Wine, Physics, and Song

OK, another must-link, to Paul Krugman’s extended New York Times version of something he’s blogged on before: the divide between “freshwater” and “saltwater” economists, and how the profession largely failed to anticipate the present economic crisis, and to some extent—especially in the “freshwater” camp—lacks the intellectual tools to deal with it.

Anybody who is interested in understanding the current economic situation, and in getting some background for their attempt to understand it, should read Krugman’s article.  (And even more importantly, read Keynes’ “General Theory”.

As a graduate student in economics round about 1985-87, for a semester at Yale and then for two and a half years at Berkeley (I moved to the Bay Area for love), I got (or rather continued, since I’d taken a bit of econ as an undergrad, and done quite a bit of reading on my own) a squarely “saltwater” (this refers to the coastal US—say, Berkeley, Harvard, MIT, Yale—as opposed to the heartland—say, Minnesota and Chicago, and I’m not sure how far the generalization holds beyond these schools…) economics education, taking first-semester macro, for example, from Jim Tobin.  Yet even then, and there, we were subjected to readings from the “rational expectations” and “real business cycles” school of macro:  Barro, Sargent, Lucas.  I must admit I found this stuff as obviously out of touch with reality then, as Krugman is now telling us it is.  Often  fitted out with impressively technical talk of autocorrelations and regressions, it made claims such as:  systematic use of monetary policy to smooth out business cycles can’t have any effect, because rational economic agents will anticipate it; business cycles are due to such “real” factors as shifts—due to underlying changes in “technological possibilities”, not due to failure of aggregate demand—in the relative rewards to leisure versus labor, resulting in more people choosing leisure (the “Great Depresssion as Great Vacation” theory, as Krugman skewers it).   The apparently supportive econometric analyses apparently worked—I don’t actually recall the econometric critiques of the time, having been more concerned at the time to acquire tools that would help me understand how the economy actually did function, than to score intellectual points against the wrong-headed—by mistaking correlation for causation, and leaving out of the analysis variables of critical importance.  Sometime somebody should—heck, somebody probably has, and I’d love to be pointed towards the analysis—take their macroeconometric work apart.  (Here’s a contribution in that direction from one L. H. Summers—pretty devastating, I’d say.)

Krugman’s article adduces two, or perhaps three reasons—the “beauty” of rational-agent equilibrium theories, the lure of “sabbaticals at the Hoover Institution and job opportunities on Wall Street” why “freshwater” macro gained as much influence as it did.  Of these, he thinks the “beauty” aspect was the more important.  I think a lengthy exploration of the culture and politics of the economics profession would reveal a lot about how the intertwining of politics, business, and academic culture enabled the rise of the freshwater school.  I’d love to see such a work, by an economically literate social scientist (perhaps even an economist).  Because to my mind, the fact that the bundle of misguided ideas Krugman is referring to as “freshwater economics” gained as much influence as it did, is a serious counterexample to the idea that economics, as practiced in the academy and the more academically-linked think-tanks and policymaking institutions, is a science that makes a serious effort to test its theories against reality, and judges the work of its practitioners accordingly.

Having said that, I’ll admit to being very irritated by people who claim that economic theory and academic economics in general have been shown up as useless by the present crisis.  For me, Keynesian theory was always at the heart of macroeconomics, certainly the macro that was taught me when I was in grad school (and that I sought out to teach myself even before then) and its value as a tool to help understand and deal with reality is only accentuated by this slump—as is the value of intelligent, reasoned, reality-based economic analysis more generally.

Anyway, I’d like to think that “freshwater” versus “saltwater” may be a bit of a calumny on the heartland.  Maybe instead of the fresh versus the salt we should (reversing the order) call them, whether or not it fits with Levi-Strauss, the Raw and the Cooked, according to whether they are willing to accept the raw facts of economic slumps, unemployed resources, burst asset bubbles, or can’t believe these are what they appear to be and (unintentionally in most cases, perhaps) are moved to cook the data via sophisticated regressions to fit their “markets can’t fail” theories. For them, or those seduced by them, maybe the words of Jonathan Richman and the Modern Lovers (if you want to listen, the track was switched with “Modern World [alternate take]” ) are apropos, put into the mouth of a hypothetical bubble-acknowledging, behavioral-economics-friendly, neo-parti-Keynesian, reality-based “raw” economist:

Now I’ve watched you walk around here.
I’ve watched you meet these
boyfriends, I know, and you tell me how they’re deep.
Look but, if these guys, if they’re really so great,
tell me, why can’t they at least take this place
and take it straight? Why always stoned,
like hippie Johnny is?
I’m straight and I want to take his place.

Joseph Stiglitz on the bank bailout, from Bloomberg:

“All the ingredients they have so far are weak, and there are several missing ingredients,” Stiglitz said in an interview yesterday. The people who designed the plans are “either in the pocket of the banks or they’re incompetent.”

Stiglitz is only one of the world’s best economists;  when he talks, you really *should* listen.

President Obama, on why the new financial bailout/rescue plan doesn’t temporarily “nationalize” the banks (as Sweden successfully did in its 1990s financial crisis):

“Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.”

Well, we voted for change, didn’t we, so let’s start changing the culture that says we can’t even temporarily nationalize the largest banks with the worst balance-sheet issues, in an emergency that threatens the world economy and is in part attributable to these banks’ irresponsibility.  Say, as many, including lefties like the former IMF chief economist Ken Rogoff, and lefty financial-history prof Niall Ferguson seem to believe, a belief perhaps even reflected in the stock market’s fall on Geithner’s press conference, we need to temporarily nationalize the banks.  Call it restructuring, make the call that the zombie banks are effectively bankrupt and an expedited, not court-supervised, receivership is needed, call it tough love, pander to our “culture” of responsibility.  Nationalization is a stupid word to use—it suggests an intention for long-term transfer of banking to the government, and few are seriously suggesting that.  We can do bank restructuring and still “retain a strong sense of that private capital fulfilling the core investment needs of this country.” Maybe it can be done, in a stealthier way, through Geithner’s plan—but it’s apparently not clear to most what Geithner’s “plan” will turn out to be, in practice.

To prevent a filibuster, the administration has to coddle the Senate’s Great Men (and Women) Of The Center.  Specter insisting the plan cost less than either the $820 billion house bill or the $838 billion senate version—knocking $40-58 billion, 5% or more, off of a stimulus that may already be too small.  And with the final total looking like it will be $790 billion, pretty much succeeding.   A few Republican moderates (and a Democrat or two) holding the economy hostage so that — what?  Their power be recognized?  It’s been a while since I saw Specter in action in a hearing, but I recall, perhaps erroneously, a really bad gut-check about the guy as he browbeat some poor sap, or maybe some perfectly reasonable guy he happened not to agree with.  True, he’s been a voice of reason on some issues, but I was not impressed.   Maybe the Republican moderates feel they have something to take back to their party in order not to be drummed out of it for supporting the plan at all.  Specter also insisting on keeping $10 billion for NIH untouched, while an increase for the NSF was scaled  back by the Senate plan—what’s with that, does NIH have a facility in Pennsylvania, or is Specter just a health nut?

Probably Obama’s playing it cool at this point is the right game plan… getting the thing passed without having to break a filibuster is probably much better for his long-run efficacy.   But I worry that it is not large enough—that by not signing on, but effectively watering it down through the implcit threat of a filibuster, the Republicans are setting up—not consciously for the most part, except that there probably are those who believe an extended recession is better than any increase in government spending—to try to benefit from an unnecessary extension of the recession.  At some point—perhaps on the second batch of stimulus that will likely turn out to be necess, crying “stimulus was ineffective”.  I’m not sure Obama will get a chance to put in another round of stimulus, though he occasionally talks of it.  And, he may be able to get in another round under the guise of longer-term public investment, which he has called for, with stimulus as a side-benefit.  But I imagine there will be a filibuster showdown at some point.  Hopefully the chits will be called in and the moderates will help him break it, maybe with another ceremonial multi-billion-dollar bone or two as compensation.   But it is frustrating that the “senate moderates” are as boneheaded as they are about this.  One can only hope they are doing it because they feel the need to shelter themselves from the ire of their party.

From the AP:

“Earlier Tuesday, the Senate sailed to approval of its $838 billion economic stimulus bill, but with only three moderate Republicans signing on and then demanding the bill’s cost go down when the final version emerges from negotiations.

Negotiators initially were working with a target of about $800 billion for the final bill, lawmakers said. But GOP moderate Arlen Specter, R-Pa., said Tuesday night on MSNBC’s “Hardball” that he was insisting on a figure at around $780 billion.”

Credit for the pound of flesh metaphor to Paul Krugman, back on Feb. 6th.

Here’s Greg Mankiw’s preferred fiscal stimulus plan.

I would institute an immediate and permanent reduction in the payroll tax, financed by a gradual, permanent, and substantial increase in the gasoline tax. I would make the two tax changes equal in present value, so while the package results in a short-run budget deficit, there is no long-term budget impact. Call it the create-jobs, save-the-environment, reduce-traffic-congestion, budget-neutral tax shift.

I recognize that some state governments are now struggling in light of the macroeconomic crisis. For the next two years, I would let each state governor have the authority to divert a portion of the payroll tax cut in his or her state and take the funds instead as state aid.

Would the equal present value of the payroll tax cut and the gas tax increase be discounted by consumers, who would save in anticipation of the effects of the future increase, resulting in no stimulus to aggregate demand from the policy?  I doubt it; I think it would have some Keynesian multiplier effect nonetheless.  But much of it may be saved, in the form of paying down debt.  It does also give a straightforward reduction in the cost of keeping people employed, a microeconomic incentive effect that might prove to have positive macroeconomic consequences in the present situation.  I still tend to think government spending will, as the simplest Econ 1 Keynesian theory suggests, have a bigger multiplier (a point Greg does explicitly address—he thinks the empirical evidence, though not conclusive, casts some doubt on this).

I’d be most concerned, though, with what would happen to the programs normally funded by payroll taxes:  Social Security and Medicare.  Social Security in particular is at least nominally supported by paying payroll tax receipts into a fund reserved for Social Security payouts to retirees;  would the program continue to pay out at current rates, now funded by general revenues or the gasoline tax?  That might not be such a bad idea, but I’m not sure it’s what Mankiw has in mind….

Note that even if the increased-state-spending-for-payroll-tax-cut exchange would be macroeconomically benefical globally, it might have some negative micro effects if only a few states adopted it, as it would put them at some competitive disadvantage for jobs.

Paul Krugman’s thoughts on Japan from around a decade ago are quite interesting.  He wrote:

But it is quite a stretch to argue that Japan in the 90s is a parallel case [to the US from the Great Depression through World War II]. It might be; but an at least equally, if not more, plausible story is that Japan has a structural excess of saving over investment, even at a zero interest rate; in that case a temporary fiscal stimulus will produce only temporary results.

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy.

The “exotic” multiple-equilibrium story must not really be that exotic, since just above this he entertains it as an explanation of the 1996 Asian financial crisis, and of the apparent success of WWII spending in lifting the US sustainably out of depression.

The current situation certainly differs from Japan’s in the 90’s in many ways, but it does raise the question which of those ways are likely to render fiscal policy more effective for us now, than for Japan then.  Of course, I think no-one would argue that we have a structural excess of savings over investment.  But it does appear that the propensity to save may have shifted up at least temporarily.  Do we face an S-shaped consumption-income relation?  If this slump drags on too long, will we need to target inflation?

At the time Krugman wrote these pieces, he felt the multiple-equilibrium possibility looked dubious because there had been prolonged fiscal stimulus, but it  hadn’t rendered itself unnecessary.  Others (see the article linked below) think apparently think it just wasn’t large enough, and intense enough over a short period of time, to succeed.  And there are those who think that Japan didn’t clean up its banking problem effectively—that its banks still had the balance sheet problems that, Krugman argues, fiscal stimulus can provide breathing room to work out.

Greg Mankiw links to an interesting article on Japan, that largely confirms the continuance of the situation Krugman described in 1999—fiscal stimulus not having rendered itself unnecessary by producing a self-sustaining recovery.  Make sure and read past the first page.  It would be interesting to further investigate the content, and methodology, of the Institute for Local Government study that concluded:

every 1 trillion yen, or about $11.2 billion, spent on social services like care for the elderly and monthly pension payments added 1.64 trillion yen in growth. Financing for schools and education delivered an even bigger boost of 1.74 trillion yen, the report found. But every 1 trillion yen spent on infrastructure projects in the 1990s increased Japan’s gross domestic product, a measure of its overall economic size, by only 1.37 trillion yen, mainly by creating jobs and other improvements like reducing travel times.

Mankiw has his own suggestion for a stimulus plan, about which a bit more in the next post.

In an LA times editorial, Niall Ferguson augments his Feb. 2 Financial Times piece, which I commented on earlier, with much more explicit Keynes-bashing and fiscal-stimulus-dissing.  This time, Brad’s on the case.

Long Treasury yields did rise a bit (roughly from just under 3, to just over 3.5, percent over the last few weeks), and there was similar if less pronounced movement across the longer end of the curve, so maybe we shouldn’t count on financing the whole stimulus at todays low rates—though I couldn’t tell you if this is a response to the clear likelihood of a stimulus package, which I would have thought would have been priced in for a while now.  But if we’re getting output closer to potential, sooner, with the stimulus, we’re increasing the overall stream of real output that the Treasury will have avaible to tax to pay these things back—increased indebtedness being met with increased debt-servicing capability.  Maybe not one-for-one, although that cuddly, big-eyed multiplier sure helps.  The cuddly reference:  “Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, they seem to be regressing to macroeconomic childhood, clutching the Keynesian “multiplier effect” — which holds that a dollar spent by the government begets more than a dollar’s worth of additional economic output — like an old teddy bear.”—Ferguson from the LA Times piece.)  Among the most multiplier-besotted economists would seem to be Paul Krugman;  here is a fairly random sample of him failing to anticipate the current crisis (you can go back much further with him on the dangers — and let’s not forget, the existence — of the housing bubble).  As for regression to childhood, there seems to be a more serious epidemic among some (but far from all!) politically conservative economists, of regression to being macroeconomically unborn.  What’s Ferguson’s argument here: If they teach it in Econ 1 in every halfway respectable university in the country, there can’t be anything to it?

Carmen Reinhardt (Economics, U MD) and Kenneth Rogoff (Economics, Harvard), on the WSJ editorial page:

“For far too long, official estimates of the likely trajectory of U.S. growth have been absurdly rosy and always behind the curve, leading to a distinctly underpowered response, particularly in terms of forcing the necessary restructuring of the financial system. Instead, authorities should be prepared to allow financial institutions to be restructured through accelerated bankruptcy, if necessary placing them under temporary receivership, and only then recapitalizing and reprivatizing them.”

But what would the former chief economist of the IMF know about such things?

Niall Ferguson seems to agree with Paul Krugman and the Axis of Smart on nationalizing, er, sorry, recapitalizing the banks:

“First, banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down. Bond­holders may have to accept either a debt-for-equity swap or a 20 per cent “haircut” (a reduction in the value of their bonds) – a disappointment, no doubt, but nothing compared with the losses when Lehman went under.”

He even cites the Swedish case as a sensible model while, of course, noting the need to avoid “the nightmare of a state-dominated financial sector”.  I don’t think Larry Summers will let that come to pass… let’s just hope the soon-to-be-announced overhaul of the rescue package for financial institutions involves an effective temporary takeover, if perhaps in some form of —voting, please— preferred equity stake by the government, rather than the perhaps more efficient outright purchase of the big banks on the open market.

Now, where does Ferguson think the money for this takeover and recapitalization will come from, if not government borrowing?   Substituting government debt for private may indeed stimulate demand, through the wealth effect and lower debt servicing costs, especially because the government can borrow at bargain-basement rates right now, so even if the–somewhat, but only somewhat, mythical—rational taxpaying consumer is factoring in the need for higher taxes in the future to pay this off, it’s a net gain.  Of course, if the rational taxpaying consumer is a Keynesian and believes output will be closer to potential because of this stimulus, the anticipation of the higher lifetime income stream that will generate is still more impetus to spend—an argument that applies to government-expenditure-based stimulus, too.

Forcing renegotiation of mortgages, and the making of new mortgages, at lower rates is another interesting idea of Ferguson’s;  noises from the Obama administration suggest they may have something in mind along these lines—and with the noise about helping out homebuyers coming from Republicans in Congress, maybe there could even be bipartisan support.  (Naah, they’ll back off on principle.)

But what about the rest of Ferguson’s piece:

“…the western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More importantly, households are groaning under unprecedented debt burdens. Worst of all are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt.

The US could end up running a deficit of more than 10 per cent of gross domestic product this year (adding the cost of the stimulus package to the Congressional Budget Office’s optimistic 8.3 per cent forecast). Today’s born-again Keynesians seem to have forgotten that their prescription of a deficit-financed fiscal stimulus stood the best chance of working in a more or less closed economy. But this is a globalised world, where unco-ordinated profligacy by national governments is more likely to generate bond market and currency market volatility than a return to growth.”

Well, the last bit sounds more like an argument for the US providing leadership in co-ordinated, global fiscal stimulus policy than for giving up on stimulus.  (It’s also the argument for buy-domestic provisions in stimulus plans, though that’s definitely a second-best option to co-ordinated, unrestricted stimulus, and perhpas somewhat silly in that much of what a stimulus package will get spent on will be nontraded goods in any case—although some good public transportation infrastructure would be highly welcome, and might well involve a lot of European-made equipment.)

It’s hard to think of a better time than now, with the lowest borrowing rates in years available to the US Treasury, to make some serious public investments.   So Ferguson’s ideas on the financial sector and mortgage loans seem reasonable, and may well provide fiscal stimulus themselves, but his argument against government expenditure for additional stimulus seems weak.  Co-ordinated profligacy with your restructuring, anyone?