Krugman expects you not to expect anything

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!!”


15 thoughts on “Krugman expects you not to expect anything”

  1. The connection between finance and macro-economic effects seems pretty straightforward to me. But I very much disagree that this crisis has vindicated the Keynesian.

    A recession/depression happens when a massive bubble pops. Usually that bubble has been in the credit markets, as a result of maturity transformation in the banking sector. The collapsing credit bubble causes stock market and real estate bubbles to also collapse.

    When a bubble bursts people’s total paper wealth drops sharply. Every person has a target paper wealth to expenditure ratio. If paper wealth falls, a person must cut spending or else they will run out of retirement money.

    When people cut spending they do so by cutting purchases on luxuries and durables. Businesses producing luxuries and durables see their income fall, and lay off thousands of workers. If the fall in paper wealth is large (10+%) mass unemployment will result.

    When aggregate demand and aggregate income falls, the deficit goes up. As the deficit goes up, the private sector increases its holdings of treasuries bills, and thus has a net increase to its balance sheet. As total paper wealth goes back up again, the recession subsides.

    The government could speed this process up considerably by initiating a policy of balance sheet repair. The easiest way to do this would be to simply take all outstanding currency and bonds ( bank accounts, CD’s, treasuries, investment grade bonds) , multiply the face value by 20%, and print enough currency to back the new higher values. The policy is clean, quick, and would avoid the unemployment altogether. Another slightly slower method of balance sheet repair is to declare a tax holiday and print money to fund government operations.

    The Keynesians have this weird idea that aggregate demand falls because of “animal spirits” or “lack of confidence”. Thus a “stimulus” is needed to get people to spend their money. This is nonsense. People are not spending money because their paper wealth is much less. If you prod them to spend more, they will run out of savings. Restore the balance sheets, and the problem is fixed.

    Keynesians also believe that the government should step in and make for the lost spending. All this does is transfer resources to the government (often permanently due to the ratchet effect) while businesses continue to shed workers because people are not spending money. The government spending may alleviate some unemployment. But even this is not guaranteed, as the stimulus money is often spent in areas where there is not much job loss (for instance, much of the current stimulus went to univerisities, but the worst job loss is in home construction and manufactured goods)

    The other response is to blow another bubble. This is basically what Greenspan did in 2001 ( and Krugman at the time called it the necessary way to restart the economy). As you point out, this only creates more problems down the road. Eventually the bubble pops again, and then you have to deal. Meanwhile, the process of blowing these bubbles transfers a lot of money to Wall St.

    Blowing the bubbles is totally unnecessary. The dollar is a fiat currency. The government should provide enough currency to meet demand. If paper wealth and aggregate demand fall sharply, the government should step in with enough newly printed money to restore the balance sheets.

    1. Thanks for the comment, Devin. Krugman clearly inspires the amateur macro-economist in all of us. But I think you miss an important part of what he is saying, which is that monetary stimulus alone, which seems to be what you are suggesting, fails at the extremes we found ourselves in at the end of last year.

      It’s called a liquidity trap. Central bankers “push on a string,” and money is not created by the banking system because it is bust or just terrified to lend. Then the only policy that works to get you out of a mess is fiscal.

      1. Baruch-

        For some reason “monetary stimulus” has become synonymous with giving money to banks that can use that money to lend. In most recessions this is not a good idea, because it will only encourage reckless lending. In our current “liquidity trap” it doesn’t work at all, because lending is constrained by a lack of credit worthy borrowers.

        The proper solution is to print money and give it to actual people. Restore the balance sheets of the American consumer. Krugman has argued before that this won’t work because people will just hoard the cash, rather than spending it. But this is the entire point. You keep printing money until you have satisfied the demand for money. Once that demand is satisfied – and not a minute before – consumer spending will resume. The dollar is a fiat currency, there is no constraint on printing money to meet an increased demand for money.

  2. Excellent thoughts. A few comments.

    1. Why not let interest rates go negative? (see post on my blog about Ising Model and “animal spirits”)

    2. Hayek is the proper antecedent to an adaptive expectations model of macro. His vision was explicitly evolutionary. People are hung up on the fact that he was non-interventionist on fiscal policy. There’s more to him than that.

    3. I don’t know and feel comfortable asserting that nobody knows whether there are useful macro models that are built from adaptive expectations assumptions. Nobody has yet gathered and modeled the appropriate data set. But the data is out there. Malmgren and Watts, for example, have shown how the behavior of crowds can be characterized by periodicities in activity patterns.

    I apologize for introducing this jargon, but it’s simply the most precise way to say it: ratex is a mean-field theory. To see additional structure on the models of macro behavior, we will need finer-grained data (both spatially and temporally). There may be some useful models yet.

  3. I think you raise a lot of good points in response to Krugman’s piece. While there has not been much written on the financialization of the macroeconomy, to that end, I believe Hyman Minsky offers some of the most profound and relevant analysis. In “Stabilizing the Unstable Economy”, Minksy takes aim at the financial impact on macroeconomics and offers constructive solutions that could help stabilize the ebbs and flows of bubble euphoria to recession and the tendency for the treatment of economic pain to yield way to deeper pains in the future.

    I wish Krugman had talked about Minsky. The fact that he is so overlooked reflects on the dogmatic sway that free-marketers have held over this country beginning with Hayek. I have many thoughts as to the flaws of Hayek’s ideas and their relevance to contemporary economic philosophy and recently wrote about some of them here:

  4. Prof Steve Keen at the University of West Sydney was one of just 12 economists that were identified as having forecast the financial crisis, along with Ouriel Roubini.

    Go read his words yourself at:

    But as he says, all 12 have one thing in common, an admiration for the work of Minsky.

    The ridiculous part of this all, is that Keen, like Roubini, is often called Dr Gloom, as if they were the ones responsible for the crisis.

    In any other sphere of life they would be deemed heroes by the mainstream media for getting it right, but because they aren’t calling the next boom, especially Keen, they are being sidelined again.

    Anyway, as you note, the “crises” are getting closer and closer, and despite all the fiddling, the market will have its way with those high on debt, and there will be less chance of the neoclassical set to dismiss debt bubbles as irrelvant as they are clearly doing now.

  5. Devin, are you really truly suggesting the fed physically prints more money?!? In 10s, 20s and 50s? I fear the global economy does not work that way. “Printing money” is all very well, but once you have physically printed it, what do you do with it? Helicopter Ben suggested droppping it from helicopters, but I think he was joking, plus it would create an unseemly scramble underneath the helicopters. Moreoever, surely the helicopter downdraft would blow lots of the money away if you flew too low, or if you flew too high what if the money fell into a tree or something? There is a distribution problem. Pray tell what is your solution? how should the cash be physically distributed?

    Normally it is banks which create money, by magically crediting accounts with positive balances in the form of overdrafts, loans and mortgages, where no money existed before. Low or zero central bank rates encourage banks to lend more (normally they borrow overnight & cheap, but lend long and expensive). But you can lead a horse to water and yet he may not drink.

    If banks choose not to lend even though rates are low, no new money will be created. That’s a liquidity trap. Are we talking about the same thing here?

    1. No, I’m talking about physical green notes.

      One simple way to do it would be a tax holiday. The Fed then simply changes a few bits in the U.S. Treasury’s account to continually fund federal spending. So the money is “physically” distributed simply by altering the ledger of the Treasury’s bank account.

      Or the Fed could simply add $1 trillion to everyone’s account at the Fed, and the Treasury could then mail out $1 trillion worth of checks to the American people. The person deposits their check at their local bank, the Treasury’s account at the Fed is decremented, and the local banks account at the Fed is incremented.

      My favorite solution is a little more complicated. USG should decree that all FDIC backed Bank accounts and CD’s, all Treasury notes, and all investment grade loans, get multiplied by 20%. The logistics of this are far more difficult, but it is doable. Every bank would have to come to the Fed with a list of its accounts, the Fed would then have to credit the bank’s account at the Federal reserve with enough dollars to back the 20% increase in all the bank accounts.

      At any rate, there is no need for physical bills or helicopters. By “helicopter” people simply mean a neutral distribution of dollars, a distribution that does not favor any particular interest group (such as Wall St. banks). There is no need for the Fed to go through the banks in order to create money. It can create money directly and mail everyone in the country checks.

      Normally it is banks which create money, by magically crediting accounts with positive balances in the form of overdrafts, loans and mortgages, where no money existed before.

      Money is created a number of ways. Money is created when banks lend. Money is created when the government spends. Money is destroyed when the government taxes. Money is created when treasury bills are destroyed. The dollar is a fiat currency. There is no need for the Fed to limit itself to creating money via bank intermediaries.

      Normally it is banks which create money, by magically crediting accounts with positive balances in the form of overdrafts, loans and mortgages, where no money existed before.

      1. Good. Then your plan sounds slightly less crazed.

        I don’t mean that in a bad way.

        Your plan is provocative. You don’t think it’s a teensy bit inflationary? You don’t think it rests on money illusion and would come a cropper over the haha of adaptive expectations? BTW, how does paying taxes destroy money? Doesn’t government sometimes spend it too, on tanks and yes, helicopters?

  6. Elliot, I read your Hayek piece. Am not sure I agree with any of it. He certainly liked free -ish markets, and approved of the price discovery mechanism over government planning, but Hayek was an anti-fascist before he was anti-communist (although he saw them economically as the same thing at the end of the day). Otherwise he advocated a quite strong welfare system with a good minimum income for everyone guaranteed by the state. I worry you are misreading him. There is a lot more there than you are giving him credit for.

    1. Baruch: I can see how the post could be viewed as an oversimplification of Hayek’s work. You draw on one of the points I find most frustrating with the shape of public discourse right now–the same people denouncing President Obama as a socialist equate socialism with Naziism. Democratic-socialism and Naziism are not remotely the same ideologically. Hayek ultimately provides the theoretical grounds for confusing the two. Does Baruch believe in the slippery slope to totalitarianism? What does Baruch think of the Friedmanites and their application of Hayek to freshwater economic theory?

      Lastly, does Baruch have an opinion about Minsky and his theories on the financialization of the economy leading to bouts of instability?

      In response to the other conversation about printing money in the face of a liquidity trap, Minsky would have some interesting ideas. The concept of welfare and unemployment checks in their present conception did not appeal to Minsky due to their inflationary impact on the economy at large. As a result, Minsky proposed that the government act as “the employer of last resort.” Instead of simply writing checks, the government should focus on employing more people to complete projects that yield positive externalities for society in order to maintain aggregate demand and fill the production gap caused by a liquidity trap.

      1. Baruch does believe in the slippery slope. Baruch likes Friedman, and some Friedmanites, doesn’t like misapplications of Hayek but likes good applications of Hayek. Baruch likey Minsky too!

  7. Baruch

    You don’t think it’s a teensy bit inflationary?

    The point is to counter the existing deflation. The existing deflation is caused by shock in the demand for money, and that must be met with a corresponding increase in the supply of money. Note that inflation is usually bad for two reasons:

    1) It transfers wealth from savers to the currency issuer

    2) It destroys demand for the dollar, which creates bubbles, financial instability, and potentially a currency run

    The plan in which USG simply multiplies all bank accounts and bonds by 20% has neither drawback. Because the money is injected into the hands of current holders of USG liabilities, in direct proportion to their current holdings, it neither transfers wealth nor penalizes dollar holders. Thus the Fed can counter the deflationary spiral, without creating nasty side effects.

    If the government reflates via tax holiday (rather than by multiplying bank accounts and bonds by 20%) the inflation problem becomes more tricky. In this case the government would need to be sure to stop the tax holiday as soon as inflation started ticking back up.

    BTW, how does paying taxes destroy money? Doesn’t government sometimes spend it too, on tanks and yes, helicopters?

    When the government taxes, the money effectively disappears. When the government spends it creates money ( it increments accounts at the Treasury). Read Warren Mosler’s explanation here if you want more details (the comments are also good).

  8. Quick question for the people who think the crisis vindicated Keynes but wasn’t the UK and US essentially running a deficit-based stimulus since 2001? Surely the bursting of that bubble is a sign that Keynes was wrong not right, that sooner or later you run out of other people’s money to spend.

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