Paul Krugman recently wrote that
As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.
This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment.
Let’s accept here, for argument’s sake, Krugman’s insistence that a large-enough quantity of idle resources nullifies, or even reverses, “many of the usual rules of economics.” (Unlike Krugman, I don’t believe that even significant unemployment of labor and resources in fact renders scarcity such a minor fact of reality that the laws of economics – nearly all of which are based on the prevalence of scarcity – are rendered null. But I here grant him that assumption.)
My question here is this one: Is an unemployment rate of 9.1 percent – heck, let’s call it an unemployment rate of 15 percent – so large, especially compared with a natural rate of unemployment of, say 4.5 percent – to truly suspend the laws of economics to the degree that Krugman suggests these laws are suspended? Does a (say) 10.5 percentage-point increase in the unemployment rate – as in, from 4.5% to 15% – work to make our world “topsy-turvy”?
Asked differently, at what rate of unemployment above the natural rate does the broken-window fallacy (start to) stop being fallacious?
I am not here attempting to be provacative so much as I’m seeking to understand how Keynesians evaluate the ‘conditional-ness’ of the laws of economics. If Krugman’s general point is correct, how high must the unemployment rate rise above the natural rate in order to justify policies that make sense only in a world of widespread super-abundance of resources?
It’s certainly not clear that even a 10 or 12 percentage-point increase in the unemployment rate above the natural rate justifies the assumption of sufficiently widespread topsy-turviness – sufficient idleness of potentially productive resources – that policies meant to work only in a world of super-abundant resources are justified.
