By Filomeno S. Sta. Ana III

Figure 1: Krugman’s workhorse macro model
Figure 2: Achieving Potential Output and Preventing Overheating (Krugman)

The economist Paul Krugman wrote an essay in The New York Times (May 7, 2021) that explains how the interaction of monetary policy (specifically interest rate) and fiscal policy affects the economy.

For an opinion column, the essay gets technical and wonkish. Yet it is on point in elucidating a complicated issue being debated in the US and elsewhere. It is, in fact, a critical policy issue in the Philippines as the economy has remained in recession since the pandemic’s outbreak.

The context of the Krugman essay is to answer the fear or criticism that the Joe Biden administration’s massive relief package — amounting to $1.9 trillion — would cause overheating.

Overheating would mean inflation, leading to stagnation. Krugman argues that even if it turned out that the relief package or the stimulus was bigger than necessary, moderately increasing the interest rate would rein in overheating and inflation without inducing a recession.

Krugman’s analysis is represented in the two graphs included with this piece. The two graphs likewise help illustrate the Philippine problem, although our situation is very different from the US conditions. Unlike the US government that has embarked on huge deficit spending, the Philippine government has avoided the heavy borrowing that is necessary to finance a huge stimulus or relief package.

Let me comment on the Krugman explanation as shown in his two graphs, but apply the annotation to the Philippine case.

In Krugman’s heuristic model, the I-S curve (Figures 1 and 2) is the investment demand. (It is called I-S because investment = saving). The sloping downward curve means that investment demand (which also has a positive effect on consumption through job creation) increases national income.

A decrease in interest rate (the vertical axis) means an increase in investment and in national income. So monetary policy through lowering interest rate can boost demand. But, as Krugman said, monetary policy can hit a brick wall and fail to achieve the goal of hitting potential output (or full employment). This is the situation (Figure 1) when the interest rate has reached the lowest point it can go — termed “zero lower bound.” Our Bangko Sentral [ng Pilipinas] (BSP) calls it the effective lower bound. Despite the interest rate having reached the zero lower bound, investment remains weak. Or the zero lower bound still fails to generate investment to meet potential output or full capacity.

The BSP has used all its policy instruments, including unconventional ones, to fight the crisis. It has sharply reduced the policy rate; expanded lending facilities; brought down reserve requirements; provided financing to the National Government by way of a repurchase agreement with the Treasury amounting to P300 billion; and has injected liquidity equivalent to almost P2 trillion. All in all, the increase in liquidity and loanable funds has brought down the interest rate to the effective lower bound. In a graph, this is represented by a sloping upward L-M (liquidity preference-money supply) curve, which is not shown in Krugman’s model.

Nonetheless, the BSP’s aggressive activist interventions have not stimulated consumption and investment. In other words, monetary policy is no longer effective. The liquidity trap, which Krugman mentions (Figure 1), refers to the reluctance of people to consume or invest despite money liquidity and low interest rates.

In the time of high pandemic transmission, consumption and investment are down because people are restricted or discouraged from engaging in normal activities. They fear the virus. The push of economic managers to reopen the economy in a situation of high COVID-19 transmission will not be enough for people to conquer their fear.

Depressed consumption and investment result in an output gap (Figure 1). The output gap means potential output or full employment has not been met. But because neither private consumption nor private investment can close the gap, government spending has to do the heavy lifting.

But government spending not only covers the huge output gap (as evidenced by the deep recession) but also the big expenditures to flatten the pandemic curve. Government must spend not only to protect the unemployed but also to save the sick, the dying, and the hungry.

Bold government spending is absolutely necessary, even if this would mean violating the conventional debt and deficit indicators. Since we are dealing with an extraordinary pandemic and economic crisis, the worry of the economic managers regarding higher debt and deficit is misplaced.

Another Krugman argument pertains to the US debate on deficit spending. Biden’s unprecedented government spending has been opposed not only by the Republican Right but also by conservative Keynesians associated with the Democrats. There are conservative Keynesians like Laurence Summers, who was the architect of the timid fiscal policy during Barack Obama’s term. Obama’s fiscal conservatism prolonged the high level of unemployment, which was a factor that explained Donald Trump’s rise.

The big Biden stimulus is working. It has aroused animal spirits. This early, it has boosted aggregate demand (moving the IS curve to the right, Figure 2). The conservative liberals fear that the big stimulus would overheat the economy and set the stage for stagflation. But Krugman shows that in case of overheating (which he doubts), policymakers have a way of preventing both stagnation and inflation.

“Tap the breaks” by adjusting interest rates. Growth, nay, potential output is met, notwithstanding the increase in interest rates (Figure 2).

The other criticism raised by Krugman is directed at Modern Monetary Theory (MMT). MMT is the new buzz that has become part of “left” heterodoxy. Quite a few think it’s a Keynesian variation. Keynesian thinking and MMT have common concepts and issues (e.g., fiscal stimulus, deficit spending, full employment), but they also have fundamental disagreements.

Principally, MMT, based on government issuing sovereign currency, does not recognize any financial constraint on government spending. The only constraint in creating money is inflation.

Claiming not to be constrained financially, MMT discards interest rate as a tool for stabilization or for full employment. Operationally, MMT assumes a zero interest rate (or the zero lower bound). To return to Krugman’s Figure 2, MMT’s zero interest rate will prevent an increase in aggregate demand (moving the IS curve to the right) to satisfy full employment. The increase in demand will result in increasing interest rate above zero (Krugman’s “tapping the brakes”). Ironically, that makes the MMT no different from the position of Summers, not to mention the Republicans. They all impede much higher government spending to achieve potential output.

We have shown that the US situation is far different from what is obtaining in the Philippines. The US has undertaken massive relief deficit spending. This, together with the vaccine rollout, has accelerated the US recovery. The burst of growth has caused concern about overheating the economy. Krugman convincingly shows that this is unlikely.

On the other hand, the Philippine authorities are reluctant to engage in bolder deficit spending even as the economy is stuck in a recession. Still, the relevance of Krugman’s model to the Philippines is undeniable. It shows the imperative for government to fill the output gap and provide relief through much bigger deficit spending.