Economist Paul Krugman wrote an essay in The New York Times (May 7, 2021) which explains how the interplay of monetary policy (especially interest rates) and fiscal policy affects the economy.
For an opinion column, the essay becomes technical and clumsy. Yet it is poised to unravel a complex issue being debated in the United States and elsewhere. This is actually a crucial political issue in the Philippines, as the economy has remained in recession since the outbreak of the pandemic.
The context of Krugman’s essay is to respond to fear or criticism that the Joe Biden administration’s massive relief program – in the amount of $ 1.9 trillion – is causing overheating.
Overheating would mean inflation, leading to stagnation. Krugman argues that even if the bailout or stimulus turned out to be more important than necessary, a moderate increase in the interest rate would curb overheating and inflation without causing a recession.
Krugman’s analysis is depicted in the two charts included with this piece. The two graphs also help to illustrate the Philippine problem, although our situation is very different from that of the United States. Unlike the US government which has engaged in huge deficit spending, the Philippine government has avoided the large borrowing that is needed to fund a huge stimulus or relief package.
Let me comment on Krugman’s explanation as it appears in his two graphs, but apply the annotation to the case of the Philippines.
In Krugman’s heuristic model, the IS curve (Figures 1 and 2) is the demand for investment. (It is called IS because investment = savings). The sloping downward curve means that investment demand (which also has a positive effect on consumption through job creation) increases national income.
A fall in the interest rate (the vertical axis) means an increase in investment and national income. Thus, monetary policy by lowering interest rates can stimulate demand. But, as Krugman said, monetary policy can hit a brick wall and fall short of the goal of achieving potential output (or full employment). This is the situation (Figure 1) when the interest rate has reached the lowest possible point – this is referred to as a “zero lower limit”. Our Bangko Sentral [ng Pilipinas] (BSP) calls it the effective lower bound. Although the interest rate has reached the lower limit of zero, the investment remains low. Or the zero lower bound still fails to generate investment to reach potential output or full capacity.
PASB used all its political instruments, including unconventional ones, to tackle the crisis. He sharply reduced the key rate; expansion of loan facilities; reduced reserve requirements; provided funding to the national government through a repurchase agreement with the Treasury in the amount of 300 billion pesos; and injected liquidity equivalent to nearly P2 trillion. Overall, the increase in liquidity and loanable funds has brought the interest rate down to the effective lower limit. In a graph, this is represented by an ascending LM (liquidity-money supply preference) curve, which is not represented in the Krugman model.
Nonetheless, BSP’s aggressive militant interventions have not stimulated consumption and investment. In other words, monetary policy is no longer effective. The liquidity trap Krugman talks about (Figure 1), refers to the reluctance of people to consume or invest despite monetary liquidity and low interest rates.
In times of high pandemic transmission, consumption and investment decline because people are limited or discouraged from engaging in normal activities. They are afraid of the virus. The push by economic managers to reopen the economy in a situation of high COVID-19 transmission will not be enough for people to overcome their fear.
Depressed consumption and investment lead to output gap (Figure 1). The output gap means that potential output or full employment has not been reached. But since neither private consumption nor private investment can close the gap, public spending has to do the heavy lifting.
But government spending not only covers the huge output gap (as evidenced by the deep recession), but also the big spending to flatten the pandemic curve. The government must spend not only to protect the unemployed, but also to save the sick, the dying and the hungry.
Bold public spending is absolutely necessary, even if it would mean violating conventional debt and deficit indicators. As we grapple with an extraordinary pandemic and economic crisis, the concern of economic managers about rising debt and deficit is misplaced.
Another argument of Krugman concerns the American debate on deficit spending. Biden’s unprecedented government spending has clashed not only with the Republican right, but also conservative Keynesians associated with Democrats. There are conservative Keynesians like Laurence Summers, who was the architect of timid fiscal policy during Barack Obama’s tenure. Obama’s fiscal conservatism prolonged the high unemployment rate, a factor behind Donald Trump’s rise to power.
Biden’s Big Stimulus is working. He awakened animal spirits. This start, it stimulated aggregate demand (shifting the IS curve to the right, Figure 2). Conservative Liberals fear the Big Stimulus will overheat the economy and set the stage for stagflation. But Krugman shows that in the event of overheating (which he doubts) policymakers have a way to avoid both stagnation and inflation.
“Press the breaks” by adjusting interest rates. Growth, no, potential output is satisfied, despite rising interest rates (Figure 2).
The other criticism raised by Krugman is directed against modern monetary theory (MMT). MMT is the new buzz that is now part of the “left” heterodoxy. Many believe it to be a Keynesian variant. Keynesian thinking and MMT have common concepts and issues (eg, fiscal stimulus, deficit spending, full employment), but they also have fundamental disagreements.
Primarily, the MMT, based on the issuance of sovereign currency by the government, does not recognize any financial constraint on public spending. The only constraint to the creation of money is inflation.
Claiming not to be financially constrained, MMT rejects the interest rate as a tool for stabilization or full employment. Operationally, MMT assumes a zero interest rate (or zero lower bound). Going back to Krugman’s Figure 2, the zero interest rate on MMT will prevent an increase in aggregate demand (by shifting the IS curve to the right) to satisfy full employment. The increase in demand will translate into higher interest rates above zero (Krugman’s “hit the brakes”). Ironically, this makes MMT no different from Summers’ stance, let alone Republicans. They all stand in the way of much higher public spending to achieve potential output.
We have shown that the situation in the United States is very different from that in the Philippines. The United States has incurred massive deficit relief spending. This, combined with the rollout of the vaccine, accelerated the recovery in the United States. The growth spurt has raised concerns that the economy is overheating. Krugman convincingly shows that this is unlikely.
On the other hand, the Philippine authorities are reluctant to engage in bolder deficit spending even as the economy is stuck in a recession. Yet the relevance of Krugman’s model for the Philippines is undeniable. This shows that it is imperative for the government to close the output gap and provide relief through much larger deficit spending.
Filomeno S. Sta. Ana III coordinates the action for economic reforms.