The US-led invasion of Iraq was a brilliant victory (Krugman: "it did the terrorists a favor"). President Bush signs into law today an historic pro-growth tax bill, enacted thanks to support from cross-over Democrats (Krugman: "the administration ...actually wants a fiscal crisis"). And the crisis in corporate malfeasance seems to have been overcome (Krugman: "they can get away with even more self-dealing than before"). The thing that seems to be doing a lot unraveling nowadays is Krugman's home base, the New York Times, sinking ever deeper into the Jayson Blair fraud scandal (Krugman: ...deafening silence). And then Krugman's had his own taste of scandal lately too, thanks to relentless fact-checking here and by the Krugman Truth Squad on National Review Online.

So what is the diminutive Princeton economics professor who found outsized fame as America's most dangerous liberal pundit to do until he finds his next hobby-horse of the apocalypse? Simple -- he retreats to the one role where he thinks (wrongly, as you will see) that no one will seriously challenge him: teaching economics. So we find in last Saturday's New York Times a column by this economics professor that is, atypically for him, about economics. And it's a big one -- over 1,500 words, about twice the length of one his usual Times op-eds.

The column is about two economic concepts: deflation, and the "liquidity trap." As you might expect, Krugman tries to make it seem that these two concepts are coming together in an imminent cataclysmic catastrophe (and only he and a few other really smart people see the looming danger).

Krugman begins with deflation, and introduces the concept using one of his favorite rhetorical tricks: pumping up the importance of the issue he wants to discuss, and legitimizing his take on it, by citing recent comments on it by a big-time authority figure who happens to agree with him. In this case, he cites "a rather ominous report" on deflation issued by the International Monetary Fund. The report, Krugman says, has Alan Greenspan "worried" because it shows Germany joining Japan as the next deflation victim.

Krugman cites the report five times, including shock jargon like "adverse dynamics" and "deflationary spiral" -- he even proudly mentions that the report "draws on my work on the subject." But hang on -- let's not get too worried just because Krugman can tell his scary stories with quotes from an IMF report. Who says the IMF is an authority on deflation? In the past Krugman himself has called the IMF "chumps," has said it operates "like medieval doctors who insisted on bleeding their patients, and repeated the procedure when the bleeding made them sicker," and derides their ideas for being based on "bankers' orthodoxy, not textbook economics."

What is deflation, anyway? According to Krugman, it's "a general fall in the level of prices." Okay, simple enough. Now can Krugman tell us what causes it? Yep -- the "liquidity trap." Krugman says, "Once an economy is caught in such a trap, it's likely to slide into deflation." And can Krugman tell us what's so bad about deflation? Yep -- "the most important reason to fear deflation is that it can push an economy into a liquidity trap."

Whoa -- how's that again? Liquidity traps cause deflation and deflation causes liquidity traps? This is what parents pay to send their kids to Princeton for?

OK, let's get our money's worth and ask the professor what a "liquidity trap" is. As Krugman puts it, "...what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy — added liquidity — sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness."

With interest rates already at zero, Japan would be said to be in a liquidity trap because the Bank of Japan can't lower rates any further. Krugman says that, in the United States, "with the overnight interest rate down to 1.25 percent, the Fed has almost run out of room to cut."

Of course all this rests on the Keynesian economic orthodoxy to which Krugman proudly subscribes -- the expectation that a central bank like the Fed can and should rescue the economy from occasional slowdowns by stimulating borrowing activity with artificially low interest rates. Krugman once described it as "the Keynesian compact" that allows brutal free-market economies to operate: "Oh, there are recessions now and then. However, when they occur, everyone expects the Fed to do what it did in 1975, 1982, and 1991: cut interest rates to perk up the economy."

The liquidity trap describes a failure of the Keynesian theory of the role of the central bank. It proves it doesn't work. In most sciences, this would be sufficient to throw out the theory. But Keynesian economics is not a science, it's an orthodoxy -- and failure is not an option among the orthodox, like Krugman. So the evidence of the orthodoxy's failure is given a technical name -- the liquidity trap -- and itself becomes a part of the orthodoxy in a new, more elaborate version, intensely studied by cultists like Krugman with even more single-minded solemnity than the original. Oddly, John Maynard Keynes himself first described the liquidity trap, but then again Keynes was never so orthodox a Keynesian as his latter-day followers.

If you don't believe the orthodoxy that a central bank is supposed to (or able to) turn recessionary lead into expansionary gold by lowering interest rates, then that leaves it with a pretty simple mission in life: to preserve and keep stable the value of the currency -- to prevent events such as deflation, correctly described as simply "a general fall in the level of prices." Such a mission is a matter of doing little more than printing the correct amount of money to meet the commercial demands of the economy -- print too much and you get inflation, print too little and you get deflation. As Milton Friedman said, "Inflation" -- or, for that matter, deflation -- "is everywhere and always a monetary phenomenon."

With that simple view of the Fed's mission, then in the words of economist David Gitlitz, my colleague at Trend Macrolytics, the liquidity trap "is akin to an urban legend," and deflation is nothing to be especially feared just because interest rates are near zero. Gitlitz wrote in a client report yesterday,

"As Fed Governor Ben Bernanke observed in a speech last fall, the Fed has an important tool at its disposal -- the monetary printing press -- that would allow it to directly inject essentially unlimited quantities of liquidity into the financial system if need be. Fed Chairman Alan Greenspan has reiterated on several occasions that the central bank could easily provide liquidity by jettisoning the rate-targeting regime and focusing its open market purchases on longer-term maturities."

But Krugman knows that. He's recommended that very solution to fix Japan's deflation for years (for example, here, in this paper whose web address includes the insensitive phrase "japtrap"). And he knows Bernanke's views intimately: earlier this month he bragged on his personal website about "Princeton - where the Fed's Ben Bernanke was department head until a few months ago..."

So just follow the money when Krugman says things in his New York Times column like, "those of us who worry about a Japanese-style quagmire find the global picture pretty scary" or "the risks look uncomfortably high" or deflation "will be very hard to reverse." As Caroline Baum put it in her Bloomberg.com column yesterday, "the Schadenfreude was palpable." That's because Krugman's desperately seeking something -- anything! -- that's unraveling (other than the New York Times). He's got books to sell!

Correction [5/28/2003] An alert National Review Online reader, Charles R. Martin, has informed me that, according to the dictionary, ravel and unravel mean the same thing. I guess I could be like Krugman about this, and claim that "all along" I was referring to the composer of Bolero, but as Richard Nixon used to say, "That would be wrong..."

Posted by Donald L. Luskin at 5:06 AM | link    

Sunday, May 25, 2003