Vintage 1948

SYNOPSIS: Krugman recalls the old models of Paul Samuelson's Economics: The Original 1948 Edition, and notices they they are still very relevant today, especially regarding the liquidity trap!

Synchonicity! There I was, rereading Trent Lott's statement about how much better things would have been if Strom Thurmond had won the 1948 election, when I looked at the bookshelf right above my computer - and there it was: Samuelson's Economics: The Original 1948 Edition (available in a new printing from McGraw-Hill, and highly recommended if you're interested in the history of thought in economics.)

Lately old-fashioned Keynesian macro has been on my mind, for a couple of reasons. We (me and my co-author, who also happens to be my wife) just finished a draft of the fiscal policy chapter of our textbook in progress; I also spent last week discussing deflation and liquidity traps in WWS 524. And it has struck me repeatedly how relevant the old stuff seems in the early 21st-century world.

It wasn't that way for most of my career. By the time I got my Ph.D., the monetarists had lost some big battles - even by 1977 it was clear that you couldn't stabilize the economy by maintaining a steady growth rate for M3.14159, or whatever aggregate was fashionable that week - but there was a consensus among economists that monetary policy could and should be the tool of choice for stabilization. Fiscal policy was too slow, too awkward, and anyway would just lead to crowding out.

More broadly, demand-side questions were no longer interesting. Yes, of course, you needed to get the timing of monetary policy right, worry about inside and outside lags, blah blah, but that was for hired analysts at the Fed or the investment banks; it wasn't the kind of thing an ambitious academic should spend time on. Aggregate demand was basically a solved problem, or so we thought. Aggregate supply - why nominal variables seemed to have real effects, whether it was really necessary to pay a high price for disinflation, and so on - was where the intellectual action was. Later still, the focus shifted to endogenous growth and all that.

Did I even read Samuelson 1948 until recently? I think I glanced at it, but it seemed impossibly musty. The way it dismissed the importance of monetary policy seemed ludicrous. "[S]short-term securities do not today yield much more of a return than cash", the book declared - referring to a bizarre world in which overnight interest rates were barely above 1 percent. Ridiculous, no? And then there was skepticism about the effectiveness of monetary policy. "If banks and the public are indifferent between gilt-edged bonds - whose yields are already very low - and idle cash, then the Reserve authories may not even succeed in .... bidding down the interest rate ... an expansionary monetary policy may not lower effective interest rates but may simply spend itself in making everybody more liquid" [Samuelson's italics] And then the book gave primacy to demand-side fiscal policy as a tool of economic management, with hardly any discussion of crowding out. How quaint!

OK, alert and well-informed readers know where this is going. Here we are in late 2002. The overnight rate is 0.02 in Japan, 1.25 in the U.S. In Japan we've had an object lesson in why Milton Friedman's monetary analysis of the Great Depression was so misleading: M2 or whatever is an endogenous variable, and when you're in liquidity trap territory conventional monetary policy can't target broad aggregates. Crowding out doesn't seem like such a big issue when you're at or close to the zero bound. Meanwhile, in the euro zone individual nations have no monetary policy, so stability-pact limitations on fiscal flexibility loom pretty large.

Oh, and sticky prices don't seem to be an obstacle to economic recovery right now. On the contrary, we're pretty happy not to see deflation developing rapidly.

In short, we are now in an economic environment that resembles the one Samuelson wrote about in 1948, and suddenly his economic analysis doesn't look all that old-fashioned anymore.

I don't mean to say that macro has learned nothing since 1948. Of course we've learned a lot. But there's not much in the current policy debate that rises above the level in Samuelson's 1948 edition, and quite a lot that falls below. For example, it's clear that the ruling party thinks that a cut in spending, matched by an equal cut in taxes, is expansionary ...

Originally published on the Official Paul Krugman Site, 12.11.02