Benn Steil: Why is Paul Krugman Still Calling for Fiscal Stimulus?

Nobel economist and New York Times columnist Paul Krugman is fond of mocking his critics for being ideologues rather than economists. In contrast, Krugman’s own policy prescriptions, he assures us, are based wholly on soundeconomic science.

Case in point is the theory of liquidity traps, which goes back to Keynes. An economy is said to be in a liquidity trap when the central bank is powerless to stimulate economic growth because the public demand for liquidity has become limitless. This could happen when interest rates have been driven down to zero, a situation in which people may prefer holding cash to consuming or investing.

Krugman has argued that the rules of the policy game are different in a liquidity trap. In normal times, when short-term interest rates are positive, governments can and should rely on monetary policy – cutting rates – to stimulate economic activity if output is running below capacity. There is no need for extra government spending to substitute for deficient private demand – what we call fiscal stimulus. The private sector can do the job on its own with an appropriate level of interest rates. But if rates are at zero, and need to go lower, the central bank is out of ammunition. The government must step in with higher spending, even if it means running large budget deficits.

While in no way disproving the theory, recent years have shown, however, to Krugman’s admitted surprise, that the so-called zero lower bound on rates is not, in fact, a lower bound. Central banks in Europe and Japan have experimented with negative rates and have found that they have thus far not driven banks to hoard cash in vaults (as a means to avoid paying the central bank to hold their balances). So the lower bound is actually somewhere below zero. And although we don’t have much experience with negative rates, we have seen that going negative pushes down the exchange rate – which is stimulative. In that regard, at least, it clearly works.

Of course, the U.S. Federal Reserve, as well as central banks in Europe and Japan, have also used quantitative easing (QE) at the zero “bound” – buying up longer-term assets in the market to push down those rates. The evidence of its effectiveness is the 2.2% U.S. GDP growth rate in 2013, a year in which there was a massive fiscal crunch from spending cuts and tax increases. Krugman had called that year a “test” for the view that monetary policy was still effective at the zero “bound,” a test he was sure it would fail. It passed with flying colors.

With the Fed having raised rates in December, the zero bound – for whatever it might have meant – is gone in the United States. This should mean Krugman, if he is truly following economic science as he claims to understand it, abandoning his calls for fiscal stimulus.

Yet he is not only still advocating a big increase in government spending, he is calling for government intervention to boost wages and union bargaining power. He further says that “mercantilism makes a fair bit of sense” in this environment. Yes, mercantilism – import barriers, export subsidies, and the like. Bring on the trade war.

Krugman justifies all this by arguing that we are still in a topsy-turvy liquidity-trap world because rates are “near zero.” Yet whatever debate we might have about the effectiveness of negative rates and QE, there can be no debate over whether we are in a liquidity trap. We are not. When the Fed’s policy rate is above zero, by any amount, it means that it has determined (rightly or wrongly) that – given the current stance of government fiscal and other policies – the appropriate rate for the economy is positive. Not zero or negative. Importantly, this also means that if the government does significantly increase spending, as Krugman wants, the Fed will react to the higher level of demand by raising rates more rapidly than it would otherwise have done. This will counteract the higher government spending; such effect is known as “monetary offset,” a concept which Krugman considers uncontroversial. Thus calling for fiscal stimulus with positive interest rates is the logical equivalent of wanting to eat more because you are a little bit pregnant. It makes no sense: you cannot be a little bit pregnant, nor can you be in a liquidity trap when rates are positive.

All of this suggests that liquidity traps are no more than a theoretical fig leaf for policies – more government spending, government wage setting, import barriers – that Krugman supports for other reasons. And he shouldn’t have any problem acknowledging that. The name of his blog, after all, doesn’t even mention economics. It is called “The Conscience of a Liberal.”

— Benn Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods.

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1 Comment

  • There are a few statements here that are a little confusing.

    They appear to come from some of the confusion that appears in text books.

    Firstly, the definition of positive interest rates which is usually adopted is that real interest rates are positive. It is not clear what this essay means by positive interest rates.

    If it means above zero does that eliminate the liquidity trap – so called?

    If it means that real rates are positive what is the relevance of that?

    I would be interested in any reply offered.

    If the Fed raises interest rates at all fast they will raise the cost of housing finance at least ten times faster.

    They do not actually seem to know how far in theory, interest rates have to be raised to slow short term borrowing demand and thus inflation.

    Take away the housing finance hit on people and crumbling property values and take away the hit to bond values, and then having a positive real rate of interest is not nearly enough.

    A ‘normal rate of interest for 4% p.a. Average Earnings Growth, AEG% p.a., would be around 7% p.a. That is because it is not real interest rates which transfer wealth from borrowers to lenders. It is the marginal rate above the rate of AEG% p.a. which does that.

    That is not a complete analysis but it gets a lot closer than what economists today think are the facts.

    The logic of this can be found here:

    and also on my main website on the pages for the Low Inflation Trap and the related pages on interest rates. This has been rated very highly as a key part of my finished tract by the head of the economics faculty at a well respected university. He was once the spokesman for a central bank and highly respected.

    The home page for that is

    Here is what one head of banking at a university, and others, had to say about these ideas to be found in my short tract on financial stability:

    REVIEWS – more are promised
    Andrew Pampallis, retired Head of Banking at the University of Johannesburg wrote, “When people realize what you have done all hell will break loose.”

    Alan Gray, Editor-in-Chief, NewsBlaze, writes, “The Macro-economic Design group’s elegant solution is so simple that it has eluded the big economic thinkers of our time, because everyone was looking for a complex solution to a complex problem.”

    Professor Evelyn Chiloane-Tsoka from the University of South Africa, says “These ideas will become prescribed reading at universities.”

    Dr Rabi N. Mishra, Economist, and a Chief General Manager, Reserve Bank of India writes: “This book will inspire rethinking on the perimeters of economic thought and theory, and their practical use in policy making. A ‘should-read’ for budding researchers in Financial Economics to expand its horizon.”

    Dr. Azam Ali ex Senior Economist Bank of Pakistan writes, “Dear Edward, I am following your endeavours of rewriting the economic framework with great interest and am on the same page with you on almost all the issues you raise from time to time.”

    For this some of this tract go to

    and read my short tract on financial stability.

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