DeLong and Krugman Don’t Get It

For a wealthy, high status man, Krugman sure sounds angry much of the time. Here’s his response to those who don’t buy DeLong and his solution of more government spending (on what is not important, highlighting how absurd this solution is):

if you’ve reached the point where you don’t pay attention to anything that might disturb your orthodoxy, you’re not doing science, you’re not even pursuing a discipline. All you’re doing is perpetuating a smug, closed-minded sect.

Yet merely two weeks ago Krugman was bragging about how pointless it was for him to hear from those he disagrees with:

Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously.

A principle is something you apply to your own disadvantage, and so I wouldn’t call ‘balance’ one of Krugman’s principles. Because he never engages in real arguments but rather ad hominem and straw men, his adversaries are unpersuaded, which makes him even angrier.

If you read Brad DeLong’s post that Krugman is referencing, you see this gem by DeLong:

I firmly believe that I am right. I firmly believe that I am right almost as firmly as I believe that the sun will rise in the east tomorrow.

Gee, there seems to be a trend here towards complete certainty in themselves. It’s a strange lack of self awareness, because of course everyone believes he in right, otherwise he wouldn’t believe what he believes, but it seems DeLong and Krugman simply think everyone else is merely a duplicitous shill or moron.

Let’s consider what 5 generations(!) of Harvard book learnin’ can do to one’s cognitive ability, as Bradford DeLong lays out his diagnosis and cure for our economy in powerpoints, indistinguishable in tone and substance from an earnest senior thesis in this Lecture. I put his PowerPoint statements in bold, my comments in non-bold.

Sources of the Downturn:

1) Irrational Exuberance
My problem with this is it is all ex post. Of course we invested too much in housing and everything related to it. But why? Every recession involves discovering one invested too much in something that was unwise: oil, commercial real estate, technology, cotton. That phrase doesn’t explain anything, it is true by definition for a recession.

2) Overleverage
ORLY? Then why were relatively low-leveraged commercial banks like WaMu, Wachovia, and National City also destroyed? The ridiculous levels of leverage at investment banks may have been high, but on average they weren’t much different than in the early 1990s. The performance of banks in the recession was pretty independent of their leverage (see here). As recessions are invaribly financial events, they necessarily imply ‘overleverage’. Again, this doesn’t explain, it is true by definition for a recession.

3) Misregulation
Here DeLong focuses upon the lack of capital for investment banks, which was incidental to the general glut of housing that would then ripple through the economy. He neglects to mention that these same regulators were threatening banks that did not comply with new ‘innovative’ underwriting standards pioneered by Bill Syron to increase home ownership among the ‘traditionally underserved communities’. Once you create all this crap it has to go somewhere, which is why I think low underwriting standards are the dog and leverage/CDO/copulas are the tail. Today the FHA dominates (90%+ share) the under $300k mortgage market because they are the only one giving out loans on 3.5% down payments, highlighting they still don’t think this had anything to do with the 2008 crisis, so it’s not like giving them more authority back it 2005 would have lessened the amount of NINJA loans–probably the reverse. Leverage, meanwhile, would not have saved Lehman, Bear, or Wachovia at any conceivable level of regulation people were talking about if you try to estimate some kind of relation between leverage and financial performance.

Consequence: flight to quality. Excess demand for high-quality assets.
Again, true by definition in a recession.

This produces a ‘general glut”: shortage of demand for goods and services.
Well, when you discover 5% of your workforce is engaged in unsustainable activities, they are now unemployed, have no income, and need to find new work. Their reduction in consumption and savings will adversely affect other sectors, but it is hardly ‘general’, rather highly specific.

Total spending Y=C+I+G+GX-IM falls short of the amount needed for full employment.
This is backwards. Full employment was at an unsustainable, nonequilibrium level due to all sorts of wishful thinking about giving away homes to poor people and thereby giving them all sorts of neat demographic qualities just like homeowners. People involved in this unsustainable activity now need new jobs, and it will take some highly decentralized introspection to reposition these workers in their best niche.

The Right Cure for the Great Recession
Regulatory Reform
Frank-Dodd? What part, exactly? The Home Affordable Modification Program? Most of this bill just gives regulators greater authority to do something, and like the CFPA, they are busy creating a bigger bureaucracy but thus far nothing really meaningful, which is my ‘best case scenario’.

Goverment spending when the private sector stops:
Well, DC has already turned this dial to ’11’, pushing our deficit to Macedonian levels. Further, the idea that ‘government spending’ and ‘private spending’ are substitutes is ridiculous: one pays for the other, an important distinction.

DeLong then mentions the importance of providing liquidity, ie, monetizing the deficit, Fannie and Freddie’s losses. The Romans often tried to solve fiscal problems debasing their currency and it never worked, and led them to angry reactions as seemingly greedy merchants would then have the gall to raise prices. Perhaps they just needed to double down?

Cure for the Great Recession: Fiscal Policy, ΔG.
He then lists the standard Keynesian Multiplier, which posits government expenditure as a free lunch via the fact that the money is then spent by someone else, who spends it again, etc. The net effect is to spend $1, create $2 in income, which taxed at 40% pays for itself like a dewdrop in terrarium. There’s just one problem: where do you get the $1 in the first place?

As per confronting his critics, he ignores anything about his model and simply criticizes their solution, which is caricature of Milton Friedman circa 1981. There aren’t many hard core monetarists out there arguing the solution to our problems is a monetary growth rule which would eliminate all recessions, but the whole point is simply to set up a straw man and smash him down.

My alternative to DeLong’s solution–which has been applied vigorously over the past 2 years without effect–is to reduce the size and scope of government. People left to their own devices will innovate, find their best niches, and create wealth without ethanol and wind programs. Such activities are sustainable because they come from myriad voluntary decisions by other free men, not someone spending someone else’s men on a project for someone else, the ultimate in whimsical expenditure. Consider that the economy grew to its heights without much guidance just fine (look at the US up to WW1, the Asian Tigers, China post-1978, Adenauer’s West German), and precisely because no one person understands it is why top-down solutions hinder growth.

In the movie BroadCast News, the insufferable Jane Craig (played by Holly Hunter) is remonstrated by her boss:

Boss: It must be nice to always believe you know better, to always think you’re the smartest person in the room.
Jane Craig: No. It’s awful.

As Krugman’s dyspeptic disposition highlights, being certain you know better can not only be bad epistemologically, but make you feel bad too. This is usually because such people unfortunately ‘100% believe’ their misconceptions of their opponents, and then become frustrated when these straw men don’t spontaneously admit to being frauds and fools.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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