Baruch has to join the paean of praise for (all via Abnormal) Paul Krugman’s NYT piece, How Did Economists Get it So Wrong. He’s going to object to bits of it in a second, but first let’s puff it up. It’s fantastic, a great summing up of the state of the art of the dismal science (sic) that is macro-economics, includes a proper skewering of some hapless midwesterners, and a set of prescription for the future that Baruch can only applaud; writing of where macro-economists need to go now, Krugman concludes:
First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
As a broad strategic outline, or a description of the destination we need to get to, it’s great.
But, but, but. Here comes the quibble: 2 problems need to be overcome on the way, and this might make the project a little/even more difficult than most of us think it is. Economics may remain a dismal pseudoscience for a long while to come.
Problem One: the hardest part of Krugman’s 3-step path to the broad sunlit uplands is step 3; integrating finance and financial theory into a macro-economic framework presupposes that such a thing as a proper academic study of finance exists. It does not. No formal discipline, no body of work, has provided so little of use and so much of harm to the human activity it pretends to study than academics of finance have done to financial markets, and indeed the macro-economy. From efficient market theory, which Kruggers rightly knocks on the head, but which unfortunately underlies CAPM, to the Black-Scholes pricing model, which worked great for LTCM, to Fisher’s factor models which so far have proven least malign (probably because no-one uses them), financial theory has produced nothing of predictive value, and even the descriptive bits look creaky at times. The false certainties that financial theories created have instead lost the practitioners trillions.
The only bits, to my mind, of the corpus of financial theory that have any enduring worth are the ones that strongly imply that no embracing financial or asset-pricing model will ever have any predictive value, the ones that incorporate adaptive expectations. We’ll get onto these in a bit, as these are also the bugbears of the Keysnian model.
In any case, asking this lot to contribute to the grand project of reviving the status of economics is simply not going to work. Totally fresh eyes are needed at the very least, and it’s probably the economists that are going to have to do it themselves. The ever-stricter separation of discipline in the period since the start of the last century is probably going to make this even harder. Very few economists proper have the wherewithal to start. The best chance we have had to do any unifiying between asset pricing and an elegant macro thesis was probably, er, um, JM Keynes himself. He must have spent as least as much time playing the market as he did theorizing, because he was one the most successful equity investors of his time, a practitioner of strict value style a la Warren Buffett, and ran a hedge fund for the Bloomsbury crew when he wasn’t shagging Duncan Grant. And this, the titan who straddled the worlds of theory and practice in both policy and markets, who more than anyone knew the necessity of having a financial and asset pricing theory as part of the Great Theory, this incredible sophisticate, what did he eventually conclude about financial markets at the end of a lifetime of study? It was all “animal spirits”, in his famous phrase.
In the end, asking that economists properly “incorporate the realities of finance into macroeconomics,” is far, far more easily said than done. I don’t think Krugman is underplaying the difficulty of this, but I still think he may be “assuming a can opener”, in the words of the terrible old economist joke*. Baruch is famous for his economics jokes.
The second major problem may be even more serious. Krugman himself hints at this when he writes:
The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.
The pattern is not lost on Krugman; more frequent crisis, or recession, and progressively lower interest rates needed to “fix” it. In fact the greater frequency of crisis is something he has discussed before in his work. But the rates have reached zero. The monetary stimulus each crisis necessitates can’t go further from here. That’s why Krugman is so keen on fiscal stimulus, which is what he is talking about in the article. But this is also why, I think, Krugman takes so seriously his issue with Niall Ferguson, who objects that high levels of debt that massive stimulus creates are unsustainable.
Krugman does not address the accusation, very popular among my fellow finance professionals, that Keynsian solutions may be making each successive crisis worse; we knew 1990 was merely going to be a tough recession; the aftermath of the internet bubble was more serious but few feared a Great Depression, but the velocity and potential downside of the popping of the great debt bubble of the 2000s, however, was seemingly as serious as the 1930s. I think there is a prima facie case to be argued that Keynsian solutions to crisis, namely monetary and fiscal stimulus, may actually sow the seeds of the bubble that causes the next crisis, and make it potentially worse. And each iteration, as is certainly the case in the examples Krugman gives us, leaves less room for future stimulus. At a certain point, and sooner rather than later, a greater crisis may emerge and we will have no room to manouvre. Just as monetary policy loses traction at the extremes of a liquidity trap, is it not naive to think that nevertheless fiscal policy will always work? Ferguson is saying just that; at a certain point, governments simply cannot borrow anymore without precipitating default or inflation. He is wrong, probably, if he thinks that that point is very near right now, but I don’t think he is wrong to fear it in general, and he doesn’t deserve the scorn poured on him in the blogosphere for saying that.
The most cogent objection to the Keynsian framework is not that neoclassical economists are heartless, nor that they are foolish, although many of them might be when it comes to their undertsanding of unemployment. It is one that Krugman simply doesn’t mention; expectations adapt. This was the key intellectual and theoretical understanding of the “stagflation of the 1970s, which”, Krugman admits, “greatly advanced the credibility of the anti-Keynesian movement”. This was drummed into me in the late 80s and early 90s, my formative years on the way to my becoming an amateur economist, and no-one seems to want to talk about this any more. Simply put, after undergoing repeated cycles of stimulus, markets and economic participants lose their money illusion; they realise lower interest rates will result in inflation and react accordingly, creating self-reinforcing inflation epectations, and they realise that excess government spending needs to be paid for in tax raises, and default risks act to raise interest rates, choking off growth.
Old school Keynsians have an extraordinary aversion to any form of economic pain. They view it, and the unemployment and even homelessness it creates, as a simply unnecessary tragedy. They are often right to do so. But I know of hardly any form of human endeavour where achieving anything worthwhile is painless, where no adjustments need to be made, where there is in fact a free lunch. As Spinoza famously said, “all things excellent are as difficult as they are rare.” It would be incredible if economics were different. Krugman’s answer to many of these objections is a simple “given the risks of inaction, what else can we do”? I don’t have a better answer. I also have to agree with Krugman’s key idea that “Keynesian economics remains the best framework we have for making sense of recessions and depressions”, just as I agree that chemotherapy, radiation and surgery are probably the best ways of dealing with cancer. But repeated doses of all these are eventually as dangerous as the condition they are being used to treat.
* Three men stranded on a desert island, starving hungry, find a can of beans washed up on their beach. But how to open it?
“Bash it in with a stone” says one, an engineer. But it merely dents the metal. “Dip it in and out of saltwater, and after a few weeks it’ll slightly rust and weaken,” says another, a chemist. “I know, I’ve got it!!” says the third, an economist, all excited. “What, what?” say the other two. “Let’s,” he says, “assume a can opener!!”