I like his columns, but Derek Thompson at The Atlantic sometimes frustrates me, as he does in this piece. Republicans have been pointing to a study showing that certain other countries who cut their deficits saw big GDP growth as a result. Many economists have been arguing that the conditions that created that growth in those countries can't exist here. What's the deal? We cover this in Macro 101:
Now, congressmen like Eric Cantor are coming at it from a very naive Adam Smith perspective-- if you shrink the size of government then capital flows to the private sector and it grows to replace it. Think of a fixed-sized pie where one crowds the other out. But Republicans have lacked an explanation of the mechanisms that make this work.
However, Paul Krugman is attacking it from a naive Keynesian perspective: decreasing government spending decreases aggregate demand, income, and all economic activity. The way the private sector would grow here is either 1) by a decrease in interest rates making investment cheaper and boosting the private economy, and also prices falling making exports cheaper; or 2) Something else stimulating aggregate demand. But in Krugman's mind since the Fed has pushed the fed funds rate to zero, there can be no gains because interest rates can't fall and there can be no boost in aggregate demand.
Both sides seem to ignore open economy Macro 101. I disagree with Thompson and others that
1.) Our currency can't depreciate against others to boost exports.
2.) Monetary policy is unable to stimulate aggregate demand while at the "zero lower bound."
The more long-run model goes like this:
Y = C + I + G + NX
National Saving = (Y - T - C) + (T - G) where T is Net Taxes. The T's here cancel out, so
National Saving = Y - C - G . So, rewrite our first equation:
Y - C - G = I + NX, or National Saving = Investment + Net Exports.
Net Exports = Net Capital Outflow (this is also an accounting identity)
Net Exports is the difference between Saving and Investment. The U.S. saves a much lower amount than the level of investment that occurs, so our Net Capital Outflow is negative (we're a net borrower) and we run a trade deficit. The way this occurs in the model is that real interest rates are greater than they would be if we saved more. Our economy is #1 in the world and our firms pretty safe to provide capital to. Our currency is also around 60% of the world's "reserve currency" meaning many institutions hold dollar-denominated assets for safety.
This is the "global savings glut," many East Asian households save an estimated 30-50% of their net income, and there is less relative domestic Investment that occurs there, so the surplus flows abroad to the U.S.
Bottom line: If you want to boost net exports the only way to do this is by increasing national saving relative to investment. This isn't some right-wing idea, liberal Keynesian Joseph Stiglitz talks about this in every book he writes. How do we increase national saving?
National Saving = Y - C - G. So, either households Consume less, or Government spends less. If we were to boost our savings rate then there would be a "global dollar glut," making the dollar depreciate and boosting net exports. Then the world would complain that we're flooding the world with cheap goods, just as it complains China does now. (China would be forced off its own export-growth strategy in order to maintain full employment. They would have to stimulate domestic consumption and investment. We'd sort of switch places, in other words.)
Now, the Fed can also cause our currency to depreciate in nominal terms, which in the short run also lowers the real exchange rate and boosts net exports. It does that simply by creating it, and can create as much of that as it wants (until prices rise).
But we can answer Krugman's aggregate demand point as well: Aggregate demand is simply nominal GDP (NGDP, P x Y in the quantity equation). As Beckworth, Sumner, Nunes, and others have spent the last several years pointing out, NGDP targeting by the central bank would help stimulate investment and aggregate demand. The Fed basically let aggregate demand fall off and has yet to get it back.
We're sort of in the exact opposite case we were in during the Reagan administration, when the Volcker fed was tightening the money supply while Reagan boosted government spending. In this case, however, we want the government to reduce spending and the Fed to pursue massive expansion to offset the decline in aggregate demand. If you buy into the fallacy that the Fed can't boost aggregate demand except by lowering interest rates, then you disagree with this (as Krugman does). But if you know the Fed can boost AD by means other than focusing on an interest rate (as Milton Friedman did and Scott Sumner does, but modern Republicans mostly do not), ie: through NGDP targeting, then you know it can happen.