Bullard vs. Krugman or the problem with output gaps

October 12, 2009

Paul Krugman likes to complain that “freshwater” economists rely on faulty mathematical models as the foundation of their theories. He’s right, they do.

And yet his own models are just as faulty. Take his weekend post that argues the Fed should keep rates on hold for “at least two years.” Justifying his argument, he points to his “entirely standard, conventional” economic analysis. (Funny that conventional “freshwater” economics is bunk, but Krugman’s conventional “saltwater” economics is beyond reproach.)

The problem with his analysis, as always, is that it ignores the dynamics of debt.

He returns to a variation of the output gap argument, that so long as the economy is operating below its potential, then inflation isn’t a threat. (He makes a similar argument in his column today.) Never mind that the high water mark he’s aiming for was artificially inflated by the credit bubble.

Luckily there’s some sanity inside the Fed. Here are comments from St. Louis Fed President James Bullard over the weekend:

Bullard also cautioned that policymakers should not place too much emphasis on output gap estimates when trying to assess inflation risks in the medium-term.

“I am concerned about a popular narrative in use today—the narrative being that the output gap must be large since the recession is so severe,” he said. “And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story.”

He added that measuring the gap is very difficult, both theoretically and practically. He cited research that shows much of the inflationary run-up in the 1970s can be attributed to a misreading of the output gap at the time.

“Even if economists were to accept a particular measure, the empirical relationship with inflation is not robust,” he said. In addition, traditional output gap measures do not account for the concept of bubbles.

“It has been popular to describe recent events as a collapse of a bubble in housing. A look at the housing data makes a convincing case,” Bullard said. “But when it comes to calculating traditional output gaps, there is no notion of a bubble. If part or most of the fall in output was a collapsed bubble, then today’s output gap would be smaller than it appears.” This would mean that inflation risks in the medium term are higher than otherwise thought.

(emphasis added)

Forex markets have been reminding us of something similar lately, namely that inflation isn’t simply a function of cost-push, of workers’ ability to negotiate higher wages for themselves. There’s also the inconvenient problem of debt, of the U.S. running up such gargantuan fiscal liabilities, both privately and publicly, that confidence in the dollar may collapse.

Krugman: “people saying that the Fed should start tightening in the near future who are inventing some kind of new, unspecified framework to justify their views.”

Indeed they are Paul. That’s because the models on offer — including your brand of Keynesianism — have utterly failed. In seeking to fight off all recessions with loose money, those models have left us such a massive debt stock relative to income, there’s no way to avoid a very painful de-leveraging of the economy.


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What do you expect from Mr. Krugman? This is the same man who argues that Republican generated debts are bad for the economy long term but Democratic generated debts are so wonderful he can’t find an argument to ever stop increasing them.

It’s often mentioned in the world that Italy is fiscally irresponsible. The US has 350% debt to GDP yet Italy is roughly 275% debt to GDP.

Posted by Steve Roberts | Report as abusive

I believe you have miscategorized Krugman’s view.

Most of the economist (both from the left and the right) that I have read seem to be in agreement that some level of monetary stimulus was required. The question is when this stimulus should end and what should be the velocity of this change (a steep rise in interest rates or a more gradual change).

Krugman was a constant critic over many years of the Fed low interest rate policy and he is one of the few people who called the housing bubble. His columns were consistent — artificially low interest rates were driving a housing bubble that was going to burst in a big way. The growth in both the deficit and the debt during a period of growth was a big problem. As I have read his recent columns over the last year, it is simply that in a recession we must be careful to not end the monetary stimulus too early lest it cut the legs off of any potential recovery. Yes, in the short term that means higher deficits and higher debt that will need to be addressed (i.e. spending cuts and/or taxes) in the medium to long run. However, if you suffocate the recovery the deficit and debt problems are likely to be more severe.

Posted by Adam Greene | Report as abusive

Adam Greene – No offense, but I think you’re the one who misunderstands Krugman’s positions. While he has at times voiced concern over deficits and low-interest rates, he has expressed more support for the opposite position – deficit-spending, bailouts, and low interest rates.

Re-read those housing bubble pieces, I actually think he was advocating another bubble to replace the tech one.

He wants everything – bailouts, sustainable deficits, artificially low interest rates, “healthy inflation”, and a healthy market. It’s just not feasible, and he thinks it is.

Posted by Adam Sharp | Report as abusive

Inflation is simply not on the horizon

Fed’s Kohn: Weak economy to keep inflation at bay
High unemployment, tight credit, vacant homes and idle factories point to a tepid U.S. economic recovery in which core measures of inflation are likely to slow further, the Federal Reserve’s No. 2 official said. “I don’t think a V-shaped recovery is the most likely outcome this time around,” Fed Vice Chairman Donald Kohn told the National Association for Business Economics. In a defense of the Fed’s pledge to keep benchmark interest rates unusually low for an extended period, Kohn said the economy would likely be producing “well below” its potential for some time and that expectations of future inflation would more likely fall than rise. “I expect that, for a while, the risk of further declines in underlying rates of inflation will be greater than the risk of increases,” he said. Kohn said U.S. economic activity turned up in the third quarter as investors waded gingerly back into riskier waters and businesses began to restock depleted inventories. Recent news on housing has been encouraging and new home construction should pick up gradually in coming months, he added. But because of weak labor markets, consumer spending, which accounts for about 70 percent of U.S. economic output, will remain muted, the Fed vice chairman said. Further, credit remains tight for many borrowers, both consumers as well as small and medium-sized businesses, he added.

Posted by Adam Greene | Report as abusive