Confidence Fairies and Inflation-Expectation Imps: Paul Krugman smacks down Robert Waldmann's (and Brad DeLong)
A couple of weeks ago I semi-endorsed Robert Waldmann's position that there is a certain symmetry between Austerians' reliance on the Confidence Fairy and expansionary monetarists' reliance on the Inflation-Expectations Imp to rebalance the economy. (I say "semi-endorsed" because there is a small difference between the two positions: austerity policies to summon the Confidence Fairy have non-expectational effects that deflate the economy right now, perhaps severely, while quantitative easing has non-expectational portfolio-balance effects that slightly boost the economy right now.) Both policies do rely on changing expectations of the future, and on the shifts in business and household behavior that those changed expectations trigger.
Now comes Paul Krugman to deliver the smackdown on any and all who see a symmetry here:
[T]here isn’t really any [close parallel]; it’s an orders of magnitude thing. What the expansionary austerity types are claiming is that the indirect effect of austerity on confidence will outweigh the large direct depressing effect of cutting government spending now. That’s a very tall order. Consider a very simple New Keynesian model with... infinitely lived [non-myopic] consumers with free access to capital markets, assumptions that would seem to be very favorable to the notion that changes in expected future policy matter. Yet even there, a perceived [and certain] permanent fall in government spending will at best have zero effect on output; if there’s any notion that the cuts are temporary, they’ll be contractionary. Add more realism, and the odds of expansionary austerity get even worse. By contrast, expectations-based monetary policy has no direct effect on the economy today, so any positives from expectations make it favorable over all...
This, to my mind, is not quite fair to the high priests of expansionary austerity.
They do not envision not a one-time permanent cut in the level of government spending leaving the future growth rate unchanged. They rather envision a one-time permanent cut in the level of government spending now followed by a permanent cut in the growth rate of government spending as well. The cut in spending now has an adverse impact effect on current aggregate demand, but the fact that you were able to summon the political moxie to cut spending now makes your promise to cut the future growth rate of spending hyper-credible, hence the expectations effect does not just offset but overwhelms the adverse non-expectational effect.
But then Paul does goes over to what I regard as the first-best and think of as the Larry Summers point that the best kind of quantitative easing involves buying not Treasury bonds or mortgage securities but rather biomedical research, the human capital of 12-year-olds, and new bridges--that expansionary fiscal policy financed by the Federal Reserve is the best expansionary policy of all:
You don’t have to believe that the effects are really big to believe that they might be there. Now, there is room for skepticism over the effectiveness of “credibly promising to be irresponsible” — which is why from the beginning of this crisis I’ve always favored using fiscal policy as the main answer, with unconventional monetary policy as a supplement. But the Fed should be doing what it can — and finally, it seems to be moving in that direction...