Bob Murphy’s Response to Cochrane (who responded to Krugman)

September 15, 2009 at 13:07 | Posted in Bubbles, economics, Financial Crisis, Krugman, Robert Murphy | Leave a comment
 

Here’s why I like Bob Murphy, and why it pains me to see him go off the deep end so often when it comes to non-economic issues.

Monday, September 14, 2009

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Cochrane Threatens Austrians More Than Krugman Ever Did
By Robert P. Murphy

Although some Austrian economists (e.g. Mario Rizzo) expressed disappointment with Chicago University economist John Cochrane’s response to Paul Krugman’s infamous NYT Magazine piece, for the most part the people on "my side" have high-fived Cochrane for kicking sand in Krugman’s face.
This is a very short-sighted view. Just because someone gets in a fight with someone who we can’t stand–and I’ve criticized Krugman enough to have credibility on that score–doesn’t mean we should endorse any old arguments. There was quite a bit in Cochrane’s response that should alarm an Austrian economist, and in fact his views are arguably more dangerous to the Austrian alternative than Krugman. After all, all Krugman did was ignore us. But Cochrane ignored us and defended himself from Krugman in a way that "proves" Austrian economics is a collection of second-rate ideas. I don’t see how any Austrian economist can overlook all of that, just because he likes Cochrane’s conclusions that "Keynesian economics is awful" and "Paul Krugman is a jerk," true those conclusions may be. In this brief essay I’ll quote from Cohrane and show how his ostensible attack on Krugman actually takes down Austrian economics as collateral damage.

Most of all, [Krugman’s article is] sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a stalwart that maybe continents don’t move after all, or that smoking isn’t that bad for you really.

I don’t need to dwell on why Austrians should dismiss this opening salvo from Cochrane. This is the incredibly naive Whig theory of history. Cochrane could just as easily blow up any Austrian who thinks Human Action contains better economic analysis than the latest edition of Mankiw.
(What’s really ironic is that later in the essay, Cochrane says, "Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas." So I’m not sure what to make of his opening paragraph. It seems Cochrane finds it "sad" that today’s Keynesians would dare to use arguments that Cochrane had deployed against yesterday’s Keynesians. A bit like the US government saying other countries shouldn’t have nuclear weapons, because after all some evil regime might use them against civilians one day.)
After lamenting the sad day when someone would dare to criticize Nobel laureates (isn’t Krugman a Nobel laureate?), Cochrane then says:

And that’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and “spend like a drunken sailor” are pretty superficial compared to all the fascinating things economists are writing about it these days.

What is Cochrane talking about? Krugman has written boatloads on what could have prevented the current financial crisis. For example, Krugman has pointed to various types of (what he labels) "deregulation." And as for the "drunken sailor" wisecrack, Krugman has put up formal models showing his views on aggregate demand and so forth.
Don’t get me wrong–I think Krugman is completely wrong (bordering on "insane" if that word is to have any meaning in reference to academics) in his views. But Cochrane’s rude dismissal of Krugman is just as much a lie as anything Krugman said about Cochrane. So again, for those Austrians who can’t stand what a dishonest thug Krugman is, you can’t very well think Cochrane did a great job taking him down. Unless it’s OK to lie for free markets (or in Cochrane’s case, significantly-less-socialized markets).
But the next paragraph is what really made me lose it:

It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.

How in the world can the proponents of the EMH continue to justify their belief in the EMH…by appeal to the EMH?!! I occasionally stop the radio channel seek on Christian stations, and it’s hilarious during the short spots when they say things like, "A lot of people wonder how we can trust the Bible. But they need to read First Corinthians 5 where Paul writes…" (I am a Christian, by the way.)
There were plenty of economists (especially the Austrians–see e.g. Mark Thornton back in 2004) who "called" the housing boom. I don’t know what exactly the EMH theorists make of this. Yes, you could argue that at any given time, you will have no shortage of economists (all of whom are ignorant of the EMH and the limits of their knowledge) shouting out all kinds of predictions, and then simple statistics show that some of them will be "proven right."
But on the other hand, what more could opponents of the EMH do than to point to the recent housing bubble?! When Cochrane says the EMH is the "best tested proposition in the social sciences," it is only because it is a tautology. Really, think about it: Do we need to go test the proposition that "if someone is making a bunch of money doing an activity, then other people will copy him and whittle away his returns, unless there is some reason that they don’t"? (I’m exaggerating slightly, but when you read the actual empirical defenses of the EMH against its typical objections, you realize that it is a way of viewing the world. It is not a conclusion derived from the facts; it is a way of organizing the facts.)

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient….Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.

I am a bit out of my league here, but I still suspect that Cochrane is once again defining away his opponents. Again I ask: What would the world look like if the EMH were false? Wouldn’t there be giant bubbles, during which many participants knew (or were quite sure) there was a bubble in progress–and invested and profited accordingly? (Of course that happened; don’t let Cochrane fool you into thinking otherwise with his "best tested proposition in the social sciences" bluff.)
As far as the equity premium puzzle, proponents of Mandelbrot’s "non-Gaussian" approach to financial markets say that it is the standard neoclassical use of a Gaussian distribution (calibrated with historical stock returns, yes including the Great Depression) that makes investors appear far too risk averse than we think they really are. What is happening is that the actual stock market is far more volatile than the calibrated models suggest. The housing bubble that just burst–as well as the 1987 crash–should have been "once-in-a-thousand-year events," according to the standard models that Krugman is attacking. (Of course I am making up that number. But the basic point is right.) That’s one of the main themes in Nassim Taleb’s work, that the value-at-risk and other risk measures used by Wall Street quants gave a false sense of security. I’m not accusing Cochrane of being ignorant of this fact, but at best he is throwing out a non sequitur to evade the very real problem that Krugman pointed out.
Oh wait, it turns out Cochrane isn’t so sure about the usefulness of the EMH after all:

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles and opeds. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now. Crying “bubble” is no good unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row.

There you have it, folks. After telling us that Krugman is attacking the best tested proposition in the social sciences, Cochrane falls back on, "Yeah we don’t know anything, but neither do you. Until you can predict when a bubble will burst, stop complaining about my theory that predicts bubbles are impossible." (Again I am slightly exaggerating to make the point–but not much.)

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.

Nope. Again I’m a bit out of my league here, but I am pretty sure that Cochrane is completely full of it on this point. Ricardian equivalence says that if the government finances a tax cut by running a higher deficit, while holding total government spending constant, that this won’t change aggregate consumption, GDP, private sector investment, or interest rates. Rational taxpayers realize they will face higher tax bills in the future, and so they put aside the tax refund to roll over at interest and pay the bills. Thus, what the government gives back with the left hand, it borrows out of the private sector with the right. (Interest rates don’t change because the extra saving by the private sector cancels out the extra borrowing by the government.)
Now there are all sorts of caveats in my argument above; it matters if it’s a lump-sum tax cut versus a reduction in marginal tax rates, it matters if the current generation of workers will die before the higher taxes hit, etc. That’s the tweaking of assumptions that Cochrane is referring to.
However, as Brad DeLong and Krugman have pointed out many times (in justified exasperation) on their blogs, Ricardian equivalence does not say that an increase in government deficit spending will be perfectly offset by the private sector. Think about it: The government decides to borrow and spend $100 billion more. Now for Ricardian "equivalence" to kick in, it means that the private sector must reduce its current consumption by $100 billion and increase savings by that amount, at the same interest rate. [UPDATE: I am assuming that the extra $100 billion in government spending is classified as "consumption" and not "investment."] In other words, faced with a higher future tax bill, the present generation decides to deal with it by slashing current consumption by $100 billion, while maintaining all future levels of consumption at their pre-announcement levels. Well why the heck would they do that? It would make a lot more sense to assume that consumers originally try to cushion the blow by reducing consumption across all future time periods. Then interest rates have to rise in the present in order to force consumers to make present consumption (and private-sector investment) channel an extra $100 billion into the government’s coffers. So you can see, there is nothing "equivalent" going on here at all. Don’t misunderstand–Krugman and DeLong are totally wrong in my opinion for thinking it’s a good idea to boost "aggregate demand" (measured in nominal terms) by having the government borrow money and spend it. But Cochrane is totally wrong for invoking Ricardian equivalence to show that, to a first approximation, such a maneuver wouldn’t boost aggregate demand in the present. (This is what Krugman is complaining about in the 7th paragraph here.)
Uh oh, now the Austrian reader isn’t sure he can continue down this path with me. Suuuure, I didn’t actually endorse deficit spending, but I suspiciously agreed with Krugman and DeLong when they claimed to defang one of the most popular Chicago School critiques of it (namely, that private sector reactions perfectly offset it in a frictionless world). Well maybe I can win you back with this final quotation from Cochrane:

Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.”…
Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research — understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?
No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.

I rest my case. Paul Krugman is a jerk and offers horrible policy advice. But John Cochrane’s response is no friend-of-the-court brief in the Austrian critique of Keynesianism.
Robert P. Murphy holds a Ph.D. in economics from New York University. He is the author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery, 2009), and is the editor of the blog Free Advice.

How did Paul Krugman get it so Wrong?

September 12, 2009 at 12:34 | Posted in Economic Crisis, economics, Keynes, Krugman, stimulus | Leave a comment

 

John H. Cochrane[1]

Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, “How did Economists get it so wrong?”

Most of all, it’s sad. Imagine this weren’t economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents don’t move after all.

It gets worse. Krugman hints at dark conspiracies, claiming “dissenters are marginalized.” Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes “new Keyenesians” such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in people’s mouths that run contrary to their written opinions. Even this isn’t enough: he adds cartoons to try to make his “enemies” look silly, and puts them in false and embarrassing situations. He accuses us of adopting ideas for pay, selling out for “sabbaticals at the Hoover institution” and fat “Wall street paychecks.” It sounds a bit paranoid.

It’s annoying to the victims, but we’re big boys and girls. It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

That’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and advice to spend like a drunken sailor are pretty superficial compared to all the fascinating things economists are writing about it these days.

How sad.

That’s what I think, but I don’t expect you the reader to be convinced by my opinion or my reference to professional consensus. Maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I thought Keynesian economics was such a wrong turn. So let’s take a quick look at the ideas.

Krugman’s attack has two goals. First, he thinks financial markets are “inefficient,” fundamentally due to “irrational” investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge “fiscal stimulus” provided by multi-trillion dollar deficits.

Efficiency.

It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and efficient marketers just ignored it all these years. This is a canard that Paul knows better than to pass on, no matter how rhetorically convenient. (I can overlook his mixing up the CAPM and Black-Scholes model, but not this.) There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency. Efficient markets did not need to wait for “the memory of 1929 … gradually receding,” nor did we fail to read the newspapers in 1987. Data from the great depression has been included in practically all the tests. In fact, the great “equity premium puzzle” is that if efficient, stock markets don’t seem risky enough to deter more people from investing! Gene Fama’s PhD thesis was on “fat tails” in stock returns.

It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is lower in bad economic times. As Gene Fama pointed out in 1970, these are observationally equivalent explanations. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of “optimism” and “pessimism,” can vary, you know nothing. No theory is particularly good at that right now. Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row.

But this difficulty is no surprise. It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.

More deeply, the economist’s job is not to “explain” market fluctuations after the fact, to give a pleasant story on the evening news about why markets went up or down. Markets up? “A wave of positive sentiment.” Markets went down? “Irrational pessimism.” ( “The risk premium must have increased” is just as empty.) Our ancestors could do that. Really, is that an improvement on “Zeus had a fight with Apollo?” Good serious behavioral economists know this, and they are circumspect in their explanatory claims so far.

But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.

Krugman at bottom is arguing that the government should massively intervene in financial markets, and take charge of the allocation of capital. He can’t quite come out and say this, but he does say “Keynes considered it a very bad idea to let such markets…dictate important business decisions,” and “finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a `casino.’” Well, if markets can’t be trusted to allocate capital, we don’t have to connect too many dots to imagine who Paul has in mind.

To reach this conclusion, you need evidence, experience, or any realistic hope that the alternative will be better. Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? As David Wessel’s excellent In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.

In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.

Careful behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.” Even my most behavioral colleagues Richard Thaler and Cass Sunstein in their book “Nudge” go only so far as a light libertarian paternalism, suggesting good default options on our 401(k) accounts. (And even here they’re not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They don’t even think of jumping from irrational markets, which they believe in deeply, to Federal control of stock and house prices and allocation of capital.

Stimulus

Most of all, Krugman likes fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of “mistaking beauty for truth.” He’s not clear on what the “beauty” is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Paul’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more, and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed “beautiful” but to me they are also basic preconditions for “truth.”

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It’s a logical connection from a set of “if” to a set of “therefore.” Not even Paul can object to the connection.

Therefore, we have to examine the “ifs.” And those ifs are, as usual, obviously not true. For example, the theorem presumes lump-sum taxes, not proportional income taxes. Alas, when you take this into account we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can affect the overall level.

Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the “ifs” and figuring out the likely “therefores.” This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false. Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find “market failures” that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal multiplier. Most “New Keynesian” analyses that add frictions don’t produce big multipliers.

This is how real thinking about stimulus actually proceeds. Nobody ever “asserted that an increase in government spending cannot, under any circumstances, increase employment.” This is unsupportable by any serious review of professional writings, and Krugman knows it. (My own are perfectly clear on lots of possibilities for an answer that is not zero.) But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo, or silly cartoons.

In fact, I propose that Krugman himself doesn’t really believe the Keynesian logic for that stimulus. I doubt he would follow that logic to its inevitable conclusions. Stimulus must have some other attraction to him.

If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.

If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.

If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.

The crash.

Krugman’s article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.

Here’s all he has to say: “Irrationality” caused markets to go up and then down. “Spending” then declined, for unclear reasons, possibly “irrational” as well. The sum total of his policy recommendations is for the Federal Government to spend like a drunken sailor after the fact.

Paul, there was a financial crisis, a classic near-run on banks. The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on. They’ve thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, and how they give incentives for excessive risk taking.

If we want to think about events and policies, this seems like more than a minor detail. The hard and central policy debate over the last year was how to manage this financial crisis. Now it is how to set up the incentives of banks and other financial institutions so this mess doesn’t happen again. There’s lots of good and subtle economics here that New York Times readers might like to know about. What does Krugman have to say? Zero.

Krugman doesn’t even have anything to say about the Fed. Ben Bernanke did a lot more last year than set the funds rate to zero and then go off on vacation and wait for fiscal policy to do its magic. Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitized debt spreads, and intervened in those markets. There is no “the” interest rate anymore, the Fed is attempting to manage them all. Recently the Fed has started buying massive quantities of mortgage-backed securities and long-term treasury debt.

Monetary policy now has little to do with “money” vs. “bonds” with all the latter lumped together. Monetary policy has become wide-ranging financial policy. Does any of this work? What are the dangers? Can the Fed stay independent in this new role? These are the questions of our time. What does Krugman have to say? Nothing.

Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis. Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension. Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation. If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.

The future of economics.

How should economics change? Krugman argues for three incompatible changes.

First, he argues for a future of economics that “recognizes flaws and frictions,” and incorporates alternative assumptions about behavior, especially towards risk-taking. To which I say, “Hello, Paul, where have you been for the last 30 years?” Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott’s 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.

Second, Krugman argues that “a more or less Keynesian view is the only plausible game in town,” and “Keynesian economics remains the best framework we have for making sense of recessions and depressions.” One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Paul bemoans, the “new Keynesians” who did just what he asks, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. (Actually, though this is the consensus, my own work finds that new-Keynesian economics ended up with something much different and more radical than monetarism.) A science that moves forward almost never ends up back where it started. Einstein revises Newton, but does not send you back to Aristotle. At best you can play the fun game of hunting for inspirational quotes, but that doesn’t mean that you could have known the same thing by just reading Keynes once more.

Third, and most surprising, is Krugman’s Luddite attack on mathematics; “economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” Models are “gussied up with fancy equations.” I’m old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize, and the old guard tut-tutted “nice recreational mathematics, but not real-world at all.” How quickly time passes.

Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research — understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?

No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.

The insults.

The level of personal attack in this article, and fudging of the facts to achieve it, is simply amazing.

As one little example (ok, I’m a bit sensitive), take my quotation about carpenters in Nevada. I didn’t write this. It’s a quote, taken out of context, from a bloomberg.com article written by a reporter who I spent about 10 hours with patiently trying to explain some basics. (It’s the last time I’ll do that!) I was trying to explain how sectoral shifts contribute to unemployment. Krugman follows it by a lie — I never asserted that “it take mass unemployment across the whole nation to get carpenters to move out of Nevada.” You can’t even dredge up a quote for that monstrosity.

What’s the point? I don’t think Paul disagrees that sectoral shifts result in some unemployment, so the quote actually makes sense as economics. The only point is to make me, personally, seem heartless — a pure, personal, calumnious attack, having nothing to do with economics.

Bob Lucas has written extensively on Keynesian and monetarist economics, sensibly and even-handedly. Krugman chooses to quote a joke, made back in 1980 at a lunch talk to some business school alumni. Really, this is on the level of the picture of Barack Obama with Bill Ayres that Sean Hannity likes to show on Fox News.

It goes on. Krugman asserts that I and others “believe” “that an increase in government spending cannot, under any circumstances, increase employment,” or that we “argued that price fluctuations and shocks to demand actually had nothing to do with the business cycle.” These are just gross distortions, unsupported by any documentation, let alone professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated; and his job is supposed to be to explain that to lay readers. It would be no different than if someone were to look up Paul’s early work which assumed away transport costs and claim “Paul Krugman believes ocean shipping is free, how stupid” in the Wall Street Journal.

The idea that any of us do what we do because we’re paid off by fancy Wall Street salaries or cushy sabbaticals at Hoover is just ridiculous. (If Krugman knew anything about hedge funds he’d know that believing in efficient markets disqualifies you for employment. Nobody wants a guy who thinks you can’t make any money trading!) Given Krugman’s speaking fees, it’s a surprising first stone for him to cast.

Apparently, salacious prose, innuendo, calumny, and selective quotation from media aren’t enough: Krugman added cartoons to try to make opponents look silly. The Lucas-Blanchard-Bernanke conspiratorial cocktail party celebrating the end of recessions is a silly fiction. So is their despondent gloom on reading “recession” in the paper. Nobody at a conference looks like Dr. Pangloss with wild hair and a suit from the 1800s. (OK, Randy Wright has the hair, but not the suit.) Keynes did not reappear at the NBER to be booed as an “outsider.” Why are you allowed to make things up in pictures that wouldn’t pass even the Times’ weak fact-checking in words?

Well, perhaps we got off easy. This all was mild compared to Krugman’s vicious obituary of Milton Friedman in the New York Review of Books. But most of all, Paul isn’t doing his job. He’s supposed to read, explain, and criticize things economists write, and preferably real professional writing, not interviews, opeds and blog posts. At a minimum, this leads to the unavoidable conclusion that Krugman isn’t reading real economics anymore.

How did Krugman get it so wrong?

So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?

The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left. I still want to be Milton Friedman, but each is a worthy calling.

Alas, to Krugman, as to far too many ex-economists in partisan debates, economics is not a quest for understanding. It is a set of debating points to argue for policies that one has adopted for partisan political purposes. “Stimulus” is just marketing to sell Congressmen and voters on a package of government spending priorities that you want for political reasons. It’s not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.

Why argue for a nonsensical future for economics? Well, again, if you don’t regard economics as a science, a discipline that ought to result in quantitative matches to data, a discipline that requires crystal-clear logical connections between the “if” and the “then,” if the point of economics is merely to provide marketing and propaganda for politically-motivated policy, then his writing does make sense. It makes sense to appeal to some future economics – not yet worked out, even verbally – to disdain quantification and comparison to data, and to appeal to the authority of ancient books as interpreted you, their lone remaining apostle.

Most of all, this is the only reason I can come up with to understand why Krugman wants to write personal attacks on those who disagree with him. I like it when people disagree with me, and take time to read my work and criticize it. At worst I learn how to position it better. At best, I discover I was wrong and learn something. I send a polite thank you note.

Krugman wants people to swallow his arguments whole from his authority, without demanding logic, or evidence. Those who disagree with him, alas, are pretty smart and have pretty good arguments if you bother to read them. So, he tries to discredit them with personal attacks.

This is the political sphere, not the intellectual one. Don’t argue with them, swift-boat them. Find some embarrassing quote from an old interview. Well, good luck, Paul. Let’s just not pretend this has anything to do with economics, or actual truth about how the world works or could be made a better place.


[1] University of Chicago Booth School of Business. Many colleagues and friends helped, but I don’t want to name them for obvious reasons. Krugman fans: Please don’t bother emailing me to tell me what a jerk I am. I will update this occasionally, so please pass on the link http://faculty.chicagobooth.edu/john.cochrane/research/Papers/#news not the document.

Krugman is actually stupid

June 15, 2009 at 19:42 | Posted in economics, Krugman | 2 Comments

 

I don’t think Krugman is stupid because he disagrees with Austrian Economics – I think he’s stupid because he so obviously is, as revealed in this particular gem:

 

[w]hy doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment?

Yup – that’s what he asks. Not rhetorically, but in all seriousness. You don’t believe it? Check it out here.

Krugman really went to pot.

Krugman was sane once

May 6, 2009 at 18:21 | Posted in economics, Krugman | Leave a comment

 

Ok, I have made at least one nasty comment about Krugman on this site. For the sake of fairness, I would like to point out that Krugman was not always a raving madman. One may quibble and nibble on small details in the article below, but it is straight-forward, sound economic analysis.

So, back in 1994, Krugman was still sane. When did that change – and how did that happen?

Without further ado, I present to you – the sane Krugman:

The Myth of Asia’s Miracle

Paul Krugman*

A CAUTIONARY FABLE

ONCE UPON a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets or unlimited civil liberties. They asserted with increasing self confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economics, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to "get the country moving again"–a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The time, of course, was the early 1960s. The dynamic young president was John F. Kennedy. The technological feats that so alarmed the West were the launch of Sputnik and the early Soviet lead in space. And the rapidly growing Eastern economies were those of the Soviet Union and its satellite nations.

While the growth of communist economics was the subject of innumerable alarmist books and polemical articles in the 1950s, Some economists who looked seriously at the roots of that growth were putting together a picture that differed substantially from most popular assumptions. Communist growth rates were certainly impressive, but not magical. The rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. Once those inputs were taken into account, the growth in output was unsurprising–or, to put it differently, the big surprise about Soviet growth was that when closely examined it posed no mystery.

This economic analysis had two crucial implications. First, most of the speculation about the superiority of the communist system including the popular view that Western economics could painlessly accelerate their own growth by borrowing some aspects of that system–was off base. Rapid Soviet economic growth was based entirely on one attribute: the willingness to save, to sacrifice current consumption for the sake of future production. The communist example offered no hint of a free lunch.

Second, the economic analysis of communist countries’ growth implied some future limits to their industrial expansion–in other words, implied that a naive projection of their past growth rates into the future was likely to greatly overstate their real prospects. Economic growth that is based on expansion of inputs, rather than on growth in output per unit of input, is inevitably subject to diminishing returns. It was simply not possible for the Soviet economies to sustain the rates of growth of labor force participation, average education levels, and above all the physical capital stock that had prevailed in previous years. Communist growth would predictably slow down, perhaps drastically.

Can there really be any parallel between the growth of Warsaw Pact nations in the 1950s and the spectacular Asian growth that now preoccupies policy intellectuals? At some levels, of course, the parallel is far-fetched: Singapore in the 1990s does not look much like the Soviet Union in the 1950s, and Singapore’s Lee Kuan Yew bears little resemblance to the U.S.S.R.’s Nikita Khrushchev and less to Joseph Stalin. Yet the results of recent economic research into the sources of Pacific Rim growth give the few people who recall the great debate over Soviet growth a strong sense of déjà vu. Now, as then, the contrast between popular hype and realistic prospects, between conventional wisdom and hard numbers, remains so great that sensible economic analysis is not only widely ignored, but when it does get aired, it is usually dismissed as grossly implausible.

Popular enthusiasm about Asia’s boom deserves to have some cold water thrown on it. Rapid Asian growth is less of a model for the West than many writers claim, and the future prospects for that growth are more limited than almost anyone now imagines. Any such assault on almost universally held beliefs must, of course, overcome a barrier of incredulity. This article began with a disguised account of the Soviet growth debate of 30 years ago to try to gain a hearing for the proposition that we may be revisiting an old error. We have been here before. The problem with this literary device, however, is that so few people now remember how impressive and terrifying the Soviet empire’s economic performance once seemed. Before turning to Asian growth, then, it may be useful to review an important but largely forgotten piece of economic history.

‘WE WILL BURY YOU’

LIVING IN a world strewn with the wreckage of the Soviet empire, it is hard for most people to realize that there was a time when the Soviet economy, far from being a byword for the failure of socialism, was one of the wonders of the world–that when Khrushchev pounded his shoe on the U.N. podium and declared, "We will bury you," it was an economic rather than a military boast. It is therefore a shock to browse through, say, issues of Foreign Affairs from the mid 1950s through the early 1960s and discover that at least one article a year dealt with the implications of growing Soviet industrial might.

Illustrative of the tone of discussion was a 1957 article by Calvin B. Hoover. Like many Western economists, Hoover criticized official Soviet statistics, arguing that they exaggerated the true growth rate. Nonetheless, he concluded that Soviet claims of astonishing achievement were fully justified: their economy was achieving a rate of growth "twice as high as that attained by any important capitalistic country over any considerable number of years [and] three times as high as the average annual rate of increase in the United States." He concluded that it was probable that "a collectivist, authoritarian state" was inherently better at achieving economic growth than free-market democracies and projected that the Soviet economy might outstrip that of the United States by the early 1970s.

These views were not considered outlandish at the time. On the contrary, the general image of Soviet central planning was that it might be brutal, and might not do a very good job of providing consumer goods, but that it was very effective at promoting industrial growth. In 1960 Wassily Leontief described the Soviet economy as being "directed with determined ruthless skill"–and did so without supporting argument, confident he was expressing a view shared by his readers.

Yet many economists studying Soviet growth were gradually coming to a very different conclusion. Although they did not dispute the fact of past Soviet growth, they offered a new interpretation of the nature of that growth, one that implied a reconsideration of future Soviet prospects. To understand this reinterpretation, it is necessary to make a brief detour into economic theory to discuss a seemingly abstruse, but in fact intensely practical, concept: growth accounting.

ACCOUNTING FOR THE SOVIET SLOWDOWN

IT IS A TAUTOLOGY that economic expansion represents the sum of two sources of growth. On one side are increases in "inputs": growth in employment, in the education level of workers, and in the stock of physical capital (machines, buildings, roads, and so on). On the other side are increases in the output per unit of input; such increases may result from better management or better economic policy, but in the long run are primarily due to increases in knowledge.

The basic idea of growth accounting is to give life to this formula by calculating explicit measures of both. The accounting can then tell us how much of growth is due to each input–say, capital as opposed to labor–and how much is due to increased efficiency.

We all do a primitive form of growth accounting every time we talk about labor productivity; in so doing we are implicitly distinguishing between the part of overall national growth due to the growth in the supply of labor and the part due to an increase in the value of goods produced by the average worker. Increases in labor productivity, however, are not always caused by the increased efficiency of workers. Labor is only one of a number of inputs; workers may produce more, not because they are better managed or have more technological knowledge, but simply because they have better machinery. A man with a bulldozer can dig a ditch faster than one with only a shovel, but he is not more efficient; he just has more capital to work with. The aim of growth accounting is to produce an index that combines all measurable inputs and to measure the rate of growth of national income relative to that index–to estimate what is known as "total factor productivity."

So far this may seem like a purely academic exercise. As soon as one starts to think in terms of growth accounting, however, one arrives at a crucial insight about the process of economic growth: sustained growth in a nation’s per capita income can only occur if there is a rise in output per unit of input.

Mere increases in inputs, without an increase in the efficiency with which those inputs are used–investing in more machinery and infrastructure–must run into diminishing returns; input-driven growth is inevitably limited.

How, then, have today’s advanced nations been able to achieve sustained growth in per capita income over the past 150 years? The answer is that technological advances have lead to a continual increase in total factor productivity–a continual rise in national income for each unit of input. In a famous estimate, MIT Professor Robert Solow concluded that technological progress has accounted for 80 percent of the long-term rise in U.S. per capita income, with increased investment in capital explaining only the remaining 20 percent.

When economists began to study the growth of the Soviet economy, they did so using the tools of growth accounting. Of course, Soviet data posed some problems. Not only was it hard to piece together usable estimates of output and input (Raymond Powell, a Yale professor, wrote that the job "in may ways resembled an archaeological dig"), but there were philosophical difficulties as well. In a socialist economy one could hardly measure capital input using market returns, so researchers were forced to impute returns based on those in market economies at similar levels of development. Still, when efforts began, researchers were pretty sure about what they would find. Just as capitalist growth had been based on growth in both inputs and efficiency, with efficiency the main source of rising per capita income, they expected to find that rapid Soviet growth reflected both rapid input growth and rapid growth in efficiency.

But what they actually found was that Soviet growth was based on rapid growth inputs–end of story. The rate of efficiency growth was not only unspectacular, it was well below the rates achieved in Western economies. Indeed, by some estimates, it was virtually nonexistent.

The immense Soviet efforts to mobilize economic resources were hardly news. Stalinist planners had moved millions of workers from farms to cities, pushed millions of women into the labor force and millions of men into longer hours, pursued massive programs of education, and above all plowed an ever-growing proportion of the country’s industrial output back into the construction of new factories. Still, the big surprise was that once one had taken the effects of these more or less measurable inputs into account, there was nothing left to explain. The most shocking thing about Soviet growth was its comprehensibility.

This comprehensibility implied two crucial conclusions. First, claims about the superiority of planned over market economies turned out to be based on a misapprehension. If the Soviet economy had a special strength, it was its ability to mobilize resources, not its ability to use them efficiently. It was obvious to everyone that the Soviet Union in 1960 was much less efficient than the United States. The surprise was that it showed no signs of closing the gap.

Second, because input-driven growth is an inherently limited process, Soviet growth was virtually certain to slow down. Long before the slowing of Soviet growth became obvious, it was predicted on the basis of growth accounting. (Economists did not predict the implosion of the Soviet economy a generation later, but that is a whole different problem.)

It’s an interesting story and a useful cautionary tale about the dangers of naive extrapolation of past trends. But is it relevant to the modern world?

PAPER TIGERS

AT FIRST, it is hard to see anything in common between the Asian success stories of recent years and the Soviet Union of three decades ago. Indeed, it is safe to say that the typical business traveler to, say, Singapore, ensconced in one of that city’s gleaming hotels, never even thinks of any parallel to its roach-infested counterparts in Moscow. How can the slick exuberance of the Asian boom be compared with the Soviet Union’s grim drive to industrialize?

And yet there are surprising similarities. The newly industrializing countries of Asia, like the Soviet Union of the 1950s, have achieved rapid growth in large part through an astonishing mobilization of resources. Once one accounts for the role of rapidly growing inputs in these countries’ growth, one finds little left to explain, Asian growth, like that of the Soviet Union in its high-growth era, seems to be driven by extraordinary growth in inputs like labor and capital rather than by gains in efficiency.

Consider, in particular, the case of Singapore. Between 1966 and 1990, the Singaporean economy grew a remarkable 8.5 percent per annum, three times as fast as the United States; per capita income grew at a 6.6 percent rate, roughly doubling every decade. This achievement seems to be a kind of economic miracle. But the miracle turns out to have been based on perspiration rather than inspiration: Singapore grew through a mobilization of resources that would have done Stalin proud. The employed share of the population surged from 27 to 51 percent. The educational standards of that work force were dramatically upgraded: while in 1966 more than half the workers had no formal education at all, by 1990 two-thirds had completed secondary education. Above all, the country had made an awesome investment in physical capital: investment as a share of output rose from 11 to more than 40 percent.

Even without going through the formal exercise of growth accounting, these numbers should make it obvious that Singapore’s growth has been based largely on one-time changes in behavior that cannot be repeated. Over the past generation the percentage of people employed has almost doubled; it cannot double again. A half-educated work force has been replaced by one in which the bulk of workers has high school diplomas; it is unlikely that a generation from now most Singaporeans will have Ph.D’s. And an investment share of 40 percent is amazingly high by any standard; a share of 7O percent would be ridiculous. So one can immediately conclude that Singapore is unlikely to achieve future growth rates comparable to those of the past.

But it is only when one actually does the quantitative accounting that the astonishing result emerges: all of Singapore’s growth can be explained by increases in measured inputs. There is no sign at all of increased efficiency. In this sense, the growth of Lee Kuan Yew’s Singapore is an economic twin of the growth of Stalin’s Soviet Union growth achieved purely through mobilization of resources. Of course, Singapore today is far more prosperous than the U.S.S.R. ever was–even at its peak in the Brezhnev years–because Singapore is closer to, though still below, the efficiency of Western economies. The point, however, is that Singapore’s economy has always been relatively efficient; it just used to be starved of capital and educated workers.

Singapore’s case is admittedly, the most extreme. Other rapidly growing East Asian economics have not increased their labor force participation as much, made such dramatic improvements in educational levels, or raised investment rates quite as far. Nonetheless, the basic conclusion is the same: there is startlingly little evidence of improvements in efficiency. Kim and Lau conclude of the four Asian "tigers" that "the hypothesis that there has been no technical progress during the postwar period cannot be rejected for the four East Asian newly industrialized countries." Young, more poetically, notes that once one allows for their rapid growth of inputs, the productivity performance of the "Tigers" falls "from the heights of Olympus to the plains of Thessaly.

This conclusion runs so counter to conventional wisdom that it is extremely difficult for the economists who have reached it to get a hearing. As early as 1982 a Harvard graduate student, Yuan Tsao.) found little evidence of efficiency growth in her dissertation on Singapore, but her work was, as Young puts it, "ignored or dismissed as unbelievable." When Kim and Lau presented their work at a 1992 conference in Taipei, it received a more respectful hearing, but had little immediate impact But when Young tried to make the case for input-driven Asian growth at the 1993 meetings of the European Economic Association, he was met with a stone wall of disbelief.

In Young’s most recent paper there is an evident tone of exasperation with this insistence on clinging to the conventional wisdom in the teeth of the evidence. He titles the paper "The Tyranny of Numbers"–by which he means that you may not want to believe this, buster, but there’s just no way around the data. He begins with an ironic introduction, written in a deadpan, Sergeant Friday, "Just the facts, ma’am" style: "This is a fairly boring and tedious paper, and is intentionally so. This paper provides no new interpretations of the East Asian experience to interest the historian, derives no new theoretical implications of the forces behind the East Asian growth process to motivate the theorist, and draws no new policy implications from the subtleties of East Asian government intervention to excite the policy activist. Instead, this paper concentrates its energies on providing a careful analysis of the historical patterns of output growth, factor accumulation, and productivity growth in the newly industrializing countries of East Asia."

Of course, he is being disingenuous. His conclusion undermines most of the conventional wisdom about the future role of Asian nations in the world economy and, as a consequence, in international politics. But readers will have noticed that the statistical analysis that puts such a different interpretation on Asian growth focuses on the "tigers," the relatively small countries to whom the name "newly industrializing countries" was first applied. But what about the large countries? What about Japan and China?

THE GREAT JAPANESE GROWTH SLOWDOWN

MANY PEOPLE who are committed to the view that the destiny of the world economy lies with the Pacific Rim are likely to counter skepticism about East Asian growth prospects with the example of Japan. Here, after all, is a country that started out poor and has now become the second-largest industrial power. Why doubt that other Asian nations can do the same?

There are two answers to that question. First, while many authors have written of an "Asian system"–a common denominator that underlies all of the Asian success stories–the statistical evidence tells a different story. Japan’s growth in the 1950s and 1960s does not resemble Singapore’s growth in the 1970s and 1980s. Japan, unlike the East Asian "tigers," seems to have grown both through high rates of input growth and through high rates of efficiency growth. Today’s fast growth economics are nowhere near converging on U.S. efficiency levels, but Japan is staging an unmistakable technological catch-up.

Second, while Japan’s historical performance has indeed been remarkable, the era of miraculous Japanese growth now lies well in the past. Most years Japan still manages to grow faster than the other advanced nations, but that gap in growth rates is now far smaller than it used to be, and is shrinking.

The story of the great Japanese growth slowdown has been oddly absent from the vast polemical literature on Japan and its role in the world economy. Much of that literature seems stuck in a time warp, with authors writing as if Japan were still the miracle growth economy of the 1960s and early 1970s. Granted, the severe recession that has gripped Japan since 1991 will end soon if it has not done so already, and the Japanese economy will probably stage a vigorous short-term recovery. The point, however, is that even a full recovery will only reach a level that is far below what many sensible observers predicted 20 years ago.

It may be useful to compare Japan’s growth prospects as they appeared 2O years ago and as they appear now. In 1973 Japan was still a substantially smaller and poorer economy than the United States. Its per capita GDP was only 55 percent of America’s, while its overall GDP was only 27 percent as large. But the rapid growth of the Japanese economy clearly portended a dramatic change. Over the previous decade Japan’s real GDP had grown at a torrid 8.9 percent annually, with per capita output growing at a 7.7 percent rate. Although American growth had been high by its own historical standards, at 3.9 percent (2.7 percent per capita) it was not in the same league. Clearly, the Japanese were rapidly gaining on us.

In fact, a straightforward projection of these trends implied that a major reversal of positions lay not far in the future. At the growth rate of 1963-73, Japan would overtake the United States in real per capita income by 1985, and total Japanese output would exceed that of the United States by 1998! At the time, people took such trend projections very seriously indeed. One need only look at the titles of such influential books as Herman Kahn’s The Emerging Japanese Superstate or Ezra Vogel’s Japan as Number One to remember that Japan appeared, to many observers, to be well on its way to global economic dominance.

Well, it has not happened, at least not so far Japan has indeed continued to rise in the economic rankings, but at a far more modest pace than those projections suggested. In 1992 Japan’s per capita income was still only 83 percent of the United States’, and its overall output was only 42 percent of the American level. The reason was that growth from 1973 to 1992 was far slower than in the high-growth years: GDP grew only 3.7 percent annually, and GDP per capita grew only 3 percent per year. The United States also experienced a growth slowdown after 1973, but it was not nearly as drastic.

If one projects those post-1973 growth rates into the future, one still sees a relative Japanese rise, but a far less dramatic one. Following 1973-92 trends, Japan’s per capita income will outstrip that of the United States in 2002; its overall output does not exceed America’s until the year 2047. Even this probably overestimates Japanese prospects. Japanese economists generally believe that their country’s rate of growth of potential output, the rate that it will be able to sustain once it has taken up the slack left by the recession, is now no more than three percent. And that rate is achieved only through a very high rate of investment, nearly twice as high a share of GDP as in the United States. When one takes into account the growing evidence for at least a modest acceleration of U.S. productivity growth in the last few years, one ends up with the probable conclusion that Japanese efficiency is gaining on that of the United States at a snail’s pace, if at all, and there is the distinct possibility that per capita income in Japan may never overtake that in America. In other words, Japan is not quite as overwhelming an example of economic prowess as is sometimes thought, and in any case Japan’s experience has much less in common with that of other Asian nations than is generally imagined.

THE CHINA SYNDROME

FOR THE skeptic, the case of China poses much greater difficulties about Asian destiny than that of Japan. Although China is still a very poor country, its population is so huge that it will become a major economic power if it achieves even a fraction of Western productivity levels. And China, unlike Japan, has in recent years posted truly impressive rates of economic growth. What about its future prospects?

Accounting for China’s boom is difficult for both practical and philosophical reasons. The practical problem is that while we know that China is growing very rapidly, the quality of the numbers is extremely poor. It was recently revealed that official Chinese statistics on foreign investment have been overstated by as much as a factor of six. The reason was that the government offers tax and regulatory incentives to foreign investors, providing an incentive for domestic entrepreneurs to invent fictitious foreign partners or to work through foreign fronts. This episode hardly inspires confidence in any other statistic that emanates from that dynamic but awesomely corrupt society.

The philosophical problem is that it is unclear what year to use as a baseline. If one measures Chinese growth from the point at which it made a decisive turn toward the market, say 1978, there is little question that there has been dramatic improvement in efficiency as well as rapid growth in inputs. But it is hardly surprising that a major recovery in economic efficiency occurred as the country emerged from the chaos of Mao Zedong’s later years. If one instead measures growth from before the Cultural Revolution, say 1964, the picture looks more like the East Asian "tigers": only modest growth in efficiency, with most growth driven by inputs. This calculation, however, also seems unfair: one is weighing down the buoyant performance of Chinese capitalism with the leaden performance of Chinese socialism. Perhaps we should simply split the difference: guess that some, but not all, of the efficiency gains since the turn toward the market represent a one-time recovery, while the rest represent a sustainable trend.

Even a modest slowing in China’s growth will change the geopolitical outlook substantially. The World Bank estimates that the Chinese economy is currently about 40 percent as large as that of the United States. Suppose that the U.S. economy continues to grow at 2.5 percent each year. If China can continue to grow at 10 percent annually, by the year 2010 its economy will be a third larger than ours. But if Chinese growth is only a more realistic 7 percent, Its GDP Will be only 82 percent of that of the United States. There will still be a substantial shift of the world’s economic center of gravity, but it will be far less drastic than many people now imagine.

THE MYSTERY THAT WASN’T

THE EXTRAORDINARY record of economic growth in the newly industrializing countries of East Asia has powerfully influenced the conventional wisdom about both economic policy and geopolitics. Many, perhaps most, writers on the global economy now take it for granted that the success of these economies demonstrates three propositions. First, there is a major diffusion of world technology in progress, and Western nations are losing their traditional advantage. Second, the world’s economic center of gravity will inevitably shift to the Asian nations of the western Pacific. Third, in what’s perhaps a minority view, Asian successes demonstrate the superiority of economies with fewer civil liberties and more planning than we in the West have been willing to accept.

All three conclusions are called into question by the simple observation that the remarkable record of East Asian growth has been matched by input growth so rapid that Asian economic growth, incredibly, ceases to be a mystery.

Consider first the assertion that the advanced countries are losing their technological advantage. A heavy majority of recent tracts on the world economy have taken it as self-evident that technology now increasingly flows across borders, and that newly industrializing nations are increasingly able to match the productivity of more established economics. Many writers warn that this diffusion of technology will place huge strains on Western society as capital flows to the Third World and imports from those nations undermine the West’s industrial base.

There are severe conceptual problems with this scenario even if its initial premise is right. But in any case, while technology may have diffused within particular industries, the available evidence provides absolutely no justification for the view that overall world technological gaps are vanishing. On the contrary, Kim and Lau find "no apparent convergence between the technologies" of the newly industrialized nations and the established industrial powers; Young finds that the rates in the growth of efficiency in the East Asian "tigers" are no higher than those in many advanced nations.

The absence of any dramatic convergence in technology helps explain what would otherwise be a puzzle: in spite of a great deal of rhetoric about North-South capital movement, actual capital flows to developing countries in the 1990s have so far been very small–and they have primarily gone to Latin America, not East Asia. Indeed, several of the East Asian "tigers" have recently become significant exporters of capital. This behavior would be extremely odd if these economies, which still pay wages well below advanced-country levels, were rapidly achieving advanced-country productivity. It is, however, perfectly reasonable if growth in East Asia has been primarily input driven, and if the capital piling up there is beginning to yield diminishing returns.

If growth in East Asia is indeed running into diminishing returns, however, the conventional wisdom about an Asian-centered world economy needs some rethinking. It would be a mistake to overstate this case: barring a catastrophic political upheaval, it is likely that growth in East Asia will continue to outpace growth in the West for the next decade and beyond. But it will not do so at the pace of recent years. From the perspective of the year 2010, current projections of Asian supremacy extrapolated from recent trends may well look almost as silly as 1960s-vintage forecasts of Soviet industrial supremacy did from the perspective of the Brezhnev years.

Finally, the realities of East Asian growth suggest that we may have to unlearn some popular lessons. It has become common to assert that East Asian economic success demonstrates the fallacy of our traditional laissez-faire approach to economic policy and that the growth of these economics shows the effectiveness of sophisticated industrial policies and selective protectionism. Authors such as James Fallows have asserted that the nations of that region have evolved a common "Asian system," whose lessons we ignore at our peril. The extremely diverse institutions and policies of the various newly industrialized Asian countries, let alone Japan, cannot really be called a common system. But in any case, if Asian success reflects the benefits of strategic trade and industrial policies, those benefits should surely be manifested in an unusual and impressive rate of growth in the efficiency of the economy. And there is no sign of such exceptional efficiency growth.

The newly industrializing countries of the Pacific Rim have received a reward for their extraordinary mobilization of resources that is no more than what the most boringly conventional economic theory would lead us to expect. If there is a secret to Asian growth, it is simply deferred gratification, the willingness to sacrifice current satisfaction for future gain.

That’s a hard answer to accept, especially for those American policy intellectuals who recoil from the dreary task of reducing deficits and raising the national savings rate. But economics is not a dismal science because the economists like it that way; it is because in the end we must submit to the tyranny not just of the numbers, but of the logic they express.

Krugman can’t think straight.

May 6, 2009 at 14:43 | Posted in deflation, economics, Keynes, Krugman | Leave a comment

 

According to this NWY article, Paul Krugman – Nobel Prize laureate in economics – is worried about falling wages. Never mind the ‘sticky wages’ theorem the Keynesians have been bantering around for decades, here’s what the world looks like today – according to Krugman:

Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

Never mind that at last a Keynesian admits that wages are not sticky – and hence falling prices do NOT result in lay-offs due to relatively increased labour cost, and hence deflation does NOT create unemployment. Never mind that the term ‘competitive advantage’ makes no sense in this context. Never mind that we have an institution called ‘bankruptcy’ that allows people to rid themselves of debt once and for all and allows for the reassessment of values. Never mind that since Keynes wrote his silly tract, none of his ideas have stood up to either logic of evidence.

Krugman – you are an incompetent fool.

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