I will not rehash the details of the Krugman cross in this post, since other bloggers have already explained the cross and some of its implications (see, e.g., Rob Parenteau’s, Scott Fullwiler’s, and Bill Mitchell’s). Instead, I want to draw out a particular (and potentially revolutionary) implication of the model.I believe that what Krugman was able to finally see, with the help of his cross, is nothing but the restatement of Keynes’s old paradox of thrift for a closed economy with a government sector able to run a deficit (though one can also represent the original paradox of thrift taught in intermediate macroeconomics if the GSFB – government sector financial balances – curve coincides with the horizontal zero deficit/surplus line, i.e. if governments run a balanced budget). Much like the simple exposition of the paradox of thrift for a closed economy without a government sector where aggregate savings are unavoidably equal to the size of aggregate investments, in an economy with a government sector the value of the private sector surplus is unavoidably determined by the government deficit. This means that when the desired level of private sector surplus rises as a share of each level of GDP, the tautological stubbornness of the accounting identity forces the adjustment to take place in one of two ways (or a combination of both). Either:(1) The government deficit rises so that the private sector is able to achieve its new desired level of surplus at the current level of GDP
(2) GDP must fall until the GS (government sector) deficit reaches the new desired level of PS (private sector) surplus as a share of GDP
This is the exact equivalent to what Keynes argued with regard to an increase in the propensity to save. When people decide that they want to save more as a share of their incomes (or alternatively, when capitalists decide to increase the mark up over wage costs), for a given level of aggregate investment, aggregate incomes must fall so that the same aggregate savings becomes a greater share of the reduced aggregate income. As Rob Parenteau argued, “If Paul [Krugman] recalls his reading of Keynes’ General Theory (and he is to be applauded for being one of the few New Keynesians to actually read Keynes in the original), this is one of the reasons Keynes argues incomes adjust to close gaps between intended investment and planned saving.”
It is time to play a little with the shapes of the curves. Here I believe that Krugman’s analysis is especially useful for explaining policy prescriptions advanced by Post Keynesian economists. First of all, in the GSFB-PSFB model I see none of the interdependency problems and stock/flow inconsistencies that exist in the IS-LM model (so far…). As many of the bloggers (Felipe Rezende here) have demonstrated, under the current set of economic policies in the US, GS deficits tend to rise substantially when GDP falls also substantially. In Krugman’s framework this is represented as a relatively steep GSFB curve. The steeper the curve, the faster the deficit increases for a given reduction of GDP bellow a given threshold (given by the level of GDP where the GSFB curve intercepts the zero surplus/deficit horizontal axis). However, it is also true that the same government who responds promptly to a fall in GDP by raising its deficit significantly also responds aggressively to an increase in GDP above the threshold by raising its surplus since the curve is equally steep going down below the intercept as it is going up above it. Maybe we should represent the curve as having different steepness below and above the threshold, but this is less important as it depends on more sophisticated assumptions about government policies. While Prof. Krugman makes the interesting and convincing argument that the fact that today’s GSFB curve is much steeper than that of the early 1930s (meaning that GS deficits in the 30s did not rise significantly despite a great reduction in aggregate incomes) has kept us from experiencing another Great Depression, we have just begun to experiment with the shapes of the curve.
First of all, let us look at extreme situations:
(1) In the absence of government deficits or surpluses in the economy (i.e. if governments were blindly committed to having balanced budgets), the horizontal GSFB curve would coincide with the zero deficit/surplus line and changes in desired PS surplus out of savings would necessarily lead to aggregate income adjustments so that new equilibrium would be reached at the new intercept where PS surplus was zero. Income fluctuations would be the most violent under these conditions since changes in spending preferences by the private sector would lead to full income adjustments. Note that any horizontal GSFB curve would produce such effect. In other words, macroeconomic instability is the result not of the unwillingness of governments to run a deficit (indeed a horizontal GSFB curve above the horizontal axis could represent any size of GDP independent GS deficits), but of governments not adjusting the size of their deficits to changes in spending propensities out of given incomes.
(2) What if governments decided to determine the level of GDP for the economy (hopefully at full employment)? Then governments could accommodate any change in the level of desired PS surplus by raising and reducing its deficit accordingly so that GDP never needed to adjust. This would be represented by a vertical (or, more realistically, almost vertical if some GDP adjustments still took place) GSFB curve at full employment GDP. These are the kind of policies we should be looking for as automatic stabilizers: policies that make the GDFB as close to vertical as possible at full employment GDP. The most effective way to achieve it: an employer of last resort policy where changes in desired PS surplus at full employment GDP that lead to falling aggregate expenditures and employment in the private sector would be largely compensated by increases in government transfers to the newly hired workers in the form of wages. Even though it is not necessarily the case that the deficit brought about by such policy will be exactly equal to the new desired PS surplus at full employment GDP so that the GSFB is completely vertical, in addition to other stabilizers such policy will significantly raise the steepness of the curve.
Krugman has hit on something of great importance. I hope others will think through the implications of his approach and not allow the momentum to wane.