Piper Alpha: July 6, 1988
IAS 107: March 17, 2011 Lecture: Inflation Economics I

What Would Call Forth a "Road to Damascus" Moment?

"And the Lord said unto [Ananias], 'Arise, and go into the street which is called Straight, and inquire in the house of Judas for one called Saul, of Tarsus: for, behold, he prayeth, And hath seen in a vision a man named Ananias coming in, and putting his hand on him, that he might receive his sight'.... And Ananias went his way, and entered into the house; and putting his hands on [Saul].... And immediately there fell from his eyes as it had been scales: and he received sight forthwith..."

Paul Krugman recounts the lessons he drew from the 1997-8 financial crisis:

Mind-Changing Events: One question that comes up occasionally in comments is, what would make me change my mind about how the economy works? Associated with this is the question of whether I have ever changed my views drastically.... Let me answer the latter question first. I had a major change of views in the late 1990s, driven by events in Asia.

Until then I had pretty much accepted the “elegant, and conceptually simple” framework described recently by Olivier Blanchard. Basically, I thought that conventional monetary policy could do the job of stabilizing the economy. The Asian crisis, however, led me to rethink that orthodox view. It showed, first of all, that a market economy can suffer huge financial shocks that can’t be offset just by using monetary policy; in particular, I found myself seeing a real role for capital controls to deal with the effect of currency crises in countries with large foreign-currency-denominated debt. And the reality of Japan’s liquidity trap showed that monetary policy can lose traction even without those kinds of currency and debt-denomination issues.

You could say that the Asian crisis made me more Keynesian — because it showed that 1930s-type problems could happen in the modern world, and that you could not, in fact, count on Uncle Alan or Uncle Ben to solve everything. So I came into the 2008 crisis with a framework based on my interpretation of what happened in Asia in the 1990s — a framework that has worked pretty well at making sense of events so far. Meanwhile, a lot of economists who had not taken the events of the 1990s on board were caught flat-footed.

What would it take for me to decide that I needed another major rethink? A major surge in domestically-driven inflation — in particular, a surge in wages — would do it. And there has been an uptick in core inflation measures that is a bit of a surprise; but at this point it doesn’t remotely count as the kind of discordance with theory that would require a major shift.

Let me say that I was not nearly as smart as Paul. My view of the Asian crisis was that capital controls were as likely to hurt as help a country with large hard-currency foreign debts--their imposition could stop capital flight in its tracks, but fear that they might be imposed in a country could start capital flight in the first place. My view was that the Asian crisis showed the limits of monetary policy in countries with large foreign hard-currency debts and shaky currencies--and those limits were that stimulative policies could not be undertaken by domestic central banks or governments but needed to be undertaken by an organization whose credibility was unimpaired, like the IMF or the U.S. Treasury. It did not seem to me to suggest that Uncle Alan or Uncle Ben would be handed problems beyond their strength.

And for Japan? It seemed to me clear that Japan's big problems were all the result of zombie banks--that normal stimulative policies had no traction because everybody believed that all of Japan's banks were insolvent. Proper marking-to-market of Japanese bank assets and proper recapitalization of the banks would, I thought, cure most of Japan's macroeconomic difficulties in short order.

As to what would cause me to substantially rethink my current positions? An upward expectational wage-price spiral with unemployment remaining above 7.5% or, given current policies, a recovery as fast as the one we saw after the Volcker disinflation would certainly do the trick.