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More Musings on the Intellectual Train Wreck that is Today's Chicago School...

Paul Krugman writes:

Freshwater Rage: I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing? And all of this, of course, without a hint of irony.... When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been...

I would put it slightly differently. I do object to the fact that Chicago macro has not read Obstfeld and Rogoff. But what I object to much more is that they have not read anything at all.

For example, consider:

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.”[1] He’s not that clear on what the “beauty” is that we all fell in love with, and why one should shun it. And for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income...

It is not just Keynesian economics that concludes that there are times when people in aggregate make plans to spend more than their incomes.

It is Milton Friedman's monetarist economics too.

It is Knut Wicksell's Swedish school.

It is Irving Fisher's quantity theory of money.

Indeed, it is David Hume writing the first article in economic theory ever--"On the Balance of Trade." In it, he supposes "all the money of Great Britain were multiplied fivefold in a night." The immediate consequence is that planned expenditure rises high above income as people try to shed their excess money balances. Planned expenditure continues to run ahead of income until the flow of nominal spending has risen fivefold.

Yet we are told that that chain of events violates "simple logical consistency."

There is nothing illogical or inconsistent about the economy being in a state in which aggregate planned expenditure is greater or less than income. Today's Chicago school would know this, had it not forgotten all of monetary economics from David Hume on.

But if you have never understood David Hume, and if you try to think about the issues on the fly, you are bound to make large, embarrassing, and elementary mistakes. Even this is not necessarily a bad thing. As Nick Rowe says: "we need to encourage finance people to do macro, and macro people to do finance, and part of the price of doing that is we will make mistakes."

But it becomes a bad thing when you think you have something to say about policy--for then you say pointless and destructive things.

[1] I actually don't mind that people spend their time developing real business cycle models or investigating the consequences of the efficient market hypothesis. I do, however, wish that they wouldn't write things like:

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds...

because such things are simply not true.

They are not observationally equivalent.

When major rises in stock prices--like that of 1995-2000--are due to increases in market risk tolerance or decreases in risk, then at their end investors and commentators tend to think that future returns are likely to be low by historical benchmarks, but that stocks are nevertheless worth holding because (a) their risks are small or (b) we have lowered the covariance between stock returns and our consumption. When major rises in stock prices are due to a wave of optimism, then at their end we find that investors and commentators are thinking that future returns are likely to be high by historical standards--Dow 36000 anyone?--but that risks are not especially low.

And to that I object, because they would be better finance economists if they did not write things that weren't true.