The Krugman tension

Efficient market hypothesis?

Paul Krugman’s latest New York Times column got me thinking about a tension in the great economist’s arguments which I’ve half noticed before.

Krugman argues that because the bond markets are showing no signs of running away from US debt, contrary to the warnings of fiscal hawks, there is plenty of scope for further stimulus. He also argues that because the bond markets are still clearly worried about Irish government debt, this is evidence that  austerity is a bad idea in the teeth of a slump.

But what if the bond markets were alarmed by US government debt? Would Krugman regard that as an indication that the time had come for fiscal and monetary tightening? Of course not. As a good Keynesian, he would argue that such tightening would merely make the economy weaker.

One of Krugman’s thoughtful Chicago-school rivals, Scott Sumner, puts his finger brilliantly on the tension:

“Krugman is an anti-EMH [efficient market  hypothesis] guy who forecasts as if he believes in the EMH.”

In other words, he thinks that markets are often wrong, or capable of acting irrationally. But he uses market sentiment to justify his macroeconomic prescriptions, implying that those markets are omniscient and inherently rational.

I’m sure Sumner over-eggs it when he suggests that Krugman relies more on market sentiment than his own Keynesian economic model. But there is a potential problem here.  If the markets do start demanding fiscal and monetary self-harm from countries (which one can plausibly argue has already happened with the PIIGS) Krugman will have to explain why, having told us to pay attention to market sentiment in the past, we must now ignore it.

UPDATE: oserdavid argues below that Krugman is merely exposing the inconsistency of the arguments of the fiscal hawks, rather than buying into those arguments. It’s a very fair point. But I still think it might be wise for him to point out more often that even if the markets were panicking about US debt they would be wrong and should be ignored by policymakers.

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