomplete, because not all spending comes from income.  A considerable amount of spending also comes from credit, but since that is neither part of the Neo-Keynesian aggregate model nor the babysitting coop story, Krugman simply omits it.  And it can’t be denied that the babysitting coop did appear to get out of its impasse by printing more coupons.

However, Krugman is guilty of a significant omission when he claims that Fed inflation – cranking up the printing presses – worked spectacularly in ending the 1981-1982 recession.  And what he omits is that one of the chief causes of the recession was the Fed’s need to slam on the brakes due to the rampant inflation of the 1970s, inflation that completely failed to cure the high rates of unemployment as it was supposed to according to conventional Neo-Keynesian economic theory.  In fact, it was this failure that led to the widespread rejection of Neo-Keynesianism and the adoption of Milton Friedman’s monetarist spin on it.

Also, when Krugman claims that the Fed was cranking up the money presses in 1983, he omits to mention that throughout that year, which more than covers his “few months” the interest rate never fell below 10.5 percent, which is higher than it was at any time after November 1978!  Somehow, we’re supposed to believe that observably tighter monetary policy amounts to cranking up the money presses!

That being said, the money supply did observably begin increasing in 1983.  From mid-1982 to mid-1983, M2 rose $228 billion.  However, L1, total credit, grew $598 billion over the same period.

Now, Krugman admits that tripling the monetary base has not succeeded in moving the economy out of depression.  If the true lesson of the spring 1983 expansion is that credit, and not money supply is the issue, then we can assume that the current dearth of economic growth should be correlated with a similar lack of growth in Z1.

As it happens, that is precisely what we see.  Z1 has been very nearly flat since 2008 and is currently $5 trillion lower than its 60-year historical rate of growth would predict.  So, the basic foundation for Krugman’s case is not only incomplete and historically inaccurate, but flawed in precisely the way that those familiar with the Neo-Keynesian model would expect.