Let me start with an anecdote: a friend of mine, whose opinions I respect, confessed to me two weeks ago that he went to his bank and withdrew a couple of months worth of living expenses, because he was very concerned about potential restrictions on accessing his money; I have to admit he nearly scared me into doing so myself. Money under a mattress: that was the moment that crystallized the financial crisis in personal terms for me.
Paul Krugman, Professor of Economics at Princeton University and famous NY Times columnist, has been awarded the Nobel Memorial Prize in Economics this year. I have followed Professor Krugman’s writings for well over a decade now. I should note that though I understand the math that underpins their models, I only have a passing familiarity with his professional work on strategic trade theory and economic geography – the work for which he won his Nobel Prize – but I do have good familiarity with his economic policy advice, which he has doled out quite liberally (no pun intended!) over the years. Rare for an academician, Krugman has had a strong public voice in economic and political discourse for several years. I will leave out his politics, because I don’t have a dog in that fight.
I do have a dog in another fight, which is unrelated to the politics of the moment, but one that very much concerns the financial and economic events that dominate so much attention today. Let’s start with with The Hangover Theory which Krugman wrote in 1998, criticizing the Austrian School theory of the business cycle in the context of the East Asian economic crisis brewing at that time. In contrast to the Austrian theory, where recessions are the inevitable byproduct of poorly conceived malinvestment during booms, Krugman offers this “extremely simple” explanation, distilling the Keynesian view (emphasis mine):
As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it’s not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?
Let’s first agree that the demand for money does go up in a downturn, as my friend’s story illustrates. Krugman’s “for whatever reason” sweeps under the rug the real question: why does the demand for money suddenly go up? Keynesians don’t care about that question, because they are so confident (even cocky, as you can tell from Krugman’s tone) they can deal with whatever comes after the demand for money goes up; as Professor Krugman so elegantly summarized his advice to the Japanese facing their post bubble blues in the 90’s:
So never mind those long lists of reasons for Japan’s slump. The answer to the country’s immediate problems is simple: PRINT LOTS OF MONEY.
This is not merely an academic argument, as anyone who turned on the news in the last few weeks can attest. Federal Reserve policy makers, both Greenspan and Bernanke, have long held the belief, which in Bernanke’s case, he recently admitted to rethinking – barns and horses come to mind – that it is easier to deal with the bubble’s aftermath than to prevent one in the first place. While Greenspan, Bernanke and Krugman occupy very different points on the ideological spectrum (right, center, left), to paraphrase Nixon, they are are all Keynesians.
Now let’s come to the second part of Krugman hang over theory quote: let’s just “junk the bad investments and write off the bad loans”. To put it bluntly, that sort of language can come so easily only to someone who has never had to lay off a real human being. As a businessman, I have faced bad investments and failing projects. During 2001-3, we faced the stark reality that our resources were invested in serving the optical communications industry, much of which turned out be a creation of venture capital, not sustained by real end demand for their products. As a supplier, even though we were very prudent with our own finances, we still got hit hard by that downturn. Krugman asks “Why should perfectly good productive capacity be left idle?” – the whole point is that credit booms create misdirected, and therefore ultimately unproductive, capacity; by 2003, our painstakingly acquired expertise in optical communications was mostly useless, and we had to reinvent ourselves.
Even at our scale, it is an extremely painful process to shut down failing projects and free up resources for other activities. That process takes a huge toll collectively, as many mistakes are made, fingers get pointed and human relationships get destroyed, and its impact on economic productivity is the least of the problems. If bad investments were made on a large enough scale in the economy, the most likely cause of which is free-flowing credit, the adjustment process takes time, resulting in a recession. Yet that process merits a breezy “just junk the bad investments” and need not result in any unemployment, in Krugman’s world. For Krugman, printing money is the magic wand that cures all recessions. It is important to keep this in mind, because Fed Chairman Bernanke, formerly Krugman’s colleague at Princeton, shares the same belief in the magic wand, and pretty much made his intellectual reputation on how inadequate money printing caused the Great Depression.
Coming to the present financial crisis. In the fall of 2004, Krugman was among the prominent economists urging Alan Greenspan to keep the interest rates at their low of 1%, just as Greenspan had started his baby-step tightening. Greenspan’s tightening was already too little and too late to restrain the housing bubble, but Krugman, of course, paid no attention to any of it, because he was fixated on fighting the ill-effects arising from the bursting of the Nasdaq bubble in 2000. To this day, Krugman has never acknowledged any connection between the low interest rate policy he was cheerleading in 2002-2004 and the present crisis. That fits his Keynesian economist worldview (as opposed to his political worldview) well, because, after all, enquiring into the origins of a crisis is irrelevant to the question of how we get out of it – we have an all powerful policy hammer, so everything must be a nail. His political worldview, of course, blames the original sin of financial deregulation conveniently placed on the other party, but that non-hunting dog is not my dog. A slightly inconvenient question: so what happened in the UK, where Prime Minister Gordon Brown, who Krugman so admires, was responsible for economic policy for well over a decade?
To give credit where it is due, economists and financial commentators with an Austrian School perspective and those with a Minskian perspective saw this one coming a long time ago. There are numerous people who fall in that category, but I will mention a few names, ranging from academic economists to professional investors to commentators: Nouriel Roubini, Marc Faber, Stephen Roach, Doug Noland and Mike Shedlock, among many others, have been predicting the trajectory of the present financial and economic crisis for a while.
Krugman goes on to explain how the Austrian business cycle theory, the work of Ludwig von Mises and Friedrich Hayek, among others, is intellectually incoherent:
The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present.
Normal people may find the “nobody has managed to explain” part a bit puzzling; after all, that is what people like Mises and Hayek thought they were doing. In Krugman’s world, “explain” means constructing a toy mathematical model, with a lot of “silly” assumptions (as he puts it himself), showing that the result derived from the analysis of such a toy model has some stylized resemblance to some aspect of the real world. So while a businessman might find the explanation “The market for that widget vanished” adequate, academic economists would model his behavior with (and I am making this one up, but only slightly!) an exponential function that is convex in its argument, because, you know, it promotes much clearer thinking when you have convex entrepreneurial response functions. It is useful to remember that Krugman has never managed to predict anything of economic consequence based on his toy models, only explain (in his terms) some already observed phenomenon. As he noted:
The truth is that nobody really imagined that something like the Asian financial crisis was possible, and even after the fact there is no consensus about why and how it happened.
What happens if a model doesn’t agree with the data in a new situation? Find another toy model, with another set of silly assumptions, of course. That suggests a suitably Keynesian recipe for getting out of the present crisis: a full employment policy for academic economists – let’s hire an army of economics professors and graduate students with their models to analyze all aspect of the present crisis.
On the subject of intellectual incoherence, here is Krugman writing in the NY Times in August 2007, just as what was then known as the sub-prime crisis was beginning to unfold. Notice how he is careful to hedge his bets at that late date (where have all the one handed economists gone?) , and contrast that to his carefully cultivated reputation as a prescient seer on all things economic.
This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.
The Fed normally responds to economic problems by cutting interest rates — and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100%. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.
But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.
There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work.
So what happened to that confident assertion he made in 1998 that whatever the reason for a change in money preference, printing money ought to cure it? And wasn’t the Fed already doing just that in 2001-2004 to recover from the tech bust and before that in 1998-99 to stave of the LTCM crisis? Could any of those episodes have to do with the subsequent bubbles they created or in other words, they were the longer range consequences of the very polices that Krugman espoused? It is intellectually incoherent to suggest any connection, of course, since in the long run we were all supposed to be dead anyway.
Let me finish with another quote from Krugman, from the same hangover theory article referenced above, on why some of us cling to the Austrian School:
And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors.
I think the good Professor may have gotten something right, finally. It is just as well that the Nobel committee only look at published scholarly work. After all, if they had bothered to look at Krugman’s long record of economic policy commentary in the run up to the most serious financial crisis of our time, they may have found, well, a distinguished record of intellectual coherence, not to mention tremendous economic foresight.
I want to end this already too long post with this quote from Keynes, which Keynesians in particular may want to keep in mind, as they contemplate ever more “unorthodox” monetary approaches:
There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
(Update: See the discussion on this at Hacker News)