Averting the Worst

According to Paul Krugman, we recently avoided a Great Depression because of Big Government; see here.

By any "reasonable" estimate, he says that the current stimulus program has saved up to 1 million jobs. Let's imagine that this is true. According to the government's own figures (see here), roughly 100 billion of the stimulus plan has been spent to date (the vast majority in the form of transfers; rather than purchases). So, if my arithmetic is correct, this translates into only $100,000 per job. Well done, government.

The thing that caught my eye in Krugman's piece was this statement:

All of this [Big Government not slashing spending the way the private sector does during recession] has helped support the economy in its time of need, in a way that didn't happen back in 1930, when federal spending was a much smaller percentage of GDP.

He is, of course correct in stating that the U.S. federal government was much smaller in 1930. And while he does not say so explicitly, I think he may leave the reader with the additional impression that, in addition to being small, the Hoover government actually chose to become smaller (mimicking the private sector in tightening its belt through hard times). The facts, as far as I can gather, seem to suggest something quite different.

According to this data, government outlays from 1930-33 increased by 9.0%, 19.4% and 46.5%, respectively. The latter two years in particular constituted classic deficit-financed expansionary policy (a policy, one might add, came under scathing criticism for recklessness by the Democratics in Congress, led by Roosevelt himself).

I'm not sure what to make of such data; but it does seem to dispell the myth of Hoover as a "do nothing" president.

It is of some interest, I think, to record how the economy recovered from recession prior to the era of Big Government. I seem to recall a fairly significant recession occurring in the early 1920s. Here is the data.
According to this data, the economy contracted by 3.3% and 4.3% in 1920 and 1921, respectively. The economy expanded by 4.5% and 11.4% in 1922 and 1923, respectively.

How did it manage this recovery after 2 years in the absence of Big Government? Why did a Great Depression not occur?

In fact, fiscal policy throughout this entire episode was significantly contractionary. How are we to make sense of this? Or, more precisely, I wonder how Krugman would make sense of this?

[Thanks to Doug Smith, for gathering this data]

Thar she blows! The Bitter Paul Krugman

The latest by Paul Krugman here: How Did Economists Get It So Wrong?

So what, pray tell, have we learned from the blowhard this time?

First thing: Krugman is not an economist. Evidence: Throughout his long rant, he is careful in referring to economists as "they." So whatever went wrong, please don't blame Krugman. On the other hand, not being an economist does not appear to place limits on his profound knowledge of how the profession should reorganize its thinking. Please show us the way, o wise one.

But first, what went wrong exactly? His claim is that the profession fell in love with its mathematically elegant models; and adopted a belief that unfettered markets achieve the best of all possible worlds (Dr. Pangloss). Evidently, this latter belief, supported by unsubstantiated modeling, translated into policy advice with predictable consequences.

Funny though: My reading of economic history suggests that economic crisis preceded mathematical modeling. Moreover, the phenomenon seems to transcend institutional regime (economic crises are endemic to "planned" societies as well). And as for how the philosophy of free market capitalism has manifested itself in reality--well, this is utterly laughable.

In any case, his claim that "Freshwater economists are, essentially, neoclassical purists" is so far off the mark as to make one question his academic credentials. The neoclassical framework is certainly viewed as a benchmark; but almost all serious work that I am aware of regularly departs from its basic tenets (in particular, by explicitly modeling the problems that arise when commitment is limited and information is private). There is, in fact, much work being done in taking institutions seriously, in modeling environments where trade is subject to search frictions, and in identifying potentially beneficial policy interventions. Krugman would not be aware of this, of course, as he spends all his time writing op-ed pieces for the NYT instead of actually engaging in difficult research questions.

It is true, however, that most of the profession adopts the view that individuals are "rational;" at least, in the sense that we model people trying to the best they can (according to a well-defined objective) subject to the constraints imposed upon them by the economic or institutional environment. I believe that this assumption is employed for three reasons: [1] the idea that people try to do the best they can subject to limitations does not sound crazy; [2] the hypothesis admits all sorts of "crazy" equilibrium behavior anyway; and [3] it is hard to know what the hypothesis should be replaced with. In particular, while there is only one way to be "rational," there are an infinitely many different ways to be "irrational."

To give you just two quick examples, Krugman offers his Capitol Hill Babysitting Cooperative anecdote as some sort of puzzle for "neoclassical" economists. I doubt, however, whether he has read this. Or, if you believe his rant the mathematically inclined are oblivious to possibility of economic catastrophe; read this.

As an alternative, Krugman proposes the methodology of behavioral finance. Basically, the approach there is to simply assume that people behave according to some (theoretically imposed or empirically estimated) rule of thumb. In less polite language, assume that people are "stupid." Personally, I believe there may be much to be learned by this approach; and I welcome the fact that a part of the profession devotes some time exploring its implications. But one gets the sense that Krugman prefers this approach because by adopting it, we admit that the general population is stupid and is therefore in need of guidance. This guidance, quite naturally, is to come from self-appointed philosopher kings, like Krugman (consulting $).

On one point, Krugman is correct: There was a growing complacency among many in the profession (and elsewhere). He is incorrect, however, in suggesting that this complacency was the product of economists falling in love with their mathematical models. The majority of the profession continues to whittle away at difficult problems in relative obscurity. The complacency, in my view, stemmed from people like Krugman -- people who poo-poo those of the profession engaged in exploring difficult problems in a rigorous manner.

Krugman prefers his simple equations--an IS curve, and LM curve, and all his "fudge factors" to explain the world. Not much else is needed when you know that the world is stupid; and that you alone hold the answers.

Unfortunately, people are evidently too stupid even to recognize Krugman's genius (confirming his hypothesis in his own mind, no doubt). Is this the source of his thinly-disguised bitterness?

On Krugman, Barro, Boneheads, and Keynes

How can one not love or hate Paul Krugman? (There appears to be no middle ground with this guy). He must have been an imp as a child; no doubt a terror to his parents and his petrified teachers. One cannot help but admire his academic contributions (primarily in international trade, for which he recently won a Nobel prize). He is courageous and opinionated; he is fun to read.

His impishness appears to have persisted well beyond middle age. On his personal webpage, he writes "With any luck, you will find many of these pieces extremely annoying." I think that he underestimates his own abilities in this regard; I am sure that luck has nothing to do with it at all.

Speaking of imps, I found it amusing to see that Robert Barro is a recent addition Krugman's Bonehead List. I am not in a position to evaluate Barro's government multiplier analysis or Krugman's critique of it. But I would like to comment on Krugman's update concerning Barro's interpretation of Keynes' economics. The quote from Barro is this:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.

In reply to this, Krugman writes:

Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes—at least enough to know that he devoted a whole chapter to explaining why a fall in wages would not expand employment?

I can hardly believe what I am about to say here, but...Krugman is absolutely correct; and Barro is being a bonehead on this matter. In support of Krugman, let me cite a relevant passage from Keynes' General Theory.

In this summary, we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages are liable to change. (Chapter 3, Part II)

Indeed, Keynes goes on to suggest in a later chapter that sticky wages were likely a good thing; and that flexible wages would serve to reinforce his general theory. The basic idea (as far as I understand it) is that falling wages would serve primarily to lower "effective demand;" leading to a further contraction in output and employment. It seems clear enough that Keynes had in mind some notion of "coordination failure;" i.e.,

Indeed it (the economy) seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. (Chapter 8, Part III).

Contrary to what some may believe, this type of outcome can be shown to be a theoretical possibility in suitably modified (and non-crazy) versions of otherwise standard neoclassical macro models (with fully flexible wages).

And so, Barro did indeed make a boneheaded remark. But to what might we attribute his error to? There is little doubt that this common boo-boo is the product of Hicks' interpretation of Keynes' theory; which relied heavily on the simplification of sticky wages alluded to above. Generations of economists were subsequently trained to believe that sticky wages were essential to Keynes' theory. The legacy of this "bastard Keynesianism" (Joan Robinson's colorful adjective) lives on today in the form of "New Keynesian" economics.

To see how this misperception lives on today, consider the following quotes from a graduate level macro course taught not too long ago at one of the world's best economics departments.

To make the transition (from neoclassical to Keynesian theory) we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline...

Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.

The lecture notes in question are available here. Who was the bonehead who made these remarks? Hint: His initials are not RB.