Friday, July 31, 2009

Krugman's Saltwater Economics

Paul Krugman made it clear yesterday, 1979-82 made him convinced saltwater economist.

Still, many people continue to use the 70s to denounce all things liberal or activist.

What’s odd, though, is how little talk there is about the way the 70s ended — which I viewed at the time, and still do, as a huge vindication of Keynesianism.

Here’s what happened: the Fed decided to squeeze inflation out of the system through a monetary contraction. If you believed in Lucas-type rational expectations, this should have caused a rise in unemployment only to the extent that people didn’t realize what the Fed was doing; once the policy shift was clear, inflation should have subsided and the economy should have returned to the natural rate. If you believed in real business cycle theory, the Fed’s policies should have had no real effect at all.

What actually happened was a terrible, three-year slump, which eased only when the Fed relented.

It was 79-82 that made me a convinced saltwater economist. And nothing that has happened since — certainly not the current crisis — has dented that conviction.

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