The USA is not in a liquidity trap any more

This post is related to the debate about fiscal policy and medium run growth which has become entangled with the Sanders or Clinton debate (which I will attempt to avoid). Some extremely Keynesian economists (DeLong, Pro Growth Liberal,, Menzie Chin, Paul Krugman, and (warning pdf) C and D Romer have expressed skepticism about the possibility that fiscal stimulus could cause US GDP to return to the pre-2008 trend.

They have focused on estimates of potential output and the output gap. Basically there are two arguments one is that simple extrapolation of the pre-2008 trend would give an over optimistic guess of potential output, because the rate of true technological progress has exogenously decreased. The other is that low demand has had permanent negative effects. The evidence for either (or both) is that measured total factor productivity growth has been very slow.

The conclusion is that it is unwise to try to calculate the output gap by trying to guess the trend in potential output. Alternatively, the output gap can be calculated by attempting to measure slack directly. The standard measure of slack is the unemployment rate which is now normal. Another is the ratio of employment to prime age (25-54) population which is very low. I’d add that the ratio of vacant jobs to employment is very high, the quit rate is normal and real wages have begun to grow. The pattern is very confusing and it is possible for the same person to reach very different conclusions on different days.

The point (if any) of this post is that I don’t think this matters much. The argument that fiscal stimulus will not cause higher output in the medium term is that, if output surpasses potential output inflation will accelerate and the Fed will raise interest rates cancelling the fiscal stimulus. The argument is based on a prediction about monetary policy.

I don’t think we need to estimate the output gap to predict the Fed’s response to fiscal stimulus or the Fed’s response to rapid GDP growth and declining unemployment. The Fed Open Market Committee (FOMC) has already raised the target federal funds rate up to the still very low 0.25%-0.5%. They have made it very clear that they are considering further rate increases. It could not be more clear that markedly reduced unemployment will convince them to raise interest rates.

The US economy is not at the zero lower bound anymore. This just means that the FOMC no longer wishes it could achieve a negative federal funds rate, that is, the interest rate is above zero so the zero lower bound isn’t binding. This is a statement about what the FOMC will do not what it should do.

Unless there is a political revolution including repeal of the Federal Reserve Act, the possible effects of further fiscal stimulus are limited.

Some people on twitter have the impression that Krugman and C Romer have suddenly ceased to be Keynesian, but they haven’t changed at all. Their views on fiscal policy depend entirely on whether the ZLB is binding (and always have). Krugman has never been what he calls (with the diplomatic tact for which he is famous) a vulgar Keynesian.

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