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Three weeks ago, Paul Krugman wrote a must-read Sunday NYT piece, "How Did Economists Get It So Wrong? " It does a very good job of presenting a broad-brush account from within the mainstream of the economics professions of why the economics profession not only failed to see the financial crisis coming, but why a majority of them foolishly believed it was impossible. However, Krugman's account doesn't really go deep enough. Later today I'll post another diary that gives a different account of who saw it coming and why-as well as who did not. As I read Krugman's piece, it's valuable both for what it tells us, and for what it leaves out. Krugman is not after all, the extreme left wing of the economics profession. He's well within the mainstream. That's why the NY Times hired him, and why he got his Nobel Prize.
The plan of this diary is this: First, I'm going to introduce a bit of an overview of where I'm headed, then I'm going to quote from, and talk a bit about what Krugman wrote, and then I'm going to go back to heading where I'm headed. I'll post two more diaries today that are related, the first, already mentioned, on those who saw it coming, and another on the man who saw it coming, Hyman Minsky, and his Financial Instability Hypothesis.
Preview: What Krugman Leaves Out
In Krugman's account, he talks of "freshwater economist" (spreading outward from the University of Chicago) and "saltwater economists" (who persist in following some bare scraps of a Keyensian approach. The problem is, (a) this doesn't exhaust the possibilities and (b) even the folks Krugman doesn't talk about aren't necessarily right, either.
I begin with a very brief post by economist Robert Vienneau, "Only Mainstream Macroeconomists Exist For Krugman, who first links to a few different comments on Krugman's article, then says:
In Krugman's article, all macroeconomists are either freshwater or saltwater. Post Keynesian critisms that apply to both types are not mentioned. Although I am not too familiar with mainstream macro, I can think of three:- Both situate their models in logical, not historical time
- Both assume a representative agent
- Both assume a single good that functions as both a capital and a consumption good.
These limitations rule out a priori the possibility of some interesting dynamics and perhaps make it difficult to see why agents in the model would want to hold money or even trade with one another.
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| My own understanding of post-Keynesian economics is limited enough that I don't want to pontificate further here. But I can say this much: post-Keynesians generally argue that standard "Keynesians" of all different strips don't really understand the core of what Keynes was getting at, or where he was coming from, which was very much a realist perspective-the commonality between all three points that Vienneau makes. To make it worse, different post-Keynesians disagree with one another-and have been criticized as a whole on the same grounds. The problem, it seems, stems in part from the fact that Keynes wrote both popular and scholarly work in the midst of tremendous struggle and upheaval, and never did step back from it all and write a comprehensive sort of "view from above." He wrote from the midst of things. From the very beginning he had students and interpreters whose works others often relied on, and there was never any comprehensive sorting out.
There are at least four things I can say about Keynes:
(1) Keynes argued that government policy could profoundly and positively impact the economy. There was not a single, God-given market equilibrium that government could do nothing to alter, except to muck up. Rather, there was a inherent tendency for the market equilibrium to fall far short of what was possible in terms of employment and productivity, and this was due fundamentally to monetary hording and tight money.
(2) There were two sorts of government action that could be taken to move the economy from a sub-optimum equilibrium toward a full-employment equilibrium in which output was maximized.
(2a) The first, most widely known was counter-cyclical deficit spending to supply public demand when private demand was lacking. This was the basis on which the Great Depression was finally ended, although it was not until WWII that government spending levels were generally high enough to accomplish this. (Sweden got there much earlier, without any war spending, Germany next, with almost nothing but war spending, long before there was any war.)
(2b) The second, poorly grasped at the time, and now virtually forgotten, was the gradual, long-term reduction in long-term interest rates-in effect, the policy of "easy money" that, among others, populists of various stripes throughout US history had always argued for.
(3) Keynes based his reasoning, in part, on rejecting certain assumptions of neo-classical economics as unwarranted. This was analogous to non-Euclidian geometers rejecting the Euclidian postulate that parallel lines never meet. The neo-classical approach was formally much neater, but it involved some very questionable assumptions that Keynes argued were simply wrong. Discarding those assumptions, and proceeding on more realistic grounds were the basis for reaching the conclusions cited above.
(4) Because Keynes rejected the full set of neo-classical assumptions, his theory of the economy as a whole (macro-economics) could not be compatible with the neo-classical theory of economic transactions at the level of individuals, firms and limited markets (micro-economics). But Keynes never supplied an alternative micro-economics to go with his theory. So-called Keynesians since him have generally tried to combine neo-classical micro-economics with Keynesian macro-economics, sometimes introducing variations, such as making the micro-economics more realistic via behavioral economics. Post-Keynesians have generally rejected this approach as intellectually incoherent. Their tendency has been toward empirical studies of actual micro-economic behavior, rather than depending on axiom-dependent models of any kind.
With this bare-bones outline in place, let's now take a brief look at Krugman's account.
Krugman's Story of What Went Wrong
From Krugman's whole 7200-word piece, this brief excerpt (less than 600 words) captures a significant piece of the essence:
In the 1930s, financial markets, for obvious reasons, didn't get much respect. Keynes compared them to "those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors."
And Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another's tails, dictate important business decisions: "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."
By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire's Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the "efficient-market hypothesis," promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company's stock, for example, always accurately reflects the company's value given the information available on the company's earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a "casino."
It's hard to argue that this transformation in the profession was driven by events. True, the memory of 1929 was gradually receding, but there continued to be bull markets, with widespread tales of speculative excess, followed by bear markets. In 1973-4, for example, stocks lost 48 percent of their value. And the 1987 stock crash, in which the Dow plunged nearly 23 percent in a day for no clear reason, should have raised at least a few doubts about market rationality.
These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward - the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) - is wonderfully elegant. And if you accept its premises it's also extremely useful. CAPM not only tells you how to choose your portfolio - even more important from the financial industry's point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory's adepts also received more mundane rewards: Armed with their new models and formidable math skills - the more arcane uses of CAPM require physicist-level computations - mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.
Of course we all know how well that turned out. I don't pretend for a moment that the above excerpt exhausts Krugman's piece, but it does capture the core of the contradiction between Keynes, and his realist insight supported by harsh reality, versus later-day economists who spun a self-contained world of illusory perfection, despite recurring evidence to the contrary. It also sets up the other core pillar of Krugmans tale, as he goes on to explain how the economy did well enough for a long period of time that the freshwater and saltwater economists more or less coexisted, their fundamental differences submerged. This agreement depended in part on disregarding much of the essence of Keynes was concerned about-even by the so-called Keynesians.
Now, in the aftermath of calamity, freshwater economists got nothing, ala George Costanza. But saltwater economists haven't been doing the hard work they need to (this is my gloss on what Krugman implicitly admits). In the end, Krugman can't point to any firm saltwater/Keynsian truths that will make everything better. He can only claim that their direction is the promising one:
So here's what I think economists have to do. 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.
Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: "There is always an easy solution to every human problem - neat, plausible and wrong."
When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won't be neat; but we can hope that it will have the virtue of being at least partly right.
The first paragraph above is the meat of what Krugman has to say. The rest is obiter dicta. But even the meat is incredibly vague. No one should consider it sufficient.
Further Ruminations On What Krugman Leaves Out
On his blog, Krugman himself said:
Some fairly extensive sections had to be taken out - for example, I wanted to include material about Paul Samuelson's 1948 textbook, which reads very well in the current crisis, but had to cut it. Hyman Minsky also got crowded out. Sorry.
That's a rather odd juxtaposition, indeed, particularly since some folks are extremely critical of Samuelson's grasp of Keynes, while Minsky is the man who saw this crisis coming. The fact that Minsky didn't make the cut at all simply shows us who the players are in Krugman's mind-the freshwaters and saltwaters, with no room at the inn for the heterodox crowd, the only ones who very clearly saw this coming. I don't pretend to be an economist, but I do know a bit about economic history, and I can remember the diaries I posted yesterday (not least because I wrote this part of the diary yesterday, too!) The story Krugman tells is one that includes a relative state of détente between the two schools he talks about, but it ignores the real world that both those schools had also ignored. To see what I mean, just back up and look at how his article began:
It's hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes - or so they believed - were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled "The State of Macro" (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that "the state of macro is good." The battles of yesteryear, he said, were over, and there had been a "broad convergence of vision." And in the real world, economists believed they had things under control: the "central problem of depression-prevention has been solved," declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.
Last year, everything came apart.
The fact that economists like Bernanke thought that economic performance was good obviously clashes with the economic stagnation faced by the bottom 99% that I wrote about yesterday. The simple fact is that entire profession seems utterly oblivious to how the bottom 99% lives. As for the "state of macro"--I'll have more to say about that in my followup diary on those who did see it coming. But my bottom line point here is that non-economists by the droves-as well as a handful of dissidents-did not have to wait for last year's collapse to know that something was terribly wrong in economics. And that in turn indicates that the two schools Krugman is talking about were much closer to one another, and much more cut off from reality--as well as other knowledgeable people--than anyone in either of those groups realized at the time.
To really find our way out of the current mess, and more than that, to create the conditions for shared prosperity in the 21st century, we need to establish a critical perspective that's radically divorced from the folie au deux that Krugman describes. In the diaries to come later today, I'll start to sketch out some outlines of what that perspective might look like.
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