Krugman/Eggertsson: Debt, deleveraging, and the liquidity trap

[Kurt_and_Hunter]

A new (serious) paper by Paul Krugman and Gauti Eggertsson of the New York Fed on the mess we're in.

Debt, deleveraging, and the liquidity trap

. . .

In the current policy debate, debt is often invoked as a reason to dismiss calls for expansionary fiscal policy as a response to unemployment; you can’t solve a problem created by debt by running up even more debt, say the critics. Households borrowed too much, say many people; now you want the government to borrow even more?

What's wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn't matter who owes the money. Yet that can't be right; if it were, debt wouldn't be a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that's not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person's liability is another person's asset.

It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn't created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.

In short, one gains a much clearer view of the problems now facing the world, and their potential solutions, if one takes the role of debt and the constraints faced by debtors seriously. And yes, this analysis does suggest that the current conventional wisdom about what policymakers should be doing is almost completely wrong.

Summary: http://voxeu.org/index.php?q=node/5823

Paper (wonkish): http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf

[Jim__]

1. Interesting, but scary: the current conventional wisdom ... is almost completely wrong.

I'll have to try to read the whole paper tonight.

[unblock]

3. the current "conventional wisdom" is far more politics than economics

good ol' keynes knew the deficit spending would help, and that was back in the 1930s.
it's not that the politerati have forgotten, it's that they're not interested in that conclusion. they want to shut down democratic spending, so they reach for a theory, however discredited, that justifies not spending. the only "spending" they find acceptable is tax cuts for the wealthy. which isn't an economic theory at all -- raiding the treasury is not an economic theory.

[Imperialism Inc.]

2. A must read for understanding the economy.