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Old 12-05-2010, 01:43 PM   #1
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Paul Krugman's Keynesianism neatly filleted

How did Paul Krugman get it so Wrong?

John H. Cochrane[1]

Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, “How did Economists get it so wrong?”

Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a stalwart that maybe continents don’t move after all, or that smoking isn’t that bad for you really.

It gets worse. Krugman hints at dark conspiracies, claiming “dissenters are marginalized.” Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes “new Keyenesians” such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in people’s mouths that run contrary to their written opinions. Even this isn’t enough: he adds cartoons to try to make his “enemies” look silly, and puts them in false and embarrassing situations. He accuses us literally of adopting ideas for pay, selling out for “sabbaticals at the Hoover institution” and fat “Wall street paychecks.” It sounds a bit paranoid.

It’s annoying to the victims, but we’re big boys and girls. It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this schlock instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

And that’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and “spend like a drunken sailor” are pretty superficial compared to all the fascinating things economists are writing about it these days.

What do I think? How sad.

That’s what I think, but I don’t expect you the reader to be convinced by my opinion or my reference to professional consensus. Maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas.

Krugman’s attack has two goals. First, he thinks financial markets are “inefficient,” fundamentally due to “irrational” investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge “fiscal stimulus” provided by multi-trillion dollar deficits.


It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient. (I can overlook his mixing up the CAPM and Black-Scholes model, but not this.) There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency. Efficient markets did not need to wait for “the memory of 1929 … gradually receding,” nor did we fail to read the newspapers in 1987. Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now. Crying “bubble” is no good unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row.

But this difficulty is really no surprise. It’s also the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” or “hold to maturity value” is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.

More deeply, the economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” (And “the risk premium must have increased” is just as empty.) Our ancestors could do that. Really, is that an improvement on “Zeus had a fight with Apollo?” Good serious behavioral economists know this, and they are circumspect in their explanatory claims so far.

But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse. Free markets are the worst system ever devised – except for all of the others.

Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital. He can’t quite come out and say this, but he does say “Keynes considered it a very bad idea to let such markets…dictate important business decisions,” and “finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.’” Well, if markets can’t be trusted to allocate capital, we don’t have to connect too many dots to imagine who Paul has in mind.

To reach this conclusion, you need theory, evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? As David Wessel’s excellent In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.

In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face horrendously distorted incentives.

Careful behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.” Even my most behavioral colleagues Richard Thaler and Cass Sunstein in their book “Nudge” go only so far as a light libertarian paternalism, suggesting good default options on our 401(k) accounts. (And even here they’re not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They don’t even think of jumping from irrational markets, which they believe in deeply, to Federal control of stock and house prices and allocation of capital.


Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income. The second siren is even vaguely plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and vaguely plausible foundations are indeed “beautiful” but to me they are also basic preconditions for “truth.”

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.

Therefore, we have to examine the “ifs.” And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.

Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.” This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false. Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, estate taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find “market failures” that might justify a multiplier, that analysis quickly suggests direct fixes for the market failures, not their exploitation along the lines Keynes suggested. Most “New Keynesian” analysis that add frictions don’t produce big multipliers.

This is how real thinking about stimulus actually proceeds. Nobody ever “asserted that an increase in government spending cannot, under any circumstances, increase employment.” This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is so much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.

In fact, I propose that Krugman himself doesn’t really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.

If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. Seriously. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he really borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.

If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.

If believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.

John Cochrane’s Response to Paul Krugman: Full Text *Modeled Behavior

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Old 12-06-2010, 08:18 AM   #2
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I found Krugman's response:

Freshwater rage -
September 14, 2009, 11:53 AM
Freshwater rage
I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing?

And all of this, of course, without a hint of irony.

For when freshwater macro took over a good part of the field, its leaders gleefully dismissed all the work Keynesian economists had done over the previous few decades, often with sneers and sniggers.

And that same adolescent quality was evident in the reactions to the Obama administration’s attempts to deal with the crisis — as Brad DeLong points out, people like Robert Lucas and John Cochrane (not to mention Richard Posner, who isn’t a macroeconomist but gets his take from his colleagues) didn’t say that when serious scholars like Christina Romer based policy recommendations on Keynesian economics, they were wrong; the freshwater crowd declared that anyone with Keynesian views was, by definition, either a fool or intellectually dishonest.

So the freshwater outrage over finding their own point of view criticized is, you might think, a classic case of people who can dish it out but can’t take it.

But it’s actually even worse than that.

When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been. Freshwater macro became totally insular.

And hence the most surprising thing in the debate over fiscal stimulus: the raw ignorance that has characterized so many of the freshwater comments. Above all, we’ve seen the phenomenon of well-known economists “rediscovering” Say’s Law and the Treasury view (the view that government cannot affect the overall level of demand), not because they’ve transcended the Keynesian refutation of these views, but because they were unaware that there had ever been such a debate.

It’s a sad story. And the even sadder thing is that it’s very unlikely that anything will change: freshwater macro will get even more insular, and its devotees will wonder why nobody in the real world of policy and action pays any attention to what they say.
Year-old beef.
Ideology on both sides.
I don't know enough to argue the issues here though.

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Old 12-06-2010, 08:25 AM   #3
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Here's a 3rd POV:

Krugman's critics go on the warpath - How the World Works -

TUESDAY, SEP 15, 2009 13:08 ET
Krugman's critics go on the warpath
Hell hath no fury like that of a scorned conservative economist
If you are inclined to believe that government should steer clear of any intervention in the economy, or stand with partisans who lean to the right-wing side of political economy debates, then you will likely agree with Donald Luskin that John Cochrane's riposte to Paul Krugman's "How Did Economists Get It So Wrong?" is "devastating."

John Cochrane, an economist at the University of Chicago, is spitting mad. He is also a forceful writer, and he makes a compelling case that in the course of his argument explaining why conservative (and liberal) economists missed the boat on the financial crisis, Krugman oversimplified the state of macroeconomic affairs over the past several decades.

As FreeExchange observes, however, Cochrane makes the same mistake he accuses Krugman of, by caricaturing and oversimplifying Krugman's argument, and, even worse, complaining that Krugman is only interested in making personal attacks on an ever-growing "enemies list," while engaging in his own litany of vicious slander. Cochrane's assertion that Krugman "wants to be Rush Limbaugh of the Left," betrays a bizarre disconnection with reality. And he proves, over and over again, that one of Krugman's central accusations -- that Chicago School economists have nothing but scorn and sneers to pile on John Maynard Keynes -- is absolutely correct.

Instead, [Krugman] calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a stalwart that maybe continents don't move after all, or that smoking isn't that bad for you really.

I find it hard to read that paragraph in any other way than to assert that believing that Keynes had something insightful to offer as to how government should respond to a recession or depression is equivalent to disbelieving in global warming or plate tectonics.

Krugman's initial response to Cochrane et al. is even less satisfying. From what I can tell -- "I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path" -- he hasn't read Cochrane's attack, although I guess we can excuse him for being on vacation with sporadic Internet access. Once he returns, however, it would be educational to see him respond to some of Cochrane's more substantive assertions as to how economists are continuing to extend the state of the art.

But to a certain extent the real dispute is over something so fundamental that no amount of parrying with the nitty-gritty of how well the latest macroeconomic model captures reality will resolve it. Cochrane is straightforward: Here, he says, is "the main point."

The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse. Free markets are the worst system ever devised -- except for all of the others.

Of course Krugman has never argued in favor of government "control" of markets. But that's a side issue. Cochrane and his brethren believe the less government the better -- Krugman believes there's a clear role for government, not just in properly regulating markets, but also in intervening when markets fail.

Which brings us to Cochrane's key point, aptly seized upon by Nick Rowe at Worthwhile Canadian Initiative. Cochrane's central critique of Keynesianism is summed up in one declaration.

Paul's Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.

Cochrane states this formulation as if it is an outright absurdity, and at first glance, maybe it does look crazy. But from a Keynesian point of view, Cochrane is totally misunderstanding how economies work. If people consume less, companies sell fewer goods and services, requiring them to lay off people, who in turn spend even less. This is the famous "paradox of thrift." This is exactly what we are living through right now. The total money supply doesn't change, but the economy goes into recession because that money is not circulating. The opposite also holds true. If people consume more, companies aiming to meet that demand hire more workers who then have the income to spend on more products. As Keynes wrote in "The Great Slump of 1930":

Yet, all the time, the resources of nature and men's devices would be just as fertile and productive as they were. The machine would merely have been jammed as the result of a muddle. But because we have magneto trouble, we need not assume that we shall soon be back in a rumbling waggon and that motoring is over.

Government -- there, when you need it, to unjam the machine. When two sides are in disagreement over such a foundational issue, it's hard to see how any amount of slash-and-burn Internet argument will ever reach resolution.
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Old 12-09-2010, 11:14 AM   #4
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Interesting arguments but the last article shows the writer is not going far enough. These arguments have been going on for years.

I tend to agree with the Hayek side more. Simply because Japan has been doing stimulus forever and all they have is a record debt. Growth requires some element of real savings and the quote....

Paul's Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.
is a spot on accusation. What is needed is a driving down of costs that naturally occurs in a recession and in turn a driving down in wages so that they aren't as inflated. The idea that we will all avoid spending until the prices are nil is ridiculous. People will eat and certain industries are absolute necessities. There will be hardship but the correction will end. After that those people in particular necessary industries will obviously be saving and investing which would mean inflation is low and there is no need for superhigh interest rates. Those investors can invest their own saved money and borrow to grow precisely because wages are affordable and prices for goods aren't high. What matters is not your wage but how much you can buy with it. After that the government needs to raise interest rates when real inflation is increasing to prevent a massive boom from happening. During the '90s and 2000s especially there was very low interest rates that basically ignored housing and energy inflation. It's obvious that political pressure prevents Central Banks from doing the unpopular thing. Even Greenspan who talked about "irrational exuberance" didn't even follow his own belief.

The problem I have most with Neo-Keynesians is that they are neo instead of Keynesian. Stimulus works best when you have lower debt and so therefore you have to pay it off in good times. When do politicians do that? WHEN????? Under Keynes debt is supposed to be paid by in good times. So every downward cycle keeps adding to the overall debt and eventually nobody can take you seriously in regards to paying investors back. The U.S. and Europe are both in situations where they can't keep doing stimulus without indangering the validity of currency, because of all the prior debt. They would have to keep printing money (which is a cost to everyone in inflation and hurts the poor with fixed incomes) and if one side starts becoming more disciplined, it will cause a currency run to that more disciplined currency. Then that currency will have trouble selling products with a high cost so everyone keeps trying to devalue their currency at the same time. Having a hangover on debt will simply mean stagflation. We'll still have unemployment (because businesses are worried about increases in taxes because of the massive deficit) and constant printing of money will mean that what goods are there are still being consumed while productivity is low.

Therefore the deficit has to be eliminated plus there has to be some plan to pay back some of the overall debt and governments have to tolerate wage freezes and benefit freezes so that the private sector can catch up. The government gets its financing from profitable people and corporations. During a recession and wages/benefits can't be sustained at the same rate when tax receipts are down. Government is at the size greater than it was during the boom (when lots of profits were being taxed) and now (with low tax receipts) is not the time to kill the goose that lays the golden egg but to curtail government spending and allow enough time for the goose to lay another egg. It's obvious that profitable companies will have less money to invest in growth if higher taxes or the threat of higher taxes will mean they will have less profits after-tax to work with.
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