The difficulty lies not so much in developing new ideas as in escaping from old ones.
~ John Maynard Keynes
You must unlearn what you have learned.
[W]e’re living in a Dark Age of macroeconomics.
~ Paul Krugman
[T]he Jedi Knights were the guardians of peace and justice in the Old Republic. Before the dark times, before the Empire.
~ Obi-Wan Kenobe
* All unidentified or unlinked quotes herein are from Paul Krugman, "How Did Economists Get It So Wrong?" Additionally, even when not directly quoted, significant portions of the following essay are paraphrased from Professor Krugman's article.
I was painfully ignorant of economics when the economy crashed in 2008. Being a progressive, I knew a bit about the evils of neoliberalism and the Washington Consensus, but mainly what I knew was this: A Great Depression-style crisis was not supposed to happen again. And then, it did. Something almost no one thought could happen, happened: The market failed!
I, like everyone, was left to wonder: How did it happen? Why did we think it couldn't? And why haven't we been able to fix it?
* * *
Let me start with a point that might seem obvious (it's actually not as obvious as people might think): Of the people currently trying to understand and/or fix the crisis, there is a major divide between people who think the present crisis is a demand problem and people who think the present crisis is a supply problem. As I'm using the term, supply-siders are not Laffer Curve, Reaganomics supply-siders. Instead, I am using the term supply-sider in a narrow sense - namely, to refer to people who believe that the present crisis is a problem of supply.
In broad terms, the supply/demand divide shakes out along both academic and political lines. First and foremost, the supply/demand divide is academic: Saltwater (New Keynesian) economists are demand-siders; freshwater economists are supply-siders (in fact, freshwater economists' models do not allow for a general shortfall of demand). But in addition to this academic divide, there's a general political divide: Democrats are demand-siders; supply-siders are Republican. There are some Republican demand-siders, but they were (at least initially) shouted down.
So okay, there's an academic and political debate that falls along the supply/demand divide, but how does the supply/demand divide relate to the crisis? Well, the answer to the supply/demand question defines the possible remedies. Specifically, if you believe the problem is a shortfall of demand, the remedies are government spending, inflation-producing stimulus and/or debt forgiveness. If, on the other hand, you believe the economy is being held down by insufficient supply, the remedies are supply-side reforms (deregulation, tax incentives for businesses, freer trade, etc.) In terms of the political debate, the question of whether the problem is supply or demand is a defining, threshold question.
However, the supply/demand divide doesn't necessarily distinguish Jedi from Sith: All freshwater economists are Siths, but saltwater economists are like a young Luke Skywalker, they have the potential to be Jedi, but they can be seduced by the dark side of the Force. So, for example, here's saltwater economist Greg Mankiw early in the crisis recommending a period of moderate inflation (recognizably Jedi); then, in the face of intense Sith resistence, he went silent; then he emerged recommending full-on supply-side (Sith) reforms, even though it's clear he knows better.
A good start towards understanding this story is to understand where the supply/demand division comes from. And the central figure of the supply/demand story is undoubtedly Keynes: The supply/demand debate is really about the ongoing battle between Keynesians and neoclassical economists. And it starts where all stories about economics start, with Adam Smith and the "invisible hand."
A NEW HOPE
There are still many people in America who regard depressions as acts of God. I think Keynes proved that the responsibility for these occurrences does not rest with Providence. ~ Bertrand Russell
The idea behind Adam Smith's metaphor of the "invisible hand" is that the market is self-regulating. This idea was the foundation of both classical economics and its 19th and 20th century predecessor, neoclassical economics. It's important to understand that the idea that the markets are self-regulating isn't just a piece of the neoclassical model, it's the foundation. To question this idea is to question the entire edifice.
Perhaps then, we shouldn't be surprised that many adherents to the model, even when faced with the horrors of the Great Depression, could not bring themselves to question the market. The idea was too foundational to be questioned, even in the face of overwhelming evidence that came in the form of human suffering. These die-hard neoclassicists' faith in the market was so unshakable that they argued the Great Depression was, at a minimum, necessary and some went so far as to see it as a force for good. Thus, Treasury Secretary Andrew Mellon advised Hebert Hoover to:
liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.
The market, in Mellon's view, wasn't broken. The market was doing God's work: "purg[ing] the rottenness out of the the system" and rewarding the "enterprising." To Mellon, market failure operated on the level of Biblical floods and plagues, smiting the wicked and rewarding the virtuous. And the Biblical analogy is apt: If you start with the assumption that God is all powerful and just, floods and plagues cannot be senseless tragedies; similarly, if you have an unshakable faith in the market - if that is your starting point - the Great Depression must be necessary, or even good. Thus, as late as 1934, neoclassical economist Joseph Schumpeter insisted that “Depressions are not simply evils,” they are “forms of something which has to be done.”
Fortunately, John Maynard Keynes was around to say: Poppycock! We created the market for our convenience and it's broken. We shouldn't stand around and moralize like a Bronze-Age shaman who believes hurricanes and earthquakes are signs from God (oh wait!), we should figure out what's wrong and fix it:
Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge.
I love that quote from Martin Wolf. I think it's exactly right and I think of it every time I hear freshwater economists prattling on about workers who don't want to work. In my opinion, Keynes had it right - moralizing about the economy is superstitious hooey, not fit for modern civilization. For Keynes, market failure wasn't analogous to a Biblical calamity, it was analogous to mechanical failure:
[T]he resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life...and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.
For Keynes, the Great Depression wasn't a Biblically-inspired morality tale; we had "blundered in the control of a delicate machine." We didn't have weak morals; we had "magneto [alternator] trouble." In the Keynesian, and I would argue scientific, world, the Great Depression wasn't moral retribution, it was a mechanical malfunction. The corollary to this approach, of course, is that depressions are fixable.
Keynes diagnosis was that the malfunction that had crippled the economy was a general shortfall of demand (Keynes was the original demand-sider). This was a refutation of Say's Law, the principle that supply creates its own demand. According to Keynes, the fix for this particular malfunction - a general shortfall of demand - was government spending. The government had to spend enough to compensate for the lack of private spending in order to keep the economy from shrinking. The efficacy of the Keynesian approach was vindicated when the United States engaged in the colossal public works program known as WWII and the country was restored to full employment.
So what happened? We're in a recognizably Keynesian crisis, a crisis we know how to solve. Why are we divided and paralyzed? Part of the answer is that almost the entire economics profession forgot how. And that forgetting started with Milton Friedman.
THE EMPIRE STRIKES BACK
It’s possible to be both a conservative and a Keynesian; after all, Keynes himself described his work as “moderately conservative in its implications.” But in practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of a socialist wedge. When William Buckley wrote God and Man at Yale, one of his key complaints was that the Yale faculty taught – horrors! – Keynesian economics. ~ Paul Krugman
The policies adopted in the wake of the Keynesian revolution produced the most equal and prosperous society in the history of our country. But, as Paul Krugman noted in the above-quoted passage, Keynesianism and movement conservatism were always at odds. Thus, it was perhaps inevitable that as soon as the pain of the Great Depression receded from memory, a neoclassical revival would begin. The leader and great populizer of that revival was Milton Friedman.
Milton Friedman and Monetarism
To fully exorcise Keynes, Friedman had to confront the problem of recessions generally and the Great Depression in particular. To the enduring chagrin of free-market purists, Friedman conceded the key point - namely, that government intervention was necessary. But Friedman confined government intervention in the economy to activities of the central bank - the Great Depression, Friedman argued, could've been prevented by increasing the money supply, fiscal stimulus was unnecessary. "Thus, Friedman recognized the potential for recessions and the necessity of government intervention, but he attempted to confine that intervention to the tinkering of central bankers:"
I’ve always considered monetarism to be, in effect, an attempt to assuage conservative political prejudices without denying macroeconomic realities. What Friedman was saying was, in effect, yes, we need policy to stabilize the economy – but we can make that policy technical and largely mechanical, we can cordon it off from everything else. Just tell the central bank to stabilize M2, and aside from that, let freedom ring!
Although Friedman's neoclassical conversion was complete by 1953, Keynesian, demand-side policies were the norm for both political parties:
A while back, a commenter led me to a Life Magazine article from 1954 where President Eisenhower’s top economists discussed their plans for a slowing economy. Here’s how they were thinking about dealing with it:Anti-depression planning by the Administration includes plenty of stop-gap measures just in case the experts prove wrong and the expected moderate decline turns into full-scale recession. On the shelf are $15 billion of public-works projects [that’s about $100bn today] already blueprinted and approved by Congress, which can quickly be set in motion. Plans have been made to speed up state and local public-works projects, if need be by buying up their bond issues. The “tight money” policy, which has already been liberalized, would quickly be switched to fast expansion of credit by decreasing Federal Reserve margins, resuming the price-pegging of government bonds, and stimulating installment buying. Taxes would be cut still more, the building industry would get special inducements to expand. The republicans say they will spend money faster than the New Deal if they have to.
But the Keynesian consensus would come to an end with the stagflation of the 1970s. For Keynesians of the 1970s, high inflation and high unemployment were considered to be mutually exclusive. However, both occurred simultaneously in the 1970s and the phenomenon was dubbed stagflation. The prescription for stagflation - a situation of simultaneous high inflation and high unemployment - is to stimulate the supply-side, a remedy that eluded the demand-oriented Keynesians. Although stagflation is a limited phenomenon, it effectively ended the Keynesian consensus and accelerated the neoclassical revival.
The Great Moderation
The Great Moderation - a period that ran from 1985 to 2007 - was a period of relative financial stability, in which the fluctuations in the business cycle were successfully controlled by the actions of the central bank. Thus, in 2003, Nobel laureate Robert Lucas confidently proclaimed that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” As one might expect, the economic models developed during this period were not particularly helpful when it turned out Lucas was wrong.
~ Freshwater Macro: Perfect Markets and Perfect Rationality
"Freshwater economists are, essentially, neoclassical purists," who believe "that all worthwhile economic analysis starts from the premise that people are rational and markets work." For freshwater macroeconomists - who assume perfect markets and perfect rationality - a general lack of demand isn’t possible because prices always move to match supply with demand. But what about recessions?
In the 1970s, freshwater macroeconomist Robert Lucas argued that recessions were caused by temporary confusion wherein workers and companies had trouble distinguishing overall changes in price levels and therefore, supply and demand were temporarily out of sync. For Lucas, any attempt to fight such a slump would just add to the confusion.
By the 1980s, Lucas’s approach was taken a step further as a new group of freshwater economists, known as Real Business Cycle (RBC) theorists, argued that price and demand fluctuations were not related to the business cycle. Instead, these economists argued, the “business cycle reflects fluctuations in the rate of technological progress.” In this model, unemployment was seen as “the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable.” In other words, “[u]nemployment is a deliberate decision by workers to take time off.”
Bottom line, that's the freshwater theory of unemployment: "The Great Depression [was] really the Great Vacation." Although Krugman believes this view is “silly” - and it is patently silly - he explains that the assumptions regarding recession and unemployment were a small part of an otherwise impressive, sophisticated and useful model. But freshwater economists don't see the model as merely useful; they believe it's true. And by the time of the crisis, whole generations of freshwater economists weren’t even taught an alternative. In fact, as early as 1980, economist Robert Lucas said that when Keynesian theorizing was presented at research seminars "the audience starts to whisper and giggle to one another."
And the return to neoclassical assumptions about perfect markets and perfect rationality, had a predictable corollary - namely, any unwanted effects are the result of human failure, not market failure. Thus, even though we all watched 750,000 jobs a month being lost following the Lehman shock of 2008, freshwater economist Casey Mulligan insists unemployment is the result of workers who don't want to work. Similarly, for freshwater economist Robert Lucas, inequality is not the result of an imperfect system, it is the result of human vice:
Now, is there too much inequality? I don’t see it. I think people who drop out of high school, take drugs and so on are going to be poorer than the guys who worked hard. It doesn’t bother me at all. Why shouldn’t they be poor? It’s hard to work!
This moralizing appears to be baked into the neoclassical model: If you start from the assumption of perfect markets and perfect rationality, all failure is human failure and all market results are necessary, if not good. And this is only a suspicion at this point, but "Confidence Fairy" policies and beliefs may represent a similar phenomenon: If markets are perfect and government intervention is useless, policy-makers are reduced to sacrificing the elderly and infirm on the alter of the market Gods in the hopes of restoring confidence (perhaps they should throw in a virgin or a goat for good measure). And I'm only half kidding about this - the freshwater faith in markets is so strong and the resulting GOP-backed policies are so out of touch with reality, it's difficult not to see it as magical thinking:
Theirs is a magical world in which the gulf oil spill and the Japanese nuclear disaster never happened and there was never a problem with smog, polluted rivers or contaminated hamburger. It is a world where Enron and Worldcom did not collapse and shoddy underwriting by bankers did not bring the financial system to the brink of a meltdown. It is a world where the unemployed can always find a job if they really want one and businesses never, ever ship jobs overseas.
~ Saltwater Macro
Despite the wholesale rejection of Keynes at inland, freshwater universities, at coastal, saltwater universities Keynes was still taught - in fact, the saltwater economists came to be known as the New Keynesians. However, even the saltwater economists accepted the core of the freshwater project and only deviated from the assumptions of perfect markets and perfect rationality to the extent necessary to incorporate the Keynesian notion of demand-driven recessions. Because only these minimal deviations were permitted, "there was no room in the prevailing models for such things as bubbles and banking-system collapse."
Additionally, "New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions." Instead, they adhered the the Friedmanite notion that "monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed." Thus - at the policy level - the primary division in macroeconomics "was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed." To return to the original metaphor, when the crisis hit, freshwater economists could only become Siths (their fate was sealed), but saltwater economists were not automatically Jedi. In fact, only a very small number of economists were really in a position to understand the nature if the crisis.
~ Japan and the Jedi
Although bubbles and banking system collapse were not a part of freshwater or saltwater models, they did occur in the real world. Such crises were generally limited to developing countries and banana republics and therefore, did not garner much attention. But then, something happened in Japan - namely, a commercial real estate bubble burst and Japan slid into a recession from which it could not escape. The Bank of Japan reduced short-term interest rates to zero and the slump persisted - it was a situation that looked like a Keynesian liquidity trap (i.e. a situation in which monetary policy, action by the central bank, is unable to stimulate the economy).
Most paid little attention. Some thought it was something specific about Japan. Others thought the Bank of Japan just wasn't trying hard enough. But there was a group of economists - primarily at Princeton - who started to worry about Japan. Those Japan worriers included Paul Krugman, Ben Bernanke, Lars Svensson, Mike Woodford, Gauti Eggertsson and Adam Posen. And then, of course, there were economists - such as Richard Koo - who were directly involved with the Japanese crisis and had spent more than a decade thinking about the problem and developing policy responses.
What Japan showed was that the Keynesian liquidity trap, which had long since been rejected by economists of all stripes, was real. The freshwater economists - who believed a demand-driven recession wasn't possible - were definitely wrong. But so were the New Keynesian, saltwater economists; there were, in fact, situations where monetary policy was not enough.
Japan really was a dry run of precisely what the first world is currently experiencing and there are a handful of economists who have been thinking and talking about these issues for well over a decade. However, as the above-summarized history illustrates, the freshwater economists were intellectually unprepared for even the possibility that such a crisis could occur and the saltwater economists were unprepared for the possibility that central bankers couldn't fix it. The result has been widespread confusion and policy response ranging from inadequate to disastrous.
Of course, this is a story told in hindsight. We know freshwater economists didn't understand Keynes because of their response to the crisis. Specifically, they started making the precise arguments rebutted by Keynes in the 1930s, but they presented these arguments as if they were brand new. Thus - right on cue - freshwater economists Eugene Fama and John Cochrane espoused what was known in the 1930s as the "Treasury View;" namely, the view that "debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed." And, of course, the ideas that recessions are good and that the unemployed don't want to work weren't far behind.
According to freshwater economists, the problem isn't a shortfall of demand (in fact, that was decided ahead of time). The problem is fill-in-the-blank social program, fill-in-the-blank regulation and fill-in-the-blank tax. Businesses don't want to hire because they're uncertain about the effects of Obamacare, environmental regulations, etc. But why now? All of a sudden business owners have decided it's too much? Does 9% unemployment have anything to do with it? What about the massive overhang in household debt created when the housing bubble burst? But it can't be those things because if it was, their model is wrong.
[T]here’s a good reason Lucas won’t even consider the obvious explanation in terms of a shortfall in demand. More than 30 years ago, in a burst of radically premature triumphalism, Lucas and his colleagues declared the “Death of Keynesian economics”. . . .
[T]o even consider the possibility that we’re in a demand-shortfall slump of the kind Keynes diagnosed, would be an incredible comedown for Lucas.
In current policy debates, freshwater economists and GOP politicians are concerned about "uncertainty," "confidence," soaring interest and out-of-control inflation. And, with rare exceptions, they seem unfazed by the fact that interest is at all-time lows and that deflation, rather inflation, continues to pose the greater threat.
I'm convinced the crisis is a Japan-style crisis and that those with the best grasp of the situation were those involved with Japan. In my opinion, the clearest explanation of the crisis is contained in this 10-minute video featuring economist Richard Koo, who coined the phrase balance sheet recession. Paul Krugman also views the present crisis as a balance sheet recession (although he and Koo have minor differences of opinion regarding the efficacy of monetary policy - Koo thinks it's useless, Krugman thinks it's almost useless).
The opposition to balance sheet theorists is not solely from freshwater purists who can't even conceive of a shortfall of demand; as was noted at the outset, the Sith/Jedi divide is not strictly a matter of supply-siders versus demand-siders. Perhaps the most dangerous opposition comes from those who recognize the problem as demand-driven, but nonetheless recommend austerity. As Richard Koo has noted, the biggest counterpoint to his policy advice - debt-financed fiscal stimulus - comes from conservative saltwater economists Kenneth Rogoff and Carmen Reinhart:
Causal link between national debt and economic growth is not one-way
A source frequently cited by the Republicans in the fiscal consolidation debate is Carmen Reinhart and Kenneth Rogoff’s This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009), which presents research showing that countries with national debt exceeding 90% of GDP have growth rates averaging 1.3ppt lower than economies with less debt.
That finding was based on a study of financial crises over the past 800 years, but—as Paul Krugman has noted—the causality is not necessarily one-way.
There are cases in which growth rates have fallen because of large fiscal deficits, but there are also instances in which fiscal deficits have increased because growth has slowed. In the former cases, excessive government deficits crowded out private investment and depressed growth rates, while in the latter, governments administered fiscal stimulus to prevent further declines in the growth rate as the private sector paid down debt during a balance sheet recession.
On the surface, the two patterns appear similar since they are both characterized by large deficits and low growth rates. What sets them apart is yields on government debt, which are high in the first case and low in the second.
The three countries in which the most clamor has arisen over fiscal deficits—Japan, the US, and the UK—are all characterized by record low yields on government debt, and their private sectors are engaged in deleveraging on a massive scale.
The conclusion we should draw from this is that all three economies are in a balance sheet recession and that fiscal deficits should be used to prevent growth rates from falling any further.
Inasmuch as deficit reduction efforts in Japan, the US, and the UK will have a greater (negative) impact on growth, the fiscal consolidation programs being pursued by governments in these nations will have exactly the opposite of the desired effect.
Support for fiscal consolidation will continue until economy suffers.
Over the past year I ran into Mr. Rogoff twice and Ms. Reinhart three times at economic conferences. In each case, it was the organizers’ intention for us to present our very different views and let listeners come to their own conclusions.
However, my theory—which holds that fiscal stimulus is essential during a balance sheet recession—has yet to gain the widespread acceptance of their very mainstream view that “deficits are bad.” Consequently, it continues to have only a limited influence.
As Joe Weisenthal has noted, thus far in this crisis, "Koo has been dead on." Where austerity has been tried - Greece, the UK, Japan - it has failed. In fact, it has failed miserably - in each of these countries growth weakened and "deficits didn't even go down!" And this was Koo's prediction; attempts to cut deficits will have the opposite effect. So, in a balance sheet recession, austerity really is an all pain, no gain strategy. In fact, worse than no gain - it actually produces tremendous pain and social instability while increasing deficits. It's the worst possible policy and therefore, of course, it's all the rage.
RETURN OF THE JEDI
Now the Jedi are all but extinct. ~ Obi-Wan Kenobe
This will all be sorted out in the long run, but we know what Keynes said about the long run. Later generations will wonder why we didn't act more boldly. Our economists had a similar reaction to Japan in the 1990s: Why didn't Japan take aggressive action to keep their crisis from becoming a lost decade? Now some economists think a lost decade is optimistic.
Although he doesn't explain why it is the case, economist Richard Koo has noted that peace time democracies have a difficult time mustering the political will for fiscal stimulus. This has definitely proven to be the case. In 1930s United States, in 1990s Japan and now throughout the first world: The political instinct is towards austerity and when stimulus is attempted, it's invariably half-hearted and insufficient.
This may owe to the Alice-Through-the-Looking-Glass nature of liquidity traps. It is a situation that is riddled with paradoxes: There's the paradox of thrift, the paradox of toil and, indeed, the paradox of austerity (attempts to reduce deficits by cutting government spending actually increase deficits). But even at its best, economics is technical, difficult and often counter-intuitive.
A more likely (but still probably not the most likely) explanation is that policy response hasn't been equal to the task because economists are hopelessly divided and therefore, politicians can pick and choose in accord with their prejudices. Unfortunately, those divisions are not likely to be resolved among the present generation of economists. In his seminal work, The Structure of Scientific Revolutions, historian of science Thomas Kuhn explains that when a new, superior theory is presented, the old guard is never persuaded by it; in fact, scientists "subscribing to different paradigms end up talking past one another." However, the up-and-coming generation of scientists adopts the new theory immediately.
Probably the most likely explanation for austerity's popularity at home and abroad is that the Rentier class has been able to exert undue political influence:
What explains this opposition to any and all attempts to mitigate the economic disaster? I can think of a number of causes, but Kuttner makes a very good point: everything we’re seeing makes sense if you think of the right as representing the interests of rentiers, of creditors who have claims from the past — bonds, loans, cash — as opposed to people actually trying to make a living through producing stuff. Deflation is hell for workers and business owners, but it’s heaven for creditors.
With persistent, mass unemployment and policy-makers hell bent on austerity, it's difficult to find even a glimmer of hope. But at some point, no one - not even rentiers - can benefit from an anemic world economy. As austerity policies continue to fail - and they clearly are failing - there's hope that better policies will prevail.
Cross-posted at Plutocracy Files.