In a piece yesterday, Paul Krugman disagrees with my assessment that there was more overheating than slack in the economy in the years leading up to the 2007-09 recession and financial crisis. That assessment was one part of a broader critique I was making of a secular stagnation hypothesis.
First, Krugman says that by using an overall GDP price index for which inflation rose during the years from 2003-2005 I am picking “whatever price index makes the point,” and thus employing “Another Taylor Rule.” No. I used an overall price index for GDP in the original Taylor Rule proposal going back two decades now. There’s no picking and there’s no new rule here. Rather than taking out food and energy price inflation I controlled for price volatility in that rule by averaging overall inflation over time. Simply taking out food and energy price inflation can lead to policy errors especially when such inflation lasts for more than a short time. And it is not only the overall GDP price level. The CPI inflation rate was also rising, not falling, during this period.
In any case, the increase rather than a decrease in overall inflation was only one part of my assessment that this was not a slack period. I also discussed the unemployment rate—which got quite low (4.4%) rather than high as in slack periods—and the huge housing boom with high housing price inflation.
Krugman does not even consider the unemployment rate in his response, and he simply dismisses the possibility that housing price inflation running at over 15 percent per year before the crisis was a sign of excesses. Instead he talks only about the housing bust and the downturn. But the bust followed the boom—as is so often the case. In my view, the boom and excessive risk-taking which lead to the bust was exacerbated by lax regulatory and monetary policy.
As I discussed in my 2009 book Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis “you have to look at more than inflation to assess the situation. Monetary economists have been concerned for years about the erratic nature of monetary policy, creating booms and then slamming on the brakes. Milton Friedman’s Newsweek columns were filled with that kind of complaint. In my view that has been a major problem with monetary policy in the past few years, after two decades of good systematic performance beginning in the early 1980s.”
Krugman finishes his piece by claiming that I always argue that policy is too loose. No. I am in favor of rules-based policy, not perpetual tightness or ease. If the federal funds rate had been adjusted more promptly in 2003-2005 (following the type of rule that described policy in the 1980s and 1990s), then it would not have had to rise above 4%. But instead it went over 5%. In this sense policy was too easy in 2003-2005 and too tight in 2006-2007.
Regarding the current unconventional monetary policy, I have long argued that it creates a two-sided risk: the risk of lower growth and the risk of higher inflation. Thus far the realized risk has been low economic growth with high unemployment. In my view, poor economic policy has been to blame.