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The Case Against Keynes (With Some Questions for Krugman, Too)

As President Obama’s bipartisan fiscal commission gets set to convene, the Greek budget disaster has triggered the predictable flood of cautionary notes about how we’re spending too much and heading toward a debt crisis. Should these concerns illuminate the commission’s work—or are they merely alarmist?  

Paul Krugman harbors no doubts: “Despite a chorus of voices claiming otherwise,” he writes, “we aren’t Greece.” But that’s not as encouraging as it sounds, he adds: “We are however, looking more and more like Japan. ... [Recent data] suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged period of high unemployment and slow growth.” 

This diagnosis of our economic disease has implications for the policy prescription, Krugman argues. “For the past few months, much commentary on the economy ... has had one central theme: policy makers are doing too much. Governments need to stop spending, we’re told. ... Meanwhile, there are continual warnings that inflation is just around the corner and that the Fed needs to pull back from its efforts to support the economy.”  

Krugman will have none of this: “[T]the truth is that policy makers aren’t doing too much; they’re doing too little.” We should enact another stimulus plan, and administration officials would push for one if Congress had not been “spooked by the deficit hawks.” For its part, he adds, the Fed should abandon its groundless fears of inflation and work instead to ward off the threat of deflation—the true cause of Japan’s failure to regain economic vitality. 

So is Japan really a better baseline for U.S. policymakers than Greece, and is it close enough to serve as a guide for policy? To be sure, there are some important resemblances. Like the U.S., Japan experienced a sharp run-up in equity and real estate, followed by a collapse. As in the U.S., this reverse weakened the banking system and coincided with a sharp contraction in commercial lending. Like their American counterparts, Japanese policymakers responded with substantial fiscal and monetary stimulus. 

These are qualitative similarities. But there are quantitative differences, and they are large enough to warrant caution about direct policy inferences. Stocks in the U.S. are down about 40 percent from their all-time high, versus 75 percent for Japan. While U.S. real estate is down about 30 percent from its peak, Japanese land values are down more than 80 percent. In Tokyo, residential real estate has fallen by more than 90 percent, and commercial real estate in the heart of the financial district sells for 1 percent of its 1989 value. Brookings economist and former CEA director Barry Bosworth estimates that as a share of GDP, the destruction of wealth in Japan from peak to trough was about five times what it has been in the United States. Given the key role of stocks as well as real estate loans in the balance sheets of Japanese banks, it’s reasonable to assume that the Japanese banking system experienced a disruption far worse than ours.  

It would stand to reason, then, that restoring Japan’s economy to health would require an even larger policy response than the one we’ve seen in the United States thus far. In some respects, that is what happened. Unfortunately, it hasn’t worked. 

After falling from its 1989 peak, the Japanese “bubble economy” collapsed in 1991. The government responded with a long series of stimulus packages and (after a lag) interest rate reductions as well. Between 1993 and 2005, Japan’s budget deficit averaged 6.3 percent per year, and the government’s gross debt rose from 67.6 percent to more than 175 percent of GDP. Nonetheless, economic growth averaged an anemic 1.1 percent during that period—the worst performance in the industrialized world. 

Japan’s Deficit, Gross Debt, and Growth, 1989 to 2008 


Budget deficit

(as percentage of GDP)*


(as percentage of GDP)

Annual rates of economic growth

















































































*A negative figure indicates a deficit 

Source: OECD Factbook 2010: Economic, Environmental and Social Statistics  

As one might imagine, these disappointing results sparked debate within Japan’s economic establishment. Writing in a special 2003 issue of the journal World Economy, Japanese scholars Toshihiro Ihori, Masume Kawade, and Toru Nakazato summarize the debate as follows: “One hypothesis is that the effects of fiscal policy were very large and hence recession would have deepened without fiscal expansion. Alternatively, it may be that fiscal policy did not have enough of an expansionary effect to push up macroeconomic activity, and hence unlimited public expenditures simply made the fiscal crisis worse.” Using quarterly economic data, which enabled them to track the effects of successive stimulus packages, they concluded that the second hypothesis is far more plausible than the first: “[I]ncreasing public investment in the 1990s crowded out private investment to some extent and did not increase private consumption much. ... The overall policy implication is that the Keynesian fiscal policy in the 1990s was not effective.” The problem wasn’t that the stimulus packages weren’t big enough; it was that they were mistaken in principle, because they rested on the incorrect assumption that sustained deficit spending would stimulate aggregate demand. 

It’s not clear whether Krugman would accept this conclusion. In a series of blog posts written while he was still at MIT in 1998 and 1999, he diagnosed the Japanese situation as a rare real-world example of Keynes’s famous “liquidity trap” in which monetary policy loses its effectiveness: while interest rates can’t be reduced below zero, it turns out that zero isn’t low enough to stimulate economic activity. At the same time, Krugman expressed deep (and as it turned out, warranted) skepticism about the effectiveness of the conventional Keynesian response—namely, expanding public expenditures to compensate for decreased private spending (fiscal “pump-priming”)—both in Japan and in other future troubled economies. His reason is interesting: for pump-priming to work, “it must lead to large increases in private demand, so large that the economy begins a self-sustaining process of recovery that can continue without further stimulus.” Any policy that depends on open-ended stimulus is a failure.  

On the other hand, he continues, “None of this should be read as a reason to abandon fiscal stimulus—in fact, one shudders to think what would happen if Japan were not to provide further packages as the current one expires.” But why should we think that? If Ihori et al are right—if the ongoing Japanese fiscal policy displaced private demand rather than stimulate it—then Japan might well have been better off abandoning that policy altogether.  And, indeed, based on their analysis of fiscal crises through the ages (This Time It’s Different), Carmen Reinhardt and Kenneth Rogoff argue that rising debt to GDP levels eventually slows economic growth. By the late 1990s, Japan was well into what they identify as the zone of danger, when the debt to GDP ratio reaches 90 percent. The U.S. is not there yet, but we’re on track to get there by the end of this decade unless we change course. 

Krugman has a different analysis. The root of the Japanese crisis, he contends, is deflation, and the only remedy is a credible shift to a long-term inflationary policy. The Japanese Ministry of Finance should publicly commit to such a policy and back it up with whatever policies are necessary to make it real, including unusual monetary devices such as scrip whose value declines and then expires on a fixed timetable. This is why he emphasizes the most recent report on U.S. consumer prices, which showed inflation at a 44-year low. Japan, he argues, got stuck in a deflationary trap more than a decade ago and can’t get out. And, unless the Fed sheds its unwarranted fear of inflation and embraces a monetary policy whose principal objective is to prevent deflation, “it could happen here.” 

The issues I’ve raised in this piece are more than academic. If the deficit hawks are right, we need to shift gears toward fiscal restraint, starting with the upcoming fiscal year. If Krugman is right, restraint would only make matters worse, and besides, it misses the point: the last thing the Fed should do is retreat from the extraordinary measures it adopted to boost the supply of money after its reduction of interest rates to zero proved insufficient. 

I’m no economist; neither are most policymakers. And one may well believe that just as war is too important to leave to the generals, the economy is too important is leave to the economists. Nonetheless, the dismal science has a key role to play. Krugman has flung down the gauntlet; others should rush to pick it up. We need our best economists to enter a robust, focused, and publicly accessible debate about the fundamentals of our current ills, and the media should serve the public interest by featuring this debate on a regular basis. 

At the same time, there’s a role for the rest of us. For what it’s worth, my preferred policy would link continued stimulus for another year or two (including basic safety net programs such as extended unemployment insurance) with credible commitments to shift our long-term fiscal course. Until someone refutes Reinhardt and Rogoff, our operating presumption must be that excessive debt accumulation will eventually reduce economic growth. Besides, if CBO is right that we’re on track to incur annual interest payments of more than $900 billion by 2020, and if foreigners continue to hold nearly half our debt, we’ll be transferring about 2 percent of GDP overseas every year in interest payments alone. And how can we afford the substantial increases in future-oriented investment—in infrastructure, basic research, science and technology, and education—if we stay on our current path?  

The future of our economy and society depends on getting these large judgments right—the need to make decisions is getting more urgent, and our margin for error is steadily shrinking. We’ll soon find out whether our economists and policymakers can do any better than BP’s experts.