The title is a play on Paul Krugman’s recent NYT piece “How did economists get it so wrong?” Krugman has a lot to say, but because he dances around the two key issues his essay doesn’t add up to much.
Krugman thinks we need to bring back (old) Keynesian economics. But the original Keynesian model was discredited for good reason; it lacked an explanation for the trend rate of nominal GDP growth. Allan Meltzer was one of many who observed that the case for fiscal policy must lie with monetary policy ineffectiveness. But Meltzer pointed out back in 1988 that if monetary policy is ineffective at the zero rate bound, the obvious solution is not fiscal stimulus, it’s a positive trend rate of inflation. I.e., a rate of inflation high enough to eliminate the possibility of a liquidity trap. Paul Krugman knows this, indeed reached the same conclusion a decade later, but for some reason fails to draw the obvious implications from this reasoning:
But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.
Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in.
This can only be described as a giant non sequitor. In fact even Krugman doesn’t believe that when conventional monetary policy fails ”the public sector must take its place.” He has repeated argued that inflation targeting can be highly effective in a liquidity trap. In other words, when conventional monetary policy has failed, the obvious solution is to adopt a more effective monetary policy regime. I can’t fathom how anyone could disagree.
[The original post had a typo, saying "private sector" rather than "public sector." HT Bryan Caplan.]
Now I expect I will get Krugman supporters writing in and telling me that he knows all that, that he agrees with me, but that he doesn’t think inflation targeting is currently politically feasible. That explanation might work in an essay about what the Fed should do next week (though I doubt it) but it certainly won’t explain Krugman’s blind spot in an essay devoted to calling for macroeconomics, both theory and policy, to be re-worked from the ground up. In this essay he has literally nothing to say about what went wrong with monetary policy. Indeed at one point he bizarrely states that:
Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.
This is despite the fact that Krugman has repeatedly criticized the Fed and other central banks for being too conservative, for being unwilling to set an explicit inflation target. It makes no sense, unless one assumes that he is so bent on rescuing old-style Keynesianism that he doesn’t want to publicize the potential of monetary stimulus. He knows full well that fiscal policy is an irrelevant 5th wheel in a world where monetary policy is always capable of boosting expected demand growth to the target level.
Some might argue that I put too much faith in the power of monetary policy to paper over the economy’s flaws. Arnold Kling argued that the crisis reflected a real problem with the economy, the need to reallocate labor and other resources. I do think there was a real problem in late 2007, but this problem was minor compared to the nominal shock experienced in late 2008. More importantly, Krugman clearly agrees with me. He ridicules the “freshwater economists” who don’t see demand shocks, and think everything is a real shock. If the problem of falling NGDP is a real shock that can’t be papered over by printing money, it is equally true that it can’t be papered over by running deficits.
[Although I don't agree with Kling's diagnosis, his conclusion that deficit spending doesn't get at the root of the problem certainly does follow from his analysis.]
So if Krugman really does believe that the problem we face is inadequate demand, he needs to come up with a reason why this problem doesn’t call for a better monetary regime, and instead requires the rehabilitation of an old-fashioned Keynesianism that confused money and credit, that confused saving gluts and liquidity traps, that ignored policy expectations, and that had no model of the trend growth rate of NGDP.
The other big theme of his essay is the failure of the EMH. There are two problems with his analysis. First, since he doesn’t understand how monetary policy failed last year, he doesn’t understand why the financial markets have been so unstable. And whenever an anti-EMH economist sees a dramatic market movement that they can’t understand, they immediately assume that there is no rational explanation. Since I think I understand why the stock and commodity markets crashed last fall, so I am not persuaded by this argument. But even I am at a loss to explain why tech stocks got so high in 2000, or houses in Arizona got so expensive in 2006. So let’s give Krugman the benefit of the doubt. Then what?
The bigger problem, which I already discussed in an earlier essay, is that the anti-EMH crowd really can’t come up with any useful implications for their theory. Or at least any implications that are useful for macro policy. If the anti-EMH crowd wants to argue for regulations specifically targeting some market failure–say banks taking on too much risk, then I won’t strongly object. The obvious regulatory fix for the sub-prime fiasco would be to require all mortgages to be backed by at least a 20% down payments on the property. It wouldn’t eliminate future banking crises, but it might make them less severe. Now try convincing Krugman’s fellow Democrats in Congress to enact such a regulation.
But Krugman has a much bigger agenda:
So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
I seem to recall Stigler once remarking something to the effect that in economics the problem isn’t in coming up with answers; it is coming up with interesting questions. Once you formulate an interesting question, the logic of economics quickly guides you to the obvious implications. I also recall constantly hearing highly technical macroeconomists talking endlessly about “research programs,” attempts to develop complex mathematical models of the economy. We kept hearing that “progress was being made” and they we were “close” to having models that could guide policymakers. One thing that Krugman and I would probably agree on is that much of this “progress” was a myth. We really don’t know much more about business cycles than Friedman did, or Irving Fisher, for that matter.
What’s my point? I completely distrust an economist who talks about a promising new area of research that will soon yield all sorts of insights. In my view when a new area is discovered, most of the really useful insights are almost immediately obvious. The only exception that comes to mind is the huge gap between the development of externalities theory, and the discovery of the Coase Theorem. Perhaps others can find some other exceptions. So one implication of this line of reasoning is that I will never live to see the day when behavioral economics and behavioral finance finally revolutionize economics and finance. I probably don’t know enough about these fields to have an intelligent opinion, but my hunch is that if the standard model that we teach in our textbooks has not yet been revolutionized by behavioral economics, it will never be revolutionized. That behavior economics will always be on the fringes, providing interesting anomalies.
And I think this is the problem with Krugman’s agenda. If we knew how to “incorporate the realities of finance into macroeconomics” we would have done so already. We haven’t done so, because we don’t know how. And I think there are good reasons why we don’t know how. Almost any proposal to do so must somehow, at least implicitly, assume the policymakers are smarter than highly paid investment bankers. And even with all the bizarre bubbles we have seen in recent decades, I think that assumption is just too much for most economists to swallow.
Krugman is a very persuasive writer. I keep telling right-wingers that if we have deflationary monetary policies, policies that reduce NGDP, the free market will be blamed. I don’t see any persuasive rebuttals to Krugman from those on the right. I don’t know if my arguments are persuasive, but at least I’m trying.