If you’re surprised, that means that you were part of the problem

Back in July, in the midst of the debt-ceiling debate, Paul Krugman argued that those that were surprised by the GOP tactic of blackmailing the administration, threatening a default in exchange for cuts on social spending and the maintenance of the tax cuts for the rich were part of the problem. Normal was already not part of the GOP. I agree.

Now Krugman tells us that in this crisis a "lot of the blame goes to the economists, by the way, who abandoned what they used to know." But the thing is that the mainstream of the profession has been dominated by the academic equivalent of the Tea Party for a very long time. My point is that if you didn't know that economists forgot certain things about recessions, and never learned a few other things, you have not been paying attention and/or you must be part of the problem too.

Krugman knows this well, since he argued that:

“By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote. So you could do exchange rate models that actually had realistic assumptions about prices and employment, but put the focus on rational expectations in the currency market, so that people really didn’t notice. Or you could model optimal investment choices, with the underlying framework fairly Keynesian, but hidden in the background. And so on.”

That is, in order to publish (in 'respectable' journals) you had to wrap your reasonable assumptions in crazy models. So it should have been clear back then that rational expectations, real business cycles, supply siders, and their political counterparts in the Reagan administration were more dangerous that Old Keynesians and New Old Keynesians (or Old New Keynesians for that matter) were willing to admit.

The problem is not just that New Keynesians of all sorts and political affiliations (Ben Bernanke, Brad DeLong, Paul Krugman, Greg Mankiw, Christina Romer or Larry Summers) can be seen as equivalents to the old Neoclassical Synthesis, the modern equivalents of John Hicks and Alvin Hansen, trying to incorporate the Keynesian insights that lack of effective demand was behind the Great Depression (now our Great Recession), and that fiscal stimulus is necessary, while maintaining the contradictory argument that the price and quantity of all "factors of production", including labor, can be determined by the equilibrium in the labor market. [If this is true lower real wages should equilibrate the labor market and involuntary unemployment should vanish].

From a policy point of view this is certainly important, but it misses the more essential question that Keynes theory was not (at least was not intended to be) about imperfections, and arguably the inability of the Neoclassical Synthesis of overcoming that original contradiction is part of the reason of the rise of New Classical economics, and the acceptance by New Keynesians of the Friedmanian notion of a natural rate.  Can you blame the profession that believes in the self-adjusting nature of the system towards the natural rate (included in all New Keynesian models) that fiscal stimulus is only needed in the short run and that the economy is on its path to recovery?

Hansen (1938, p. 34), in the book depicted above, said that the profession was: "living in a time when economics stands in danger of a sterile orthodoxy." [The time, by the way, was the 1937-38 recession]. We are in that position again, and people like DeLong and Krugman, as I said before, the best within the mainstream, would miss the opportunity of providing a more solid foundation for economic theory if they do not recognize the importance of the heterodox contributions of the more radical disciples of Keynes and Kalecki. We do not need another Neoclassical Synthesis, and we should try not to miss this new opportunity to complete the Keynesian Revolution.

Further, although we have our Hansens, so to speak, we do not have our Lauchlin Currie or our Marriner Eccles.  That is, the real heterodox Keynesians within the administration. Currie, by the way, wrote an unpublished review of the General Theory, for the eyes of the Board only, that is far better than most responses in academia, which did not rely in either interest rate (liquidity trap) or real wage rigidity. In fact, Currie argues correctly that (following chapter 19 of the General Theory) falling wages would make things worse. If respectable economists in the mainstream, like Krugman and DeLong, miss this opportunity this period will be remembered as 'the years of low theory.'

PS: For a discussion of Eccles and Currie see here. The classic book on Currie is by Roger Sandilands here.

Public debt is too small

That's what Alex Izurieta says in his last paper (available here). He provides several important points to justify this view. First, once one excludes the debt owned by intra-government institutions the net debt-to-GDP ratio is around 60%. Not particularly large. Second, since 2009 government spending has faded away in its contribution to growth is turning negative, which means that in the absence of other sources of demand, the government is the only thing between us and a protracted recession. More importantly, since agents are in a "liquidation phase", that is still dealing with the consequences of falling assets prices on their balance sheets, then:

"to recover from a financial crisis, the ideal instrument is government support in the form of public debt, i e, government liabilities that are transferred to the balance sheets of private sector agents as their assets."

Not very likely to happen, but the reasons are not economic, and the solution is within the reach of reasonable, well-informed policy makers.

Bernanke at Jackson Hole

Finally got around reading Bernanke's speech.  A bit underwhelmed to tell you the truth. Krugman seems to be happy with the fact that Bernanke acknowledged that the recovery is weak, at best. In terms of policy what he said is the following:

"In light of its current outlook, the Committee recently decided to provide more specific forward guidance about its expectations for the future path of the federal funds rate. In particular, in the statement following our meeting earlier this month, we indicated that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

In other words, short-term rates will remain low.  On long-term rates (i.e. quantitative easing) he said nothing.  Worse, his comments on fiscal policy were terrible.  He said:

"To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage."

Can you imagine if in 1937-38 (the Roosevelt recession) the concern would have been with not allowing the debt-to-GDP ratio to grow.  Why? Does Bernanke know anything about a magical number above which the debt-to-GDP ratio has a negative impact on the economy?  Has he accepted the Rogoff-Reinhart view that beyond 90% we are doomed? The size of debt in domestic currency with respect to GDP is irrelevant, and shouldn't be a concern.



At any rate, it seems that between congressional Republicans and Obama fiscal stimulus is off the table (in fact, expect fiscal contraction), and monetary policy is wait and see with no radical measures.  So the economy will continue to stagnate.  As Christina Romer said we're "pretty darned f_cked!"



PS: I'll say more on Rogoff-Reinhart in another post.

Global Monetarism Strikes Back



Olivier Blanchard, the chief economist at the International Monetary Fund (IMF) announced in a triumphalist tone that “earlier fears of a double-dip recession—which we did not share—have not materialized” and defended the need for “fiscal consolidation that is neither too fast, which could kill growth, nor too slow, which would kill credibility.” For Blanchard fiscal expansion has done its job, since “private demand has, for the most part, taken the baton.” The risks are associated to the higher prices of commodities and inflation. The Bank of International Settlements (BIS) has added to the IMF’s view that inflation is the main risk on an otherwise recovering world economy. In their recent Annual Report they argue that: “spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally.” That is, add monetary contraction to the policy mix.

Read the rest of the entry here.