An Even More Dismal Science

BERKELEY – For the past 25 years, a debate has raged among some of the world’s leading economists. At issue has been whether the nature of the business cycle underwent a fundamental change after the end of the “30 glorious years” that followed World War II, when the economy was characterized by rapid growth, full employment, and a bias toward moderate inflation. Three positions have been staked out.

First out of the gate, in 1991, was Larry Summers, with his seminal paper, “How Should Long-Term Monetary Policy Be Determined?” Summers was unconvinced that the underlying economic reality had changed, so his focus was technical – an attempt to guard against a repetition of the inflationary disturbances of the 1970s that marked the end of the glory years. His prescription was to strengthen the technocratic independence of central banks. Politicians should set goals, but they should avoid micromanaging the economy or imposing strict rules that would inevitably fail in unexpected circumstances. Technocrats were far better placed to carry the policy forward, Summers argued, guided by a target of 2-3% annual inflation.

The debate continued with Paul Krugman’s 1998 paper, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap” and his book The Return of Depression Economics, published the following year. Krugman made the case that central banks had already succeeded in anchoring inflation expectations to low levels, but had nonetheless failed to put the economy back on track. The economy in Europe and the United States, Krugman argued, had fallen from glory and returned to a pre-World War II pattern of “depression economics,” in which its dominant features were shortages of aggregate demand, risks of deflation, financial crises, and liquidity traps.

Then Ken Rogoff entered the fray with a comment on Krugman’s paper. In Rogoff’s view, what Krugman described as a long-term return to “depression economics” was a temporary condition, the consequence of failures to regulate properly and curb debt accumulation. This phenomenon, which he identified as the cause of the economic turbulence, inevitably ended in catastrophe, which could be resolved only through painful deleveraging and heterodox government-enforced debt write-downs.