Chicago strikes back

It has never been a better time for people like Paul Krugman. This is what he said in New York Review of Books.

The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work.

Krugman is the leader of the movement of reviving Keynesian economics. The popularity of Keynes right now is very puzzling to me. Didn't the monetarists have the last laugh about the Great Depression already? Why people are still advocating big government spending, instead of focusing on monetary policy?

We all know that when nominal interest rates are at zero, the liquidity trap is not far. But does that mean we have to yield to fiscal policy? The defense offered by Mankiw is not very satisfying. In essence, he thinks that the Fed should work on creating moderate inflation to drive down the real interest rates. But how?

Fortunately, Robert Lucas came to the rescue. He said in the Wall Street Journal,

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day.

Later I learned that what he described is called quantitative easing. Whew, what a relief. We have not reached the end of this whole mess yet, but we should never give up on the Chicago School.

(Picture: University of Chicago)