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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 http://www.project-syndicate.org/commentary/the-risks-and-costs-of-quantitative-easing-by-nouriel-roubini 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.

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