Paul Krugman: Three Wrongs Don’t Make a Right
The empirical failures of Krugman’s macroeconomic model
One of the running themes throughout Paul Krugman’s public commentary since 2009 is that his Keynesian model — specifically, the old IS-LM framework — has done “spectacularly well” in predicting the major trends in the economy. Krugman actually claimed at one point that he and his allies had been “right about everything.” In contrast, Krugman claims, his opponents have been “wrong about everything.”
As I’ll show, Krugman’s macro predictions have been wrong in three key areas. So, by his own criterion of academic truth, Krugman’s framework has been a failure, and he should consider it a shame that people still seek out his opinion.
Modeling interest rates: the zero lower bound
Krugman’s entire case for fiscal stimulus rests on the premise that central banks can get stuck in a “liquidity trap” when interest rates hit the “zero lower bound” (ZLB). As long as nominal interest rates are positive, Krugman argued, the central bank could always stimulate more spending by loosening monetary policy and cutting rates further. These actions would boost aggregate demand and help restore full employment. In such a situation, there was no case for Keynesian deficit spending as a means to create jobs.
However, Krugman said that this conventional monetary policy lost traction early in the Great Recession once nominal short-term rates hit (basically) 0 percent. At that point, central banks couldn’t stimulate demand through open-market operations, and thus the government had to step in with a large fiscal stimulus in the form of huge budget deficits.
As is par for the course, Krugman didn’t express his views in a tone of civility or with humility. No, Krugman wrote things like this in response to Gary Becker:
Urp. Gack. Glug. If even Nobel laureates misunderstand the issue this badly, what hope is there for the general public? It’s not about the size of the multiplier; it’s about the zero lower bound….
And the reason we’re all turning to fiscal policy is that the standard rule, which is that monetary policy plus automatic stabilizers should do the work of smoothing the business cycle, can’t be applied when we’re hard up against the zero lower bound.
I really don’t know why this is so hard to understand. (emphasis added)
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