James Pethokoukis

Politics and policy from inside Washington

Paul Krugman and the New Normal

December 28, 2009

Paul Krugman makes his case for the New Normal:

1) Earlier recessions were preceded by sharp rises in interest rates, as the Fed tried to choke off inflation. This produced a housing slump, with a lot of pent-up demand; when the Fed decided that we had suffered enough, it relented, and both housing and the economy sprang back.

2) But later recessions took place in a low-inflation environment, in which booms died natural deaths from overextended credit and overbuilding. Getting the economy growing fast enough to bring unemployment down after these recessions was therefore much harder, since the usual channel of monetary policy — housing — lacked any pent-up demand.

3) So what about our current situation? It’s just like the two previous “postmodern” recessions, only more so, since the bubble before the slump was in housing itself. This suggests a long period of jobless growth; so does the international evidence on the aftermath of financial crises.

That said, there’s been a lot of optimism out there lately, reflected in the steepening yield curve. I’d like to think that’s right. But Ed McKelvey at Goldman (no link) has a new report titled “Recovery more Ho-Hum than Ho-ho-ho”, in which he acknowledges that growth will be good this quarter, but presents evidence that it’s all a temporary inventory bounce.

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