Tag Archives: Paul Krugman

The Fresh and the Salt, or the Raw and the Cooked?---Krugman on how economics got it wrong...and Jonathan Richman on getting it straight.

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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.

Blowin' Hot and Cold---Niall Ferguson on recapitalization versus stimulus

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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?