A new paradox – Paul Krugman Blog

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A new paradox - Paul Krugman Blog - NYTimes.com.

This is important, so I hope I'm going to be forgiven for re-posting a loot of it:

Gauti Eggertsson is in the process of presenting a new paper on fiscal policy; the paper is here. In his presentation — though not in the paper — he offers great phrase: the “paradox of toil.”

According to his paper, when you’re in the liquidity trap, certain kinds of tax cuts have perverse effects. Cutting taxes on capital income, for example, encourages more saving — which is a bad thing, because we’re suffering from the paradox of thrift. In fact, reduced taxes on capital income actually end up reducing investment.

So what’s the paradox of toil? If you cut taxes on labor income, this expands labor supply — which puts downward pressure on wages and leads to expectations of deflation, which increases the real interest rate, which leads to lower output and employment.

All of this only applies in a situation of zero interest rates, which wouldn’t be interesting except that that’s the situation we’re in.

The general point is that we’re really through the looking glass, in a world in which lots of things have perverse effects — and basing your policy ideas on intuition from “normal” times can lead you very much astray.

Conservatives please note.