Krugman in 2002:
The key point is that this isn't your father's recession -- it's your grandfather's recession. That is, it isn't your standard postwar recession, engineered by the Federal Reserve to fight inflation, and easily reversed when the Fed loosens the reins. It's a classic overinvestment slump, of a kind that was normal before World War II. And such slumps have always been hard to fight simply by cutting interest rates.
Now there's no question that the Fed's rapid rate reductions last year helped avert a much bigger slump. But a hard look at monetary policy suggests that the Fed hasn't done enough -- and possibly can't do enough. Although the Fed funds rate, the usual measure of monetary policy, is at its lowest level in generations, the real Fed funds rate -- the interest rate minus the inflation rate, which is what matters for investment decisions -- is actually about the same as it was at the bottom of the last recession, in the early 1990's, because inflation is considerably lower.The link is found in this blog post from February 2009:
So, how does this all end?
I’ve been saying for a long time that this isn’t your father’s recession — it’s your grandfather’s recession. (I actually used the phrase about the last recession, too.) That is, it isn’t something like the 1981-82 recession, which was brought on by the Fed to control inflation, and ended when the Fed decided that we had suffered enough. Instead, it’s like the 1929-33 recession — or the recession of 1873-1879 — a slump brought on by the collapse of an investment and credit bubble. And monetary policy, at least in its conventional form, has already reached its limits.
Now, the Great Depression was ended by massive fiscal expansion, in the form of World War II. Maybe that will happen again; but so far policy seems inadequate to the task, and the political environment raises concerns about whether we’ll be able to do much more.
So we may end up waiting for the economy’s ills to go into spontaneous remission. Which raises the question, how does that happen?
And it turns out that this is a question our grandfathers thought about quite a lot. Maybe it’s time to dust off Keynesian business cycle theory.
Keynes himself actually didn’t have much to do with this theory. In fact, one of the key moves in his development of the General Theory was the decision to focus on how economies stay stuck in depression for extended periods, rather than on the more complex question of explaining the economy’s ups and downs. But he did devote a brief chapter at the end to the subject, and Hicks elaborated on this quite a lot.
What’s notable about this theory is that it made no use of the self-correcting mechanism expounded in every principles textbook, mine included — the mechanism in which falling prices lead to a rising real money supply, which
shifts the aggregate demand curve outmoves the economy down the aggregate demand curve. Why? Well, as we’ve now learned the hard way, a sufficiently severe bubble-bursting pushes you into the liquidity trap, and makes the aggregate demand curve more or less vertical.
Instead, recovery comes because low investment eventually produces a backlog of desired capital stock, through use, delay, and obsolescence. And eventually this leads to an investment recovery, which is self-reinforcing.
And what do we mean by use, delay, etc.? Calculated Risk had a nice piece on auto sales, which I find helps me to think about this concretely. As CR pointed out, at current rates of sale it would take 23.9 years to replace the existing vehicle stock. Obviously, that won’t happen. Even if the desired number of vehicles doesn’t rise, people will start replacing vehicles that wear out (use), rust away (decay), or just are so much worse than newer models that they’re worth replacing to get the spiffy new features (obsolescence).
How is Japan's lost decade different? Deflation?As autos go, so goes the capital stock. In the long run, we will have a spontaneous economic recovery, even if all current policy initiatives fail. On the other hand, in the long run …