Arnold Kling  

Old-time Religion?

My Jobs Speech... Don't Just Sit There: Undo Som...

Paul Krugman writes,

You often hear people saying that the crisis has revealed the need for new economic thinking, for new ideas about macroeconomics. Yet the first priority seems to be to resuscitate old ideas. Brad DeLong describes an interview of Larry Summers by Martin Wolf as follows: "Asked to name where to turn to understand what was going on in 2008, Summers cited three dead men, a book written 33 years ago, and another written the century before last." And in my view, Summers basically got it right.

Thanks to Timothy Taylor for the pointer. The three dead men, by the way, are Walter Bagehot, Hyman Minsky, and Charles Kindleberger.

I have long had a soft spot for Kindleberger. Almost ten years ago, when I was more Keynesian than I am today, I wrote,

Why does aggregate demand sometimes fall short of the level needed to maintain full employment? My beliefs about this issue are influenced to an unusual degree by Charles Kindleberger, who was not considered a macroeconomist.

Kindleberger was an economic historian, who wrote extensively on the Depression and on historical episodes of speculative frenzy. He noted that these episodes, such as the Dutch Tulip Mania in the 1620's and 1630's or the South Sea Bubble in England in roughly 1710-1720, had common elements. A country achieved wealth as a result of the combination of winning a war and encountering a new market opportunity. Kindleberger called this process "displacement." Displacement resulted in early speculators achieving riches, leading masses of people to join in, resulting in overspeculation. This was followed by a panic, a crash, and an economic recession. This model of fluctuations was laid out by Kindleberger in his book Manias, Panics, and Crashes.

I got involved with the commercialization of the Internet very early, in 1994. I saw its resemblance to the Kindleberger model as early as August of 1995, when Netscape Communications became the first Internet company to sell stock to the general public.

I recently re-read CPK and discussed his relevance.

Back to Krugman. He makes three points. One is that the profession should have recognized the housing bubble for what it was. The problem is that you are tempted to explain asset prices, not to cry "bubble." Just the other day, Krugman himself gave in to that temptation regarding gold. In fact, his rationale for high gold prices is the same as my rationale for high house prices--low real interest rates. What I would suggest is that any time you get the urge to provide an economic interpretation of asset price movements, lie down until the feeling goes away.

The second point is that the profession should have recognized the fragility of the financial system. But that is asking technocratic experts to recognize the fragility of technocratic expertise. Because, contrary to myth, the financial regulators were not swept up in a wave of religious faith in free markets. Rather, they were convinced that with Taylor-rule-based monetary policy and Basel's risk-based capital regulations, they had built a macroeconomic and financial house that could withstand any storm.

Finally, Krugman complains that the profession forgot about the Keynesian multiplier. That may be true of some economists, but "folk Keynesiansim" has such a strong grip on politicians and the media that I do not think it much matters. I would say that, if anything, the idea that government deficits can create jobs has too much standing in the public debate, not too little.

My candidate for worst macroeconomic idea entered into the debate would be the "liquidity trap," for which the proponent is none other than Paul Krugman. What the liquidity trap says is that we need fiscal stimulus because the monetary authority cannot debase the currency, no matter how much it wants to. While policy makers certainly can have an argument over whether the monetary authority should want to debase the currency, Krugman has done a disservice by insisting that we are in a trap where debasement is impossible.

Of course, I am not convinced that the old-time religion of aggregate demand is the road to salvation. It is possible that I am wrong, and that aggregate demand is the big issue today. But you will find no mention of it in my jobs speech.

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COMMENTS (10 to date)
Alex Godofsky writes:

What I would suggest is that any time you get the urge to provide an economic interpretation of asset price movements, lie down until the feeling goes away.

Poor Scott Sumner...

mark writes:

It's funny that Hayek never gets mentioned anywhere in that post about "old" and "dead" economists and yet his perspective is probably the wisest.

TallDave writes:

Very good points, thanks for sharing.

I was fascinated to read that during TGD the economy was so cash-poor that hundreds of local scrips emerged -- clearly THAT was a liquidity problem. Whatever we have today isn't that.

Robert Bell writes:

"But that is asking technocratic experts to recognize the fragility of technocratic expertise."

I don't see the problem as being purely technocratic.

One admirable characteristic of good technocrats is the ability and willingness to say when a model does and doesn't apply. If, for example, you estimate volatility of an asset price from a sample of daily prices, surely statisticians would be the ones to discuss whether or not you can trust the results based on how skewed or fat-tailed the distribution is. In particular, if the process is more or less brownian motion with occasional Poisson jumps, then the statistician is going to to tell you that your sample period better include some jumps to be anywhere near valid.

On the other hand, if someone takes the perspective that the highest priority is the internal consistency of the model rather than the fit of the model to reality as in the old joke ("Ah it works in practice, but does it work in theory") that seems like a kind of methodological or ideological choice that is *not* technocratic.

I know this seems like I'm splitting hairs, but I think it's a substantive point.

Paul Johnson writes:

Perhaps the problem was that the technocratic experts who were consulted were being asked to evaluate their own actions. Wall streeters were the regulators of their former and future colleagues on Wall street. When has that ever worked out well?

Maximum Liberty writes:

It seems to me that the problem is not that we have forgotten the Keynesian multiplier but that it appears to be less than one, at least as implemented through the stimulus packages.


Hoosier writes:

That was one depressing video. Is all we have to look forward to low wages and waiting around for the invaders to start creating these jobs? We're also putting a lot of faith in the idea that the invaders are going to create jobs. Just throwing our hands in the air seems to me admitting defeat. How long would this process last? Would it be worth the sacrifice of all the people who are currently unemployed?

I think the idea of wage subsidies is a good one. If we're just going to be stuck with low paying jobs for the peasants then we as a society ought to do something to help those people out.

Mike Huben writes:

Let me get this straight. You were spectacularly wrong about the housing bubble because you attempted to explain it with asset prices. Krugman explains what model he is reasoning with and why he has chosen it, and you, having been burnt by an unwise choice in the past now think you know more than he does. When your thinking might still be unwise.

Krugman's model describes one of several possible reasons why prices for gold should rise, in this case a reason during a liquidity trap. He explicitly says there could also be a bubble. His purpose is not to explain the price of gold, but to explain why the price of gold is not evidence of expected high interest rates. A bubble would not be evidence, nor would Hotelling model behavior.

It is sort of sad that you ignore the context because you got burnt when you tried to do similar analysis.

Jim writes:

I would add at least two ideas:

1. Most economic models (especially at the Fed) are fundamentally incorrect. This is a different argument than saying macroeconomics is valueless because it can not make accurate predictions.

2. The banking collapse says more than that intelligent people thought their rules had defeated risk. It is impossible to defeat risk, only trade it. And ultimately it is useless to trade it if the industry is seriously incestuous. Canadian banks avoided the need for bail-out first and foremost because they are more retail based, not just because they avoided MBS markets. No subsequent regulation has fixed the American exposure.

aaron writes:

Keynsian Spending: Shifting consumption from the future to the present, hoping that in the future people will consume what they've already consumed, smile, and ask for more.

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