Krugman’s Liquidity Claptrap

June 19, 2009 • Commentary
This article appeared in Forbes on June 19, 2009.

The laureate gets his history wrong.

In his June 15 column, “Stay the Course,” Paul Krugman suggests it is simply foolish to worry that the government could possibly borrow too much, or that the Federal Reserve might buy (“monetize”) too much of that debt.

In a closely related blog, claiming Art Laffer is “way off base” about future inflation, Krugman insisted “for the 1.6 trillionth time, we are in a liquidity trap.” That makes 1.6 trillion times he’s been wrong about that.

His column says, “A rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19%. Japan’s monetary base rose 85% between 1997 and 2003; deflation continued apace.”

A 100% increase in the U.S. monetary over 10 years (1929–1939) amounts to just 7% a year. That is scarcely comparable to the 113% increase over the past 12 months. Besides, the 1930s do not support his “liquidity trap” argument once we examine what happened when.

To say U.S. prices fell 19% from 1929 to 1939, for example, means they fell much more than 19% from 1929 to 1933 before rising from 1934 to 1937 when the monetary base was growing.

With the exception of a brief Fed easing in the spring of 1932, the U.S. monetary base was generally falling or flat from January 1929 to early 1934. From March 1934 to July 1937, by contrast, the rate of growth of the monetary base jumped above 16% on a year‐​to‐​year basis. If we had been in a “liquidity trap” that would have had no effect. Yet real gross domestic product grew by 9.5% a year from 1934 to 1937, and consumer prices by 2.6% a year. Since the facts contradict his liquidity trap thesis, Krugman pretends the rebound after 1933 was “helped along by New Deal policies.”

On the contrary, Christina Romer’s research clearly demonstrates that strong rebound of 1934–37 was “helped along” by a 42% increase in the money supply. She found, “monetary developments were very important and fiscal policy was of little consequence … Even in 1942, the year that the economy returned to its trend path, the effects of fiscal policy were small.”

In his blog, Krugman argues that “a Friedman‐​style focus on a broad monetary aggregate gives the false impression that Fed policy wasn’t very expansionary. But it was; the problem was that since banks weren’t lending out their reserves and people were keeping cash in mattresses, the Fed couldn’t expand M2.”

In any bank crises, the public wants to hold more currency rather than bank deposits, and banks also want excess reserves as insurance against bank runs. Japan’s central never adequately accommodated that demand for bank reserves and currency before 2001 (if then) nor did the Fed in 1929–33. But that does not mean (as the liquidity trap implies) that monetary policy was impotent and merely “pushing on a string.”

Once monetary policy stopped pulling and started pushing after 1933, both real output and prices went up. Krugman then turns to Japan from 1997 to 2003 as his second bad analogy with current Fed policy. Although Japan’s “lost decade” began in 1992, Krugman starts with 1997. Why? Because Japan’s monetary base grew very slowly before then. The Bank of Japan did not try even a mild dose of “quantitative easing” until March 19, 2001, and it may have helped. Economic growth was 2.7% in both 2004 and 1996, so Krugman talks only about 1997 to 2003.

Krugman’s other reason for starting with 1997 is to argue that Japan’s economy slipped into recession that year because the budget deficit shrunk too much. He says, “Japan experienced a partial recovery, with the economy growing almost 3% in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.” This Keynesian focus on deficits is untenable: Japan’s budget deficit reached 10.7% of GDP by 1998–up from 4% in 1996.

What really happened is a classic example of “intertemporal shifting” to avoid a tax hike. In 1996, Japanese consumers knew the consumption tax (VAT) was scheduled to rise from 3% to 5% in April 1997. So they rushed to stock up on big‐​ticket items in 2006 before the tax increase. That tax‐​induced shopping spree artificially boosted GDP in 1996 at the expense of 1997–1999.

Even if Krugman’s two historical examples of an alleged liquidity trap were not so obviously flawed, he also never managed to tie them in any way to recent events. His only (flawed) evidence of a liquidity trap in the 1930s was that “the Fed couldn’t expand M2.”

Yet Krugman’s claim about the Fed’s inability to increase M2 during liquidity traps proves for the 1.6 trillionth time that we are NOT in a liquidity trap! M2 increased by 14.8% from August to February, thus lifting M2’s year‐​to‐​year increase to 9% in May from 5.3% last August.

If Paul Krugman hopes to base his sanguine inflationary forecasts and go‐​go policy advice on historical analogies, he needs to (1) get the history right, and (2) show how that history is comparable to recent experience. On both counts, he failed. Again.

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