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Krugman, Fox, McCain, Prescott, and Company

Justin Fox:

Paul Krugman tells how economists got it all wrong: the one big issue I have with the piece is that, while economists certainly got lots of things wrong before the crisis (as did almost all of us), many members of the profession have acquitted themselves pretty well since things turned really ugly last year. Krugman goes on and on about the "freshwater" economists (at the Universities of Chicago, Rochester and Minnesota) and their crazy ideas about perfect markets. But what's telling is that the hardcore freshwaterites have had almost no impact on economic policy for the past year—neither in the Bush months or the Obama ones. Sure, Nobelist Ed Prescott, a former freshwater economist who now teaches in Phoenix and thus should probably be described as a no-water economist, made the statement that:

"I don't know why Obama said all economists agree on [the need for a stimulus bill]," Prescott said. "They don't. If you go down to the third-tier schools, yes, but they're not the people advancing the science."

Unless you believe that pretty much anyplace other than Arizona State University is a third-tier school, this is patently untrue, evidence of the extreme isolation of the remaining true believers in rational expectations and real business cycles and other such elegant but profoundly unhelpful macroeconomic theories developed since the 1960s. Even some of the true believers seem far more aware than Prescott that the past year's events have challenged their theories—as the University of Chicago's Robert Lucas told me last fall, "everyone is a Keynesian in a foxhole." Among economists with actual influence on policy over the past year—Philip Swagel in the Paulson Treasury, Larry Summers and Christina Romer and Austan Goolsbee and etc. in the current White House—there's been a great willingness to experiment and accept that markets don't always deliver optimal results. The result: an economic recovery that seems to be gaining strength. So don't totally count the economists out...

Four remarks:

(1) In context Lucas's "everyone is a Keynesian in a foxhole" is not an endorsement of the position and an admission that he holds it, but instead much closer to a denunciation of economists for their intellectual weakness in reaching for Keynesian remedies:

Well I guess everyone is a Keynesian in a foxhole, but I don't think we are there yet. Explicitly temporary tax cuts do nothing: people just bank them. Supply side tax cuts are fine with me, but they take time to work and at some point we need the revenue to run the government. I feel the current situation requires a lender of last resort but not a fine tuner.

As, indeed, was clear when Lucas made his big denunciation of Christy Romer (and by implication Summers, and Orszag, and Elmendorf, and Bernanke, and Swagel, and so on) for what I can only characterize as "corruption":

Why a Second Look Matters: The Moody's model that Christina Romer -- here's what I think happened.  It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning. So she scrambled and came up with these multipliers and now they're kind of -- I don't know.  So I don't think anyone really believes.  These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning.  These are kind of schlock economics. Maybe there is some multiplier out there that we could measure well but that's not what that paper does.  I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons...

Note what Lucas does not say: He does not say that Christy Romer has a different reading of the evidence than he has. He does not say that Christy Romer has a different assessment of policy risks than he has. He does not say that Christy Romer has a different tolerance of policy risks than he has. He says that she is providing a "very naked rationalization" for economic policies that Obama decided upon for completely non-technocratic political reasons.

Now this is complete garbage. Christy Romer does have a very different view--she would call her view an evidence-based view--of what fiscal policy does in conditions of extremely low interest rates than Robert Lucas does.

(2) Unfortunately for us these are not fringe figures. To an outsider to academic economics like Justin Fox they may appear to be embarrassing madmen in the attic--and to the extent that that becomes the conventional wisdom then I think the good guys will have won this one. But inside the profession that is not the case.

Robert Lucas is a Nobel Prize winner and the head of the still-dominant school of business-cycle analysis when he claims that Christy Romer (and by implication Ben Bernanke, and Doug Elmendorf, etc.) is providing "very naked rationalization[s]" for politically motivated policies. John Taylor is a former Undersecretary of the Treasury for International Affairs when he claims that forecasters like Mark Zandi and Larry Meyer who find the stimulus to be being somewhat effective are just "repeating what they said in January" because they "haven't looked at the numbers." Edward Prescott is a Nobel Prize winner and head of the second-plae school of business-cycle analysis when he claims that supporters of current economic policies "are not the people advancing the science."

Eugene Fama is the head of the dominant school in finance and perennially on the Nobel Prize short list and he claims that the existence of the savings-investment identity makes it logically impossible for the government to boost the economy via spending--an analytical error that we here at Berkeley teach our freshman not to do for it is, as Paul Krugman calls it, "the most basic fallac[y] in economics--interpreting an accounting identity as a behavioral relationship." John Cochrane is the smartest analyst of aggregate asset prices I know, and yet he too commits fallacies that I had thought were dead since the 1920s when he writes that "every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out.”

Luigi Zingales is one of the smartest young Chicago economists I know of, and yet demonstrates that he has not thought about general equilibrium in even the most cursory sense--has not thought how you analyze a system in which you have to keep straight the three commodities of cash, financial assets, and goods--when he writes that "if a nuclear bomb had destroyed all roads... [would] we [then claim] that to alleviate the economic impact... we should invest in banks[?]... [I]f the problem is the roads, you want to rebuild roads.... And if the problem is the financial sector, you want to fix this and not build roads."

(3) These are not dumb people. But these are people for whom whole blocks of what used to be called "economics"--the monetary history of the nineteenth and the first half of the twentieth centuries, the "lowbrow" theories of 1920-1980 from Fisher, Wicksell, Keynes, and Hicks through Metzler, Tobin, and Friedman--are taboo. They would be demonstrating to their peers that they were not serious highbrow economists if they consulted them, and so when they have to deal as they have in the past two years with Fisher-Wicksell-Hicks issues they approach them with great ignorance and get them wrong.

(4) Were it not for the Republican Party, this would not matter very much. The failure of high brow macro to have anything to say about our current situation--where is the misperception of relative prices that has given us 10% unemployment with both firms and workers being happy with the situation? Where is the technology shock that has pushed aggregate production relative to trend down by 8%--would lead their colleagues in other subdisciplines to draw the natural conclusions, cut back on hiring domestic macroeconomists, and hire more international finance specialists (where the analytical culture is, I think, healthy), microeconomists, historians, and institutionalists instead. The big problem is the interaction of the guys in the attic on the one hand and the Repubican Party on the other.

Had John McCain won the presidential election of 2008, at the start of 2009 he would have in all likelihood proposed a trillion dollar fiscal stimulus bill--3/4 tax cuts and 1/4 aid to states--and he might have picked Tim Geithner for his Treasury Secretary. Democrats would have called for fewer tax cuts, more state aid, and some government infrastructure spending initiatives in the fiscal policy mix, but the need for the government to cushion the recession would have brought them into line. When Obama took office he bid $800 billion for his fiscal stimulus bill--about 1/3 spending, about 1/3 aid to states, about 1/3 tax cuts--thinking that would be a plan that would win broad bipartisan assent. And he was wrong. The Republicans decided to follow the Gingrich strategy: try as hard as they could to make the Democratic president appear a failure by blocking all his initiatives. But you can't block an initiative without a story for why it is bad for the country. And that, all of a sudden, makes the madmen in the attic the favored economic advisors of the Republican Party.

This is, I think, very dangerous. The Republicans will win elections in the future. And when they do will we want Ed Prescott to be running economic policy?