How the Princeton School Shaped US Policy in the 21st Century

Summary

• Since the 1990s, five Princeton economists have significantly advanced New Keynesian theory.
• This ‘Princeton School’ comprises Paul Krugman, Ben Bernanke, Lars Svensson, Michael Woodford, and Gauti Eggertsson.
• They developed the now-standard view of monetary policy in the 21^st century and provided early insights into quantitative easing, forward guidance, and the ‘whatever it takes’ approach.
• Central banks adopted their policy recommendations to great success during the pandemic.

Introduction

Fiscal policy played a leading role during the pandemic. Its size and duration eclipsed that of any previous recession. The reason was a shift in government mandates from its traditional role of distributing income to an objective more familiar to central banks: macroeconomic stabilization and stimulating economic growth. This sharply contrasted the Great Recession when governments shied away from prolonged and significant support.

This attitude shift is just one example of how Princeton’s economists have influenced policy in the 21^st century. The group of five, whom fellow prominent economist Scott Sumner refers to as the ‘Princeton School’, contains Michael Woodford, Gauti Eggertsson, Lars Svensson, Nobel laureate Paul Krugman, and former Fed Chair Ben Bernanke. In this piece, we summarise their ideas and their recent rise to prominence.

Lessons From Japan

During the 1990s, Japan experienced one of the largest real estate and stock price bubbles ever. Valuations were stretched so much that the land below the palace of the emperor in Tokyo was theoretically worth as much as the entire state of California. When asset prices inevitably crashed, it threw the Japanese economy into recession.

What ensued was a prelude to the West’s economic challenges of the 21^st century. The Bank of Japan decreased interest rates to zero and boosted the monetary base via asset purchases, but to little avail. The economy entered deflation as growth plunged and low inflation expectations became entrenched (Chart 1). 

Why? In Krugman’s influential paper on the liquidity trap, he explained why central bank balance sheet expansion at the zero-lower bound (ZLB) could be entirely ineffective, as it was in Japan. The process involved simply swapping one zero-interest-bearing asset for another – short-term bonds for base money – which does not affect broader monetary aggregates or inflation (and therefore nominal GDP).

Japan’s inadvertent fall into a liquidity trap may also have been self-induced, as Bernanke wrote in an influential paper at the time. He pointed to three key policy mistakes. First was the failure to tighten policy when inflationary pressures rose during 1987-89. Second was the ‘pricking’ of the stock market bubble that induced an asset-price crash. And the last was failing to ease policies adequately during 1991-94.

More recently, Eggertsson (and Summers) have suggested other factors that can lead to a persistently lower interest rates environment. These are adverse demographic trends (i.e., an aging workforce), lower productivity growth, and higher inequality. How the aging Japanese workforce has been a long-term economic problem for the country is well documented.

The Princeton School – Monetary Policy

Borne out of the lessons learned from Japan, the Princeton five developed the now-standard view of macroeconomic policy in the 21^st century when interest rates are low. So what does that policy mix look like from a monetary perspective?

It is mostly being ‘credibly irresponsible’. That is, the central bank doing whatever it takes to boost demand while in the short-term accepting above-target inflation. And a central ingredient is guiding expectations. The bank must convince the public and markets that monetary expansion through large injections of money (also known as quantitative easing) is permanent and that any inflation overshoots are more than tolerable.

Many countries adopted this ‘whatever it takes’ approach during the pandemic. In the US, the shift to average inflation targeting (AIT) is a prime example. By accepting higher inflation in the short term, the Fed signalled its intention of restoring growth to trend. And it worked. The Fed stuck to its promise – necessary to build credibility – and GDP is now on a higher growth path than before the pandemic (Chart 2).

Krugman was very early to the table with his views on how central banks could exploit their credibility to avoid a permanent liquidity trap environment. However, Woodford and Eggertsson have also worked extensively on forward guidance, and their efforts are visible in the significant improvements in Fed communications throughout the 21^st century.

Together, these economists showed central bank communication strategies matter greatly. Further, if central banks create a credible commitment for monetary policy after the zero-lower bound is no longer binding, it would be equivalent to a more expansionary policy. The key is to convince the private sector that the central bank will, by all means necessary, pursue an expansionary policy that will allow for the price level to catch up once interest rates are rising.

The Princeton School – Fiscal Policy

Beyond monetary policy, the Princeton School and particularly Eggertsson have promoted the importance of fiscal policy. He was the first to provide a theoretical framework in which economies could land in permanent states of stagnation. In it, he showed how only with a substantial fiscal push can economies escape a liquidity trap.

Eggertsson’s 2014 work was arguably the starting point for the emergence of a huge literature investigating fiscal policy’s effectiveness at the zero-lower bound. This literature has shown with broad consensus just how important government spending is when monetary policy is constrained.

The enormous fiscal support offered during the pandemic is a real-life example. The pandemic was the first US recession during which household disposable income surged even as GDP plunged, thanks to massive government income support (stimulus checks and increased unemployment benefits). This support is likely why the economy recovered so quickly (Chart 3).

International Macroeconomics

Domestic policies at the zero-lower bound can also exploit international linkages, argued Svensson. His ‘foolproof way’ of escaping the liquidity trap environment involves pegging an exchange rate at an undervalued rate relative to a foreign currency. Such currency depreciation would make domestic goods more competitive in international markets. But more importantly, it would also lead to higher inflation expectations and actual inflation, boosting domestic demand.

For this to work, central banks must be willing to defend the peg by all means necessary. They must buy as much foreign exchange as necessary to keep their currency undervalued. The Czech National Bank successfully implemented this strategy in 2011 when interest rates were at zero and inflation was plunging. In the process, its balance sheet expanded to more than 80% of GDP within a few years, but the strategy boosted domestic demand and returned inflation expectations to 2% amid low interest rates (Chart 4).

Remember, however, that international linkages do not always help countries avoid being stuck at the zero-lower bound. Eggertsson, alongside fellow economists Neil Mehrotra and Summers, has also shown how secular stagnation can be ‘exported’ via capital markets. Capital inflows from countries with a secular stagnation problem to those without one depress international interest rates.

Bottom Line

Japan’s experiences in the 1990s provided many lessons about policy at the zero-lower bound for the US and other Western countries. The Princeton School of economists documented these lessons. Their insights paved the way for quantitative easing during the Great Recession and large fiscal stimuli during the pandemic. They have also led to improved central bank communication through explicit forward guidance and promoted the ‘do whatever it takes’ brand of policy. Krugman’s seminal work underpinned most of this achievement, who deserves a second Nobel Prize for his macro contributions!