Bullard vs. Krugman or the problem with output gaps
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.
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.