Krugman vs. Druckenmiller: A Blow by Blow Analysis

Paul Krugman (PK) recently accused Stan Druckenmiller (SD) of insensitivity to the working class because of the hedge fund superhero’s worries (as reported by Business Insider, from an interview with Bloomberg) that QE and an explicit policy of holding rates down for very long might [lead to bubbles].

Of course SD is NOT against recovery, per se. He seems to be against recovery that comes with the hidden expense of large risks, (e.g. Listed here by RGE Chairman Nouriel Roubini) or that results in one bubble being replaced by a bigger, more damaging one. These consequences (the foreseen ones of inflation, damaging liquidity, difficulty in exiting loose policy, and causing bubbles) are legitimate but not a present concern for Bernanke and a large majority of the FOMC. SD identifies the previous recession’s cause correctly as the gigantic credit bubble, for which in turn he ascribes some culpability to the Greenspan and Bernanke Fed for failing to normalize rates fast enough after the 2001 recession had turned to recovery.

PK is right that 7.9% unemployment and slow growth call for very expansionary monetary policy. But what if policy is even looser than it ought to be—is there any harm in that? In normal times, are there no penalties for when the Fed keeps rates very low, or when in the midst of a boom the Fed ignores the irrational exuberance? History shows that the cost of misguided monetary policy is high.

While I’m at it, another annoying thing that PK and some others tend to do, related to the above argument, is to compare the state of a given recovery to the pre-crisis high. PK did this with the Bush “jobless” recovery—doesn’t seem so bad now, does it?—and the present one in the US, and does it as a matter of course with Ireland, Latvia, Spain, Iceland, etc. But he really should know better. All of those pre-crisis points were the peaks of giant unsustainable bubbles. The bubble-level equity (Nasdaq 5000) and credit spreads (Bank of America and Ireland at a few bps over USTs) are equally meaningless now, except as a reminder of quite how irrational the exuberance can get. More prosaically, the IMF estimates the US had a “positive output gap” in 2000 and 2006 of 4.3% and 1.8% respectively, meaning output was way above potential. For the PIIGS, Latvia, and Iceland those overheating episodes are estimated at 3-9%, and manifested themselves in asset bubbles, grotesquely large current account deficits, and huge buildup of external debt to finance them.

Based on this the Greenspan criticism of SD looks on target: after preventing a major recession, the effort to reflate GDP was misguided. PK and SD seem to agree that dealing with our future obligations is a problem as well, though they might differ on how to measure it (SD probably would go with Kotlikoff’s number of $222 trillion or so = 148% debt/GDP on top of reported debt = US is bankrupt, and characterize it as fiscal child abuse, while PK would say seniors were promised and deserve every penny and that the $222 trillion should be divided not by 2012 GDP but by the sum of 2012-2055 GDP = $1 quadrillion = 22.2% of future GDP.) But while we shouldn’t aim to restore the economy to 2006-07 levels, the chart below shows that not advocating forceful fiscal and monetary measures to help the economy normalize now is foolish or cruel.

8 Responses to "Krugman vs. Druckenmiller: A Blow by Blow Analysis"

  1. Burk   March 12, 2013 at 5:42 pm

    1- An economy working "above potential" is literally impossible- were there more than 24 hours in the day back then? It means that employment was high and productivity was high. Perhaps you could point to measurement errors, where GDP came from financial jiggery-pokery, rather than labor productivity, etc. That would make more sense and would need to be decomposed. But the overall point is that from an employment perspective, booms are ideal times that we should try to replicate more consistently.

    2- The presentation of "risks" here is highly biased. The risk of inflation is highly sensitive to class interests. If you are rich, inflation is far more damaging than if you are poor, with no assets to depreciate. So there are going to be sharply diverging perspectives on the fundamental goals of good policy here. Controlling inflation tightly and forever is simply not the only goal worth pursuing.

    3- If I may add, the story that low rates led to this credit bubble is heavily biased as well, blind to the role of deregulation, which opened the floodgates of fraudulent credit. The fact that people across the country bought homes with non-existent money and then were summarily dispossessed again in a planet-wide catastrophe… that would only have been marginally modulated by the blunt instrument of higher rates. It would have been addressed far, far more productively by regulating underwriting and credit analysis and title conveyance standards.

  2. D. Nowakowski - RGE   March 13, 2013 at 10:48 am

    1 – you certainly can have an economy above potential: the signs are inflation pressures, widening current account deficits, build up of debt. Booms are not ideal times, they are characterized by unsustainable dynamics.

    2 – general inflation should be completely harmless, e.g. prices rising by 10% per year, wages rising by 10% a year, bond yields at 10% plus risk premium, nominal growth at 10% price + 2% productivity. I disagree that inflation hurts the rich: equities and business values are natural hedges. A jump in prices not matched by wages is what badly hurts the poor, whose disposable income gets hit.

    3 – I completely agree that low rates for too long were only a minor contributor to the bubble, and I'm not convinced that rates being 1-2% higher 1-2 years earlier would have worked. Weak regulation of banks, and nearly no regulation of non-bank financials (Lehman, Merrill, GS, Morgan Stanley; New Century, Countrywide, Fannie, Freddie) and mania among U.S. homebuyers were far more important. Sadly most of this was not fraudulent at all!

    • jack straw   March 31, 2013 at 3:47 pm

      World War II is the only example i can think of…and i would call it "at capacity" not "potential." the potential for an economy…especially an American or European one…is truly spectacular. "the special sauce" of course is not the currency. obviously declaring SD "insensitive to the working class" is a compliment. i DARE you to say "he is insensitive to his investors" however. that's FIGHTIN' WORDS…although ironically enough "perhaps very good one's right now." this has been a bear of a market to short…both of these clowns love to short more than anything…the only one who believe in a recovery thesis was Bernanke…"right man at the right time." history will remember him WELL in my view. with SD getting his balls ripped off in the Yen trade…clearly this guy has more than just working class people in mind when he wants to go "in for the kill." we'll see if he is ultimately right…i'm not sure i'd want to be though. i have no idea what the Kroogman is up to…he reminds me of The Deacon at this point in Waterworld "dispensing free cigarettes to the masses to keep them mollified" as we search for some dry land in this OCEAN of liquidity.

  3. lucad10   March 13, 2013 at 10:56 pm

    Please allow me to ask your opinion on currency rate regimes: why FED (or ECB) doesn't pursue an expansionary monetary policy by devaluating $ (or €) x-rate vs. chinese Renminbi ?

    I mean, as Renmimbi still benefit from a x-rate currency regime which is not based on a free market value fluctuations (but it is pegged to $ and €) its nominal appreciation in last 5 years has been almost +4% per year (you may find related figures at ECB site).

    At the same time, China has been experiencing almost 20billions $ per month in current accounts surplus for years.

    Shouldn't FED (and ECB) focus urgently on a policy focused on implementing a free x-rate regime for Renmimbi too in order to rebalance trade flow and employment ?

    Thanks in advance for your reply.

    Luca (from an almost de-industrialized italian economy)

  4. Tom   March 23, 2013 at 12:00 pm

    I'll take SD's side in this debate.

    I think the low interest rates were very powerful in driving the housing bubble. Which was close to being the explicit policy. The Economist was already explaining how it was working in March 2002: As for poorly regulated underwriting, sure. But regulation was never where you wish it would have been when you're looking in the rear-view mirror. Low interest rates helped convince people that the subprime market was good because it was spreading home ownership more broadly. There was a consensus that regulation wasn't needed, that the rising tide would lift the ricketiest boats, or at least enough of them that losses would be manageable. The easy money being made blinded almost everybody.

    This was not simply a matter of interest rates, but of credit growing much too quickly. This is why I don't listen much to Krugman. He acts as if he saw the crisis coming, but actually he didn't. He was on the right side about Bush's deficits, but he was warning of a CAD crisis, not a credit crisis. To this day he sticks to the notion that debts are balanced by assets so they don't matter. He still doesn't get that credit expansion creates money supply which funds further credit expansion, that that process inflates demand, that the faster it grows the poorer the average credit quality, that the bigger the debt stocks the higher the average default rate, and when taken too far it eventually collapses and reverses into debt deflation that destroys demand as quickly as the bubble inflated it.

    Bernanke likewise still doesn't get it. He still rejects that overlow low rates fed a bubble, he still won't call it a bubble. He tries to explain it entirely with underwriting standards. Those lousy underwriting standards didn't come from nowhere. The bubble came first, then the lousy underwriting standards developed as things moved into late cycle. The most wretched mortgage bonds were issued just before the bubble popped. That's how unsustainable systems collapse, by taking it to the extreme past which it just can't go. It was kind of like Iksil: because he was in so deep, he thought the only way he could save himself was going in deeper.

    As for the situation now, I disagree that not loosening monetary policy is "cruel". First, you have far too much faith in IMF estimates of "potential" GDP. The important aspects of economics are in the details, not in the aggregates. It's meaningless to say the US economy ought to be producing x% more, without saying what more it would produce. Millions more houses again, when the household formation is all in apartment rentals? That seems to be the monetarist notion.

    Monetary policy is a very, very roundabout way of addressing unemployment. Loose monetary policy boosts consumption but at the expense of lower savings, which sooner or later is reflected in lower investment and a lower growth trend. Arguably that has already happened. More importantly, our unemployment is mostly structural, mostly middle age and older men with no college who worked in construction or manufacturing, and there's just not much need for those guys now. Granted, small portions are taking low-paid service jobs, moving to the fracking boom counties, or even getting put back to work by the extra construction that's being spurred by low interest rates. But the vast majority of them are not going back to work. They are falling out of the unemployed ranks by falling out of the labor pool, when their benefits expire. Monetary policy couldn't have been much looser and it didn't put them back to work. The only thing that really could would be a federal employment program along the lines of the WPA. I would be for that, personally.

    Monetary policy distortions can be inappropriate and harmful without creating asset "bubbles". When asset prices rise, it can encourage homebuilding, but it makes most kinds of business investment more expensive, and deprives them of funds (savings). There's a lot to be said for letting asset prices fall so that investors can pick up assets cheaply. That process has a lot to do with why economies tend to bounce back quickly from deep recessions, and the relative lack of it this time arguably helps explain why recovery has been slow. The Fed isn't yet creating bubbles, but it is making assets prohibitively expensive.

    If there is another bubble, it will most likely be driven by corporate finance, not consumer. The current surge in housing prices in some areas appears to be financial investors punting well ahead of natural buyers, but that seems more likely to fizzle sooner than bubble and pop later. My feeling is that equities are more likely to bubble this time than real estate. We'll see.

  5. Brainsmart Memory   April 4, 2013 at 1:47 am

    Am i the only one who feels that the debate is skewed .Greenspans efforts have been marginalised by the way the economy has been handled over a term that is longer than he was in office .The reality is that hedge find performance is not a measure of the overall economic growth (or lack of ) globally

  6. EEB   April 12, 2013 at 2:57 am

    But of course, in vulgar neoclassical junk economics, there is no objective definition of "potential GDP". The capitalists might define it as that state which produces the maximum rate of return on equity, or the maximum percentage of the national income accruing to capital and the bourgeoisie. Once upon a time, it was defined as 4% official unemployment; today, the neoliberal bourgeois apologists might posit a "NAIRU" of 8- 10% and call it "potential GDP". Probably the only objective definition of "potential GDP" would be that state in which the number of job seekers equals the number of job openings, but we would have to improve the methodology of measurement and upgrade the data gathering and analysis to use this metric. The important thing to remember is that "potential GDP" is grossly and systemically underestimated for political reasons.

  7. Nomad Capitalist   April 27, 2013 at 8:06 am

    Paul Krugman has been debunked. He's a bozo bereft of ideas. Can't we move on from him?