‘Last year, everything came apart’ writes Paul Krugman in The New York Times weekend review.
As recently as early 2008 Oliver Blanchard of MIT and now the IMF told us macroeconomics was in good shape. In 2003, Bob Lucas of Chicago University said depression-prevention was a solved problem and in 2004 Ben Bernanke ‘celebrated the Great Moderation in economic performance ... which he attributed in part to improved economic policy making’.
The lessons of the Great Depression had been forgotten or overlooked. Economists had come to believe that markets were inherently stable, assets were always priced just right or would quickly be corrected by ‘stabilising speculation’ or at least that major deviations from the path of prosperity would be corrected by the all-powerful Fed.
Krugman sees the primary problem is that economists ‘mistook beauty, clad in impressive-looking mathematics, for truth’. Until the Great Depression, most economists ‘clung to a vision of capitalism as a perfect or nearly perfect system’. The mass unemployment of the Great Depression destroyed this vision but as prosperity returned there was a ‘renewed romance with the idealised market’.
Economists ‘turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets – especially financial markets – that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation’.
Economists have to ‘learn to live with messiness, allow for irrational and often unpredictable behaviour and accept that an elegant economic “theory of everything” is a long way off. In practical terms this will produce more cautious policy advice and reduced faith that markets will solve all problems.
One imagines these conclusions are widely agreed, but Chicago’s Bob Lucas describes Obama’s stimulus plans are 'schlock economics' and a colleague says they are based on 'fairy tales'.
The body of Krugman’s essay discusses the journey from Smith to Keynes and back. He describes the 'monetarist' approach – at least the moderate version he ascribes to Friedman - as allowing intervention by the Fed. But the ‘anti-Keynesian counterrevolution went far beyond Friedman’s position’.
'Efficient markets' theory revived the idea that financial markets always got it right. This theory became widely accepted, despite the periods of excess and bear markets, including the 1987 crash, when the US stock price index fell almost 23 % in one day. My library includes in pride of place Charles Kindelberger’s Manias, Panics and Crashes, Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds and Geoffrey Blainey’s The Great Seesaw, explaining based on 250 years of history the dramatic economic and cultural effects when ‘the seesaw tilts to extreme optimism or pessimism’.
The ‘perfect market’ economists included Fed chief, Alan Greenspan, ‘whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control’. Critics were mocked as ‘misguided’. Greenspan had the grace and honesty to say in October 2008 that he was in a state of ‘shocked disbelief’, because ‘the whole intellectual edifice’ had ‘collapsed’.
US economists are divided into “saltwater economists” – mostly in coastal universities with a more or less Keynesian view of what recessions are about - and “freshwater economists” , led by Chicago’s Bob Lucas, who asserted in 1980 that ‘at research seminars, people don’t take Keynesian theorising seriously anymore; the audience starts to giggle and whisper to one another’.
“Freshwater economists“ need to explain recessions, of course. One idea is that the ups and downs of business reflects the rate of technical progress, amplified by the rational response of workers who voluntarily work more when the environment is favourable and less when it is unfavourable. Krugman says this idea ‘really is silly’ – ‘was the Great Depression really the Great Vacation?’ – and some of the more naive freshwater shrimps certainly leave themselves open to the charge of silliness. (One such is quoted as saying: 'We should have a recession. People who spend their lives pounding nails in Nevada need something else to do') Lucas himself has argued that recessions are caused by temporary confusion: ‘workers and companies have trouble distinguishing overall changes in the level of prices because of inflation or deflation in their own business situation’. Attempts to improve things by activist policies would only add to the confusion.
I am not so critical of the “freshwater economists” as Krugman, but then I have not recently been savaged by these folk. Surely wrong expectations are a major part of Keynes’ vision of how the economy works, or fails to work well. Equally plausible is the hypothesis that a change in technology can produce mistakes that build on each other to produce temporary recession. What would be the consequence of a deliberate choice to switch quickly from existing methods of energy generation to near universal use of renewable energy sources now (with effective incentives), one is moved to ask.
The real weakness of the “freshwater” view is that asset bubbles (followed by busts) cannot occur, at least not in their universe. At the books mentioned earlier attest, history is full of booms, bubbles, panics and busts. Failure of neo-classical ”freshwater” economics to build such experiences into their models is a massive mistake.
But it is equally a mistake of modern Keynesian economists. Krugman says ‘new Keynesian’ economists, including Krugman himself, have been forced to build into their models some kind of ‘fudge factor’. I cannot see why extreme pessimism after a boom that has bust cannot plausibly explain a strong downturn. Add unwillingness of workers to take wage cuts, house owners to sell at greatly discounted prices and reluctance of firms to cut prices and a strong downturn can plausibly turn into a depression. If banks have overlent and onsold packages with many suspect assets in them, general confusion and mistrust of financiers cannot fail to make things worse.
If the slump is at a time of rapid technical change, ‘confusion’ about prices will afflict both buyers and sellers and the situation may well be compounded by this, at least for a time.
The chance of downturn becoming depression if pessimism causes bankers or ordinary people to hoard money so the expansionary monetary policy is like ‘pushing on a string’ and no modern government – except perhaps Zimbabwe’s – will fail to resort to fiscal expansion. If such expansion makes capitalists reduce private spending, at least for a time, the slump could in principle be long lasting and self reinforcing.
The current downturn was greatly worsened by the Bush government’s failure to bail out Lehman Brothers. This produced a severe loss of confidence among bankers and meant the global financial system went into virtual gridlock. This might be seen in analytic economics as an exogenous shock, but since the general rule both before and after the failure of Lehman Brothers was the sensible use of public funds to bailout financial institutions that were judged too big to fail, it seems to me the spotlight should be on the one aberrant decision.
At the start of his stimulating essay, Paul Krugman says economists must accept than an elegant ‘theory of everything’ is a long way off. If this means a formal, self-contained theory expressed in mathematical terms I am inclined to agree.
But in terms of understanding, economics currently has too many theories, not too few, or none. We now have more than two hundred years of experience with modern economic systems. There are many booms and busts, several Great Depressions and now, perhaps (it is too soon to be sure) one Great Recession that suffered a near catastrophe (caused by the failure of Lehman Brothers) but was far less severe than it might have been. Careful analysis of all this rich experience, including surges of technical change and plenty of episodes of mistaken expectations – generating manias and panics - will move us toward a really General Theory.
There may need to be some serious help from physics. I sometimes think that the ultimate economic model must await the development of the unified field theory sought by modern physicists. Individuals in the economic systems behave, it seems to me, like elementary particles in quantum theory where there is an inevitable indeterminacy. Yet the behaviour of whole systems behaves in a far more predictable, ‘classical’, manner. How to reconcile these two aspects of economic reality is the challenge, and may require the example of modern physics to show the way. I am confident this will include many ‘Keynesian’ elements and also those of at least some of the “freshwater” economists.
However, to return to current economic experience, it seems to me likely – it is too soon to be sure - that the world has avoided another Great Depression because of more or less co-ordinated Keynesian fiscal policies, very expansionary monetary policy and a general willingness to bail out foolish, greedy and in some cases corrupt financiers.
My guess is that the next problem will be inflation, for the simple ‘monetarist’ reason that too much money will soon be chasing too few goods - severe monetary disequilibrium.
Henry invites economists or other interested readers to comment further on these matters.
Contact Henry here.
Bruce McComish, economic history please, 8/9.
This must be an opportunity to point out that a lot of our troubles have come from failing to study economic history, from believing the accountants and rating agencies, and permitting the regulators to insist on more capital precisely when one should be allowed to run down what is there already.
Anon (name supplied), a regulator's view, 8/9.
Good that you have bought into this argument. Though I can't have any of what follows attributed to me, let me expound:
Krugman should acknowledge his culpability - he taught most of the working age economists he now blames for missing this crisis.
Worse, there are several people acting like Krugman (Ian Harper from your mailing list is one) who say their moral compass has been wrecked by the GFC. More fool them - they should always have listened to Minsky and realised that bubbles and crashes are part of life.
I am arguing whenever I am given the chance that the assumptions behind efficient markets theory were always overstated (as all simple models are), but the assumptions - lowest possible transaction costs, greatest number of participants, prohibition on collusion and insider trading in order to promote confidence, most equal possible distribution of information, best availability of credit/absense of financing constraints - are wonderful immediate targets for regulatory policy.
So what I want is better regulation, which should be judged by whether it gets us closer to the characteristics of an efficient market.
What could be fairer, and what could achieve a better outcome for the economy, so long as the central bank, ministry of finance and prudential regulator operate countercyclical policies to contain any Minskian Ponzi finance tendencies? The latter is essential.
It is amusing that the hard right (those freshwater crocs, now up a dry gully) have to be rescued by the far left (the Minskian followers of Keynes). But that way real world economics can still rule.
Cameron, on the wrong bus, 8/9.
An interesting article as always, but to construct the edifice described you are going to require a way to quantify, at the very least, the policies and their interactions (globally, of course...) which form a major part of the environment in which the next stage of calculations must take place.
If you are attempting to build a model with predictive powers in a national context, then this is going to get very convoluted, very quickly.
Requisite input data i can see after an exhaustive 1 minute analysis on the high powered ENVELOPE computing apparatus.
a - historical data showing relationships between percentage based research expenditure and economic gains over time. This would probably also require breakdowns for man hours/equipment (forgive my sexism) and show the differences between public and private expenditure.
b - mathematical representations of all different types of economic (and social, if possible) activity and their interactions with one another.
c - comparative information on investment in 'status quo maintenance' i.e. political lobbying or 'think tank' research funding etc, versus innovation and new technologies.
d - resource usage patterns, trends and availabilities, and models of their dependence/interaction with a,b and c.
e - bigger ENVELOPES
This could just expand exponentially, but the model of the ecosystem in which all other variables interact is probably the most important aspect. And the most difficult. Well, at least until Asimov's psycohistory can be figured out in order to predict likely political trends that will allow prediction of probable future regulatory and policy frameworks ...
Bruce Littleboy, the tyranny of the mob, 8/9.
I think that so-called 'cutting-edge' economists believe more seriously in efficient markets and rational expectations than they realise.
Their latest working papers contain all the latest and best information. There is no need to go back and read anything written longer than a year ago. If this old stuff were valid, somebody would already have discovered this and included it in their recent paper. Money won’t stay on the sidewalk; ergo good ideas are not found lying around in old books.
Excellence has been redefined. The study of the history of ideas is replaced by a smirking pride in one’s ignorance. The idiot savants, the technicians and the self-publicists, heap admiration and prestige on each other. And worse, our administrators urge us to mimic these in-breeds.
PhilBest, Tampering with free markets, 14/9.
'I believe that the fingerprints of political tampering with free markets are all over this crisis. Thomas Sowell's "The Housing Boom and Bust" is one of the best books you will read on the contributing causes, beginning with the fashionable "Green" restrictions on housing development, urban limits and the like, which are a prerequisite for the unique house price bubbles that have developed this time. Previous bubbles involved "supply" of new homes and developments keeping a ceiling on prices and even though supply tended to overshoot and contribute to eventual collapse, the total sums of money were much lower for this simple reason.
'The global crisis did NOT begin in Manhattan. This popular media narrative confuses causes and symptoms. Northern Rock Finance collapsed in the UK before anything went wrong in the USA.
'The CAUSES of the crisis apply to many nations independently and separately, not just the USA. It is intellectually dishonest and lazy to blame the global crisis on "Wall Street" when local policies in numerous nations already had delivered recession and finance sector distress independently of what occurred in the USA'.
Comment by a distinguished historian (name supplied), 17/9.
Dear Peter, I like your article very much. Most thoughtful. Read it and thought about it and read it again.
A couple of minor points.
A. With ageing population and emphasis on superannuation and more and wider interest in stock markets in the world, the stock market has become more important and more newsworthy as a spectacle. There is a tendency, more than in the past, to treat it as a reliable and also highly newsworthy barometer of the health of the economy, which it often is but sometimes is definitely not. I think this trend is a bit dangerous. In the last 6 months the share index has been treated by the financial media as the main signal of recovery. Isn’t this trust rather strange when the index only 15 months ago proved so be such a misleading barometer?
B. Your inflation message rings bells. Credit-stimulus packages, as you know, are as old as the hills and very inflationary. The Australian gold rush of the 1850s was one. World War Two, esp. after 1941, was another. It ended the bad times of the 1930s but its inflationary tendencies required an enormous amount of attention from Prof Copland and others – in Australia rent and food and even share prices were regulated. Korean War was another stim-package, and v. inflationary. If notable inflation re-appears, the medium-term recovery road could be a rocky road.
C. A lot of the observations in your article are examples of amnesia or over-confidence amongst businessmen and economists. (I call that recent boom the Manhattan Mania.) Here is possibly another. In years to come the clusters of stimulus packages in 2009 may be seen as signs that govts and their econ advisers thought that inflation had been licked and that therefore a stim-pack could do no indirect harm.
D. If slumps and econ setbacks could be assayed with a kind of geiger counter, this present one might be seen to have generated, for a short time, an unusually high element of fear and panic Maybe the degree of panic was an effect of the preceding over-confidence.