Grasping Reality with Both Hands

But the Economics Profession Right Now *Is* Useless...

The Economist gives us economists too much credit. It writes:

In... the idea that economics as a whole is discredited... backlash has gone far too far.... Economics is less a slavish creed than a prism through which to understand the world...

I would like to draw a distinction between economics as a way of thinking--the way good economists think, at least--and academic economics as a profession. Economics as a way of thinking is, I believe, still very valuable. But academic economics as a profession has proven itself to be not valuable at all in this financial crisis. As the Economist writes later on:

the financial crisis has blown apart the fragile consensus... [about] monetary policy... [because] in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness...

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

And I for the life of me cannot see what the arguments of the "purists" are. The basic quantity theory of money:

(M/P) * V(i) = Y

tells us that output depends on (a) the real money stock M/P, and (b) the velocity of money V, which (c) is an increasing function of the short-term nominal interest rate on government securities i. Fiscal policy--government deficits--change the quantity supplied of government bonds, and by supply-and-demand things that change the quantity of something change its price, and the price of government bonds is this interest rate i. It is true that Robert Barro has an argument that deficits caused by tax-law changes create offsetting changes in desired savings that neutralize the effect of increasing the supply of government bonds, but I know of no argument that claims the same for deficits caused by government-spending changes unless the goods the government buys and distributes with its spending are perfect substitutes for private consumption expenditures.

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Some more context:

Economics: What went wrong with economics: OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.”

In the wake of the biggest economic calamity in 80 years that reputation has taken a beating.... [T]heir pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”...

[T]wo central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined.... There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it. The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas.

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”. A recent ranking of academic economists was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions.... But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added.... The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be....

Macroeconomists also had a blindspot.... Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis--the sort used in many central banks--incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness....

[T]here is a clear case for reinvention, especially in macroeconomics.... [A] broader change in mindset is still needed. Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.

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The other-worldly philosophers: [M]acroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.... For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the “General Theory of Employment, Interest and Money.”... [The] classical mode of thought held that full employment would prevail, because supply created its own demand... whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle. Keynes... [thought] investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply.... The Keynesian task of “demand management” outlived the Depression, becoming a routine duty of governments... aided by economic advisers.... [T]heir credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to “stagflation”, a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.

The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps.... The purists... blamed stagflation on restless central bankers trying to do too much. They started from the classical assumption that markets cleared, leaving no unsold goods or unemployed workers. Efforts by policymakers to smooth the economy’s natural ups and downs did more harm than good.... [P]ragmatists... [saw] the double-digit unemployment that accompanied Mr Volcker’s assault on inflation was proof enough that markets could malfunction. Wages might fail to adjust, and prices might stick. This grit in the economic machine justified some meddling by policymakers. Mr Volcker’s recession bottomed out in 1982. Nothing like it was seen again until last year. In the intervening quarter-century of tranquillity, macroeconomics also recovered its composure. The opposing schools of thought converged.... For about a decade before the crisis, macroeconomists once again appeared to know what they were doing....

[Willem] Buiter... believes the latest academic theories had a profound influence.... He now thinks this influence was baleful... a training in modern macroeconomics was a “severe handicap” at the onset of the financial crisis, when the central bank had to “switch gears” from preserving price stability to safeguarding financial stability. Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets....

Before the crisis, many banks and shadow banks... believed they could always roll over their short-term debts or sell their mortgage-backed securities, if the need arose. The financial crisis made a mockery of both assumptions. Funds dried up, and markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows how both of these constraints fed on each other, producing a “liquidity spiral”. What followed was a furious dash for cash, as investment banks sold whatever they could, commercial banks hoarded reserves and firms drew on lines of credit. Keynes would have interpreted this as an extreme outbreak of liquidity-preference.... But contemporary economics had all but forgotten the term....

In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks.... Frederic Mishkin... presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model... [because] the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”. Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.

Mr Krugman and others advocate a bold fiscal expansion... stimulating resources that might otherwise have lain idle.... Mr Barro thinks the estimates of Barack Obama’s Council of Economic Advisors are absurdly large. Mr Lucas calls them “schlock economics”, contrived to justify Mr Obama’s projections for the budget deficit....

Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.

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Financial economics: Efficiency and beyond: IN 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price.

On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics. That verdict is too simple. Granted, financial economists helped to start the bankers’ party, and some joined in with gusto. But even when the EMH still seemed fresh, economists were picking holes in it.... Academia thus moved on, even if Wall Street did not.... The EMH, to be sure, has loyal defenders. “There are models, and there are those who use the models,” says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice.

Financial firms plugged in data that reflected a “view of the world that was far more benign than it was reasonable to take, emphasising recent inputs over more historic numbers,” says Mr Scholes. “Apparently, a lot of the models used for structured products were pretty good, but the inputs were awful.” Indeed, the vast majority of derivative contracts and securitisations have performed exactly as their models said they would. It was the exceptions that proved disastrous.... Even as financial engineers were designing all sorts of clever products on the assumption that markets were efficient, academic economists were focusing more on how markets fall short....

Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”. The title of Mr Shiller’s latest book, “Animal Spirits” (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes’s description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology. “In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. Mr Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”...

One task, also of interest to macroeconomists, is to work out what central bankers should do about bubbles—now that it is plain that they do occur and can cause great damage when they burst. Not even behaviouralists such as Mr Thaler would want to see, say, the Fed trying to set prices in financial markets. He does see an opportunity, however, for governments to “lean into the wind a little more” to reduce the volatility of bubbles and crashes. For instance, when guaranteeing home loans, Freddie Mac and Fannie Mae, America’s giant mortgage companies, could be required to demand higher down-payments as a proportion of the purchase price, the higher house prices are relative to rents. Another priority is to get a better understanding of systemic risk, which Messrs Scholes and Thaler agree has been seriously underestimated. A lot of risk-managers in financial firms believed their risk was perfectly controlled, says Mr Scholes, “but they needed to know what everyone else was doing, to see the aggregate picture.” It turned out that everyone was doing very similar things. So when their VAR models started telling them to sell, they all did—driving prices down further and triggering further model-driven selling...

Paul Krugman Urges Greg Mankiw to Pay More Attention to Quality Control

There are very good health economists at Harvard--Newhouse, Cutler. He doen'ty have to manufacture his opinions on health care out of faxed Republican talking points.

Paul Krugman:

Live long and prosper: Via Andrew Gelman, Greg Mankiw describes the use of international comparisons of life expectancy as part of the argument for reform as “schlocky.” Grrr. Not many serious advocates of reform use the life expectancy differences to argue that health care is clearly better in other advanced countries than it is in the United States; when it comes to care, the general assessment seems to be that it’s comparable, with no advanced country having a clear advantage. The reform argument actually goes like this:

1. Every other advanced country has universal coverage, protecting its citizens from the financial risks of uninsurance as well as ensuring that everyone gets basic care.
2. They do this while spending far less on health care than we do.
3. Yet they don’t seem to do worse in overall health results.

So Greg suggests that maybe it’s all because we have an unhealthier lifestyle — what Ezra Klein calls the well-we-eat-more-cheeseburgers argument.... [W]e’re spending 6 or 7 percent of GDP more on health care than other countries — call it a trillion dollars a year — without any clear advantage. That’s not the sort of thing you wave away with a casual suggestion that maybe we have bad habits.... [Second,] people have thought about this — and tried hard to measure it... the huge McKinsey Research Institute... tried to quantify the costs of lifestyle-related issues — and found that it didn’t explain much. Third, read Atul Gawande!

Bottom line: this is the most important domestic policy issue we face. It deserves more than casual just-so stories about how the kids American health care might, despite all appearances, be alright.

To me, the thing to note about the economists--the Mankiws, the Lucases, the Beckers, the Barros, and all the rest--who have pledged allegiance to the Republican Party this year is how much they hagve stopped thinking like economists. When an economist thinks about American health care, he or she begins with what we give up and what we get: we give up $1 trillion dollars in real resources a year relative to other countries, and we get... what?... not much. But this is not how Mankiw or Becker approach it. When an economist thinks about nominal demand, he or she thinks about (a) the money stock and (b) the determinants of velocity--the incentives people have to spend their money quickly or to tend to hoard it. But that is not how Lucas or Barro think when they claim that fiscal policy cannot affect nominal demand.

I still remember being convinced by Rick Ericson when I had just turned 18 that thinking like an economist required that one always pay attention to three key principles: market equilibrium, individuals responding to incentives, cost-benefit tradeoffs. And I remember him convincing me that if you kept those three principles in mind always you could do a much better job in understanding the world. I thought that Chicago-School economists believed in these principles too. But someone--was it Mark Lemley?--told me more recently that intellectual principles almost always weigh much less in the balance than political allegiances.

The Duties and Privileges of an Academic Speaker

Eszter Hargittai writes:

Clueless? Rude? Neither? Both?: [A]n incident I experienced years ago. I was surprised economists didn’t get more of a mention in the thread following John H’s post earlier given what I’ve seen in their colloquia. I have close-to no experiences in philosophy exchanges... but I’ve attended quite a few talks among economists so I’m used to their style of Q&A.... [I]t often starts a few slides in – or in some famous cases the speaker doesn’t get to proceed past the title slide for most of the time allotted – and being rather aggressive seems standard. If that’s the local norm, they are likely used to it and it doesn’t raise any eyebrows. However, what if you put such an economist in a room full of sociologists? Is it okay for him to import his style or should he take a moment to familiarize himself with the local norms?

What struck me as rather curious was the way an economist behaved during a job talk I attended in a sociology department.... The economist engaged in the usual norms for his own department’s culture: interrupting at pretty much every slide. He didn’t take any cues from the rest of the group.... [S]ociologists don’t tend to interrupt a speaker, certainly not a slide or two in, and certainly not for questions that are more than mere points of clarification.... [T]his was a job talk, which in... this particular department meant that people would... more courteous [than] usual. (Do not confuse courteous with lack of very serious and difficult questions, of course.) The audience was listening intently and the room was quiet for the most part except for the economist’s questions.... [I]t is a bit surprising that he did not pick up on the fact that his approach was not in line with local norms. Perhaps he did, but just didn’t care. I was clearly not the only one bothered by the economist’s style. The uneasiness in the room was palpable. In the end, a senior sociologist stepped in. She turned to the economist and explicitly stated that this is simply not how we do things and asked that he hold his questions until the speaker had finished his talk. You could tell that everyone (presumably other than the economist) in the room was quite relieved to have had her do this...

Eszter seems to me to be getting three things wrong:

1. Economists are used to situations in which you are supposed to be quiet until the paper-giver has finished speaking, only those are not "workshops" but rather "conference presentations." A conference presentation would, typically, have the presenter speak for 30 minutes, an assigned discussant speak for 10, the presenter respond for 5, and then 15 minutes for questions from the floor and answers by the presenter. It's not a discipline-wide norm that economists follow in workshops, but rather one specific to the format of the "workshop."

2. The difference between interrupting and non-interrupting cultures is not a simple and arbitrary choice of social norm, but instead reflects a judgment about whose words are likely to be most valuable to hear. In an "interrupting culture" the presumption is that everyone has read and thought about the paper beforehand, and that to spend half or more of the available time with the presenter simply summarizing the paper (or, worse, reading large chunks of it) is a waste of everybody's time. Much better to have people raise and argue the points that puzzled them or that they think need to be expanded at their appropriate place in the argument. Moreover, when questions are asked in non-interrupting cultures at the end of the seminar, they don't lead to any discussion: questions come in response to things the presenter said 15, 30, or 45 minutes ago, and lead to formulaic thrust-and-parry-and-end rather than any more complex discussion. Now in a conference, where the presenter and the discussant are up at front for a reason, and where many in the audience have indeed not read the paper, the noninterrupting culture format makes a certain amount of sense. But in a workshop it does not.

3. The noninterrupting culture format is, in the last analysis, one that does even the presenter no favors. It greatly diminishes the fraction of the audience that will read the paper beforehand--for everyone knows that the presenter is going to eat up the lion's share of the time going over it with everyone else sitting around like bumps on a log. A good presenter is more interested in what an intelligent and thoughtful audience thinks of his or her argument than in listening to himself or herself summarize the paper one more time. And if for some reason the presenter gets off on the wrong foot and does not make contact with the audience, then an interrupting culture gives the presenter clues that may allow him or her to adjust on the fly and reconnect. In a non-interrupting culture--no chance of that.

This last was brought home to me when I heard about a job talk in another discipline than mine at... let me call it Potlatch State University...

The young presenter was, the story goes, making an argument that the British classical economists in fact had as much of the milk of human kindness and as much of a desire to build a better world as any group--but just found themselves by their observations and by the logic of their discipline led to conclude that lots of policies that you might think of as good were in fact counterproductive. And he went through example after example, while the audience sat silently. And then he got to the end of his presentation with ten minutes left, because he had gone over. And, the story goes, one of the most senior people asked the first question, which was:

It is said that Benjamin Jowett, Master of Balliol College, was seated at High Table next to British classical economist Nassau Senior during the Irish Potato Famine. And that Jowett asked Senior how many people would die in the famine. And Senior replied: "About one million--and that is not nearly enough..."

Now if there is a better anecdote to back the claim that the British classical economists were Enemies of Humanity--shills for the ruling classes, social darwinists before Darwin, who sought to exalt the wealthy while gleefully grinding the bones of the poor into meal in the Dark Satanic Mills of the Industrial Revolution--I don't know what it is.

If this question had been raised at the start or even in the middle of the seminar, the speaker could have scrambled to recover--qnd would have had a chance of fitting that story into his broad argument. He would have said that Nassau Senior:

• believed that Irish land was good enough to support 4 million people at a reasonable standard of living, but that at the start of the Potato Famine it had 8 million.

• thought that at a population of 4 million average labor productivity in agriculture would be high enough that children could be released from farmwork to go to school, where they would learn self-respect and the fear of God, that as a result the people of Ireland would be prudent and chaste and marry relatively late, and the population would be stable and the island prosperous.

• thought, on the other hand, that at a population of 7 million average labor productivity in agriculture would be so low that children too would have to work digging potatoes and would grow up illiterate and unchurched, that not fearing God they would have sex as often and as young as possible, and that the population would then grow back to its pre-Potato Famine level of 8 million--at which Ireland was starving even when the potato harvest was good, and at which population was kept from growing further only because babies were so malnourished that their immune systems were compromised and women so thin that they stopped ovulating.

Senior believed that Ireland was trapped in a bad poverty-stricken Malthusian subsistence equilibrium at a population of 8 million, and that while a fall in population to 4 million would knock it out of that bad equilibrium and put it on the road to a better one, that a fall in population to 7 million would not and thus, as Jowett later quoted Senior, "would scarcely be enough to do much good." This was, Jowett said, why he had "always felt a certain horror of political economists."

Now Senior was wrong: Ireland in the mid-1840s was no longer hopelessly trapped in a bad Malthusian equilibrium. And Senior's policy advice was wrong because his analysis of Ireland was wrong. You can judge Senior harshly: he ought to have figured out that the Age of Malthus was over. But Nassau Senior did not think that with each Irish famine death an angel got its wings.

That was the argument that the presenter could have made had he been embedded in an interrupting culture and figured out that the most senior people he was talking to were starting from Jowett's High Table at Victorian Balliol. But in a noninterrupting culture in which you have two minutes to respond to each question at the end because there are ten other senior faculty members who want to ask their questions that they have been nursing since minute 20? In a noninterrupting culture you are dead if your audience is starting at a different place than you think they are starting.

A Sokratic Dialogue: Liquidity Preference, Loanable Funds, and European Hedge Funds that Fear the Collapse of U.S. Treasury Bond Prices

Meno: I haven't seen you since spring classes ended.

Adeimantos: I have been away: Paris. London. Frankfurt.

Meno: Oh. Pleasant? Interesting?

Adeimantos: Not really interesting--too jet-lagged, so I sit in my hotel room in my underwear, read the Economist and Financial Times,, and reflect on how if in my 20s I had been in a fancy hotel in central Paris with someone else paying I would have thought I was in heaven, but that now I am just tired. Thus not too pleasant either.

Meno: Middle age is a shipwreck?

Kephalos: It gets worse...

Adeimantos: However, it was somewhat lucrative: talking to European hedge funds.

Meno: And what do European hedge funds think?

Adeimantos: They look at things like this:

Then they demand that I tell them why U.S. Treasury bond prices have not already collapsed (and Treasury interest rates risen) in anticipation of this forthcoming tsunami of bond issues. Given that Treasury bonds have not yet collapsed they are very very bearish about U.S. Treasury bond prices and interest rates. Supply and demand. The supply of U.S. Treasury bonds is about to become huge, and when supply goes up price should go down.

Sokrates: But if that argument is correct, then rational profit-seeking traders should already have sold U.S. Treasury bonds and already have pushed their prices down in anticipation of the sudden increase in supply...

Meno: Are you Sokrates or Milton Friedman?

Kephalos: There are two supply-and-demand arguments that can be made here. The first is that the supply of U.S. Treasury bonds is about to jump enormously--and so by supply-and-demand the price will be low once the extra bond issues hit the market, and should be low now in anticipation of this low-price Treasury bond market equilibrium. The second is that the inverse of the price of U.S. Treasury bonds--the Treasury nominal interest rate--is the price of liquidity: the amount of interest income you forego by keeping your wealth in cash rather than in securities. According to this second argument, the supply-and-demand is the supply and demand for cash: when the supply of cash is high, the price of liquidity is low, and since the price of liquidity is the short-term Treasury interest rate the short-term Treasury interest rate should be very low.

Adeimantos: Which it is...

Kephalos: And the long-term Treasury interest rate is the average of expected short-term future Treasury interest rates. Since the Federal Reserve has flooded the economy with cash and will keep flooding it with cash for the foreseeable, Treasury interest rates should be low which means Treasury bond prices should be very high--which they are--and stay high.

Adeimantos: Loanable funds vs. liquidity preference.

Sokrates: So, Kephalos, with your impeccable logic and deep wisdom derived from a long career financing expeditions to the shores of the Black Sea, you have presented us with two different supply-and-demand arguments, one saying that Treasury bond prices should be low and hence are about to collapse, and the other saying that Treasury bond prices should be high and are likely to stay more-or-less where they are for some time to come.

Meno: Which argument is right? Is the price of bonds the price that balances the supply and demand for bonds in the bond market? Or is the price of bonds the inverse of the interest rate which balances the supply and demand for cash in the money market? Both cannot be true, can they?

Adeimantos: Ah. But both arguments are true...

Meno: Why do I get the feeling that I am being cast as the dumb straight man in this dialogue?

Sokrates: Because you are a sophist and we are philosophers. We write the dialogues, and we write them to make ourselves look good so that everyone thinks that philosophers are the roxxor and sophists are lame...

Meno: What have I ever done to you?

Glaukon: Tried to take our students and their fees, perhaps?

Sokrates: And we have won. There are now departments of philosophy everywhere. But when was the last time you saw a department of sophistry?

Meno: OK. I will take up my role: Kephalos: Can you explain to me how two perfectly-coherent supply-and-demand arguments lead to opposite conclusions? And if both arguments are coherent, why do European hedge funds all believe the first?

Kephalos: I can answer the second question but not the first: European hedge funds live in the bond market and they see the supply and demand of bonds all day, so that is the market they believe is most important...

Adeimantos: That is true about European hedge funds. But, Meno, the way you have posed the issue is somewhat misleading. It is not which supply-and-demand argument is correct--for both are: the price/interest rate on Treasury bonds clears both the bond and the money market, both loanable funds and liquidity preference. It is how does the economy adjust in order to make the Treasury bond price/interest rate clear both these markets.

Meno: And I have the feeling that you are about to tell me...

Adeimantos: Let's start with an economy in equilibrium--where Treasury bond prices are such as to satisfy both loanable funds and liquidity preference, so that everyone is happy to hold the bonds given their current price and everyone is happy to hold the economy's cash supply given the current interest rate. Now suppose the Treasury issues a huge honking tranche of bonds (and Obama spends the money hiring the unemployed to give people cholesterol screenings on the street and hand out statins). Now the supply of bonds is greater than demand at current bond prices. So what happens?

Kephalos: The prices of Treasury bonds fall--interest rates rise...

Adeimantos: And what happens in the money market as interest rates rise?

Kephalos: People are no longer happy holding the economy's cash--it's too expensive; it's burning a hole in their pocket. So they start spending it faster...

Adeimantos: And as they start spending it faster?

Kephalos: This puts upward pressure on prices and employment, as businesses find that they can charge more and make hire profits and so hire more people...

Adeimantos: Incomes rise, and as incomes rise savings rise because people don't spend all of their increased incomes, do they?

Sokrates: Very true, Adeimantos.

Adeimantos: And what happens as savings rise?

Kephalos: People want to park those savings somewhere. They want to park those savings in Treasury bonds. And so demand for Treasury bonds rises...

Adeimantos: And the economy settles back at its new equilibrium, with (a) somewhat higher interest rates and (b) higher spending and income so that (c) people are happy holding the economy's cash at the current interest rates and rate of spending, and (d) people are happy holding the bonds at the current bond prices and level of income.

Kephalos: So both supply-and-demand arguments are true...

Meno: And the way that they can both be true is that there isn't just one quantity--the bond price--that adjusts to match supply and demand in the bond and the money markets...

Sokrates: But there are two quantities that adjust: the bond price and the level of spending...

Adeimantos: Yes. You have just derived things that were well-known 72 years ago. See John Hicks (1937), "Mr. Keynes and the 'Classics': A Suggested Interpretation."

Sokrates: But which adjusts more?

Adeimantos: Once again back to Hicks (1937). When the unemployment rate is high and the nominal interest rate on Treasury bonds is very very slow, adjustment comes in the form mostly of changes in spending and only slightly in changes in interest rates--the world is then "Keynesian." But when the unemployment rate is normal or low and the nominal interest rate on Treasury bonds is near its normal levels, adjustment comes in the form mostly of changes in interest rates and only slightly in changes in spending--the world is than "Classical." That's why the title of the article is "Mr. Keynes and the 'Classics'."

Meno: So when European hedge funds predict the collapse of U.S. Treasury bond prices as the new issues hit the market and ask where is the extra demand to hold all these new bonds come from, the answer is...?

Adeimantos: That even as the government issues the bonds it is also spending the money, and as the money it spends is parked in the bank accounts of the businesses the government is buying things from, the banks in which the money is parked take it and use it to buy Treasury bonds.

Meno: That sounds like sophistry...

Sokrates: You should talk...

Glaukon: Actually, it's just general equilibrium...

Meno: But is this doctrine--that the government's issuance of a fortune in bonds and spending of a fortune in money will show up primarily not as a collapse in bond prices and a spike in interest rates but as an expansion of spending--true?

Sokrates: We will see. Keynesian--or maybe I should say Hicksian--economists would say that bond prices/interest rates and spending/income levels are the two quantities that together adjust to jointly clear the bond and the money markets, to satisfy both loanable funds and liquidity preference equilibrium; that sometimes the principal movement is in interest rates; that sometimes the principal movement is in spending levels; and that right now it is likely that spending will adjust by much more than interest rates.

Adeimantos: And there is a little bit of empirical evidence that the Hicksian economists are right. Tim Fernholz http://www.prospect.org/csnc/blogs/tapped_archive?month=06&year=2009&base_name=compare_and_contrast_economic sends us to Nelson Schwartz, who writes:

Europe Lags as U.S. Economy Shows Signs of Recovery - NYTimes.com: There was more evidence Thursday that the United States economy might be stabilizing, if not rebounding, even as economic reports in Europe remained gloomy. The American news — showing slight growth in retail sales and a dip in first-time jobless claims, as well as rising stocks — was not enough to end the disagreement between bulls and bears over how soon the economy would improve. But the apparent divergence of fortunes between America and Europe highlighted the different approaches to solving the financial crisis, and why some economists say the more aggressive American strategy may be working better, at least for now. It is a debate that is likely to be one of the issues dominating discussions when finance ministers from the eight largest economies meet in Italy this weekend.

Some private economists are even predicting that the American economy will resume growth in the fourth quarter, while Europe’s economy is expected to remain in recession well into 2010, after contracting an estimated 4.2 percent this year compared with an expected 2.8 percent decline in the United States. “The shock originated in the U.S., but Europe is paying a higher price,” said Jean Pisani-Ferry, a former top financial adviser to the French government who is now director of Bruegel, a research center in Brussels. Almost from the beginning of the crisis, the United States and Europe chose largely different paths to aiding their economies. The most stark was Washington’s willingness to commit hundreds of billions of dollars to stimulus spending — in addition to moving aggressively to shore up banks and keep credit flowing — versus Europe’s worry that similar spending would increase inflation in the future. Just as the policies pursued during the Great Depression have been dissected ever since by economists, the fate of the United States and Europe as the two regions emerge from the global crisis will be analyzed for decades to come.....

One crucial concern about America’s increased deficit spending — that it would lead investors to demand higher interest rates on United States debt, making it far more expensive to borrow and slowing the economy — has been allayed, for now. An auction on Thursday of $11 billion in 30-year Treasury bonds found enthusiastic buyers, helping to push the Standard & Poor’s 500-stock index to a seven-month high...

Meno: And the Chicago School economists who say that government borrow-and-spend logically cannot increase overall spending? The Robert Lucases who say: "[W]ould a fiscal stimulus somehow get us out of this bind...? I just don't see this at all. If the government builds a bridge... by taking tax money away from somebody else, and using that to pay the bridge builder... then it's just a wash.... [T]here's nothing to apply a multiplier to. (Laughs.)... [And] taxing them later isn't going to help, we know that..."? And the John Cochranes who said: "[W]hile Tobin made contributions to investing theory, the idea that spending can spur the economy was discredited decades ago. 'It’s not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false.'" To borrow money to pay for the spending, the government will issue bonds, which means investors will be buying U.S. Treasuries instead of investing in equities or products, negating the stimulative effect, Cochrane said. It also will do nothing to unlock frozen credit..."?

Sokrates: I, at least, find myself unable to understand them. They say they believe in the quantity theory of money--that spending is equal to the economy's cash times its velocity. And they say that they believe that velocity is interest elastic--that people respond to incentives and spend the cash in their pockets more rapidly when nominal interest rates are high. They say that they believe that bond prices/interest rates are such as to balance saving and investment and make people willing to hold the stock of bonds. That's all you need to be a Hicksian. Yet they also claim that Hicks is wrong, somehow--without giving arguments. I can trip up and make foolish anybody who makes an argument, but if they don't make an argument I cannot make them look any more foolish...

My Favorite Minor Post-Ricardian Economist

Mountifort Longfield:

The Economic Writings of Mountifort Longfield, edited by R.D. Black.

To call Karl Marx a "minor post-Ricardian" is an insult to Longfield, at least.

The "Treasury View" and Fiscal Policy

'I can call spirits from the Vasty Deep!" "Why, so can I, and so can any man. But do they come when you call them?" Felix Salmon calls Alan Beattie of the FT and Justin Fox of Time:

What use economic history? : How relevant is economic history at times like this? I asked. Can studying history prevent us from repeating past mistakes, or does it just end up forcing us into committing new ones? And how much of a good thing is it that an economic historian is chairman of the board of governors of the Federal Reserve?

Successfully:

Beattie replied first:

yes, I think it definitely helps when looking at such once-in-a-century events to have a discipline which focuses on specific similar episodes in the past, not least because the sample size is so small. And that does seem to be having some effect on the policy response now. Despite the best efforts of some, I don’t think the Montagu Norman/Andrew Mellon liquidationist instinct or the 1930s “Treasury view” on deficit spending are getting much serious traction in the US or UK, for example. (Irrelevant trivia: I am very distantly related by marriage to Andrew Mellon - something like a third cousin three times removed. She divorced him in a spectacular case involving all sorts of legal shenanigans and managed to walk off with a sizeable chunk of the Mellon loot, though not a nickel has trickled down to me.)

but of course you need to learn the right lessons and pick the right comparator. the current German reluctance to increase fiscal stimulus, for example, seems to be assuming that this is a 1920s/1970s inflationary situation, not a 1930s deflationary one.

it is good that an economist who is also an economic historian is Fed chairman. Not sure you’d want someone who was reading entirely out of the previous playbooks without also being able to recognise that the monetary transmission mechanism has changed out of all recognition. The General Theory is a bit light on what to do about credit default swaps, for example.

Then Justin weighed in:

My book is basically the story of a bunch of guys who decided to ignore financial market history (the dodgy parts, at least) in order to create more elegant models of financial markets’ future. That didn’t work out so well, so yeah, knowing economic history would seem to be useful. But Alan’s right that there are lots of different lessons that can be drawn from the past, and sometimes people draw the wrong ones. I too am related to a liquidationist, by the way—George Washington Norris, the hard-line president of the Philly Fed in the early 1930s, was my great great uncle.

On Bernanke, I’d certainly rather have somebody with his background in that job than an ahistorical rational expectations type who believes bubbles and panics don’t happen...

And then Felix summons me:

I’d be interested in what Brad DeLong — one of the foremost economic historians of our own time — thinks about whether the “Treasury view” is getting much serious traction — I suspect he might have killed it before it had a chance to spread widely, and it certainly doesn’t seem to have been mentioned much since January 20. And in general I think that economic historians are having something of a day in the sun right now, with lots of people looking back to previous economic crises around the world, and fewer people finding modern theory-based economics particularly helpful from a policymaking perspective. Maybe economic history is a classic countercyclical asset.

I am here:

(I) With respect to the “Treasury View” that Obama's fiscal policy will be ineffective--well, I think it is very common. In the past two months across my desk I have seen it advocated by Robert Barro; Eugene Fama; John Cochrane; Luigi Zingales; Michele Boldrin; Niall Ferguson; Nobel Prize winners Gary Becker, Edward Prescott, and Robert Lucas; John Cogan; John Taylor; and Peter Klenow. Of these, only John Taylor and John Cogan on the one hand and Pete Klenow on the other had even a slightly-coherent argument based on a slightly-recognizable model. And I'm stretching it to call Taylor and Cogan's argument slightly coherent. It was that: (a) Jared Bernstein and Christie Romer say that fiscal expansion is likely to be powerful, (b) they assume a certain reaction by the Federal Reserve to fiscal expansion, (c) a reaction that makes fiscal policy so powerful that we cannot calculate its effects--our model explodes--(d) so we assume a different reaction by the Federal Reserve that makes fiscal policy much less powerful, and so (e) we find that fiscal policy is not very powerful. To which my reaction is: Huh!? Assuming that fiscal policy is not powerful is a reason to think that it is not powerful. That simply will not do.

Klenow said that (a) the Federal Reserve is not powerless to affect spending right now, (b) the Federal Reserve is happy with the projected growth path of spending, so (c) policy moves by Obama that raise the projected path of spending in the future will be offset by the Federal Reserve's raising interest rates to keep the projected growth path of spending the same. This seems to me to be false as a description of what the Federal Reserve is doing. But at least it is coherent--you can at least have a response to it other than "Huh?!"

The assumption of some version of the quantity theory of money plus the recognition that money demand is usually interest elastic create a presumption that fiscal policy is effective. There are then four coherent ways to argue to try to rebut that presumption and arrive at the "Treasury View":

1. Klenow's--that the central bank is happy with the projected growth path of spending and both can and will take action to make sure that fiscal policy is ineffective by offsetting its effects.

2. The goods-crowding out argument: that we are at full employment so workers have so much bargaining power at the moment fiscal policies that increase spending will go 100% into increasing wages and prices and 0% into increasing production and employment. This seems to me to be false.

3. The the interest-crowding out argument: that when the government sells a bond interest rates will rise and induce a private-sector firm not to sell a bond, and thus investment spending falls by as much as government spending increases. This requires that in this particular case the increase in interest rates resulting from a higher government budget deficit have no effect on the velocity of money, which could happen as a limiting case but I see no reason to think that it would happen now.

4. Increases in government spending now lead private individuals to cut back on their spending out of fear of future tax increases by so much that total spending is unchanged. This seems to me to fundamentally misunderstand the permanent income hypothesis.

The interesting thing from my perspective is that Barro, Fama, Cochrane, Zingales, Boldrin, Ferguson, Becker, Prescott, and Lucas don't appear to be making any one or any combination of the four coherent arguments for the "Treasury View." They do believe in the quantity theory of money. But either they don't believe that households and businesses respond to incentives in their money-holdings or they have not tought about the issue. And so they don't recognize that they have to make one or more of the four valid argumentative moves if they are to be coherent.

(II) Nevertheless analytical incoherence seems to be no barrier to influence. Last January I thought that the numbers from the fourth and forecast for the first quarter told us that we should (a) immediately do $1.2T of effective fiscal stimulus, and (b) stand ready--preferably by putting the money into the Budget Resolution--to do another $1.2T of effective fiscal stimulus in October with the Reconciliation Bill if things turned out to be worse than expected. We did about $0.6T of effective fiscal stimulus, nothing got into the Budget Resolution, and there is no legislative prospect for additional fiscal stimulus this year. By my count that is at least a 2/3 victory for the "Treasury View"--we are doing less than we should be doing, and certainly much less than it would be prudent to be doing, and we are doing less than we should be doing because the "Treasury View" advocates have muddied the analytical waters.

(III) As to history--well, yes, of course. Economics does not have solid foundations. We pick episodes from history that seem interesting and informative, and we crystalize these historical episodes into economic theory. But then theorists teach this crystalized history as if it were handed down from Mount Olympus. And so we wind up with a lot of young and many old economists who can manipulate theories but who do not understand what they are good for or where they come from.

Jacob Viner at His Most Arch

Bull, meet red flag:

Jacob Viner (1937), ["Mr. Keynes on the Causes of Unemployment"(http://www.jstor.org/stable/pdfplus/1882505.pdf): Written tho it is by a stylist of the first order, [Keynes's General Theory] is not easy to read, to master, or to appraise. An extremely wide range of problems, none of them simple ones, are dealt with in an unnecessarily small number of pages. Had the book been made longer, the time required for reading it with a fair degree of understanding would have been shorter, for the argument often proceeds at breakneck speed and repeated rereadings are necessary before it can be grasped. The book, moreover, breaks with traditional modes of approach to its problems at a number of points--at the greatest possible number of points, one suspects--and no old term for an old concept is used when a new one can be coined, and if old terms are used new meanings are generally assigned to them...

Jacob Viner (1933), "Balanced Deflation, Inflation, or More Depression"

Perhaps the most important single document with respect to how much the Chicago School of Economics has forgotten over the past seventy-five years--how much less they know now than Irving Fisher or Knut Wicksell did.

As I understand things, Jacob Viner's estate has rights to this document until 2040, and there is at present no way for me to get permission to legally distribute it. So I think it is time to hoist the jolly roger...

Download now or preview on posterous: 20090527_viner_lecture.pdf

Jacob Viner (1933), "Balanced Deflation, Inflation, or More Depression" (Minneapolis: University of Minnesota).

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Posted via email from http://braddelong.posterous.com/viner-balanced-deflation-inflation-or-more-de at Brad DeLong's Scrapbook

The Chicago School on Dealing with Depression in 1933 I

Milton Friedman in "A Comment on the Critics" approvingly quotes Jacob Viner's (1933) "Balanced Deflation, Inflation, or More Depression":

Even more pertinent is a talk Viner delivered in Minneapolis of February 20, 1933, on "Balanced Deflation, Inflation, or More Depression"....

[I]t woul dhve been sound policy on the part of the federal government deliberately to permit a deficit to accumulate during depression years, to be liquidated in prosperity years.... The outstanding though unintentional achievement of the Hoover Administration in counteracting the depression has in fact been its deficits of the last two years....

[...]

I will use the term 'inflation' to mean an inrease in the total amount of spendable funds.... It is often said that the federal government and the Federal Reserve system have practiced inflation during this depression and that no beneficial effects resulted from it. What in fact happened was that they made mild motions in the direction of inflation.... At no time... since the beginning of the depression has there been for so long as four months a net increase in the total volume of bank credit....

Assjming for the moment that a deliberate policy of inflation should be adopted, the simplest and least objectionable procedure would be for the federal government to increase its expenditures or decrease its taxes, and to finance the resultant excess of expenditures over tax revenues either by the issue of legal tender greenbacks or by borrowing from the banks...

---

From J. Rennie Davis (1968), "Chicago Economists, Deficit Budgets, and the Early 1930s," American Economic Review 58:3,1 (June), pp. 476-481:

Frank H. Knight to Senator Robert F. Wagner (May 8, 1932): As far as I know, economists are completely agreed that the Government should spend as much and tax as little as possible at a time such as this--using the expenditure in ways to do the most good in itself and also to point toward relieving the depression...

Jacob Viner (1931): [T]he public works or other useful services so financed [by deficit spending] during a period of economic depression are from the national economic point of view almost costless...

As If an Invisible Hand Had Played a Losing Card...

Gavin Kennedy sets out all the things that Adam Smith did not mean by "invisible hand," and the historical process of misreading by which the phrase acquired the meaning we give it.

What did Smith mean? These:

• That the love of power and authority by the rich induces them to trade real resources to the poor in return for deference, which has an enormous levelling effect on the true distribution of income.
• That the fear of merchants of the strange and foreign leads them to concentrate their investments at home to the benefit of domestic workers.

Smith focused--quite rightly--on what Kenneday aptly terms "emergent order." "Invisible hand" is a metaphor we use for "emergent order." But Smith did not use it so.

But Daniel Klein comments on Gavin Kennedy, and strikes out. It is not even clear that Klein knows what home plate is, and that he is supposed to swing the bat over it:

We will never know whether Smith intended the phrase invisible hand to serve as a tag for the comparative merit of freedom. It certainly is not outlandish to think that he did. As Minowitz (2004, 407) puts it, Smith all but “evicts God” from WN, making the invisible hand all the more striking.... Gavin notes that the phrase appears only infrequently in Smith’s work.... But... [t]hat the phrase appears close to the center, and but once, in TMS and in WN might be taken as evidence that Smith did intend for us to take up the phrase.

It is fun... to speculate that... Smith had the notion of invisible hand occurring but once in each of his masterworks, and in each case near the center. The invisible hand passage in WN is just about dead center. As for TMS, Hamish Riley-Smith... has kindly informed me that the invisible hand passage occurs at page 273, while the whole is 436 pages plus 10 unnumbered pages including title and contents.... In the 6th edition, however, the passage comes closer to the center. Moreover, the 3rd, 4th, 5th, and 6th editions were published with Smith’s essay on language following the text of TMS, and hence in those editions the passage may have been quite close to the center of the combined pages.... But it does not much matter whether Smith intended the phrase to serve as a tag for the comparative merit of freedom. The phrase is as worthy a tag as any for that worthy idea...

How Much Intellectual Steam Did the Conservative Movement Ever Have?

Richard Posner writes that the American conservative movement is losing intellectual steam:

Is the Conservative Movement Losing Steam? Posner: Until the late 1960s (when I was in my late twenties), I was barely conscious of the existence of a conservative movement. It was obscure and marginal... Barry Goldwater... Ayn Rand, Russell Kirk, and William Buckley--figures who had no appeal for me. More powerful conservative thinkers... Milton Friedman... Friedrich Hayek... George Stigler, were on the scene, but were not well known outside the economics profession.

The domestic disorder of the late 1960s, the excesses of Johnson's "Great Society," significant advances in the economics of antitrust and regulation, the "stagflation" of the 1970s, and the belief (which turned out to be mistaken) that the Soviet Union was winning the Cold War--all these developments stimulated the growth of a varied and vibrant conservative movement... free-market economics... "neoconservatism" in the sense of a strong military and a rejection of liberal internationalism... cultural conservatism, involving respect for traditional values, resistance to feminism and affirmative action, and a tough line on crime.

The end of the Cold War, the collapse of the Soviet Union, the surge of prosperity worldwide that marked the global triumph of capitalism, the essentially conservative policies, especially in economics, of the Clinton administration, and finally the election and early years of the Bush Administration, marked the apogee of the conservative movement.... By the end of the Clinton administration, I was content to celebrate the triumph of conservatism as I understood it, and had no desire for other than incremental changes.... I saw no need for the estate tax to be abolished, marginal personal-income tax rates further reduced, the government shrunk, pragmatism in constitutional law jettisoned in favor of "originalism," the rights of gun owners enlarged, our military posture strengthened, the rise of homosexual rights resisted, or the role of religion in the public sphere expanded. All these became causes embraced by the new conservatism that crested with the reelection of Bush in 2004....

[T]he policies of the new conservatism are powered largely by emotion and religion and have for the most part weak intellectual groundings... weak in conception... failed in execution... political flops.... The major blows to conservatism... have been fourfold: the failure of military force to achieve U.S. foreign policy objectives; the inanity of trying to substitute will for intellect as in the denial of global warming, the use of religious criteria in the selection of public officials, the neglect of management and expertise in government; a continued preoccupation with abortion; and fiscal incontinence in the form of massive budget deficits, the Medicare drug plan, excessive foreign borrowing, and asset-price inflation.

By the fall of 2008, the face of the Republican Party had become Sarah Palin and Joe the Plumber. Conservative intellectuals had no party.

And then came the financial crash last September and the ensuing depression. These unanticipated and shocking events have exposed significant analytical weaknesses in core beliefs of conservative economists concerning the business cycle and the macroeconomy generally. Friedmanite monetarism and the efficient-market theory of finance have taken some sharp hits, and there is renewed respect for the macroeconomic thought of John Maynard Kenyes, a conservatives' bête noire...

At least Posner knows (unlike his co-blogger Gary Becker) what "conservatism" means.

But is he arguing that conservatism has lost steam or that it never had much steam in the first place?

Richard Posner sees things wrong with Bush era conservatism:

• fiscal incontinence
• the inanity of trying to substitute will for intellect
• cultural-conservative issues ("continued preoccupation with abortion" "religious criteria in the selection of public officials")
• the failure of military force as a first resort in attempting to achieve U.S. foreign-policy objectives

But weren't these also the key components of the Reagan administration. Ronald Reagan was the original fiscal incontinence. And the substitution of will for intellect--was it ever any greater than in the rush to cut taxes to raise revenues, or in Alexander Haig's belief that U.S. national security would be enhanced if the IDF gave the Syrian army a thrashing in Lebanon? We had to rely on the alliance of Nancy Reagan and her astrologer to get a sane policy toward Gorbachev, for God's sake. And cultural conservatives--if I understand Posner, his complaint is that Reagan paid them only lip service and they patiently sat in the back of the bus and were quiet, while Bush, Palin, and Joe the Plumber take them seriously.

And, of course, the piece of Reagan-era conservatism of which Posner was most proud--deregulation and the trimming-back of government--has either turned out to be (a) destructive, or (b) accomplished by Carter and Clinton.

How much intellectual steam did hte conservative movement ever have?

Progress in Macroeconomics?

A decade ago, Olivier Blanchard, now IMF chief economist, wrote that there had been a lot of progress in macroeconomics since 1920:

What Do We Know that Fisher and Wicksell Did Not?: The answer to the question... is: A lot.... Pre 1940. A period of exploration.... From 1949 to 1980. A period of consolidation... an integrated framework was developed--starting with the IS-LM, all the way to dynamic general equilibrium models--and used to clarify the role of shocks and propagation mechanisms.... since 1980. A new period of exploration, focused on the role of imperfections... nominal price setting... incompleteness of markets... asymmetric information... search and bargaining in decentralized markets....

[...]

The right [picture] is one of a steady accumulation of knowledge.... [R]evolutionaries make the news... [their ideas are] discarded... bastardized, then integrated. The insights become part of the core....

[...]

Relative to Wicksell and Fisher, macroeconomics today is solidly grounded in a general equilibrium structure. Modrn models characterize the economy as being in temporary equilibrium, given the implications of the past, and the anticipations of th efuture. They provide an interpretation of shocks working their way through propagation mechanisms...

[...]

One way to end is to ask: Of how much use was macroeconomic research in understanding... the Asian crisis?... Macroeconomists did not predict either the time, place, or scope of the crisis.... [W]hen the crisis started, macroeconomic mistakes... were made. But fairly quickly the nature of the crisis was better understood, and the mistakes correcxted. And most of the tools needed were there.... since then, a large amount of further research has taken place, leading to a better understanding of the role of financial intermediaries in exchange-rate crisis...

Even then Paul Krugman snarked:

Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model. The answer is probably that most do, but many of them probably do not know it well enough to tell..

Today things look considerably different on the progress-in-macroeconomics front. John Quiggin:

Refuted/obsolete economic doctrines #7: New Keynesian macroeconomics at John Quiggin: [Here is] a new entry for my list of refuted economic doctrines... the target... has... [been] rendered obsolete by events... New Keynesianism an approach to macroeconomics, to which Akerlof and Shiller have made some of the biggest contributions, but which they have now... repudiated.... [T]he research task was seen as one of identifying minimal deviations from the standard [rational foresight, self-interest, and competiative markets] microeconomic assumptions which yield Keynesian macroeconomic conclusions.... Akerlof’s ‘menu costs’ arguments... are an ideal example of this kind of work. New Keynesian macroeconomics has been tested by the current global financial and macroeconomic crisis and has, broadly speaking, been found wanting. The analysis of those Keynesians who warned of impending crisis combined an ‘old Keynesian’ analysis of mounting economic imbalances with a Minskyan focus on financial instability.... [T]he policy response... has been informed mainly by old-fashioned ‘hydraulic’ Keynesianism... massive economic stimulus... large-scale intervention in the financial system. The opponents of Keynesianism have retreated even further into the past, reviving the anti-Keynesian arguments of the 1930s and arguing at length over policy responses to the Great Depression.

There is of course, still a need to explain why wages do not adjust rapidly to clear labour markets in the face of an external financial shock. But in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality, and seeking to minimise those deviations....

New Keynesianism... was a defensive adjustment to the dominance of free market ideas.... New Keynesians sought a theoretical framework that would justify medium-term macroeconomic management based on manipulation of interest rates by central banks, and a fiscal policy that allowed automatic stabilisers to work, against advocates of fixed monetary rules and annual balanced budgets. But now that both... the efficient markets hypothesis and the policy framework that brought us the Great Moderation have collapsed, there is no need for such a defensive stance...

George Akerlof and Robert Shiller agree with Quiggin rather than Blanchard:

Akerlof and Shiller, Animal Spirits: The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality.... [E]ach of us has spent a good portion of his life writing in this tradition. The [self-interest and rational foresight-based] economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works.... In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations [from competitive markets, self-interested motivation, and rational foresight] that actually do occur...

So does Greg Clark: his rant from his seat as chair of the U.C. Davis Economics Department:

Dismal scientists: how the crash is reshaping economics - The Atlantic Business Channel: In the long post WWII boom, as free market ideology triumphed, economists have won for themselves a privileged place inside academia.... [C]ash.... Not much by the pornographic standards of finance, but a fat paycheck compared to your average English or Physics professor. It is not just the stars.  Journeyman assistant professors in economics routinely come in at $100,000 or more... fresh from their PhDs, without a publication to their name and without years of low pay as post-docs. The high salaries have been accompanied by dramatic declines in the teaching burden....

Why did academic economics generate so much prestige?... [W]hat drove demand was the unquenchable thirst for economists by banks, government agencies, and business schools - the Feds, the Treasury, the IMF, the World Bank, the ECB.  Economics had powerful insights to offer the world, insights worth a lot of treasure.  Economics was powerful voodoo....

The current recession has revealed... as useless the mathematical contortions of academic economics. There is no totemic power.... (1) Almost no-one predicted the world wide downtown.  Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history. There was indeed much recent debate about the sources of "The Great Moderation" in modern economies, the declining significance of business cycles.... [M]acroeconomists had turned their considerable talents to a bizarre variety of rococo academic elaborations.  With nothing of importance to explain, why not turn to the mysteries of online dating, for example.... (2) The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1.  What is the multiplier from government spending?  Does government spending crowd out private spending?  How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner. The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s.  There has essentially been no advance in our knowledge in 80 years....

Bizarrely, suddenly everyone is interested in economics, but most academic economists are ill-equipped to address these issues. Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama's stimulus plan.  As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus -- thinking that would be a timely and lively session.  But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that "all I know on this issue I got from Greg Mankiw's blog -- I really am not equipped to debate this with anyone." Academic economics will no doubt survive this shock to its prestige.... [But] the days of the $500,000 economics professor may have passed.... [W]ill the focus of academic economics change?... I would rate the chances of Chrysler producing once again a competitive US automobile at least as high as the chances of academic economics learning any lesson from this downturn...

Watching the scrum over the past six months, I have to call this one for Krugman, Clark, Akerlof, Shiller, and Quiggin and against Blanchard's vision of growing knowledge and analytical convergence. Economists have been worrying about the industrial business cycle and the proper role of the government in trying to tame it since 1825. Yet there are an extraordinary number of people out there calling themselves macroeconomists who do not have the slightest clue as to what the issues have been over the past two hundred years.

DeLong: Econ 202b Lecture May 7, 2009: Trying (and Failing) to Understand the "Modern Chicago" View of the Financial Crisis

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Cryptic Note to Self: I Will Never Understand Chicago Today...

"But monetary policy can still be very effective: you just have to buy things other than Treasury bonds in your open-market operations..."

So you grow the money stock: what does that do? Unless your expansionary monetary policy raises short-term interest rates--in which case it is not what I at least think of as expansionary monetary policy--it moves you by the little red line--and it creates a huge excess demand-inflation problem whenever interest rates return to their normal (black) levels as shown by the big black arrow.

By contrast, fiscal policy--or perhaps flow-of-funds policy: fiscal and banking policy--that sops up the flow of savings and raises short-term safe nominal interest rates gets you quickly to the blue arrow--with no long-run monetary-overhang problem to produce a big burst of inflation later.

More to follow...

A Present for Me

Friedrich A. Hayek (2009), Contra Keynes and Cambridge: Essays, Correspondence, Bruce Campbell Caldwell, ed. (Liberty Fund).

The Effects of Fiscal Policy in 2009 and Beyond: A Discussion of Cogan-Cwik-Taylor-Wieland

STANFORD INSTITUTE FOR ECONOMIC POLICY RESEARCH ANNUAL POLICY FORUM 2009

The Effects of Fiscal Policy in 2009 and Beyond:

A Discussion of Cogan-Cwik-Taylor-Wieland

J. Bradford DeLong

University of California at Berkeley and NBER

brad.delong@gmail.com; http://delong.typepad.com/; +1 925 708 0467

May 1, 2009

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Last March I got a note from Ward Hanson asking me to come down today and talk about:

the impact of the Stimulus Bill on jobs creation… the contrast between the Romer/Bernstein estimates of the benefits of the stimulus plan versus… Cogan, Taylor et. al. that estimate/argue that there will be very little benefit…. I've got agreement from the "Taylor group" to present, as well as Martin Giles of the Economist Magazine to serve as a moderator…

So I said yes. And Tuesday afternoon I sat down to reread Romer and Bernstein (2009), which I had read before, and Cogan, Cwik, Taylor, and Wieland (2009), which I had not, and I ran into a problem.

On page 2 Cogan et al. write that their Figure 1 shows how Romer and Bernstein think government spending affects the economy alongside:

exactly the same policy change… in another study… by one of us [John Taylor]… the results are vastly different…. [T]he Romer-Bernstein estimates apparently fail a simple robustness test, being far different from existing published results of another model…

Source: Cogan et al. (2009).

This surprised me. I had talked to Christy. I had talked to Jared. I knew that their intention had been to pull standard models off the shelf and use them--not to push the envelope in economic modeling in any way.

So I dug--and found that Cogan et al.’s claim of “exactly the same policy change” was simply wrong. Romer-Bernstein model an increase in government spending with the Federal Reserve expanding and keeping on expanding the money supply in order to keep the short-term Treasury Bill interest rate the same. Taylor (1993) models an increase in government spending with the Federal Reserve contracting the real money supply to push the short-term Treasury Bill interest rate up over time as unemployment falls and inflation creeps up. There is no “robustness” problem with Romer-Bernstein at all: the results are different because the policy changes are different. Expanding the money supply on the one hand, contracting it on the other.

“Geez,” my first thought was, “this is embarrassing—none of four coauthors of Cogan actually read Romer-Bernstein. Sloppy.” Then I got to page 5 of Cogan: “Romer and Bernstein assume that the Federal Reserve pegs the interest rate—the federal funds rate—at the current level of zero…” Cogan et al. know perfectly well that the policy changes are not “exactly the same.” They just say they are.

I am sorry. In Europe, that gets you four red cards. In America, that gets you sent to the showers. The first intellectual responsibility of critique is to accurately present what you are critiquing. When Cogan et al. learn that they can come back into the game. But not until then.

Cogan is simply not what it is being sold as--a critique of the argument of Romer-Bernstein. It should not be taken as such.

I could stop here.

But I have extra time.

I think the best way for me to spend the rest of my time is to lay out why right now at this moment someone like Christy Romer--fundamentally a monetarist, a believer in monetary policy, author of papers on how it was monetary expansion that substantially alleviated the Great Depression in the late 1930s--is now a believer in, a designer of, and an advocate for Barack Obama’s plan to give the U.S. economy a fiscal boost to try to cushion the current fall in employment.

The analysis I am going to give is essentially that carried out nearly eighty years ago by one of Milton Friedman’s teachers, Jacob Viner, in his analysis of the Great Depression when he called for “large and continuous deficit budgets to combat the mass unemployment and deflation of the times.” Friedman applauded Viner’s analysis and saw it as superior to those of others like John Maynard Keynes: “so far as policy was concerned,” Friedman wrote in the early 1970s, “Keynes had nothing to offer those of us who had sat at the feet of [Henry] Simons, [Lloyd] Mints, [Frank] Knight, and [Jacob] Viner…”

Start with Robert Lucas’s observation that in a modern economy you cannot deflate--you cannot have the total nominal volume of spending fall--without having production, sales, and employment falls as well.

And also start with the quantity theory of money:

PY = MV

The total flow of spending in the economy--the amount produced and sold Y times the prices at which goods and services are sold P--is equal to the stock of money in the economy M--bank reserves, cash, checking-account balances, other liquid assets--times the velocity of money V. If PY threatens to fall--threatening a fall in production and sales and a rise in unemployment—then the standard policy Jacob Viner, Milton Friedman, and Christy Romer would recommend would be to boost M. Provided that V does not move in the opposite direction to offset the increase in M, nominal spending will stabilize and deflation and depression and high unemployment will be averted.

The loose end is V--how fast households and businesses spend their cash balances. Milton Friedman in Studies in the Quantity Theory of Money maintained that the key determinant of velocity is the (nominal) interest rate: the higher are nominal interest rates, the higher is velocity because the faster you want to spend your money. Holding purchasing power in cash rather than in bonds is expensive when interest rates are high: you would rather either spend it and buy something or move it back into bonds that pay interest rather than keep it around idle. The velocity of money of money is low when interest rates are low because delaying purchases while you comparison shop is not costly: you lose little in foregone interest that you could have been earning.

This dependence of velocity on the interest rate puts a limit on the effectiveness of monetary expansion. When you expand the money stock you increase the ratio of money to bonds. By simple supply and demand raise the price of bonds in terms of money—and the price of bonds in terms of money is the inverse of the interest rate. So when you raise the money stock, you lower velocity.

This matters when interest rates on assets like Treasury Bills get very low, like zero, like they are now. If you hold your money in a six-month Treasury Bill you get essentially no interest--0.3% per year Monday afternoon--and you run the small risk that interest rates might rise over the next month and your Bill might lose a little value. If you hold your money in cash you get exactly no interest and it is safe--FDIC insured. Thus there is no economic incentive pushing you to spend your cash when interest rates are very low. And so there is no economic reason for the velocity of money to be any particular value. When the central bank tries to boost nominal spending through standard monetary expansion it might prove ineffective: interest rates will drop even closer to zero as the ratio of money to bonds rises, and the velocity of money might well drop to offset the boost to the money stock.

Guess where we are now? The Federal Reserve is boosting the money supply with extraordinary force, and the velocity of money is dropping like a stone.

In order to ensure that monetary expansion is effective, you need to do something to boost interest rates. What can you? Here is where “large and continuous deficit budgets” comes in. When the government runs a deficit it floods the market with bonds. Once again by simple supply and demand more bonds means a lower price of bonds which is the same thing as higher interest rates. The government cannot hold on to the money it gets from selling bonds for that would reduce the money stock, and the whole point of the exercise is to make the increase in the money stock effective. It has to return the money to the private sector by spending it. And it can spend it in four ways:

• By buying up assets like mortgage-backed securities.
• By buying up companies like Fannie Mae, Freddie Mac, AIG, GM, Citigroup, and more to come.
• By refunding the money to taxpayers by cutting taxes.
• By spending the money directly--boosting government purchases.

Which of these ways would be most effective at keeping the velocity of money from falling further to offset expansionary monetary policy? The answer is that we really do not know which of the ways would be most effective--and that is the reason that we are trying them all right now, with Tim Geithner buying GM and mortgage-backed securities with the government’s money and Peter Orszag directing the flow of spending and tax cuts that is the American Recovery and Reinvestment Plan.

Will it work? It is hard to see how it could not work. Nobody disputes that in normal times monetary expansion boosts spending, demand, production, and employment. But the worry is that these times right now appear to be not-normal. Nobody disputes that in not-normal times when interest rates are very low--as they are now--there are no strong incentives to spend cash working to keep monetary velocity from falling to offset increases in the money supply. Purchasing insurance against this eventuality--which appears to be a reality outside the building--seems a reasonable thing to do.

Is this a good use of the government’s money? It does, after all, saddle us with additional government debt. If we did not spend money on the stimulus program now, we could use that debt capacity for some other, different purpose in the future. But as of 4 PM EDT on Monday, the U.S. government could borrow for seven years at a real interest rate I estimate at –0.5% per year. Government expenditures on national security, on Medicare, on the Center for Disease Control, on the Interstate Highway System, on research and development into green energy technologies would have to be extraordinarily and uniquely inefficient right now for them not to be worth doing right now when they come with the extra bonus of making monetary policy effective in the current situation.

Will it be big enough, or will in two years we wish we had done more? I think the odds are one-in-three that in two years we wish we would have done more, and that the odds are close to zero that in two years we wish we would have done less.

Thus my analysis of the stimulus program is quite positive. And this analysis, remember, is not mine alone. It is modeled on the analysis of Milton Friedman’s teachers at the University of Chicago in the 1930s--men of whom he highly approved as having left him nothing to learn at the feet of John Maynard Keynes, men who called for a two-handed approach to the Great Depression:

• “the Federal Reserve banks systematically pursue open-market operations with the double aim of facilitating necessary government financing and increasing the liquidity of the banking structure…”
• “the use of large and continuous deficit budgets to combat the mass unemployment and deflation of the times…”

That two-handed strategy is the approach we are pursuing now, in a situation that in its level of short-term interest rates has considerable similarities to the Great Depression.

It seems a wise and prudent bet.

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References

John Cogan, Tobias Cwik, John Taylor, and Volker Wieland (2009), “Old Keynesian versus New Keynesian Government Spending Multipliers” < http://www.volkerwieland.com/docs/CCTW%20Mar%202.pdf>.

Milton Friedman (1972), “Comment on the Critics of ‘Milton Friedman’s Monetary Framework’,” Journal of Political Economy.

Milton Friedman, ed. (1956), Studies in the Quantity Theory of Money.

Christina Romer and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan” http://otrans.3cdn.net/45593e8ecbd339d074_l3m6bt1te.pdf.

John Taylor (1993), Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation.

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David Warsh Has Lost His Mind

Warsh writes:

Economic Principals: The American newspaper industry has fallen on hard times, and its authority has dimmed, at least for the moment. But the conservators of its traditions quietly took an admirable stand last week. The Pulitzer Prize Board passed over The New York Times columnist (and Princeton professor) Paul Krugman and gave its 2009 commentary award to Eugene Robinson... for columns on the election of the first African-American president that exhibited “graceful writing and grasp of the larger historic picture.” Krugman and Regina Brett, of the Cleveland Plain Dealer, were runners-up....

[T]here is something about Krugman’s newspaper journalism that chafes. True, he gets half-a-dozen scoops a year. He has become a columnist of enormous influence. He is an energetic blogger, too. Yet he often cloaks his claims in professional authority, overstates them, omits arguments that undermine his case, and is a bit of a bully.

Being one of two runners-up for commentary--being number two or three--is a mark of high distinction for Paul Krugman. David Warsh's interpretation of it as a slam against Paul is... extremely weird at best.

I think something else is going on here in David's mind--best summarized by a sentence from one of David Warsh's fellow journalists: "that Paul Krugman was totally right about almost everything doesn't make me like or forgive him."

Why oh why can't we have a better press corps?

Is Anything Karl Marx Wrote After He Turned Thirty Worthwhile?

Circling around again to Chris Bertram's whine about how lousy my "evaluating Karl Marx as an economist" lecture is, and how he would do something else:

Explaining Marx to newbies: Suppose I were lecturing about Karl Marx: I’d do the same thing. I’d probably start by discussing some of the ideas in the Manifesto about the revolutionary nature of the bourgeoisie, about their transformation of technology, social relations, and their creation of a global economy. Then I’d say something about Marx’s belief that, despite the appearance of freedom and equality, we live in a society where some people end up living off the toil of other people. How some people have little choice but to spend their whole lives working for the benefit of others, and how this compulsion stops them from living truly truly human lives. And then I’d talk about Marx’s belief that a capitalist society would eventually be replaced by a classless society run by all for the benefit of all. Naturally, I’d say something about the difficulties of that idea. I don’t think I’d go on about Pol Pot or Stalin, I don’t think I’d recycle the odd bon mot by Paul Samuelson, I don’t think I’d dismiss Hegel out of hand, and I don’t think I’d contrast modes of production with Weberian modes of domination...

Something occurs to me: Bertram thinks that the lecture should be exclusively about the Communist Manifesto and before. Karl Marx wrote the Communist Manifesto when he was 29, drawing substantially on what Engels had written about the condition of British textile workers in Manchester in his Condition of the Working Class in England when he was 23. Chris Bertram doesn't think that what either of them wrote about for the rest of their lives is worth wrestling with.

That is, I think, a much harsher judgment of Karl Marx-as-economist than I would deliver...

DeLong Smackdown Watch: Marx on India

Apropos of DeLong: Understanding Marx Lecture for April 20, 2009, Michael Perelman--whose knowledge of the history of economic thought far exceeds mine--takes exception to my classifying Marx's writings on the British in India as Marx in his "prophetic mode"

Michael Perelman: I have done some work on the subject. It was not Marx the prophet. The articles [on India] were directed toward Henry Carey, who was undermining Marx's position on the New York Tribune. The story is very interesting, including others, including Frederick Law Olmstead.

Marx says that Carey sent him at least one book. I have tried to locate Marx's correspondence with Carey, but have been unsuccessful.

I am not sure. When I read Marx's:

All the English bourgeoisie may be forced to do will neither emancipate nor materially mend the social condition of the mass of the people, depending not only on the development of the productive powers, but on their appropriation by the people. But what they will not fail to do is to lay down the material premises.... Has the bourgeoisie ever done more? Has it ever effected a progress without dragging individuals and people through blood and dirt, through misery and degradation?... The bourgeois period of history has to create the material basis of the new world... universal intercourse founded upon the mutual dependency of mankind... the development of the productive powers of man.... When a great social revolution shall have mastered the results of the bourgeois epoch... and subjected them to the common control of the most advanced peoples, then only will human progress cease to resemble that hideous, pagan idol, who would not drink the nectar but from the skulls of the slain...

I definitely hear the voice of Daniel and see the Great Social Revolution coming on clouds of glory...

DeLong: Understanding Marx Lecture for April 20, 2009

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Understanding Karl Marx
J. Bradford DeLong
University of California at Berkeley and NBER
brad.delong@gmail.com

http://delong.typepad.com/>
+1 925 708 0467
April 20, 2009

In the beginning was Karl Marx, with his vision of how the Industrial Revolution would transform everything and be followed by a Great Communist Social Revolution—greater than the political French Revolution—that would wash us up on the shores of Utopia.

The mature Marx saw the economy as the key to history: every forecast and historical interpretation must be based on the economy's logic of development. This project as carried forward by others ran dry. Sometimes--as in, say, Eric Hobsbawm's books on the history of the nineteenth century--this works relatively well. But sometimes it led nowhere. The writing of western European history as the rise, fall, and succession of ancient, feudal, and bourgeois modes of production is a fascinating project. But the only person to try it seriously soon throws the Marxist apparatus over the side, where it splashes and sinks to the bottom of the sea. Perry Anderson's Passages from Antiquity to Feudalism and Lineages of the Absolutist State are great and fascinating books, but they are not Marxist. They are Weberian. The key processes in Anderson's books concern not “modes of production” but rather “modes of domination.” And when Marx and Engels's writings became sacred texts for the world religion called Communism, things passed beyond the absurd into tragedy and beyond tragedy into horror: the belief that the logic of development of the economy was the most important thing about society became entangled in the belief that Joe Stalin or Mao Zedong or Pol Pot or Kim Il Sung or Fidel Castro was our benevolent master and ever-wise guide.

But let us go back to a time before Marxism lost its innocence. Let us go back and look at the thinker, Karl Marx, and what he actually wrote and thought.

Karl Marx had a three part intellectual trajectory. He started out as a German philosopher; became a French-style political activist, political analyst, and political historian; and ended up trying to become a British- style economist and economic historian. At the start of his career he believed that all we had to due to attain true human emancipation was to think correctly about freedom and necessity. Later on he recognized that thought was not enough: that we had to organize, politically. And then in the final stage he thought that the political organization had to be with and not against the grain of the truly decisive factor, the extraordinary economic changes that the coming of the industrial revolution was bringing to the world.

At each stage Marx had the enthusiasm of the true-believing convert: it was never the case that philosophy alone could bring utopia, it was never the case that after the revolution all problems will be resolved, and it was never the case that the underlying economic mode of production was the base and that its evolution drove the shape of the superstructure. Karl Marx never completed the intellectual trajectory he set himself on. He tried as hard as he could to become a British-style classical economist- -a "minor post-Ricardian theorist" as Paul Samuelson once joked--but he did not make it: the late, mature Marx is mostly an economist and economic historian, but he is also part political activist--and also part prophet.

Marx the prophet, here is a sample: Marx on India:

The ruling classes of Great Britain.... The aristocracy wanted to conquer [India], the moneyocracy to plunder it, and the millocracy to undersell it. But now the... millocracy have discovered that the transformation of India into a reproductive country has become of vital importance.... They intend now drawing a net of railroads over India... exclusive view of extracting at diminished expenses the cotton and other raw materials for their manufactures....

You cannot maintain a net of railways over an immense country without introducing all those industrial processes necessary to meet the immediate and current wants of railway locomotion, and out of which there must grow the application of machinery to those branches of industry not immediately connected with railways. The railway-system will therefore become, in India, truly the forerunner of modern industry.... All the English bourgeoisie may be forced to do will neither emancipate nor materially mend the social condition of the mass of the people, depending not only on the development of the productive powers, but on their appropriation by the people. But what they will not fail to do is to lay down the material premises.... Has the bourgeoisie ever done more? Has it ever effected a progress without dragging individuals and people through blood and dirt, through misery and degradation?...

The bourgeois period of history has to create the material basis of the new world... universal intercourse founded upon the mutual dependency of mankind... the development of the productive powers of man.... When a great social revolution shall have mastered the results of the bourgeois epoch... and subjected them to the common control of the most advanced peoples, then only will human progress cease to resemble that hideous, pagan idol, who would not drink the nectar but from the skulls of the slain...

Large-scale prophecy of a glorious utopian future is bound to be false when applied to this world. The New Jerusalem does not descend from the clouds "prepared as a Bride adorned for her Husband." And a Great Voice does not declare: "I shall wipe away all tears from their eyes; and there shall be no more death, neither sorrow, nor crying, neither shall there be any more pain: for the former things are passed away..." But Marx clearly thought at some level that it would: he never got to the island of Patmos on which John the Divine lived, but there is a sense that he got too much into the magic mushrooms.

Marx the political activist. As I see it, he had three big ideas:

1. that while previous systems of hierarchy and domination maintained control by hypnotizing the poor into believing that the rich in some sense “deserved” their high seats in the temple of civilization, capitalism would–replace masked exploitation by naked exploitation. Then the scales would fall from people's eyes, for without its masking ideological legitimations unequal class society could not survive. This idea seems to me to be completely wrong. Cf. Antonio Gramsci, passim, on legitimation and hegemony. See also Fox News.

2. that even though the ruling class could appease the working class by using the state to redistribute and share the fruits of economic growth it would never do so. They would be trapped by their own ideological legitimations--they really do believe that it is in some sense “unjust” for a factor of production to earn more than its marginal product. Hence social democracy would inevitably collapse before an ideologically-based right-wing assault, income inequality would rise, and the system would collapse or be overthrown. The Wall Street Journal editorial page works day and night 365 days a year to make Marx’s prediction come true. But I think this, too, is wrong.

3. that factory work was the wave of the future, and factory work-- lots of people living in cities living alongside each other working alongside each other--would lead people to develop a sense of their common interest. Hence people would organize, revolt, and establish a free and just society in a way that they could not back in the old days when the peasants of this village were suspicious of the peasants of that one, and peasants formed not a class for themselves but, rather, a sack of potatoes which can attain no organization but simply remains a sack of potatoes. Here I think Marx mistook a passing phase for an enduring trend. Active working-class consciousness as a primary source of loyalty and political allegiance was never that strong. Nation and ethnos trump class, never more so that when the socialists of Germany told their emperor in 1914 that they were Germans first and Marxists second.

Add to these the fact that Marx's idea of the "dictatorship of the proletariat" was clearly not the brightest light on humanity's tree of ideas, and I see very little in Marx the political activist that is worthwhile today.

Marx the economist--well, Marx the economist had six big things to say, some of which are very valuable even today across more than a century and a half, and some of which are not. I would call them the three goods and the three bads:

1. Marx the economist was among the very first to recognize that the fever-fits of financial crisis and depression that afflict modern market economies were not a passing phase or something that could be easily cured, but rather a deep disability of the system--as we are being reminded once again right now, this time with Ben Bernanke, Tim Geithner, and Larry Summers in the Hot Seats. Marx pointed the spotlight in the right direction here. However, I don't think that his theory of business cycles and financial crises holds up. Marx thought that business cycles and financial crises were evidence of the long-term unsustainability of the system. We modern neoliberal economists view it not as a fatal lymphoma but rather like malaria: Keynesianism--or monetarism, if you prefer--gives us the tools to transform the business cycle from a life- threatening economic yellow fever of the society into the occasional night sweats and fevers: that with economic policy quinine we can manage if not banish the disease.

2. Marx the economist was among the very first to get the industrial revolution right: to understand what it meant for human possibilities and the human destiny in a sense that people like Adam Smith did not. In his Politics Aristotle observed that it was not possible to run a household in a way that permitted its head enough leisure and freedom to, say, become a lover of wisdom unless the household owned slaves, and that this would be true unless and until we had instruments like "the statues of Daedalus, or the tripods of Hephaestus, which, says the poet, 'of their own accord entered the assembly of the Gods;' if, in like manner, the shuttle would weave and the plectrum touch the lyre without a hand to guide them, chief workmen would not want servants, nor masters slaves..." Karl Marx was among the very first to see that the industrial revolution was giving us the statues of Daedalus, the tripods of Hephaestus, looms that weave and lyres that play by themselves--and thus opens the possibility of a society in which we people can be lovers of wisdom without being supported by the labor of a mass of illiterate, brutalized, half-starved, and overworked slaves.

3. Marx the economist got a lot about the economic history of the development of modern capitalism in England right--not everything, but he is still very much worth grappling with as an economic historian of 1500-1850. Most important, I think, are his observations that the benefits of industrialization do take a long time--generations--to kick in, while the costs of redistributions and power grabs in the interest of market efficiency and the politically- powerful rising mercantile classes kick in immediately. You have to take seriously the idea that the industrial revolution did not make most or even many people better off right away. Reflect also that, as Tyler Cowen observes, capitalist systems can produce less autonomy than small scale production. Standards of living do rise from industrialization--which can undercut the cultures and networks of suppliers that make the choice of a petit bourgeois lifestyle sustainable.

Now on to the three bads:

1. Marx believed that capital is not a complement to but a substitute for labor. Thus technological progress and capital accumulation that raise average labor productivity also lower the working-class wage. Hence the market system simply could not deliver a good or half-good society but only a combination of obscene luxury and mass poverty. This is an empirical question. Marx's belief seems to me to be simply wrong.

2. Marx the economist did not like the society of the cash nexus. He believed that a system that reduced people to some form of prostitution--working for wages and wages alone--was bad. He saw a society growing in which worked for money, and their real life began only when the five o’clock whistle blows--and saw such an economy as an insult, delivering low utility, and also sociologically and psychologically unsustainable in the long run. Instead, he thought, people should view their jobs as expressions of their species-being: ways to gain honor or professions that they were born or designed to do or as ways to serve their fellow- human. Here, I think, Marx mistook the effects of capitalism for the effects of poverty. The demand for a world in which people do things for each other purely out of beneficence rather than out of interest and incentives leads you down a very dangerous road, for societies that try to abolish the cash nexus in favor of public- spirited benevolence do not wind up in their happy place. We neoliberal economists shrug our shoulders and say that we are in favor of a market economy but not of a market society, and that there is no reason why people cannot find jobs they like or insist on differentials that compensate them for jobs they don’t.

3. Marx believed that the capitalist market economy was incapable of delivering an acceptable distribution of income for anything but the briefest of historical intervals. As best as I can see, he was pushed to that position by watching the French Second Republic of 1848-1851, where the ruling class comes to prefer a charismatic mountebank for a dictator--"Napoleon III"--over a democracy because dictatorship promises to safeguard their property in a way that democracy will not. Hence Marx saw political democracy as only surviving for as long as the rulers could pull the wool over the workers' eyes, and then collapsing. I think that Western Europe over the past fifty years serves as a significant counterexample. It may be difficult to maintain a democratic capitalist market system with an acceptable distribution of income. But "incapable" is surely too strong. Beveridgism or Myrdalism--social democracy, progressive income taxes, a very large and well-established safety net, public education to a high standard, channels for upward mobility, and all the panoply of the twentieth-century social- democratic mixed-economy democratic state can banish all Marx’s fears that capitalist prosperity must be accompanied by great inequality and great misery.

The good things that Marx was able to think must, I believe, be credited to his own account--to his thoughtfulness, his industry, his intelligence, and his desperate desire to try to get things right. The bad things have, I believe, two of his intellectual origins: Marx's beginnings in German philosophy, and the fact that he hooked up in the 1840s with Friedrich Engels whose family owned textile factories in Manchester. German philosophy, or perhaps rather Hegel. I remember reading Capital for the first time. The first three sections of chapter 1 seemed (a) boring, and (b) tautological. For example:

When, at the beginning of this chapter, we said in common parlance that a commodity is both a use value and an exchange value, we were, accurately speaking, wrong. A commodity is a use value or object of utility and a value. It manifests itself as this twofold thing that it is as soon as its value assumes an independent form – viz., the form of exchange value. It never assumes this form when isolated but only when placed in a value or exchange relation with another commodity of a different kind. When once we know this such a mode of expression does no harm...

And then I hit section 4: "The Fetishism of Commodities and the Secret Thereof":

A commodity is… a mysterious thing… in it the social character of men’s labour appears to them as an objective character stamped upon the product… the relation of the producers to the sum total of their own labour is presented… as a social relation… not between themselves but between the products…. In the same way the light from an object is perceived by us not as the subjective excitation of our optic nerve but as the objective form of something outside the eye…. But in the act of seeing there is at all events an actual passage of light from one thing to another, from the external object to the eye. There is a physical relation between physical things. But it is different with commodities. There the existence of the things quâ commodities and the value relation between the products of labour which stamps them as commodities have absolutely no connection with their physical properties… [I]t is a definite social relation between men that assumes in their eyes the fantastic form of a relation between things… we must have recourse to the mist-enveloped regions of the religious world… the productions of the human brain appear as independent beings endowed with life and entering into relations both with one another and the human race. So it is in the world of commodities with the products of men’s hands. This I call the Fetishism which attaches itself to the products of labour so soon as they are produced as commodities…. This Fetishism of commodities has its origin, as the foregoing analysis has already shown, in the peculiar social character of the labour that produces them...

Marx describes this as coquett[ing] with the modes of expression peculiar to [Hegel].

Put me on record as saying that this “coquetting” is profoundly unhelpful.

What is going on here? What I think is going on inside Marx's head is something strange. To say that "the value relation[s] between the products of labour... have absolutely no connection with their physical properties" is simply wrong: if the coffee beans are rotten--or if their caffeine level is low--they have no value at all, for nobody will buy them. Marx says that the value of a good is something inscribed within it and attached to it--the socially-necessary labor time for its production—that then bosses people around. And it is the values--not the prices at which things are actually bought and sold--that are the elements of the real important reality. And those values: "appear as independent beings endowed with life and entering into relation both with one another and the human race." Now I have never found anybody who thinks this way.

Nobody I talk to believes that "values" are objective quantities inherent in goods by virtue of the time it took to produce them.

Everybody I talk to believes that things are both (a) useful to me and (b) useful to other people, and moreover (c) we live in a society where we exchange stuff--where we, in Adam Smith's words, truck, barter, and exchange. If the combination of my wealth and its usefulness to me makes me value it the most, then I use it--it is to me what Marx calls a use value. If there is somebody else out there whose combination of their wealth and its usefulness to them makes them value it more than I do, then I trade it away to them directly or indirectly for stuff that I value more--they consume it, and it is to me what Marx calls an exchange value. But what Marx calls exchange values are really use values to others: a combination of (a) bargaining power--wealth--and (b) utility to actual concrete breathing humans. Things have value not because of the abstraction that socially-necessary labor time is needed to produce them but because of the concretion that somebody somewhere wants to use it and has something ese that others find useful to trade in turn. What Marx calls the mysterious and bizarre dual character of commodities is nothing mysterious or bizarre: it is simply the fact that I am not the only person in the world, and that things very useful to me may be less useful to others, and vice versa.

Moreover, capitalist production has nothing to do with what Marx describes as this mysterious dual character of commodities. The distinction between use-value and exchange-value is not something invented by or peculiar to the capitalist mode of production: it is found in all human societies, no matter how large or small, no matter what the glue that holds them together. The cattle slaughtered and cooked by the thralls of Hrothgar, King of the Geats, have use-value to Hrothgar: He and his family can eat (some of) them. The cattle have exchange-value to Hrothgar as well: He feeds them to his warriors at their nightly banquets in his great hall of Heorot. In exchange for livery and maintenance, the warriors fight Hrothgar's wars. Success in war gains Hrothgar more thralls, more cattle, and a bigger and better reputation as a great drighten worth following--until Grendel comes along and makes eating Hrothgar's cattle in exchange for following him into battle too hazardous to life and limb.

In my view, Marx has trapped himself. He has been primed to expect a deeper layer of real reality underneath mere appearances. And he has chosen the wrong model of the underlying real reality--the labor theory of value, which is simply not a very good model of the averages around which prices fluctuate. Socially-necessary labor power usually serves as an upper bound to value--if something sells for more, then a lot of people are going to start making more of them, and the prices at which it trades are going to fall. But lots of things sell for much less than the prices corresponding to their socially-necessary labor power lots of the time. And so Marx vanishes into the swamp which is the attempt to reconcile the labor theory of value with economic reality, and never comes out.

This matters because one conclusion Marx reaches is that markets and their prices are a source of oppression--that they aren't sources of opportunity (to trade your stuff or the stuff you make to people who value it more) but rather of domination by others and unfreedom: the system forces you to sell your labor-power for its value which is less than the value of the goods you make. And it is that conclusion that human freedom is totally incompatible with wage-labor or market exchange that leads the political movements that Marx founded down very strange and very destructive roads.

I've done Hegel. Now let me do Manchester.

The British interests of the German partnership of Ermen and Engels were not in London or in Birmingham but instead in Manchester. Engels's 1845 Condition of the Working Class in England, cribbed for section 1 of the Manifesto, was about the condition of the working class in Manchester. Yet as Asa Briggs (1963) stressed most strongly, Manchester was not typical of England. Briggs quotes Tocqueville's descriptions of Manchester as a city with "a few great capitalists, thousands of poor workmen and little middle class" compared to Birmingham with "few large industries, many small industrialists... workers work in their own houses or in little workshops in company with the master himself... the working people of Birmingham seem more healthy, better off, more orderly and more moral than those of Manchester..." Briggs speculated that Engels's book would have been very different indeed had Ermen and Engels's interests been elsewhere than Manchester: "his conception of ‘class’ and his theories of the role of class in history might have been very different.... Marx might have been not a communist but a currency reformer..."

Back in 1998, we got George Boyer of Cornell to take a look at the historical circumstances of the composition of the Manifesto:

[A]verage age of death of "mechanics, labourers, and their families" in Manchester was 17, as compared to 38 in rural Rutlandshire... despite the fact that laborers’ wages were at least twice as high in Manchester... 57 percent of children born in Manchester to working class parents died before their fifth birthday.... Engels arrived in Manchester in the late fall of 1842, Britain was just beginning to recover from the deep depression of 1841-42... "crowds of unemployed working men at every street corner, and many mills were still standing idle" (Engels, 1845 [1987], pp. 121 – 22).... The Economist reported that in the first six months of 1848 [as the Manifesto was being written], 18.6 percent of the workforce in Manchester’s cotton mills was unemployed, and another 9.5 percent was on short time (Boyer, 1990, p. 235)....

John Stuart Mill (1848 [1909], p. 751)... concluded that "hitherto it is questionable if all the mechanical inventions yet made have lightened the day’s toil of any human being. They have enabled a greater population to live the same life of drudgery and imprisonment, and an increased number of manufacturers and others to make fortunes."... Marx and Engels… were not alone in asserting that the standard of living... was quite poor, and perhaps declining... during the "hungry ’40s."... [A]rmy recruits born around 1850 were shorter than those born around 1820...

It looks as though Marx and Engels wrote the Manifesto--and made their permanent intellectual commitments--in 1848, at the nadir of living standards as far as British Lancashire textile workers were considered. Their assertion that wages declined as capitalism progressed looks good up until 1848 if you take Manchester as your guide. Thereafter it proved wrong. By 1880 manual workers were earning 40% more than in 1850. Parliament began to regulate conditions of employment in the 1840s. Parliament began to regulate public health in the 1850s. Parliament doubled the urban electorate in 1867, just as volume 1 of Capital was published. Parliament gave unions official sanction to bargain collectively in the 1870s.

Marx appears to have responded to this not by rethinking his opposition to markets as social allocation mechanisms or by reworking his analyses of the dynamics of economic growth, capital accumulation, and the real wage level, but by blaming British workers for not acting according to his model in response to predictions by Marx of continued impoverishment and ever- larger business cycles that had not come to pass. Boyer quotes Marx writing in 1878 about how British workers "had got to the point when [the British working class] was nothing more than the tail of the Great Liberal Party, i.e., of the oppressors, the capitalists." And Boyer quotes Engels writing in 1894 of how "one is indeed driven to despair by these English workers... bourgeois ideas... viewpoints... narrow-mindedness..."

In the late 1870s--after the failure of the British working class to become more militant, the failure of the Paris Commune and the founding of the French Third Republic, and Bismarck's creation of a unified Prussified German Empire--Marx and Engels started to turn their attention toward Russia.

4500 words

Silvio Gesell and Stamped Money: Another Thing Fisher and Wicksell Knew that Modern Economists Have Forgotten

Greg Mankiw in 2009, in the New York Times:

It May Be Time for the Fed to Go Negative : The problem with negative interest rates... is... it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less. Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that.... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender.... That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10....

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea...

Ummm... Greg... You make it sound as though Keynes noted it in an obscure footnote somewhere. But Silvio Gesell is the topic of part VI of chapter 23 of Keynes's flagship work, The General Theory of Employment, Interest and Money. And it's not just Keynes in his flagship work. There are 55,000 google hits for "Silvio Gesell." Patinkin (1993) reports that Irving Fisher advocated Gesell-based "velocity control" in his 1932 Booms and Depressions. Nobel prize-winning Maurice Allais was an advocate as well. Gerardo della Paolera and Alan Taylor are Gesell's biggest boosters today in their book Straining at the Anchor: The Argentine Currency Board and the Search for Macroeconomic Stability, 1880-1935, a University of Chicago Press book that is part of the NBER's series on "long term factors in economic development." Willem H. Buiter and Nikolaos Panigirtzoglou writing in the Economic Journal in 2003: "Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell's Solution."

This is, I think, yet another example of how much economics has lost by cutting itself off from its moral philosophical and historical roots. Something that Keynes and Fisher and the other founders of monetary economics seriously wrestled with is today seen as something unknown and new to be thought of by clever graduate students. Once again the answer to Olivier Blanchard's question "What Do We Know that Fisher and Wicksell Did Not?" is that Olivier is asking the wrong question: what did they know that we have forgotten?

Here is John Maynard Keynes writing in 1936, summarizing Silvio Gesell writing in 1916:

J.M. Keynes, General Theory of Employment, Interest and Money, chapter 23: It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight.... [T]he English version (translated by Mr Philip Pye) being called "The Natural Economic Order". In April 1919 Gesell joined the short-lived Soviet cabinet of Bavaria as their Minister of Finance, being subsequently tried by court-martial.... Professor Irving Fisher, alone amongst academic economists, has recognised its significance. In spite of the prophetic trappings with which his devotees have decorated him, Gesell's main book is written in cool, scientific language; though it is suffused throughout by a more passionate, a more emotional devotion to social justice than some think decent in a scientist.... I believe that the future will learn more from the spirit of Gesell than from that of Marx.... Gesell's specific contribution to the theory of money and interest is... that the peculiarity of money, from which flows the significance of the money rate of interest, lies in the fact that its ownership as a means of storing wealth involves the holder in negligible carrying charges.... [H]e had carried his theory far enough to lead him to a practical recommendation, which may carry with it the essence of what is needed... the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of 'stamped' money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher.... [C]urrency...would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps... should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per week, equivalent to 5.2 per cent per annum.... The idea behind stamped money is sound...

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UPDATE: Ah. Here's the original draft of Greg's New York Times column http://gregmankiw.blogspot.com/2009/03/reloading-weapons-of-monetary-policy.html, with Alan Taylor weighing in. And here is Bruce Champ of the Cleveland Fed writing about this a year ago http://www.clevelandfed.org/Research/commentary/2008/0408.cfm.

IS-LM

Scott Sumner writes:

The Money Illusion:More Reverse Causation: I have to confess that I don’t understand the IS-LM model very well, as I never us it in teaching...

Hmmm... My first reaction is "what's to understand?" If you use the quantity theory of money--well, that is the LM curve. Even if you deny that money demand is interest elastic, well, that is still the LM curve--it is merely a vertical LM curve. If you use the real flow-of-funds balance through financial markets or the income-expenditure framework with exports and investment depending on the real interest rate--well, that's the IS curve. You then have to stitch them together, which requires a model of (a) expected inflation, (b) term premia, (c) default premia, (d) information premia, and (e) risk premia. But I have not yet seen a theory of nominal spending or real output determination that does not have an IS-LM representation...

Mr. Keynes and the 'Classics'

When John Hicks wrote down his IS-LM model in 1937, he meant it as a halfway house between Keynes and what Keynes called "classical economics." And, indeed, it is. You can think of it in any of three ways:

1. That the LM curve (plus the inflation rate and the risk premium) tells you more-or-less what the real interest rate is, and then the Keynesian income-expenditure function does the real work of determining output, employment, and the shape of the business cycle.

2. That the IS curve (in its flow-of-funds through financial markets form) tells you more-or-less what the nominal interest rate is and thus what the velocity of money is, and then the quantity theory does the real work of determining output, employment, and the shape of the business cycle.

3. That the two sets of factors are symmetric, and that whether it is more like a Keynesian or more like a classical theory depends where on the LM curve you are--and on what the local slope of the LM curve is.

Hicks clearly thought of it as (3), Alex Tabarrok and Tyler Cowen think of it as (2), and it seems as though everybody else thinks of it as (1).

Why?

Yet More Things I Have Never Read and Clearly Should Have

Things to Read:

• Stephen Holmes, “The Secret History of Self-Interest”
• Allan Silver, “’Two Different Sorts of Commerce’ – Friendship and Strangership in Civil Society”

Things to Reread:

• Paul Krugman, Introduction to The General Theory of Employment, Interest and Money
• T.H. Marshall, “Citizenship and Social Class”
• Daniel Bell, "The Public Household" (from The Cultural Contradictions of Capitalism)
• Friedrich Hayek, “The Use of Knowledge in Society”

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Jeff Weintraub's History of Economic Thought Syllabus at UPenn:

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Posted via email from http://braddelong.posterous.com/weintraub-history-of-economic-thought-syllabu at Brad DeLong's Scrapbook

Economics 202b: Prologue: History of Macroeconomic Thought, April 2-9

Lecture Notes:

• April 2
• April 7
• [April 9]

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Readings: In the Shadow of Milton Friedman:

• DeLong, "America's Only Peacetime Inflation: the 1970s" http://tinyurl.com/dl20090311h
• DeLong, "Keynesianism, Pennsylvania Avenue-Style" http://tinyurl.com/dl20090311i
• Hicks, "Mr. Keynes and the 'Classics': A Suggested Interpretation" http://www.jstor.org/stable/pdfplus/1907242.pdf
• Samuelson and Solow, "Analytical Aspects of Anti-Inflation Policy" http://tinyurl.com/dl20090311a
• Friedman, "The Effects of a Full-Employment Policy on Economic Stability: A Theoretical Analysis," in Milton Friedman, Essays in Positive Economics (Chicago: Univerity of Chicago Press), p. 117 ff http://tinyurl.com/dl20090311e
• Friedman, "The Role of Monetary Policy" http://www.jstor.org/stable/pdfplus/1831652.pdf
• Tobin, "Friedman's Theoretical Framework" http://tinyurl.com/dl20090311b
• Friedman, "Comment on the Critics" http://tinyurl.com/dl20090311d
  • Friedman, "A Theoretical Framework for Monetary Analysis" http://tinyurl.com/dl20090311c
  • Hawtrey, "Public Expenditure and the Demand for Labour" http://tinyurl.com/dl20090311f
  • Kahn, "The Relation of Home Investment to Unemployment" http://tinyurl.com/dl20090311g
• Romer, Advanced Macroeconomics, chs. 5, 6, and 10

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Problem Sets:

Problem Set 1 due April 6: Romer 5.1, 5.3, 5.4, 5.9, 5.14, 5.15.

Problem Set 2 due April 13: Romer 6.2, 6.6, 6.13, 6.15, 10.1, 10.6, 10.14, 10.16.

DeLong: Thinking About Macroeconomic Issues 1925-2006: Economics 202b Lecture (April 7, 2009)

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Posted via email from http://braddelong.posterous.com/delong-thinking-about-macroeconomic-issues-19 at Brad DeLong's Scrapbook

Maynard Keynes Might Say: Real Wages and the Great Depression

From RJW:

Maynard Keynes comments on Ohanian and Cole

in the short period, falling money-wages and rising real wages are each, for independent reasons, likely to accompany decreasing employment; labour being readier to accept wage-cuts when employment is falling off, yet real wages inevitably rising in the same circumstances on account of the increasing marginal return to a given capital equipment when output is diminished."

General Theory Chapter II section 2.

As you know, one didn't have to wait for Blanchard and Kiyotaki or for New Keynesians or--well read Keynes to find the argument that real wages are determined (certainly were determined in the 20s and 30s anyway) by firms when they set prices and must be high when demand is low.

I personally don't share Keynes' certainty that, in the short run, employment is a decreasing function of real wages and vice versa. However, he expressed no doubt whatsoever on the point and managed to explain the Great Depression without appealing to trade unions. I think that if he had known that a reputable professor at UCLA had the idea that the US had extraordinarily huge unemployment in 33 because it had extraordinary strong unions he would have lowered his opinion of Americans (hard as that is to imagine).

There is an argument that the "Red Scare" Palmer raids of the early 1920s plus the fact that nominal wages had just been boosted by wartime inflation made it easy in the early 1920s to shrink nominal spending during the post-WWI deflation without causing a Great Depression--nonfarm unemployment peaked at only 16%. But to me, at least, the spectacle of a market system that is capable of rapid nominal adjustment only under a police state is not to attractive.

An Appeal for Help: Recent History of Economic Thought

Somewhere, somehow, without as far as I know leaving any paper trail, Chicago-School economists became convinced of two false things:

1. Ricardian equivalence means not just that deficit-financed tax cuts have no short-term stimulative effects but also that deficit-financed spending increases have no short-term stimulative effects on nominal spending.

2. There are no issues worth discussing at the zero nominal interest rate bound: monetary expansion via open market operations retains its full potency and power to affect the level of nominal spending spending even when open market operations are just the swap of one zero-yielding government liability for another.

If anyone can help me understand the process by which these strange doctrines of economics became Holy Writ among the Monsters of the Midway, I would be very grateful...

The latest to show up in these camps is Robert Lucas:

Why a Second Look Matters: [1929-1932] added up to four years of negative [nominal income] growth averaging minus-8 percent a year.... [T]he Federal Reserve didn't cause this decline.... My guess is it was... people seeking safety in liquidity after the stock market crash... people... wanted to build up their cash holdings. [T]he Fed could have responded to that situation by... creating... reserves... to supply the added liquidity.... But the Fed didn't do anything to relieve this liquidity. They... cut interest rates to zero. They were, I guess, the believers that the only thing... monetary policy can do is fix interest rates. And once interest rates get to zero, you're over.

Friedman and Schwartz... [argued] that this passive response by the Fed must bear the ultimate responsibility for the severity of the contraction.... So even today, many people think of the Depression as evidence that monetary stimulus is ineffective when the real problem was that it wasn't used....

[T]his is one policy mistake that's not going to be repeated in the current situation.  The Fed, under Bernanke's leadership, had added something -- I never know quite know what number to say, I'll say 600 billion (dollars) in bank reserves... [to] a system that operated with $50 billion in reserves last August... just a mountain of new reserves.... I think this is the right thing to do.... It is not possible to pull a modern economy through a neutral or painless deflation.  Economic theory doesn't really tell us why -- what's hard about it.  But, the evidence, I mean, it just doesn't work....

[W]ould a fiscal stimulus somehow get us out of this bind, or add another weapon that would help in this problem? I've already said I think what the Fed is now doing is going to be enough to get a reasonably quick recovery committed. But,could we do even better with fiscal stimulus? I just don't see this at all. If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that's just a monetary policy. We don't need the bridge to do that. We can print up the same amount of money and buy anything with it....

But if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder... then it's just a wash.... [T]here's nothing to apply a multiplier to. (Laughs.) You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge... taxing them later isn't going to help, we know that...

Attention: It Is Not Real. It Is an April Fool's Joke!

This:

Who Are The Top Hayekian Public Intellectuals in America?

is not real. It is an April Fool's joke.

Calm down, everybody.

That is all.

Maynard Keynes Might Say: JMK Comments on Christina Romer's Analysis of the Benefits of Quantitative Easing in the Great Depression

From RJW:

Robert's Stochastic thoughts: C Romer with lots of data in 1992 "What Ended the Great Depression?" The Journal of Economic History vol 52 pp 757-784:

This paper examines the role of aggregate demand stimulus in ending the Great Depression. Plausible estimates of the effects of fiscal and monetary changes indicate that nearly all the observed recovery of the U.S. economy priort to 1942 was due to monetary expansion. A huge gold inflow in the mid- and late 1930s swelled the money stock and stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods. That monetary developments were crucial to the recovery implies that self-correction played very little role in the growth of real output between 1933 and 1942.

Now, I'm not sure if Obama understands that Romer is saying that the US recovered because of Hitler who scared the gold out of Europe (she is very clear on this point in the text). She makes a strong case, but the party line is that Roosevelt deserves the credit.

Keynes, with almost no data and writing in 1935 (hence before the flight), understood the issue. In The General Theory of Employment Interest and Money, Chapter 23: Notes on Notes on Merchantilism, the Usury Laws, Stamped Money and Theories of Under-consumption, Keynes argued that back in the bad old days, going for the gold was the only feasible approach.

Now, if the wage-unit is somewhat stable and not liable to spontaneous changes of significant magnitude (a condition which is almost always satisfied), if the state of liquidity-preference is somewhat stable, taken as an average of its short-period fluctuations, and if banking conventions are also stable, the rate of interest will tend to be governed by the quantity of the precious metals, measured in terms of the wage-unit, available to satisfy the community’s desire for liquidity.

At the same time, in an age in which substantial foreign loans and the outright ownership of wealth located abroad are scarcely practicable, increases and decreases in the quantity of the precious metals will largely depend on whether the balance of trade is favourable or unfavourable.

Thus, as it happens, a preoccupation on the part of the authorities with a favourable balance of trade served both purposes; and was, furthermore, the only available means of promoting them. At a time when the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade were the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of the precious metals was their only indirect means of reducing the domestic rate of interest and so increasing the inducement to home investment.

That does not mean that Keynes was a merchantilist. In particular, one can imagine how delighted he was by a process that enriched the USA at the expense of Europe:

For this and other reasons the reader must not reach a premature conclusion as to the practical policy to which our argument leads up. There are strong presumptions of a general character against trade restrictions unless they can be justified on special grounds. The advantages of the international division of labour are real and substantial, even though the classical school greatly overstressed them. The fact that the advantage which our own country gains from a favourable balance is liable to involve an equal disadvantage to some other country (a point to which the mercantilists were fully alive) means not only that great moderation is necessary, so that a country secures for itself no larger a share of the stock of the precious metals than is fair and reasonable, but also that an immoderate policy may lead to a senseless international competition for a favourable balance which injures all alike.[4] And finally, a policy of trade restrictions is a treacherous instrument even for the attainment of its ostensible object, since private interest, administrative incompetence and the intrinsic difficulty of the task may divert it into producing results directly opposite to those intended.

Thus, the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire doctrine upon which I was brought up and which for many years I taught;— against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time. For we, the faculty of economists, prove to have been guilty of presumptuous error in treating as a puerile obsession what for centuries has been a prime object of practical statecraft...

Basically, Keynes' insight into the results reported by C. Romer is that, given the fools in the Fed and the timidity of Roosevelt, the US might as well have been an early modern country (and US policy was relatively Keynesian compared to say that of France).

DeLong: Thinking About Macroeconomic Issues 1890-1935—Plus What Is Going on Today: Economics 202b Lecture (April 2, 2009)

Lecture Notes:

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Audio:

• 20090402a-first 35 minutes.mov
• 20090402b-second 35 minutes.mov
• 20090402c-end.mov

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Posted via email from http://braddelong.posterous.com/delong-thinking-about-macroeconomic-issues-18 at Brad DeLong's Scrapbook

J. M. Keynes Comments on the Current Crisis

Non-Standard Monetary Policy: Robert Lucas on Non-Standard Monetary Policy 2008:

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" -- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector...

Maynard Keynes on Non Standard Monetary Policy 1937:

If the monetary authority were prepared to deal both ways on specified terms in debts of all maturities, and even more so if it were prepared to deal in debts of varying degrees of risk, the relationship between the complex of rates of interest and the quantity of money would be direct. The complex of rates of interest would simply be an expression of the terms on which the banking system is prepared to acquire or part with debts; and the quantity of money would be the amount which can find a home in the possession of individuals who — after taking account of all relevant circumstances — prefer the control of liquid cash to parting with it in exchange for a debt on the terms indicated by the market rate of interest. Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management....

Ben Bernanke (2009) is following their advice. I'd say that, when Robert Lucas and Maynard Keynes agree, they probably have a point.

I am Robert Waldmann and Brad DeLong approved this message.

Maynard Keynes Discusses the Current Crisis, Parts I-III

Hoisted from comments: Robert Waldmann writes:

Grasping Reality with Both Hands: Ex-College Roommates Write Letters: Self referential blog commenting: Uhm, Brad, don't expect to have a monopoly on Keynes Comments on Current Events Blogging. I'm up to III already:

• http://rjwaldmann.blogspot.com/2009/03/music-prince-and-revolution-those-who.html
• http://rjwaldmann.blogspot.com/2009/03/limits-of-monetary-policy-we-have.html
• http://rjwaldmann.blogspot.com/2009/03/maynard-keynes-comments-on-current.html

Ex-College Roommates Write Letters

Robert Waldmann:

Dear Brad,

...Anyway, I really think you ought to have posts of the form: "Maynard Keynes Discusses the Current Crisis part MDCCLXXIV." It seems to me that he is one of the most insightful commentators on current events, in spite of the disadvantage of writing say 70 years ago.

This, despite the mildly embarrassing URL, is searchable and cutandpastable: http://www.marxists.org/reference/subject/economics/keynes/general-theory/...

ciao

Robert

Question of the Day

From Justin Fox:

Paul Krugman: Smart economist, or all-knowing being?:

The Intellectual Decline Collapse of Chicago School, Part LIX

bdbd points out, in comments:

Grasping Reality with Both Hands: Ricardian Consumers and Fiscal Policy Once Again: [John] Cochrane's piece [contributing to the Economist debate is odd all the way down... [see] Keynes' 1930 essay "Economic Possibilities of our Grandchildren".

Yes indeed. The Economist's moderators did a bad job in letting things go by--in giving the representatives of Chicago not only their own private positions but their own private facts. Cochrane does begin his piece:

John Cochrane: Nobody is Keynesian now, really. Keynes distrusted investment and did not think about growth. Now, we all understand that growth, fuelled by higher productivity, is the key to prosperity...

What did John Maynard Keynes say? This:

John Maynard Keynes (1931), "Economic Possibilities for Our Grandchildren": We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the nineteenth century is over; that the rapid improvement in the standard of life is now going to slow down.... I believe that this is a wildly mistaken interpretation of what is happening to us. We are suffering, not from the rheumatics of old age, but from the growing-pains of over-rapid changes.... The increase of technical efficiency has been taking place faster than we can deal with the problem of labour absorption; the improvement in the standard of life has been a little too quick; the banking and monetary system of the world has been preventing the rate of interest from falling as fast as equilibrium requires. And even so, the waste and confusion which ensue relate to not more than 7½ per cent of the national income; we are muddling away one and sixpence in the £....

[D]own to the beginning of the eighteenth century, there was no very great change in the standard of life of the average man living in the civilised centres of the earth.... This slow rate of progress, or lack of progress, was due to two reasons-to the remarkable absence of important technical improvements and to the failure of capital to accumulate. The absence of important technical inventions between the prehistoric age and comparatively modern times is truly remarkable.... The modern age opened; I think, with the accumulation of capital which began in the sixteenth century.... From that time until to-day the power of accumulation by compound interest, which seems to have been sleeping for many generations, was re-born and renewed its strength. And the power of compound interest over two hundred years is such as to stagger the imagination. From the sixteenth century, with a cumulative crescendo after the eighteenth, the great age of science and technical inventions began, which since the beginning of the nineteenth century has been in full flood--coal, steam, electricity, petrol, steel, rubber, cotton, the chemical industries, automatic machinery and the methods of mass production, wireless, printing, Newton, Darwin, and Einstein, and thousands of other things and men too famous and familiar to catalogue.

What is the result? In spite of an enormous growth in the population of the world, which it has been necessary to equip with houses and machines, the average standard of life in Europe and the United States has been raised, I think, about fourfold. The growth of capital has been on a scale which is far beyond a hundredfold of what any previous age had known. And from now on we need not expect so great an increase of population. If capital increases, say, 2 per cent per annum, the capital equipment of the world will have increased by a half in twenty years, and seven and a half times in a hundred years. Think of this in terms of material things--houses, transport, and the like. At the same time technical improvements in manufacture and transport have been proceeding at a greater rate in the last ten years than ever before in history. In the United States factory output per head was 40 per cent greater in 1925 than in 1919. In Europe we are held back by temporary obstacles, but even so it is safe to say that technical efficiency is increasing by more than 1 per cent per annum compound. There is evidence that the revolutionary technical changes, which have so far chiefly affected industry, may soon be attacking agriculture. We may be on the eve of improvements in the efficiency of food production as great as those which have already taken place in mining, manufacture, and transport. In quite a few years-in our own lifetimes I mean-we may be able to perform all the operations of agriculture, mining, and manufacture with a quarter of the human effort to which we have been accustomed.

Tyler Cowen Wants to Become a Fisherian-Pigovian-Vinerian-Hawtreyan

Tyler writes:

Marginal Revolution: Irving Fisher on the liquidity trap: The very healthy influence of Scott Sumner has induced me to read the Irving Fisher works I had never looked at before.  Wow.  It's Fisher, not Keynes, who is the prophet of our times and the superior analyst of the Great Depression.  Circa 1932, Fisher wrote:

...in the depression of 1929-32, while the volume of deposit currency in member banks was falling 21 per cent, the velocity of it was being reduced by 61 percent....a mere new supply of money, to replace what has been liquidated or hoarded, might fail to raise the price level by failing to get into circulation...a mere increase in M might prove insufficient, unless supplemented by some influence exercised directly on the moods of people to accelerate V -- that is, to convert the public from hoarding.

One wishes that Keynes were so clear. And what is the best way to restore confidence and break the liquidity trap?  Restoring confidence in banks, so that a multiplier, working through credit, may be effective again.  Fisher also suggests negative interest on reserves and he outlines in detail how this might be done. That is all from his Booms and Depressions, First Principles, a very sophisticated work.  Pigou, Hawtrey, and Viner are also all worth reading; they are more advanced in their thinking than Keynes was willing to admit. Hail Irving Fisher, still one of the most underrated economists of the 20th century.  By the way, 1936 - 1932 equals 4.

Here is what Pigou said about Keynes (after Pigou hqd gotten over his snit, of course): his Marshall lectures, Keynes’s General Theory: A Retrospective View:

Nobody before [Keynes], so far as I know, had brought all the relevant factors, real and monetary at once, together in a single formal scheme, through which their interplay could be coherently investigated...

You need the bond market and the goods market

A Note on Friedrich Hayek and Lionel Robbins in the Great Depression...

Larry White continues his war with Milton Friedman over Friedman's condemnation 25 years ago of "the London School (really Austrian) view that I referred to... when I spoke of 'the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists'. This time I appear to be Friedman's proxy:

Lawrence White: DeLong acts as though he is unaware (though elsewhere he has indicating having read my paper) Hayek's and Robbins' monetary policy norm was not that the central bank should let a deflationary monetary contraction procede. Rather, the central bank should stabilize nominal income MV, meaning expand M to offset a drop in V, and expand the monetary base to offset a drop in the money multiplier...

Since Friedman can no longer speak, let me say that I still agree with him. I think that White's painting of Hayek and Robbins as people who wanted to stabilize MV is completely wrong--it is Ben Bernanke and the inflation targeters who want to stabilize MV, not Hayek and Robbins. If you had asked Hayek back at the time, he would have said that increasing the monetary base from 1929-1933 in order to offset the decline in monetary velocity was the very last thing that he wanted to see done. Stabilizing MV at its 1929 level was not on his or Robbins's agenda by any means.

In fact, he did say so.

Let me pull out his 1932 denunciation of monetary policies that stabilize the price level:

Hayek (1932), "The Fate of the Gold Standard": ...the extraordinary influence exercised by two particular representatives of... the concept of a systematic stabilization of the price level... Irving Fisher and Gustav Cassel... succeeded in making the concept of price stabilization as the objective of monetary policy into a virtually unassailable dogma... the influence of which upon actual developments it is impossible to overestimate....

[...]

It was not a big step from the desire to be released from the unpleasant necessity of adapting the general standard of living to the lower level of national income by reductions in wages and prices, to a theoretical justification of a monetary policy which rendered inoperative the tendencies of the gold standard in that direction.... The most important error is the distinction drawn between temporary movements of gold... [which] should not be allowed to bring about any changes in the domestic volumes of credit, and 'genuine' movements.... What is left unexplained in this is why movements of gold should under any circumstances represent movements of capital that are not genuine.... [T]he great monetary theorists of the classical period from Ricardo onwards always insisted that a non-metallic circulation of money ought always to be so controlled that the total volume of all money in circulation changes in just the same way as would happen if gold alone were in circulation....

[T]he artificial prevention of the fall in prices... up to 1929... is not meant to depict the fall in prices which has occurred since then as innocuous.... Instead of prices being allowed to fall slowly [from 1918 to 1929]... such volumes of additional credit were pumped into circulation.... Whether such inflation merely serves to keep prices stable, or whether it leads to an increase in prices, makes little difference...

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UPDATE: amv comments:

DeLong is again making uniformed claims. In support of Horwitz, I quote Hayek from The Constitution of Liberty (1960/2008):

This means that when at any time people change their minds how much cash they want to hold in proportion to the payments they make (or, as the economists calls it, they decide to be more or less liquid), the quantity of money should be changed correspondingly. However we define 'cash,' people's propensity to hold part of their resources in this form is subject to considerable fluctuation both over the short and over long periods, and various spontaneous developments (such as, for instance, the credit card and the traverlers' check) are likely to affect it profoundly. No automatic regulation of the supply of money is likely to bring about the desirable adjustments before such changes in the demand for money or in the supply of substitute for it have had a strong and harmful effect on prices and employment. (p. 284)

The automatic regulation is, for instance, Friedman's k-rule.

amv is both right and wrong. He is right in that while writing The Constitution of Liberty Friedrich Hayek wrote like an orthodox Chicago monetarist--a Friedmanite. He is wrong in claiming that this is an accurate summary of Hayek's position either while he was a leader of the LSE-based Austrian School contra Keynes during the Great Depression or indeed of Hayek's long term thinking. The phase during which Hayek was (or perhaps thought it impolitic not to pretend to be) a Friedmanite came after his monetary-overinvestment phase and before his private-money phase.

More representative of his enduring thought, I would argue, is the Hayek of a later period Hayek who would flat-out deny even the possibility of the government's altering M in order to offset changes in V:

[W]e never know what the quantity of money in this sense is. I think the rule ought to be that whoever issues the money must adapt the quantity so that the price level will remain stable. But to believe that there is a measurable magnitude which you can keep constant, with beneficial effects, I regard as completely wrong. I don’t like criticizing Milton Friedman not only because he is an old friend but because, outside of monetary theory, we are in complete agreement. Our general views on what is desired and what is not are almost identical until we get on to money. But if I told him what I said before, that I very much doubt whether monetary policy has ever done anything good, he would disagree. He personally is convinced that a good monetary policy is a foundation for everything...

Horwitz, by contrast, in comments is simply incoherent: if you stabilize Q by stabilizing MV then you automatically must be stabilizing P, for PQ = MV. As long as you are trying to stabilize Q, saying "Hayek's correct arguments against stabilizing P... [are not] denying his belief that stabilizing MV is the correct policy norm..." makes no sense at all.

Attempted DeLong Smackdown Watch: The Authority of Milton Friedman

Hoisted from Comments: Robert Waldmann admonishes me:

Grasping Reality with Both Hands: DeLong: Rebuttal to Zingales's Reply: I think a better title would be "Miltion Friedman Vs Luigi Zingales." You don't present enough evidence for Friedman's claims to make the post a rebuttal. Your case is based on an appeal to authority. Now another possibility is to write "so you think the current decline in employment is efficient, is not a consequence of market failure? How about you go down to the employment office and share your view with the unemployed?" (that is, argument by intimidation).

I mean do you really need Friedman's help to convince people that markets are not behaving in a Pareto efficient manner right now?

The answer is: "Yes, I do. I need all the help I can get..."

I'd say your interest in intellectual history (why have they forgotten Friedman) should not be mixed with your contribution to the debate (Friedman isn't worshipped outside of Chicago where his name is sacred as was the name of Jesus to the crusaders).

I am trying an intellectual judo move here. The Chicago School of economics takes Milton Friedman to be an authority--they are starting a Milton Friedman Institute, for Jeebus's sake. Therefore I am free--wherever Friedman was right--to use him an authority, and to demand to know why they have not spent the time and energy to learn what their authority figure taught.

This is, I believe, a logical and reasonable part of what Michael Walzer calls "internal critique": you give people a choice between abandoning the point of issue and abandoning their broader intellectual framework--and if they abandon their broader intellectual framework then a great deal more is up for grabs: their God has Failed, and they need a new God.

Of course, knowing the Chicago School, the new God they choose will be Huitzilopochtli...

I'm Picking Up Economics 202b Next Week...

... and I still have not decided what to do. The subject I have been given is "macroeconomic policy"--but repeating any macroeconomic policy syllabus from any year in the past seems like a really stupid thing to do right now.[1]

So let me send out a list of first week's readings--ancient history and culture--to tide the students over...

Week 1: March 17 & 19: In the Shadow of Milton Friedman

• DeLong, "America's Only Peacetime Inflation: the 1970s" http://tinyurl.com/dl20090311h
• DeLong, "Keynesianism, Pennsylvania Avenue-Style" http://tinyurl.com/dl20090311i
• Hicks, "Mr. Keynes and the 'Classics': A Suggested Interpretation" http://www.jstor.org/stable/pdfplus/1907242.pdf
• Samuelson and Solow, "Analytical Aspects of Anti-Inflation Policy" http://tinyurl.com/dl20090311a
• Friedman, "The Effects of a Full-Employment Policy on Economic Stability: A Theoretical Analysis," in Milton Friedman, Essays in Positive Economics (Chicago: Univerity of Chicago Press), p. 117 ff http://tinyurl.com/dl20090311e
• Friedman, "The Role of Monetary Policy" http://www.jstor.org/stable/pdfplus/1831652.pdf
• Tobin, "Friedman's Theoretical Framework" http://tinyurl.com/dl20090311b
• Friedman, "Comment on the Critics" http://tinyurl.com/dl20090311d
  • Friedman, "A Theoretical Framework for Monetary Analysis" http://tinyurl.com/dl20090311c
  • Hawtrey, "Public Expenditure and the Demand for Labour" http://tinyurl.com/dl20090311f
  • Kahn, "The Relation of Home Investment to Unemployment" http://tinyurl.com/dl20090311g
• Romer, Advanced Macroeconomics, ch. 5: 5.1 Aggregate Demand. 5.2 The Open Economy. 5.3 Alternative Assumptions About Wage and Price Rigidity. 5.4 Output-Inflation Tradeoffs. 5.5 Money and Output. 5.6 The Cyclicality of the Real Wage

Problem Set Out: Romer 5.1, 5.3, 5.4, 5.9, 5.14, 5.15, due 30 Mar

Dani Rodrik on the Sorry State of (Macro)economics

Dani is puzzled:

Dani Rodrik's weblog: The sorry state of (macro)economics: The failures of contemporary macro theory remind me of the time we were interviewing a highly touted graduate student on the academic job market (I believe he was from the University of Minnesota, but I am not totally sure).  We asked him how he would teach macro to public policy students at the Kennedy School.  He thought for a while, and said: "I guess I would do it all using the overlapping-generations model, and since this is an introductory course, I wouldn't bring money in at all."  Enough said.

The good news is that the problem, in my view, is confined largely to macroeconomics.  The rest of economics is in good shape, even if, as I argue here, economists haven't done a good a job of putting to use what they know (or should know, from their own models). The bad news is the world could really use some practical, relevant macroeconomic theory at the moment.  Brad DeLong and Paul Krugman are doing a superb job of reminding us of the continued relevance of Keynesian thinking.  But they are hampered by the absence of micro-founded models that plausibly deliver the Keynesian remedies they advocate.  The economics profession doesn't take an argument seriously until the argument can be laid out with a well-specified model that respects accepted standards of modeling--an attitude that Krugman himself has vociferously defended in another context.  Maybe the problem is with those standards of modeling, but other fields within economics have been much more willing to adapt themselves to behavioral thinking, or the fact of missing markets, or the role of market failures.   

So what is wrong with macroeconomists?

I must say that the rot is confined to domestic macroeconomists--the international macro side of the profession still seems to me to be relatively healthy...

The Intellectual Bankruptcy of the Modern Chicago School, Part LXXIV

I swear, Milton Friedman is spinning in his grave...

The debate over at the website of The Economist is even more horrifying than I thought it would be, as Luigi Zingales simply does not appear to have thought any of the issues through at all. I think that his views are what Steve Sheffrin calls the product of knee-jerk pre-theoretical Austrianism--but it is very hard to tell.

For example, Luigi Zingales:

With zero personal saving and a large budget deficit the Bush administration has run one of the most aggressive Keynesian policies in history. Not only has adherence to Keynes's principles not averted the current economic disaster, it has greatly contributed to causing it. The Keynesian desire to manage aggregate demand, ignoring the long-run costs, pushed Alan Greenspan and Ben Bernanke to keep interest rates extremely low in 2002, fuelling excessive consumption by the household sector and excessive risk-taking by the financial sector. Most importantly, it has been the Keynesian training of our policy-makers that has led them to ignore the role that incentives play in economic decisions. The main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates.... The current crisis is not a demand crisis, it is a trust crisis. Bad corporate governance coupled with bad government policies has destroyed the financial sector, scaring investors and freezing lending. It is as if a nuclear bomb had destroyed all roads in America and we claimed that to alleviate the economic impact of such an event we should invest in banks. It is possible that eventually the effect will trickle down. But if the problem is the roads, you want to rebuild roads, not subsidise the financial sector. And if the problem is the financial sector, you want to fix this and not build roads.

As you all know by now, I have four problems with this:

The first problem, of course, is Zingales's characterization of Bush administration economic policy as "Keynesian." John Maynard Keynes would certainly not The essence of Keynesian policies is not running big budget deficits--Keynesians call for big budget surpluses in boom years. The essence of Keynesian policies is using monetary policy and the government deficit as balance wheels to try to keep the flow of total nominal spending stable. And, yes, it does surprise me that Luigi Zingales does not seem to know what Keynesianism is.

The second problem, of course, is the characterization of Bernanke and Greenspan as "Keynesians" actively managing aggregate demand in 2002. They would say that they were, rather, monetarists--and Greenspan would especially protest extremely strongly that he was no Keynesian but rather a Randite. They would say that they were trying to keep a stable environment for private decision making by following Milton Friedman's monetarist instruction to keep the nominal money stock growing smoothly in order to keep nominal spending growing smoothly. And, indeed, they did pretty well at that task:

You can argue that Greenspan and Bernanke should have slammed on the monetary growth breaks in 2002 and 2003. But it is hard to see why. Why would one would have wished to sharply slow the rate of growth of nominal monetary aggregates back then? Inflation was not increasing, and neither equity nor housing prices in 2002 appeared to be at irrationally exuberant levels.

You have to think that Zingales simply does not know what he is talking about--does not remember what the situation in 2002 was, and did not bother to go back and look at the data.

The third problem, of course, is Zingales's claim that "Keynesian[s]... ignore the role that incentives play in economic decisions." To which one can only say, "Huh?" Keynes's analysis of liquidity preference was among the very first successful discussions of incentives to hold money, and thus of the demand for money, in economics.

And, fourth, I cannot help but be very disappointed at Luigi Zingales's claim that the "current crisis is not a demand crisis, it is a trust crisis..... It is as if a nuclear bomb had destroyed all roads in America and we claimed that to alleviate the economic impact of such an event we should invest in banks... if the problem is the roads, you want to rebuild roads, not subsidise the financial sector. And if the problem is the financial sector, you want to fix this and not build roads..." This appears to me to miss the point entirely. The banking system is broken. That is crisis 1. The breakdown of the banking system has produced a collapse in private spending that is sending unemployment into the sky. That is crisis 2. The question is: Should the government boost its spending to fill the gap and keep the unemployment rate from spiking quite so high? The answer is: Yes. But Zingales misses all this.

Thus, as best as I can tell, Luigi Zingales's argument comes in four steps:

1. Our problem is in the banking system.
2. Keynesian deficit spending will not fix the banking system.
3. Keynesians say that even though Keynesian deficit spending will not fix the banking system, it will keep unemployment from rising much higher while we do other things to fix the banking system.
4. The weakness of this Keynesian argument is--LOOK!! THERE IS HALLEY'S COMET!!!!

So it is kind of hard to figure out how to respond.

The current crisis started as a trust crisis, but has now generated a demand crisis as well--and the fact that we need to fix the first does not mean that we should do nothing to fix the second.

Will Wilkinson Comments on the Debate Over at the Economist

Over at http://www.willwilkinson.net/flybottle/2009/03/10/this-house-believes-we-are-all-keynesians-now/?disqus_reply=7087846#disqus-claim, Will Wilkinson writes:

Brad DeLong and Luigi Zingales debate it at Economist.com. DeLong’s opening statement too effectively arrays a huge amount of intellectual firepower against him. If he could persuasively cut this team of giants down to size, it would be a killer opening. But his response to the challenge he erects seems to amount to the contention that this squad of bona fide geniuses are really benighted halfwits guilty of an elementary error. That’s pretty hard to swallow...

Exactly so.

I have learned more about asset prices from John Cochrane than anybody else. And yet--I seem to have fallen into some bizarro alternate world in which they are making an elementary mistake that Charlie Kindleberger, Peter Temin, and Barry Eichengreen taught me back in 1980 had not been taken seriously in 50 years.

You know. It is, like, like that Star Trek episode? Where there is a transporter malfunction? And they beam back to the Enterprise but the Enterprise is, like, different because the Federation is, like, evil? And Spock has a beard?

It is like that. Exactly.

It is terrifying.

Reopening the Stimulus Debate

Hoisted from Comments: Robert Waldmann writes:

Grasping Reality with Both Hands: DeLong: Reply to Luigi Zingales: Brad 2 heads ups:

1. you can't write "insolvent (at least temporarily)" you have to write "insolvent (or at least illiquid)." Don't ask me why.

2. Be careful when you use the word "trust" around Luigi Zingales. Trust me, he has thought a lot about trust. It is different from risk tolerance. Perceived risks have increased. Willingness to bear risk has, for all I know, increased too, but not enough.

There seems to be an Italians in the USA consensus that one can argue against the stimulus by arguing that it isn't, in itself, the optimal policy response. Now to me it makes no possible conceivable sense to say "the stimulus debate is a distraction from the debate we have to have, so, after the bill has been passed and signed, I will reopen the debate to argue that it is a distraction." I mean if the [stimulus] debate is a distraction it's time to "mettere una pietra sopralo."

Time to bury it underneath big rocks? Isn't it also time to put a stake through its heart, cut off its head, and stuff its mouth with garlic?

DeLong: Opening for Debate with Luigi Zingales

Download now or preview on posterous ---- Posted via email from http://braddelong.posterous.com/delong-opening-for-debate-with at Brad DeLong's Scrapbook

DeLong: Deficit Spending Does too Spur Employment and Production: U.C. Davis Stimulus Debate

UC Davis: Institute of Governmental Affairs : IGA: Stimulus SmackDown: Can Deficit Spending Save the Economy? A Debate Between Michele Boldrin, Joseph Gibson Hoyt Distinguished Professor in Arts & Sciences, Washington University in St. Louis, and J. Bradford DeLong, Professor of Economics, U.C Berkeley. March 4, 2009

It was very strange. Boldrin did not argue:

• that the stimulus would be ineffective and not boost employment and production,
• that the stimulus would produce an inflationary spiral because of domestic bottlenecks,
• that the stimulus would produce an inflationary spiral because it would induce a collapse of the dollar,
• that the stimulus would produce a recovery with too-low investment because government borrowing would raise interest rates,

or:

• that the benefits of the stimulus would be outweighed by the long-run costs of servicing the added debt.

Instead, he argued that:

• the stimulus was a bad idea because the debate over it would distract political and policy attention from the most important task--fixing the banks.

Seems to me that if that is what is wrong with the stimulus, the best thing Professor Boldrin could do is support it: the more people support it, the quicker the debate is over, and the quicker we can focus 100% of our attention on fixing the banking system.

CPR: Programs | Insight: Stimulus Smackdown

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Download now or preview on posterous

UC Davis: Institute of Governmental Affairs: Stimulus SmackDown: Can Deficit Spending Save the Economy?: When: March 04, 2009 from 06:00 pm to 08:00 pm. Where: University Club Lounge. Contact Name: Mary Davis. Contact Email: mvdavis@ucdavis.edu: Contact Phone 752-5570.

A Debate Between Michele Boldrin, Washington University in St. Louis

And

J. Bradford DeLong, Professor of Economics, U.C Berkeley

Moderated by Gregory Clark, Professor and Chair, Department of Economics, University of California, Davis

With questions from an expert panel of UC Davis economists and audience Q&A.

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Posted via email from http://braddelong.posterous.com/delong-deficit-spending-does-t at Brad DeLong's Scrapbook

More "Treasury View" Fiscal-Policy-Always-Ineffective Blogging

A very smart middle-aged Washington economic policy bureaucratic hand emails me his reaction to the New York Times's "When Will the Recession Be Over?":

Whoa. Just realized. Kevin A. Hassett is now sounding more coherent and sensible than William Poole.

Dear god. Not only does the Emperor have no clothes, but he is starring in a Japanese tentacle porn flick with two sheep, a duck, a rabbit, Marilyn Manson, and some zombies.

I must say, I have always been partial to Marilyn Manson since he starred in an episode of my cousin Phil Lord's "Clone High"--an episode in which he sang the USDA food pyramid healthy diet song...

DeLong: Are We All Keynesians Now?

Download now or preview on posterous

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Posted via email from http://braddelong.posterous.com/delong-are-we-all-keynesians-n at Brad DeLong's Scrapbook

Stimulus Ostriches

Project Syndicate | The Stimulus Ostriches: BERKELEY - Of all the strange things that have happened this winter, perhaps the strangest has been the emergence of large-scale Republican Party opposition to the Obama administration's effort to keep American unemployment from jumping to 10% or higher. There is no doubt that had John McCain won the presidential election last November, a very similar deficit-spending stimulus package to the Obama plan - perhaps with more tax cuts and fewer spending increases would have moved through Congress with unanimous Republican support.

As N. Gregory Mankiw said of a stimulus package back in 2003, when he was President George W. Bush's chief economic advisor, this is not rocket science. Deficit spending in a recession, he said, "help[s] maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: you can find it in all of the leading textbooks..."

I can understand (though I disagree with) opponents of the stimulus plan who believe that the situation is not that dire; that the government spending will be slow and wasteful (whereas properly targeted tax cuts would provide a more effective stimulus); and thus that it would have been better to defeat Obama's stimulus bill and try again in a couple of months.

I can also understand (though I disagree with) opponents who believe that the short-run stimulus effect of the plan will be small, while America's weak fiscal position implies a large long-run drag on the economy from the costs of servicing the resulting debt.

What I do not understand is opposition based on the claim that the stimulus package simply will not work: the government will spend its money, households will receive their tax rebates, and nothing will happen afterwards to boost employment and production. In fact, there is a surprisingly large current of thought that maintains that stimulus packages simply do not work, ever.

This opposition is not coming only from politicians who are calculating that opposition to whatever is proposed may yield electoral benefits; indeed, it does not even reflect any coherent right-wing or indeed left-wing political position. Root-and-branch stimulus opponents whose work has crossed my desk recently include efficient-markets fundamentalists like the University of Chicago's Eugene Fama, Marxists like CUNY's David Harvey, classical economists like Harvard's Robert Barro, gold bugs like the Council on Foreign Relation's Benn Steil, and a host of others.

I simply do not understand their arguments that government spending cannot boost the economy. As far as I can tell, they are simply burying their heads in the sand.

At the start of 1996, the US unemployment rate was 5.6%. Then America's businesses and investors discovered the Internet. Over the next four years, annual US spending on information technology equipment and software roared upward, from $281 billion to $446 billion, the US unemployment rate dropped from 5.6% to 4%, and the economy grew at a 4.3% real annual rate as the high-tech spending boom pulled extra workers out of unemployment and into jobs.

Back at the start of 2004, America's banks discovered that they could borrow money cheaply from Asia and lend it out in higher-yielding domestic mortgages while using sophisticated financial engineering to wall off and strictly control their risks - or so they thought. Over the next two years, annual US spending on residential construction roared upward, from $624 billion to $798 billion, the US unemployment rate dropped from 5.7% to 4.6%, and the economy grew at a 3.1% real annual rate.

In both of these cases, large groups of people in America decided to increase their spending. You can argue that neither group should have boosted its spending to such a degree that both were subject to "irrational exuberance" - and that someone should have taken away the punchbowl earlier. But you cannot argue that these groups did not increase their spending, and that their increased spending did not pull large numbers of Americans - roughly two million in each case - into productive and valued employment.

The government's money is as good as anybody else's. If businesses' enthusiasm for spending on high-tech gadgetry and new homeowners' enthusiasm for spending on three-bedroom houses can boost employment and production, then what argument can Harvey, Fama, Barro, Steil, and company make that government spending will not? I simply do not see it.

Scrapbook: Tobin: Friedman's Theoretical Framework

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