The Stability of Extremes

I take some comfort in learning that Brad DeLong and Paul Krugman appear to be as baffled as I by the traction that right-wing political and economic ideology seems to achieve, even with those who will be hurt most by it. I also find it reassuring that both men, who have sufficient standing within the discipline to critique it credibly, are willing to critique some of our brethren who have forgotten (or never learned) the economic lessons of the 1930s and 1940s. Admittedly, it's a cold comfort, but a comfort nonetheless.

I want to offer some thoughts about why extreme macroeconomic policy may trump moderate policy. They should be viewed as supplements to Krugman, rather than disagreements with him. Here's Krugman:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasizes the way the economy can develop magneto trouble, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential.

In my opinion, the intellectual instability of the Samuelsonian synthesis runs deeper than "strategic inconsistency." I believe it derives from two aspects of the synthesis. One is Samuelson's propagation of the myth that "the invisible hand leads to generally desirable outcomes" has caused real economic and political harm, yet it continues to shape how many if not most economists and non-economists think about the economy. Gavin Kennedy does a much better and more scholarly job than I could of debunking the generalization of Smith's very specific uses of the term "invisible hand" to cover every possible manifestation of something we imagine are the natural benefits of "rational self-interest." (See also a recent post by Kennedy here.) That the economics profession, at least since Samuelson, has sanctified the myth and elevated it to high orthodoxy has in my opinion provided substantial political and ideological cover for those who benefit from laissez faire financial markets. It almost certainly accounts for pushing "the dividing line between micro and macro" in the direction it was "pushed."

The other aspect of the Samuelsonian synthesis that is problematical, at least to me, is its somewhat ad hoc synthesis of macroeconomics and microeconomics, which some have argued isn't a true synthesis. To me it has always looked like an uneasy attempt to reconcile a near-Utopian view of micro markets (ruled by an imaginary all-powerful, all-knowing invisible hand) with a more realistic Keynesian view of less than perfect macro markets. As noted above, it is perhaps no surprise that the tendency outside of the Fed "monasteries" has been to gravitate to micro principles and beliefs that appear to support laissez faire in macro policies, particularly those that affect finance. That the monasteries have a better anchor to reality is also not surprising, but as Krugman notes their "voice" in academic publications (and in promotion and tenure policies I would wager) has been systematically muted.

I also want to suggest another possible source of political instability for moderate macroeconomic policy that I think Krugman misses. It relates to the disconnect between economists' and non-economist voters' perceptions of the merits and effects of macroeconomic policy.

Let me give you an example from a protracted period of stagflation in the US during the 1970's. During the early stages of stagflation, a variety of government interventions aimed at countering a wicked combination of high inflation and high unemployment appeared to be ineffective. This weakened consumer and voter confidence in the government's ability to intervene effectively and produce beneficial macroeconomic outcomes.

I write that last sentence from the perspective of my business men and women relatives and the outrage they felt when wage and price controls were imposed by a Republican president (no less). The point here is that everyone, even non-economists, noticed the wage and price controls and how perfectly unpleasant and ineffective they were. And in the unlikely event that someone wasn't paying attention, the OPEC oil embargo in combination with gasoline price controls and very long lines at gas stations focused attention. Then, after nearly a decade of rapidly eroding purchasing power and high unemployment, interest rates soared as Paul Volcker effectively applied the brakes to inflation by raising interest rates in the early 1980s.

What the average non-economist noticed during the remedial period was the very high credit card and mortgage interest  payments they were making. Had they been economists, they might have rationalized this by noting that housing and other prices were stabilizing. Not being economists, they imagined that if only interest rates were lower and they could still pay the same, now stabilized price for their house, they would be better off. Instead, the "government," by raising interest rates, seemed to be making the banks and mortgage companies better off at the home purchaser's expense. They certainly did not notice, at least not right away, that the economy was slowly being restored to something that in the long run would have been better for them and for their grandchildren had we only been able to sustain it.

Let me emphasize. I'm not telling this story as an economist, I'm telling it from the eyes of members of my family and friends who bought homes or waited in gas lines. Many came out of it convinced, convinced, that the guvmint is always and everywhere the problem. (Most of the businessmen in my family had already concluded this based on the 2 years post-WW II when continuing wage and price controls by the Office of Price Administration forced their suppliers to stop or slow production, while my family members were forced to scour the countryside looking for manufacturers who would supply goods for cash under the counter so my family could stay in business.)

I'm going to suggest that even though many who espouse anti-government ideas may not have directly experienced the 1970s, that period provided the political right with a "teachable moment." Everyone was paying attention, most were noticing that the government seemed to be creating more problems than it was solving, and many became open to the idea that guvmint is the problem. It established an intellectual beachhead from which foot soldiers could advance and reinforce the idea that a democratically elected government constituted in such a way as to protect the people from its own predations and power was in fact the enemy and incompetent to boot.

Now combine carefully fostered distrust of the government, the only thing that might reasonably be expected to stand between us and the private interests of concentrated, unfettered wealth and power, with the myth of an all-wise, all-knowing, beneficent invisible hand embedded in a Utopian free market. Then propagate the myth by a discipline that trains its young: to assume rather uncritically fully-informed, unchanging over time, prudent, industrious, self-interested preferences and behavior; to downplay the "friction" of transaction costs and information asymmetries; to assume that many externalities are or soon will be internalized; that labor and goods markets clear rapidly; that capital is more putty than clay; and until recently that financial markets were both rational and efficient. That many of these same so-trained youth sought employment in the highly lucrative financial sector can only have contributed to the intellectual and political disconnect between Wall Street and Main Street and the dark age of macroeconomics to which Krugman alludes.

It most likely also explains the young assistant professor in economics at a top ten US university who opined at lunch a few weeks ago that "the thing I like most about economics is that there is no truth."

Unfortunately, there are some truths. One is that whatever equilibrium we move to next, we can't go back in time to the fairer income distribution and employment rates and economic growth we had in the 1950's and 60's. We can only go forward with the human, physical and financial capital that we have now. If any of these need to change in order for us to go forward, then we need to tinker with or replace the defective "magneto" now. That's why how we go forward is so important to get right. Our choices will determine whether eventually we restore a fairer distribution of higher output or create a highly unequal and unproductive society that rewards only a few.

We have broken the economy at least twice in the last 100 years and in pretty much the same way both times. And with pretty much the same rhetoric both as we were breaking it and as we were and are attempting to repair it. Yet, as DeLong puts it

Still, here we are. The working classes can vote, economists understand and publicly discuss nominal income determination, and no influential group stands to benefit from a deeper and more prolonged depression. But the monetarist-Keynesian post-WWII near-consensus, which played such a huge part in making the 60 years from 1945-2005 the most successful period for the global economy ever, may unravel nonetheless.

I share DeLong's bewilderment. I would suggest several steps that might remedy this. First, at a minimum economists had better learn to speak and write in parables so that the working classes can understand macroeconomic policy as readily as they understand gas station lines and and as well as they misunderstand payroll taxes, marginal tax rates, and estate taxes. Second, it would help if we could agree on what the message (in 25 (OK, maybe 50) word soundbites) should be.

Finally, it might help if we all acknowledged that moderate and extreme macro polices will almost certainly lead to different macro equilibria and that while both may be efficient, it doesn't necessarily make them both good. Unfortunately, deciding which one is "good" would depend on a normative judgement, which we as a profession have tended to eschew.

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Update: Brad DeLong's longer talk here is a must read. The disturbing conversations with the tea partiers fit with my own anecdotal experience regarding working and business class attitudes towards both macroeconomic policies and the "morality play" that underlies how many non-economists that I know think about the economy.

Comments

[Bruce Wilder]

Krugman:"When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential."

I've done micro, and assumed nothing of the sort. Actual markets are dominated by individuals behaving strategically and lots of markets do not clear. Economists, who study them, know this. Didn't the macro people get the memo? (Phelps had something to say about this, a long time ago. Alan Blinder wrote a book asking about prices and price formation. what happens to this stuff?)

I know what Krugman says is true about how NK macro is done, because I've skimmed Michael Woodford, but why isn't Woodford embarassed? Is it only because he can feel superior to the unreality of RBC and NC?

Krugman praises the Fed "monasteries" in a back-handed way, but I don't see why. Minneapolis, Atlanta, St. Louis -- their research departments look like hobbyshops run by right-wing crackpots to me, and they fund and burnish the reputation of academics all the time.

Income distribution and (social) insurance might have something to do with economic performance. One might suspect that full-employment and shared growth is incompatible with a sufficient degree of concentration of wealth and income, but this is a topic macro-economics never wants to touch. Krugman and DeLong pass for the Left in the Economics, and they won't touch it.

Krugman admitted he was shocked to discover that Presidents and policy mattered to income distribution. DeLong, when confronted with Piketty and Saez data said he couldn't "find" the mechanisms responsible, and, of course, was shocked and surprised by a trend of more than 20 years duration.

I don't think economists on the right are all that reluctant to express their normative views. On the contrary.

But, economists, left and center, are unaccountably reluctant to admit that the economy is a political struggle over income and wealth. With that kind of wilful ignorance in place, it shouldn't be surprising that, instead of a parable on on-going class warfare, understandable by the oppressed masses, Brad DeLong gives the world an impenetrable phrase, such as, "nominal income determination" and wonderment that, with banksters robbing us blind, that we are not more aware that we are all in this leaky macroeconomic lifeboat together.

I like Brad DeLong, but how the heck did a guy with the ideology of an Eisenhower Republican get to represent the Economics Left?

[Richard H. Serlin]

Below I'll print the comments I left on the Krugman post. But they are by no means exhaustive. For example, I agree that the field is much too enamored with the idea of the invisible hand, and it's largely controlled by such people -- they force others to tow the line because they control publication in the top journals which is almost all of what money, position, and other rewards are based on in academia. I also agree that assumptions like perfect rationality, no frictions, perfect information -- and expertise -- and self discipline, etc. are best discarded in some micro analysis too, not just macro; micro shouldn't ignore these things either.

I'd also add this theory: people who are win at all cost, and with a history of winning, are more likely to be libertarians, and more likely to be workaholics from childhood, so such people tend to be successful in economics, especially today with how publication has come to depend so much on mechanics rather than high level intelligence. Someone who has little high level intelligence can get tenure at Chicago just by working 100 hours a week from age 5 at things that are time consuming and mechanical but not that hard to understand. Thus, libertarians are in positions of control in academic economics much more than their representation in the general population.

Now, here are my original comments:

The Krugman post, "The Instability of Moderation" is very important, and excellent even by Krugman's standards. I consider it an instant classic. My comments:

1) "It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential."

There's really, at a fundamental root level, no inconsistency here. It is, in fact, consistent with the high level intelligent principle that you make the assumptions that are sensible for the given particular situation and purpose, not necessarily one size fits all, and then you interpret the implications to reality intelligently not necessarily literally, or near literally.

2) "the law of diminishing disciples"

Great phrase, and I think there's a lot of truth to this. The disciples that follow the originator are often far more mechanical, black and white, simple-minded, and inflexible. This is really true of Adam Smith, who would be stunned to see how he's mischaracterized today.

3) "Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters..."

You have something similar in Finance. I wonder if the internet can have a strong effect in decreasing the control of information dissemination, reward, and punishment these people have in academia.

4) "This is Minskyism: the long period of relative stability led to greater risk-taking, greater leverage, and, finally, a huge deleveraging shock."

There's also another kind of Minskyism that I think might be important: You have a crisis, like the Great Depression, so active monetary and fiscal policy gets used because things get so desperate and conservative economics so obviously and painfully doesn't work. Then, the use of active monetary and fiscal policy results in a great moderation for decades, and the depression or other crisis gets forgotten. So people now start to think active monetary and fiscal policy isn't needed – look how great the market works! Of course, it's worked so well because of the government intervention, but they deny that, and they ignore history, or ignore the inconvenient parts of history, or come up with bogus interpretations. So they gain credibility and power, and start dismantling regulation, and stopping fiscal and monetary stimulus, until we have another crisis bad enough to disprove their theories. Then, we again get active government policy resulting in a great moderation with outstanding equal widespread growth..., and the cycle continues.

On the positive side, I think after enough strong cycles most people will really start to learn and we'll discard extreme freshwater economics and conservative ideology, but it's taken a great deal of suffering and loss and sadly will take more to learn.

[Andy]

Ok, so how does "concentrated, unfettered wealth and power" come into being? Was it the market or government that saved Goldman Sachs, Citi, BOA etc.? Was it the market or big government that allowed them to become too big to fail? Why are they seeing record profits today while over 150 smaller banks have been liquidated this year alone? The lesson for small banks is clear - the best way to avoid market forces is to become big enough so that the government will protect you from market forces.

It's not surprising that the concentrated wealth frequently occurs in highly-regulated industries. Does that occur because of markets or because of regulatory capture? The old adage that big business, big government and big labor all enjoy and incestuous relationship is truer than ever.

The problem especially with Krugman, is the naive belief that titans like the big banks can be regulated.

[Bruce Wilder]

Andy: "so how does 'concentrated, unfettered wealth and power' come into being? Was it the market or government that saved Goldman Sachs . . .?

There's an economics parable for you, and it wouldn't be hard to find similar from John Cochrane or Robert Barro.

Krugman would say, in reply, "what's your model?", not "what's my narrative?" How's that working out?

[Peter T]

One major thing that strikes me about economics is that I cannot find (in my admittedly spotty reading) any account of the hierarchies that are a constant feature of human societies. The hierarchies that shape attitudes, rewards and outcomes. Even Smith glosses over this. Consider the passage quoted by Kennedy, that landlords

"are led by an invisible hand to make nearly the
same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among its inhabitants..."

"Nearly the same distribution of the necessaries of life"??? Did Smith really think that landlords had much the same access to necessaries as cottagers? Or was he reflecting a view that the chain of social hierarchy was inevitable, natural and constant?

You can make more sense of the current situation if you ask about relative social position, power and ability to secure rents than if you talk about debt or demand as if it does not matter whose debt and whose demand.

I'll add that if there is any serious economic work that addresses these issues I would be glad to know of it.

[reason]

Andy
"Why are they seeing record profits today while over 150 smaller banks have been liquidated this year alone? "

Yes, thats why. (Because the market share that was taken by the 150 smaller banks - and Merryl Lynch - is up for grabs.)

P.S. I don't really believe that concentration is a direct result of too big to fail. More failures, would have just meant even more concentration. Niches are occupied by small companies, but every downturn blows some of them away, and economies of scale win out in the end.

[El Snarko]

It is important to understand how voters and non-economists translate this stuff. Here are some of what I believe are the actual translations and a few potential problems.
Capitalism: Money talks. I have money so I get to have what I want.
Golden Rule: Them that has the gold makes the rules. Ok, well many have more gold but we all want the same stuff so those who have less gold should shut up.
Free Enterprise: I get to do what I want to make money. Since this is a sacred duty YOU pay the externalities.This is necessary because you have to purchase freedom from the lenders.
Invisible Hand: The best thing I an do for you is exactly what I want to do. Interfering with me is anti growth and you should be made anathma, cursed and probably water boarded.I think much of the war on terror is based on Muslim nations relatively small purchasing power and TSA/Homeland Sec stuff is really to ensure the airline industry.
"Following your bliss" and human potential my arse! Back to your cubical buckeroo or you will be replaced by your neighbors Aunt Betsie.
85% of jobs have been routinized and dumbed down. Your "presence" in your job is not needed just your function. Outside finance personality is not required, and usually not even there.

A final question: If there is rational self interest why is there a marketing and advertising industry ? I think perhaps marketing execs are the true real time economists.

[S Brennan]

"First, at a minimum economists had better learn to speak and write in parables so that the working classes can understand macroeconomic policy as readily as they understand gas station lines and and as well as they misunderstand payroll taxes, marginal tax rates, and estate taxes."

That's pretty condescending. FYI, I used to work as a carpenter before I got my degree in Aeronautical engineering, the lunchtime conversations of blue collar workers are at least as erudite and grounded in facts as those of most economists I have spoken to.

But on that subject, didn't Uncle Milton achieve this with his 12 part unparalleled/unchallenged series "Freedom to Loose"

[Andy]

reason,

My question was rhetorical. I agree concentration is not the result of "too big to fail" - rather it's the opposite - over-concentration is why we have too big to fail. My complaint is that the big banks never should have become as big as they did. Absent that, they should have been broken up as part of the bailout. Instead we've institutionalized too big to fail.

And of course I agree that size brings economies of scale. However, size also brings the ability to unduly influence government policy through regulatory capture and other means. The benefits of large firms must be balanced against their increased ability to use their size in order to obtain government protection and competitive advantage.