Krugman on the real-time test of Keynesian versus classical economics.

DeLong posts a quote from Joe Gagnon

Away from the zero bound, monetary policy can stick to buying safe short-term assets because money yields zero and all other assets have a positive yield. At the zero bound, as you note, for monetary policy to have any effect it must buy other types of assets that do not have zero yield. But in both regimes the way monetary policy works is by pushing down the rates of return on financial assets. That is quite distinct from fiscal policy which works by increasing demand directly, albeit at the expense of higher rates of return on financial assets. And of course, helicopter drops increase demand directly without increasing rates of return on financial assets.

So maybe QEII isn't a helicopter drop, technically speaking? I don't know, I can't really follow what they're talking about. Is the Fed doing fiscal policy in Gagnon's view? So you push down the rates of return on financial assets and then what happens?

Incoming!

More evidence that the Fed intends to drop QEII on us after the election. Via Mark Thoma who writes:

QEI was the expansion of the Fed's balance sheet from around 800 billion to 2.3 trillion, and QEII would increase the size of the balance sheet even further -- though if they do move to QEII, how much and how fast that balance sheet would be extended is not known.

Obama in Rolling Stone:

The idea that we’ve got a lack of enthusiasm in the Democratic base, that people are sitting on their hands complaining, is just irresponsible.... We have to get folks off the sidelines. People need to shake off this lethargy, people need to buck up. Bringing about change is hard -- that’s what I said during the campaign. It has been hard, and we’ve got some lumps to show for it. But if people now want to take their ball and go home, that tells me folks weren’t serious in the first place. If you’re serious, now’s exactly the time that people have to step up.

Simon Johnson on how things could turn quickly for Obama:

What this conventional wisdom misses is that we experienced a severe credit crisis of the kind more typically seen in recent decades in middle-income emerging-market countries. The U.S. can recover quickly -- and jobs can come back much faster than expected -- but only if the dollar now depreciates.

Like it or not, significant dollar depreciation is more probable than most now suppose. The depth of the crisis in late 2008 stunned many U.S. observers, but its features were fairly obvious to people who have worked in Russia, Mexico, Argentina, or South Korea. Similarly, the recovery can share some characteristics with what those countries have experienced.

Korean Rebound

We shouldn’t anticipate any kind of immediate growth miracle in the U.S., but just keep in mind that after its economic collapse in 1997-98, South Korea grew almost 11 percent in 1999, while Russia -- written off in economic terms after its currency, public finances and banking system effectively collapsed in the fall of 1998 -- still managed a 6.4 percent expansion in 1999 and 10 percent in 2000.

The main reason the U.S. isn’t bouncing back so fast is because of exports and the dollar. South Korea, Russia, and other emerging markets that go through severe crises usually undergo a sharp depreciation in the inflation-adjusted value of the currency, making them hypercompetitive, at least for a while. This makes it easier to replace imports with domestic goods and services and much more attractive to export.

In contrast, the global financial crisis actually strengthened the U.S. dollar as it was seen as a haven, although the dollar has fallen somewhat from its recent peak against major trading partners.

A reciprocity requirement: The easy and legal way to stop currency manipulation by Daniel Gros

Overall it seems that the rest of the world with free capital markets can do little to stop the Central Bank of the People’s Republic of China to continue "steering" its exchange rate by accumulating more and more international reserves - it does not matter whether these are US or Japanese. The US, Japan, or the ECB cannot do the same because China has capital controls and there are simply no significant renminbi assets that foreigners are allowed to invest in.
...
But there is another way. The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt. Instead of the "moral suasion", tried in vain by the Japanese, the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt.

Imposing such a "reciprocity" requirement on capital flows would be perfectly legal - although the US (and Japan and all EU member countries) have notified the IMF that they have liberalised capital movements under Article VIII of the IMF. Yet, in contrast to the area of trade, there are no legal constraints on the impositions of capital controls.

This "reciprocity" measure would of course be equivalent to a very specific form of controls on capital inflows. Capital controls are always somewhat leaky, but not in this case because the Chinese Central Bank would find it difficult to hide its huge investments going through western financial institutions. No reputable financial institution would dare to become a hidden intermediary for the Chinese given that no institution bidding for hundreds of billions of T-Bill would take the risk of secretly fronting the Chinese government or central bank as it would have to certify that the beneficial owner is not from a country in which foreigners cannot buy and hold public debt instruments.

As a practical matter the introduction of the reciprocity requirement should provide a grand fathering of the existing stocks of Chinese official assets abroad (already above $2,500 billion). However, the Central Bank of China would still not be able to continue its interventionist policy - and that is what counts for foreign exchange markets.

(via Mark Thoma)

China does have capital controls unlike other countries. If the US blocks China and they in turn buy from Japan who has to in turn buy from the US, then we can block Japan also.

It's important to point out that the world economy is working under exceptional circumstances as Krugman continuously points out. There's too much savings and too much unemployment and not enough demand. China and Germany are exacerbating the problems with beggar-thy-neighbor policies.

Stephen Roach argues that China should adopt policies to boost its consumer spending. 

China’s gross domestic saving rate is 54 percent of national income, the highest in the world for a major economy. But its consumption share of G.D.P. is only about 36 percent, the lowest for a major economy and about half the 70 percent ratio in the United States.

I would therefore urge China to opt for aggressive and immediate pro-consumption structural policies. Stimulating domestic consumer demand would be a far more direct - and potentially a far less destabilizing - way of reducing saving and trade imbalances than a currency realignment would be.

These policies should include an expanded social safety net, with a public retirement program, private pensions and medical and unemployment insurance. China should also provide major support for rural incomes through tax policy and land ownership reform, as well as enhanced initiatives to encourage rural-urban migration. And it should encourage the creation of service-oriented jobs in industries like retail and wholesale trade, domestic transportation, leisure and hospitality.

Surveillance State 2.0
(or Welcome to the Panopticon)

The government wants to monitor all Internet communication.  It argues the baddies not longer use telephones which can be tapped.

New York Times article.

Internet Wiretapping Proposal Met With Silence

An Obama administration plan to make wire tapping the Internet easier for law enforcement and national security agencies was met with silence by online companies Monday.

Google, Facebook, Microsoft, Yahoo and Research in Motion - never shy about issuing press releases - all declined to talk about what would be a major shift in privacy law.

FBI's covering its ass in case of an October surprise? Terrorists win again simply by existing?


Tech Firms Resist India on Software Code Secrets

India basically wants to do the same thing.

The government said it needed to set up a procedure to detect any software embedded in the machines that could be used by foreign governments to spy on or otherwise harm India. Many orders for equipment were stalled for several months and gear from Chinese vendors has been held up for much of the year.

The Bond Market Bogeymen and the Liquidity Trap
(or Our Nation's Patriotic Creditors)

I seem to be writing a lot about Krugman's thoughts lately. It must be because he's on fire. Also he preciently wrote a book titled Depression Economics which is the land we currently inhabit.

Howard Kurtz on Krugman. Looks like we are in debt to Harold Raines and Gail Collins for raising Krugman's profile.

I found Krugman's columns frustrating during the Democratic primary, but he was on the right side during the health care reform debate and has been hitting on all cylinders since.

Exhibit A is his and Robin Wells's two New York Review of Books articles The Slump Goes On: Why? and The Way Out of the Slump. It's too bad more bloggers haven't engaged them on their articles.

I wrote about the first piece here, here and here.

The second article focuses on what needs to be done to get us out of the slump. They write "most of the time, we count on central banks to engineer economic recovery following a slump, much as they did after the 2001 recession." Usually a central bank will cut short-term interest rates, but the Federal Reserve Bank has already reduced rates to near zero.

Applying the Taylor rule, "the Fed's main policy rate, the overnight rate at which banks lend reserves to each other should currently be minus 5 or 6 percent." So we're in a liquidity trap where adding more liquidity has no effect.

Ideally the government should step in to spend with fiscal policy where the private sector will not.* But there isn't much chance of getting any significant stimulus through the US Congress. However the Fed can perform some uncoventional monetary policies. They could buy long-term government debt and long-term private debt directly thereby reducing premiums and reducing long-term rates. This is known as "quantitative easing" or QE.

The Fed could also state its intention of raising the inflation target to 3 or 4 percent. Inflation would help get businesses and people to spend and would help consumers work off debt and deleverage. Once consumers work off their debt, demand will pick up, followed by businesses hiring.

Wells and Krugman also present other ways to reduce consumer debt: allow mortgages to be covered by personal bankruptcy procedures or "as Bill Gross of the bond fund PIMCO has proposed, allowing Fannie Mae and Freddie Mac to engage in mortgage refinancing."

Finally Wells and Krugman take China and Germany to task for following beggar-thy-neighbor strategies. The essential problem of the world economy is an excess of savings, with not enough borrowers. Countries that run large trade surpluses in this environment "are propping up their own economies at the rest of the world's expense." Wells and Krugman don't mention it, but  Matt Yglesias and Barry Eichengreen have suggested that one way to counter China and Germany would be for the Federal Reserve Bank, the European Central Bank and Japan's Central Bank to do rotating/complementary devaluations which would reduce debt and spur demand.

A common thread running throughout the debate on ways to emerge from the slump is an irrational fear of the bond market.** People talk as if we were not up against the zero bound. Conventional wisdom seems to accept that Obama's fiscal stimulus, TARP, and the Fed's unconventional policies helped saved us from a second Great Depression. However conventional wisdom is now arguing that in the wake of Greece and the European Sovereign Debt Crisis and the rise of the Tea Party, anymore stimulus or unconventional behavior by the Fed to help lower record unemployment rates will upset the nation's creditors. People say the "bond vigilantes" will exact vengeance, but there has been no evidence that the conventional wisdom is doing anything more than making excuses for inaction. Rates on 10-year Treasuries have dropped down around 2.6 percent.

Maybe the Fed will butch up after the November election. Calculated Risk writes "(note: many people think that Hilsenrath has taken over Greg Ip's role (now at the Economist) and leaks to Hilsenrath [at the Wall Street Journal] might be part of the Fed's communication strategy).... Although QE2 isn't a done deal, the odds are very high that the next round will be announced on November 3rd at 2:15 PM ET."

And if the bond market ever does gather its toys and heads home, just raise taxes. "Soaking the fat boys" is a much better way to go than borrowing from them.
--------------------------
* Krugman had a nice blog post on fiscal stimulus and the Arsenal of Democracy.
** In Bob Woodward's book on the Clinton White House titled the Agenda, he recounts a story where at the beginning of his first term Clinton raged "I hope you're all aware we're all Eisenhower Republicans.  We're Eisenhower Republicans here, and we are fighting the Reagan Republicans. We stand for lower deficits and free trade and the bond market. Isn't that great?" Clinton was upset that Treasury Secretary Rubin and Fed Chairman Greenspan had counseled him to moderate his spending bill so as not to upset the bond market gods which Clinton ended up doing.

Arsenal of Democracy

Dean Baker points us to an editorial at the Washington Post.

Nor is Mr. Obama or his economic policy to blame for the economy's inability so far to resume robust, job-generating growth. The economy faces a painful, protracted process of deleveraging. Households and companies must work off a huge overhang of debt built up during the boom, and they can't resume spending and investing in the meantime. That deleveraging will hamper growth for -- well, for as long as it takes. Government efforts may ease deleveraging, but to the extent they succeed, it is generally by postponing the day of reckoning and making it more expensive when it inevitably arrives. 

Baker also notes that those calling for sacrifice failed to foresee the $8 trillion housing bubble which caused the overleveraging of debt. As Krugman argues, we can work off the debt cleanly or ugly. In the meantime the government could boost aggregate demand to utilize excess capacity until the private sector recovers. 

Here Krugman blogs about a new paper which shows that fiscal stimulus worked during the prewar buildup to World War II.

What Gordon and Krenn point out is that we actually have more information than a simple comparison between the depressed peacetime economy and the war economy after Pearl Harbor: there was a period of more than two years when the United States was gearing up for war but not yet engaged in combat -- the Arsenal of Democracy era. Rationing was not yet in effect, and for at least part of this period the economy still had excess capacity despite a very large rise in government spending.

...in the prewar buildup you had a clear-cut expansion of federal spending on the order of 14 percent of GDP. That’s a real experiment with the economy. And the results were clearly Keynesian.

The editors at the Post seems to the think the stimulus bill worked to help prevent another Great Depression - actually it was negated by the "50 little Hoovers" at the state level - but they don't advocate more to get us to full employment and full capacity usage.

It seems to the editors at the Post were a little too complacent about the housing bubble and are currently too complacent about high unemployment, slow growth and disinflation.

Interesting bit from a commenter at Baker's blog:

From Keynes's The General Theory of Employment, Interest, and Money: Chapter 21 - Trade Cycle - Section III:

"Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it."

Sebastian Mallaby review Robert Reich's new book

Interesting post from a commenter at Baker's blog:

From Keynes's The General Theory of Employment, Interest, and Money: Chapter 21 - Trade Cycle - Section III:

"Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it."

Yglesias writes about the Patient Protection and Affordable Care Act of 2009