Paul Krugman’s piece on “Why did economists get it so wrong” has attracted a vitriolic response from John Cochrane, reproduced here. Krugman’s piece was strongly worded, but the reply ups the ante, and I expect further escalation. Economics conferences in the next few years are going to be interesting events.
Given that, as Krugman himself notes, disagreements between economists were notably mild until the crisis erupted, what is going on here?
I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.
One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in the Economics Department of the University of Chicago) intensely dislike Krugman’s writing for the NYT.
But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.
Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.
Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.
In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.
Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]
So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.
Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.
fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.
fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.
John Quiggin 
“If one admits that the models only work under assumptions that are patently false, then that is an admission that the model itself is false.”
It’s not binary, it’s a spectrum. They are ‘false’ because they can never replicate reality, only approximate it, but that’s not to say they give no information or insight.
@Jarrah
Jarrah – the solution is not to lurch from one extreme to the other (get rid of taxi plates altogether). They tried that in NT and attracted every no hoper across the countryside. The government was indundated for three years by customer complaints “rides from hell” “drunken taxi drivers” “assaults”..you name it, it happened. They reversed their “competition policy decision”. The market never settled and in the stupid words of competition policy “kept churning”. Blind Freddy could have predicted that.
@Jarrah
Levels of confidence may have rebounded, and that is good, but unless that translates into increased consumption within the local economy we will have trouble maintaining the moderately low unemployment rate. Is demand showing signs of increasing – eg, are people anticipating a bigger spend this Xmas? Are retailers stocking up in anticipation of increased demand?
If the answers are “no” to either or both, then to use the now hackneyed expression, “We’re not out of the woods yet.”
Off now to support the local coffee shop with some increased consumption…
“The government was indundated for three years by customer complaints ”
There’s part of the problem right there – people thinking government is the solution to all problems. It’s becoming an entrenched cultural attitude, a very damaging one in my opinion.
Jarrah & Alice, did you know that apprenticeship targets are months ahead of schedule thanks to Premier Nathan Rees recruitment drive and that 1,000 apprentices now have jobs with the NSW State Government. Thumbs up Rees.
@Alice
I agree.
Getting rid of taxi licenses hasn’t worked on the other side of the Tasman either. Hasn’t stopped the true believers from believing in it. Maybe they should do some research to find out why taxis became regulated in the first place. They became regulated because there were problems.
And yes, that’s Keynes, animal spirits. We are not automatons and it ought to be re-remembered.
Jarrah & Alice, I forgot to mention that Rees is a compassionate man and recently announced $110,000 support for the Wyong Outreach Service of Coast Shelter for those in real need of a helping hand. Thumbs up Rees.
Freelander, that’s a very simplistic view, and wrong to boot. There are many areas to consider in deregulation – eg plates/licences, fares, driver qualifications, industry firms – and you can include some or all, and to varying degrees (ie by increasing plate numbers, not abolishing them).
Typical benefits include an increase in taxis, decrease in fares, increase in differentiation, increase in innovation. These are all predicted by free market theory.
The main problem is that the benefits are usually small, depending on which case you’re talking about. Also, new problems arise, again depending on case. Overall, however, there is a clear majority view that the benefits outweigh the costs when deregulation is done well, with sufficient but not rent-seeking-level regulation.
John, credit must be given to where credit is due and the compassionate Premier must be congratulated for setting up CAPS early this year. And if the private sector really want to do something positive in NSW then why don’t they take on board the 500 plus registered apprentices looking for work. Thumbs up Rees.
I didn’t know that Rees donated a lot of his income to charity – well done Rees (although I prefer to keep my thumbs to myself)
Nanks, what can I say about a compassionate Premier who today issued a formal apology to the state’s ‘forgotten Australians’, an estimated 200,000 people who grew up in orphanages, children’s and foster homes in New South Wales with many suffering abuse and mistreatment. Thumbs up Rees.
@Michael of Summer Hill
Yep – and they have made a lot of donations of our money to MR Cabcharge and a lot of donations of our land to Mr Mirvac and Mr Meriton and lot of nice planning law changes for Mr Lowy, Mr Coles and Mr Woolies. That is so sweet of Rees. Donations up Rees!.
Alice, if anyone has information about the Labor government breaking the law then I suggest they forward the information to the appropriate authorities for investigation rather than rant and rave. Thumbs up Rees.
Michael’s right Alice – after all, Labor make the laws, why would they want to break them? Only stands to reason.
Nanks, interesting that you should say that considering ICAC is ‘independent’ in that its operations, including investigations, are not subject to the direction of politicians, bureaucrats, any political party, or the government.
exactly Michael – and I’d hope you’d agree that ICAC operates according to law.
Nanks, I totally agree and would like to see an eqivalent federal ICAC set up.
@Jarrah
“Typical benefits include an increase in taxis, decrease in fares, increase in differentiation, increase in innovation. These are all predicted by free market theory.”
Some of the claimed benefits include … but that’s not what is found. And what is ‘free market theory’? Deregulating taxis, tried and failed. It could have been predicted by theory anyway. The market needs regulation to work.
“Overall, however, there is a clear majority view …”
Even if that were true, so what. In the middle ages there was a clear majority view that burning the local witch was the solution to most calamities.
Might I add that the benefits outweight the costs when anything is done well (because that is a tautology).
@nanks
LOL Nanks – how can NSW Labor be breaking the laws when they are making the laws to make sure they are not breaking the laws? Like that one about the rail track land in NSW – that pesky old law was really a bit of a nuisance for Landcom, Mr Meriton and Mr Mirvac wasnt it?? Now I can hardly go to the authorities can I? (are there any authorities left ??)
@Freelander
Freelander – it could also have been predicted by an idiot without a theory.
@Alice
Agreed by not every idiot!
“but that’s not what is found…Deregulating taxis, tried and failed. ”
Au contraire. Did you read the links?
“Even if that were true, so what.”
It means there’s room for some disagreement, but blanket statements about failure are refuted by the experts.
“In the middle ages there was a clear majority view that burning the local witch was the solution to most calamities.”
You sound like those climate sceptics talking about the scientific consensus. It’s a completely ridiculous argument, intellectually bankrupt. Are you seriously comparing today’s engineers and economists to medieval villagers?
The point to take away from this is that opposing deregulation on reflex marks you out as ignorant and/or stupid.
And apologies for dragging the thread off topic. Some of my other comments were more closely related to the original issue, perhaps we can move on to those.
@Jarrah
Jarrah says “Are you seriously comparing today’s engineers and economists to medieval villagers?
Careful what you ask Jarrah. Some might say…”not the engineers”.
@Jarrah
I wouldn’t compare engineers with the medieval intelligentsia. Even more recently, someone like Leibnitz, genius that he was, had some pretty silly ideas. However, I would compare significant swathes of today’s economists with them. So you can be clever and have silly, risible, ideas. Hell, I’ve even had them myself! And don’t discount the possibility that I may, at a later date, find some of my current views risible. Contrasting economists with engineers, engineers tend to know what they are doing, there is not much dispute on that, hence the absence of debate about core issues. Economics is not yet sufficiently scientific to hold it in similar regard. It took a giant backward step with Friedman’s essay (‘The methodology of positive economics’) which introduced the ‘F-twist’, as Samuelson called it. As for deregulation, deregulation is simply ideology. The goal for policy makers should be to try to maximise net benefits with available instruments. In individual cases, when it comes to regulation, that may mean reducing regulation, leaving regulation alone, or increasing regulation, or simply changing regulation to more efficient or effective regulation. (As increasing/decreasing are fuzzy sorts of concepts in this regard.) Talking about ‘deregulation’ is begging the question. Words like ‘deregulation’ and ‘free market’ (or ‘continuous revolution’) are conveniently available to disguise that their proponents have become to lazy to think.
This is what the macro wars are about. Wish craft – wishing that your speculation is true, and real science. The battle between magical a priori reasoning and scientific evidence based reasoning.
I can remember many years ago when I sat through the first seminar I attended where someone had used a real business cycle model. As I wasn’t interested in macro, I wasn’t aware that this was a serious research agenda. I thought the person had put together the model and estimated it for a bit of fun, not as something they were serious about. I was surprised to find out how wrong I was!
“Contrasting economists with engineers”
That’s just it – both groups have a majority recommending some form of taxi market deregulation or another (depending on individual cases, as always). On a side note, engineers are also statistically more likely to side with liberalisation policies in general, along with economists. This is possibly due to the math-heavy, logic-heavy, empirically-grounded training.
“The goal for policy makers should be to try to maximise net benefits with available instruments.”
Absolutely, no question. And sometimes benefits are maximised by minimising the use of the instruments! Hence ‘deregulation’.
I take your point that it’s a shorthand term, there’s a lot more to it than what is implied, but it was appropriate to the level of discussion.
Freelander, I thought about what you said ‘contrasting economists with engineers’ and in many ways they are similar for economic formulas tend to be similar to the Macaulay method it is an approximation.
@Jarrah
A lot of engineers, unfortunately, become amateur economists. Some become real economists, as you probably know some have become famous economists. Because they can do math, they often become seduced by mathematical sophistry and by mechanical explanations for economies, which, unfortunately, are made up of humans. Sadly, there are other specialties that can shine more light on many economic problems. And just because engineers are competent in their own area doesn’t make them competent in economics. Also, engineers are not scientists. They apply science. Also, their training is not particularly logic heavy. The approach to mathematics used is not so logic heavy, it is more ‘cook book’. Other than that I think you are entirely right!
I can confess to having once thought that taxi deregulation was a good idea. In defence, I didn’t really think about it that much. Having seen the results I have changed my mind, and also thought about it more thoroughly. I can see that it wasn’t even a good idea in theory. (And we all know the joke about the economist who said “That’s all very well in practise, but how will it work in theory!”)
Mathematics seems to cop the blame a lot, these days, for the failings of economists. This blog’s topic indicates that the problems within economics are more foundational.
I enjoyed reading Krugman’s article, especially having read Cochrane’s response first (don’t ask me why I read them in that order, I don’t have an answer).
There is nothing wrong with mathematics. As you quite rightly note it is the failing of economists, and the way I read it this is exactly what Krugman said, but is not the way that Cochrane and others choose to interpret what Krugman said. A simple story, model if you will, expressed without maths, that happens to be right (or approximately right in some domain) is better than any impressive mathematical model that happens to be wrong.
I found a comment on Krugman’s blog “Freshwater Rage” that sums up everything very nicely; they could’ve almost been my words, although to be honest I am not particularly gung-ho about defending the so-called “fresh-water” school, as the Hayekian explanation of the business cycle is better. Nevertheless:
“The truth is downturns are adaptive and corrective. They are morally neutral, mechanistic and designed to find new and stable equilibria at more sensible levels, given the true real possibilities… Keynesians sing at the market tops they largely create and then whine and point fingers at market bottoms, which invariably ensue from their excesses (my italics).
“The fact that Keynesians want to jump in, pump demand and preserve the earlier market misalignments is what irks freshwater economists, particularly when those Keynesians invariably misfire and plant the seeds for yet a new boom and bust cycle. The Fed’s history is one of doing precisely that. The Keynesians track record at the macro level, particularly of late, is simply abysmal.
“The Keynesians and their followers who have rejected regulation (e.g., Larry Summers) — that is, the saltwater economists — are the problem for the US economy, not the sensible freshwater group.”
I have no doubts that the Keynesians will continue to stick their fingers in their ears, saying “na na na, can’t hear you, na na na” as we continually remind them that Keynesianism didn’t die in the 70s, it’s still alive and “well” and its adherents, despite the lip service they pay to free markets, are continuing to wreck havoc. It is not the One True Faith, it the one of the greatest Zombie Ideas in economics, almost on par with Classical Marxism. And whenever it doesn’t work (which is all the time), we can always say “we didn’t spend enough”.
Anyway, how can Keynesians complain about mathematics? Keynes’ General Theory of Money, Mercantilism and Inflationist Garbage (upon which Keynesian economics is based) has more than its fair share of differential equations and linear algebra, and is utterly lacking in logic and completely incoherent.
Yet again Krugman shows his skill in the art of strawmanology. Besides, anyone who refers to WWII as a “public works programme” should be hanged.
Perhaps we need a new paradigm, and I’m not going to be sad if the “freshwater school” loses its prestige. But that does not imply a return to archaic Keynesian dogma.
G’day everyone, long time since I’ve been on but this is a good debate to get back into.
Now I was taught the saltwater economics but as a pro-marketeer I am scoring this a draw. Krugman has a tendency to overreach and he has done it but Cochrane’s response suffers from arguing incorrectly that more mathematics is required even though he previously states that no one can know exactly what the correct price of goods should be. This is a contradictory statement because mathematical rigour is meant to provide a certain, clearly-definable, outcome. Arguing that there needs to be more mathematics but then arguing that we cannot adequately decide prices et al is a poor argument to make. It would have been better to have agreed with Paul Krugman that the growing use of mathematics instead of using mathematic logic is a problem because it assumes near-predictable outcomes.
This debate is going to get very rough but I think that in the long-run the Keynesians will lose out. The reasons are that in western democratic countries, government and personal debt have reached endemic levels. Therefore, over the coming decades there will be less scope for western developed nations to have a near-permanent government deficit which is what has happened in the US, UK, and western Europe. Therefore, with a shrinking work force government activity has to be curtailed. Keynesians tend to argue for ever-greater government spending ignoring Keynes’ central premise that during good times the government should run a surplus. Therefore, as money via taxes becomes tight, the government must naturally cut back and because there will be a prolonged period of deleveraging by western governments the Keynesian argument (as argued by economic commentators) for pump priming, will eventually fade because the financial markets are no longer willing to engage in an endless round of bond auctions.
Intellectually, I think that the post-Keynesian and Austrian schools will emerge strongly from this crisis because of the boom-bust financial markets (oddly this is what tends to happen but for some reasons academics seem to believe that is does not) and because there is a strong case to make of credit creation leading to the bust we have seen and are experiencing.
SG, I think you are assuming that the tax revenue share of national income can’t be increased. On the contrary, there is a lot of scope to restore progressivity to the system and raise more revenue. One important point is that, with all governments in similar straits, the scope for international tax competition has been reduced. And international tax avoidance/evasion is becoming much more difficult.
I agree that the post-Keynesian/Austrian element will be strengthened, but in policy terms these groups have a natural fit with broadly Keynesian approach (it’s the failure of Austrians to recognise this that has rendered them ineffectual)
John, in my opinion President Lula of Brazil is correct when he says the rich countries, the IMF & World Bank didn’t have a clue on how to resolve the global financial crisis. The ‘one’ solution was for governments around the world to turn to Keynesian policies and prime pump economies and stimulate growth. Some say John Maynard Keynes is dead but I say he lives on.
Tax revenue as a share of national income will have to go up – I cannot and do not doubt that and neither do most serious economists, market participants or politicians. However, in a democracy people dislike tax increases and the complexity of tax systems and the use of tax experts to evade/avoid tax regimes is on the increase. You are correct to say that countries such as Switzerland are being targeted by governments but we are talking about many thousands of people who are making a lot of money to avoid their clients pay tax.
Getting back to the macro side. Tax has to rise but in the US, UK and western europe the tax rates cannot go up enough to plug the structural deficit. The UK is a great example. At this moment they have a deficit that is above 12% of GDP. Even if you increase every single income tax bracket this will not plug the structural component of that deficit. In Europe, tax rates are already very high impeding private sector investment so increasing taxes in Europe is not a possibility. The US has a more complex system (because of State and Local tax laws) but even they cannot increase the rate high enough to plug the gaps.
Across the world deficit-cutting is growing. In the UK and in Germany, most major politicians are talking about winding back fiscal stimuli and the German government is talking about enacting a law to legislate for a balanced budget. Considering the scope for expensive government involvement in the economy will be a limited consideration for the next decade, serious Keynesian policies (as envisaged by today’s variant of Keynesian economists) cannot be implemented.
Michael,
Keynes never died. Pump priming has been used by governments the world over. In 2001 there was both fiscal and monetary stimuli applied to the US economy. In 2008 the US government applied multiple fiscal stimuli which all failed. New Keynesian economics dominate government and public policy-making in many western countries.
I disagree with a broad-based argument in favour of pump priming. I am a believer in finding the root cause of the problem and then addressing it. The root cause of this crisis was financial which then lead to a drying up of credit flows and consequent impacts on supply and demand. Too often we have people attempt to apply their economic theory to every crisis rather than ask – what are the specific problems? Should we get involved and how should that be? What we have is people apply pump-priming to an economy to boost demand while there is a strangling of supply of credit.
SG, and where would the global economies be today if their was no pump priming?
@Michael of Summer Hill
I happen to think no one has come close to Keynes for his insight and practical solutions to economic problems, bar a few honest economists, who have been absolutely marginalised like Stiglitz. For the past 20 to 40 or so years…the wannabes with their pretty models and Treasury jobs scoffed, sneered at snickered at those brave souls who refused to throw the baby out and the same wannabe souls have virtually emptied the domain of economics of old fashioned common sense. They have looked to a future outcome that only existed in their models and refused to examine the real outcomes of their policies (the excessive de-regulation, the growing inequality, the rising underemployment and of course the bubbles).
Yet behind all this I see a financial sector out of control, speculative, obese and distorted and yet hailed as one of “our great sectors”. How many times have we read – “there has been enormous growth in the financial sector”, the “financial sector is a great employer and wages in this sector have grown strongly” (obscenely). The wannabes hail the great god, the financial sector, efficient, clever, smart, rational, productive and just cannot see how it has become so distorted its destroying genuinely productive activities in other sectors into a short term vortex of spin, media hype, inflation, crash and burnout.
We need to stop feeding the beast of our own creation. We need to take care of our own retirement savings as we choose and if that is anti government intervention then in that respect I am anti interventionist. We urgently need to restrict what banks can lend (and relend).
I am not anti interventionist when it comes to correcting the mess the bursting of the bubble in Wall street has created, yet why do it with yet more money, the root cause of the bloated financial sector?. It is not the banks who should be helped here. It is the victims. We are still making the assumption that by supporting the banks with bailouts it will all trickle down. Same old faulty assumption and the exec high pays just continue unabated. The disease has not been rectified.
Alice, governments and economists are still coming to terms on how best to live within a global economy. And when you speak of the financial sector I believe it is necessary to distinguish between the micro, intermediatary and global levels. At the moment governments are tackling all three levels to ensure there is no repeat of the 2008 global financial credit crisis.
Krugman – also has revisited the 1970s “the era of the split” in economics..in this article
http://krugman.blogs.nytimes.com/2009/09/19/memories-of-the-carter-administration/
It seems Lucas was one of the false prophets deified by the Freshwaters and a key mistake was that they were unyielding in throwing out both Keynes and Friedman. Freshwater Turks caught up in the world of rapidly advancing computer mathematical modelling?? (it must have been so intoxicating for the logically inclined).
@Michael of Summer Hill
Moshie – not much has happened by way of regulation. Not much has happened by way of giving more power to shareholders. Not much has happened by way of controlling the obscene greed in executive remuneration. Not much has happened to stop the wealthy hiding their tax or not paying much tax and I will be not much will happen except that people will ultimately distrust the financial markets as a repository.
Not much has happened at all Moshie.
Alice, I’m a bit more optimistic.
Alice,
Both are as bad as each other. It’s like watching two 3 year olds fight over stale chocolate. Cochrane is an idiot and neo-liberalism is just old-style fascism with a new name (as Lew Rockwell points out so well). But Krugman’s pro-govt bias is painful. He’s right that the banks should have been nationalised but he’s wrong on virtually everything else. He’s just an old-style socialist with a very (very!) poor understanding of real economics. His criticism of ABCT as a “hangover theory” looks laughable now. Wait for a double dip recession once the govt stimulous packages burn out. We’ll end up with no net gain and much more public debt. Stupid, stupid, stupid.
To get beyond both idtiots you need Mises, Rothbard, Ron Paul, Lew Rockwell. And the revocation of legal tender laws, the abolition of central banks, and a return to a gold or silver standard.
Michael,
We can guess where the economies will be but we can never know.
ABOM,
How exactly is neo-liberal old style fascism when the latter is about authoritarian governments, the removal of individual liberties and greater government control over the economy? After all, fascist governments ultimately go for control rather than letting the “market economy rip”?
There is a significant fat tail risk of a double-dip recession. I think, personally, that governments are pushing to restore consumer demand and this is a wrong thing to do. Consumer demand is more closely attached to unsecured lending rather than by tax cuts or what not. What we need to do is supplement the drop in consumer demand for a pick-up in private and public sector investment in capital infrastructure. This has a greater long-term payoff, can mitigate the effects of unemployment and will improve the efficiency of the private sector (i.e. improve the supply side).
How will the movement to the gold standard have helped Australia? Considering that the gold market movement is independent of the Australian economy?
ABOM, as usual the Libertarians offer a mixture of sound and original ideas. Unfortunately none of the sound ideas is original and none of the original ideas is sound.
SG,
“authoritarian governments” (Bush was nothing but disdainful of Congress), the removal of individual liberties (Wall Street vs main street, Wall Street won with the abolition of Glass Steagall) and greater government control over the economy (central banking powers have only been increased all around the world).
If you haven’t read these “real” free market texts yet, please don’t comment again without doing so:
Click to access foranewlb.pdf
Click to access RAE8_2_2.pdf
Click to access fed.pdf
ABOM, you should have said Obama’s victory is a time for celebration whereby an overwhelming majority of Americans approved of his socialist policies in direct contrast to Bush’s inept administration.