Eggertsson is a former Mike Woodford student, and a committed New Keynesian who works at the New York Fed (and appears to be visiting at Princeton, which explains the Krugman connection). He's supplying the New Keynesian technology to help Krugman to flesh out his thinking. The basic structure in the underlying model (some of which you need to go to the appendix to understand) is a standard New Keynesian framework. We have some infinite-lived optimizing consumers, and monopolistic competition. Some fraction of firms can set prices at will, and some must set prices one period ahead, i.e. there is time-dependent pricing. The nominal interest rate is set by the central bank according to a Taylor rule, and there is no money in the model (Woodford "cashless economy"), but of course goods prices are set in units of money.
The novelties here are the following. First, there is some heterogeneity among consumers, i.e. consumers can be one of two types, and types differ according to discount factors, so we have patient and impatient consumers. Second, there is an exogenous debt limit faced by each consumer, set in real terms. Third, debt is denominated in nominal terms, by assumption.
What we get from this is the following. Suppose the economy is in a steady state where the impatient consumers are borrowing from the patient ones, and impatient consumers are debt-constrained. Then, suppose that there is an exogenous shock to the debt limit. There is then a "deleveraging" effect. Debtors have to reduce their debts, and they do this by reducing consumption. The real interest rate falls, and could fall sufficiently that, in this sticky price framework, the nominal interest rate hits the zero lower bound. There is a further effect from debt deflation in that the price level falls, increasing the value of the debt, and requiring further deleveraging. Fiscal policy can have a big multiplier in these circumstances, in part for reasons Mike Woodford has studied, and in part because the debt constraint implies that Ricardian equivalence does not hold.
My comments are as follows:
In the introduction, the authors state:
Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models– especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy1.In the footnote they cite a few papers, including Bernanke and Gertler, Kiyotaki and Moore, and Gertler and Kiyotaki. It is certainly true that much of mainstream macroeconomics ignores the frictions that make credit, banking, and monetary exchange important. Indeed, this has been one of the key drawbacks of New Keynesian economics. Since the mid-1990s, Keynesian economists have focused their attention on sticky wages and prices, and have neglected other frictions, and the financial crisis made it clear that they had missed the boat. It's good that they are trying to make up for lost time now, but they have a lot to learn. Some neoclassicals were not any better at recognizing the importance of financial and monetary factors, for example the "Great Depressions of the 20th Century" volume gives short shrift to monetary and financial factors.
There is a lot of relevant work that Eggertsson and Krugman are unaware of, or are ignoring. Bruce Smith spent his career working on models of credit market frictions in monetary frameworks. I have work closely related to Bernanke-Gertler, and predating it (including my 1987 JPE paper). Many people have studied related debt-constrained problems. These include Kehoe and Levine (1993) and Kocherlakota (1996). There is a large literature that uses standard incomplete markets models (e.g. Aiyagari QJE 1993) to study problems associated with bankruptcy (e.g. this paper). New Monetarist Economics is all about monetary and financial frictions (see this).
In constructing and analyzing the model, the authors cut a lot of corners. First, the debt constraint is imposed exogenously. The authors are clearly aware that something deeper is required, but they don't seem to think this is a big problem. Second, the debt constraint is set in real terms, but for some reason (also not in the model) the debt contracts are nominal. Third, in analyzing the model, there is some linearization around a deterministic steady state, but the dynamics are not worked out from the model - these are essentially pseudo-dynamics.
Cutting corners matters. In particular, in environments where we are explicit about debt constraints, for example with explicit limited commitment, Ricardian equivalence can be hard to escape. For example, borrowers can face binding debt constraints in equilibrium, but if the government has no advantage over the private sector in collecting its debts, then the government is faced with the same problem in tax collection. If someone defaults on their private debts, they also default on their taxes. The economy will only be non-Ricardian if the government has some advantage in collecting on its debts. Maybe it does in practice, but it is important to model this so that we can understand it properly.
This is a kind of chicken model. We assume an advantage for the government in the credit market, in that the government can cut taxes today and increase taxes in the future, which effectively relaxes the credit constraints of borrowers, but only because the government can always collect the future taxes at no cost. This helps to give us big fiscal policy multipliers. In addition, there is some sleight-of-hand associated with an effect similar to what is in this paper by Woodford, where it is essentially monetary policy that is doing the work.
I can add to this my usual complaints about New Keynesian models. First, they are not explicit about monetary quantities and transactions, which are critical to how we need to think about monetary economies and monetary policy. This paper is more about fiscal policy, but the liquidity trap comes into play. If we want to understand that properly, we need a full-blown story about monetary frictions and central banking. Second, of course the constraints on pricing are exogenous. This obviously violates the Lucas critique. If pricing is so important, we need to think about how it responds to changes in policy rules. Third, Keynesian output effects are essentially by assumption. Firms have to, by assumption, supply whatever output is demanded at the price the firm is stuck with.
I think what the paper needs is the following:
1. Work out the results for the case with flexible prices. Indeed, one could start with a non-monetary economy. A basic Aiyagari incomplete-markets model will have the property that tightening up the borrowing constraint will lower the real rate, for example, but not much is known about dynamics. One could even compute solutions.
2. The linearization needs to be done for a fully-specified underlying stochastic model.
3. Where are those shocks coming from? It is not very informative to introduce a shock to the debt limit. The key thing is to understand how an increase in credit market frictions occurs as a result of factors that were occurring during the financial crisis.
4. The hard part is the debt-deflation story. In early versions of Bernanke-Gertler (1989), they tried to tell a debt-deflation story, but without success. The problem is that the best we have in terms of optimal contracting models are setups that deliver real debt contracts.
There are certainly some interesting ideas in here, but there are too many moving parts, and too many corners cut to feel very confident about the results the authors want to extract.