Monday, September 7, 2009

On Krugman on Macroeconomics

. Monday, September 7, 2009

Everyone should read the Krugman essay on the state of macroeconomics, if only to see where the faultlines lie. The piece is basically Krugman's victory lap: he thinks that he and the other paleo-Keynesians have been vindicated, the Chicago school has been vanquished once and for all, and the New Keynesians have been forced to take a side: you're with Keynes or you're against him. No more trying to have it both ways.

He has good reason for thinking this: the Chicago School's strong-form belief in markets as efficient price aggregators has been tempered, if not refuted, by the current crisis*. But as Krugman notes, this is nothing new: financial crises happen with alarming regularity all over the globe, and only a fool or ideologue would suggest that these manias, panics, and crashes are efficient. In short, the current crisis tells us nothing about the truthiness of the Efficient Markets Hypothesis (EMH) that the Asian financial crisis, or the Argentinian depression, or the collapse of LTCM didn't tell us. All financial crises have very significant costs, and it takes a very brave person to argue that bubbles are good for an economy.

Krugman is also right to question economists' faith in the Fed. To be sure, the Fed had a great run during the "Great Moderation" from 1982-2008, where recessions were generally brief and mild. Perhaps such successes lulled economists into a "In Fed We Trust" mentality, and Krugman claims that this is the fundamental failing of the New Keynesians: the Fed can do quite a lot to stabilize the economy, but it is not omnipotent. In such circumstances where the Fed's normal tools of management fail to gain traction -- when the Funds rate reaches its zero bound -- the New Keynesians have no answer (according to Krugman). Krugman proposes paleo-Keynesianism.

But Krugman fails to acknowledge the weakness of his own position, and paleo-Keynesianism certainly has its faults. Not only is the academic literature on the effectiveness of fiscal policy mixed**, the justification for it seldom holds. In order for fiscal expansionism to succeed where monetary expansionism has failed, Krugman must model individuals as holding contradicting expectations. Second, actual incidents of Keynes' "paradox of thrift" are very rare, and maybe non-existent. Without these theoretical supports, the Keynesian view of fiscal stimulus is severely weakened.

Perhaps worse for Krugman's case is our actual experience over the past year. It is now clear that the Fed was effectively able to fight the recession and stave off deflation, and that bumping against the zero bound does not necessarily involve getting snared by the liquidity trap. As Krugman himself acknowledges, the U.S. economy is most likely already out of recession despite very little stimulus spending (something like $100bn). Unless you believe that $100bn in stimulus spending was enough to shock a $14tn economy out of recession, you must conclude that monetary policy was effective (if unconventional) and thus the main justification for stimulus advanced by Krugman and other paleo-Keynesians was wrong. Score one for the faith of New Keynesians in the efficacy of the Fed.

Never mind, says Krugman, fiscal stimulus is still justified to fight a "jobless recovery" in which GDP growth is positive but high unemployment persists. In fact, the data seem to show that this is happening in the U.S. at present. It's possible that Krugman is right and stimulus could have a positive effect in fighting unemployment. But employment is often a lagging indicator and the recovery is barely underway. It is more likely that employment would improve without stimulus over the next year than that it wouldn't. Moreover there is no theoretical tradition that believes in the persistence of high unemployment during economic expansion. The case for stimulus doesn't look all that strong at the moment, so Krugman is on very shaky ground. But even if he's right, this sort of "mission creep" is worrisome.

All of that said, Krugman's main point stands -- economic theory is not as sound as it appeared a year ago -- and is in fact stronger than he believes since he exempts his own theoretical tradition from criticism. As I said, the whole thing is worth reading to get up to speed on the arguments. But keep in mind the source: Krugman has a strong interest in denigrating any school of thought but paleo-Keynesianism; he has plenty at stake in this debate. There is more of benefit in the Chicago and New Keynesian schools than Krugman acknowledges, and less in the paleo-Keynesian school. So if there is to be a "New Economics" it should combine the best from all three traditions and others besides.

P.S. After I wrote all this, I saw that Scott Sumner addressed some of the same concerns and came to some of the same conclusions, albeit in a different way. Sumner, like me, sees Krugman's dismissal of monetary policy as premature and therefore sees his core argument in favor of paleo-Keynesian fiscal stimulus as a non sequitur. Please read his post.

*The weak-form belief in markets as most efficient price aggregators has not, I think, been refuted by the crisis. It simply states that markets reflect all information about the prices of a good, and thus represent the best estimate of a good's value. It is possible for the best estimate to be very wrong and still be better than even-more-wrong "other" estimates of value. Or fluctuations in financial markets reflect changes in information, and thus be rational. Tellingly, neither Krugman nor any other critic of EMH even propose an "other", much less defend it, which is why some version of the EMH has persisted for so long and will continue to persist: markets may not be infallible, but they are better than anything else. The Chicago school might not be quite dead after all.

**Yes, I know about Romer/Romer, but all other studies are less positive. And as this Brookings report states, the negative consequences of debt accumulation and deadweight loss from implied future tax increases must be weighed against any positive benefits from stimulus.


Anonymous said...

I wonder why no one talks about Minsky? Didn't he foresee the problem with excessive debt and prescribe what policy should do? regulation and leverage/credit control?

Cochrane talks about Madoff in his rejoinder to Krugman's article but stops short of naming Minsky? Why?

Why is Minsky not important today?

Kindred Winecoff said...

Anon -

This piece was picked up by Seeking Alpha, where it generated some discussion of Minsky. That thread is here:

In fact, there has been some renewed interested in Minsky, but not as much as Keynes. I think it's because Minsky never formalized anything, contradicts himself somewhat frequently, and is generally very difficult to read.

On Krugman on Macroeconomics
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