[Note for bibliographic reference: Melberg, Hans O. (1997), Economic sense and
nonsense - A review of Krugman's Peddling Prosperity, http://www.oocities.org/hmelberg/papers/970714.htm]
Economic sense and nonsense
A review of Krugman's Peddling Prosperity
by Hans O. Melberg
Introduction
Peddling Prosperity by Paul Krugman is a good book. It is entertaining -
opinionated and gossipy; important - because of its policy implications; thoughtful -
since he deals with many counter-arguments to his thesis; and clear. In short, most people
will learn something from reading this book. This, of course, does not mean that I agree
with everything Krugman writes, or that the book is without flaws. For instance, at times
I felt his explanations were not rigorous enough to be convincing, although this may be
inevitable in a book aimed at the general public as well as professional economists.
The book is divided into three parts and ten chapters. The first part deals with the
rise of conservative economics. In this section, Krugman shows how the intellectually
respectable - but in his opinion wrong - ideas of conservative economists were distorted
by political entrepreneurs before they entered politics as vulgar supply-side economics.
The second part deals with the record of conservatives in power. The main message of this
section is that the conservative policies failed to deliver the promised economic growth.
Finally, in the last section Krugman argues that the ideological pendulum has now turned
back to the left, but this too has produced vulgar policies, such as strategic trade
intervention. Within this structure - the rise of conservative economics, its empirical
record, and the intellectual response from the left - Krugman deals with a wide range of
topics. I shall focus on three: His argument that Keynes was basically right about the
nature of recessions (and that conservatives are mainly wrong); The explanation of how bad
economic ideas crowds out good ideas in a political environment; And, finally, Krugman's
discussion of various economic myths.
Recessions, Keynes and the anti-interventionists
Keynes' idea was that "a recession represents a failure of coordination in which the
efforts of the public to hold cash play a central role ...." Moreover Keynes thought
that "government policy, in particular an increase in the money supply, can usually
cure the problem." (p. 216). This, Krugman argues, is basically right. I will now try
to assess this argument more closely, as well as the conservative counter-arguments, and
the replies of the new Keynesians.
In what sense does recessions represent a failure of coordination? Imagine that people
become more pessimistic about the future. This leads to a desire to hold larger reserves
i.e. they try to reduce their consumption (especially of durables). This works as long as
I am the only one trying to do this, but if we all try to increase our reserves by
reducing our consumption, we will not succeed. As Krugman explains:
"I try to accumulate cash by reducing my purchases from you, and you try to
accumulate cash by reducing your purchases from me; the result is that both our incomes
fall along with spending, and neither of us succeeds in increasing our cash
holdings." So, "what works for an individual [increase his reserves by reducing
consumption] does not work for the economy as a whole, because the amount of cash in the
economy is fixed." (p. 27).
For a long time this was accepted as a true and important idea, but in the 1970s
several developments raised doubts about Keynes theory. First, Friedman argued that
recessions were caused by a fall in the quantity of money in circulation - not because the
private sector tried to increase its holdings of a fixed amount of money (p. 35). If this
story is true, then the role of the government is not to intervene to increase the economy
in a recession, rather it is a question of maintaining a stable money supply. Moreover,
Friedman argued that attempts to intervene to avoid recessions would in practice be
harmful since there were long and variable lags in the economy. Attempts to stimulate the
economy would not take effect until the economy itself had gone out of recession, in which
case it would only fuel inflation. Thus, Keynes theory of recession was wrong, and his
recommendation was harmful.
Krugman presents both theoretical and empirical arguments against Friedman.
Theoretically Friedman has a problem in terms of distinguishing between cause and effect
since his definition of money is very wide. The problem is this: To prove that the money
supply causes recessions, Friedman demonstrates that the statistical record shows that
recessions are associated with falls in the money supply i.e. there is a correlation
between recession and reduction in the money supply. However, this correlation is not a
very strong piece of evidence since there is a strong tendency for all large scale
measures of economic activity to be correlated. The real question is whether and how the
money supply and real GDP are causally related, not whether they are correlated.
Empirically monetarism also failed. For example, the Bank of England used M3 as a
target for monetary policy from 1979 to 1986, but this failed to stabilize the economy
(see p. 174). The Federal Reserve in the US also appeared to follow Friedman's advice from
1979, but gave it up in 1982. Finally, after the stock market crash of 1987 the Federal
Reserve did exactly the opposite of keeping the money supply stable. Instead, it followed
the Keynesian policy of loosening the money supply when the economy threatened to go into
a recession. The result was a success - there was no great depression following the crash
in the stock market. Hence, the empirical record shows that monetarist advice of keeping
the money supply stable by following a mechanical rule ("add 3% every year") did
not produce the desired result. In fact, a discretionary policy regime seemed better
suited to produce stability.
It is important to note that Krugman does not argue that we can use discretion to
choose a higher rate of inflation in exchange for lower unemployment. He accepts, an
applauds as a great achievement, Friedman's line of arguments against the Phillips curve
(see p. 45). For some time you might reduce unemployment by raising inflation (which
reduces the real wage and thus increases employment). However, you cannot fool everybody
all the time - and soon the workers would demand even higher wages to compensate for the
unexpected inflation. This, in turn, would lead to accelerating inflation. Thus, only one
level of unemployment - the natural rate or the non-accelerating inflation rate of
unemployment (NRU/NAIRU) - is compatible with stable inflation. Still, it is possible to
accept this, and also believe that government intervention is desirable. [1] As Krugman
writes:
"The point is that nothing in Friedman's natural rate argument suggests that the
private economy, left to its own devices, tends to keep unemployment more or less stable
near the natural rate. On average the economy should more or less achieve the
natural rate, but it may oscillate wildly around it; one may still advocate Keynesian
policies to try to stabilize the economy." (p. 46-47)
A second intellectual development working against Keynes, was the rational
expectation's revolution. Recall that Keynes's argued that the recession could be cured
with an expansion of the money supply. However, one could argue that the economy will do
this automatically during a recession. The reasoning would be as follows: During a
recession there is high unemployment and low demand for goods. This will lead to a
reduction in wages and prices, and this reduction increases the real money supply
(assuming a constant nominal amount of money). Ergo, the economy has its own stabilizing
devices - and the call for intervention is wrong.
Now, the big question, of course, is how fast this process is. If the process is slow,
government intervention might still be desirable to speed things up. It is at this point
Lucas' rational expectations model enters the picture. Essentially Lucas argued that the
recession could only last as long as people were confused about the true nature of the
economic situation. A fall in the demand for my products will lead me to decrease the
prices of my products to the extent that I believe that the fall represents a general
deflation as opposed to a temporary event specific to my firm. It is this hesitation which
makes prices sticky, but as soon as the confusion is sorted out, I will adjust my prices
and the economy will once again be in the NRU. Now, since the government does not know
more than rational people, there is no way the government can speed up this process
(which, in any case, appears to be short). [see Steven Sheffrin's Rational Expectations
for a good presentation and discussion of Lucas' model.]
One problem with this theory, is that it seems to be contradicted by historical
evidence: recessions simply last too long to be explained by confusion between general and
local prices (see p. 201). Surely, the public is not unaware of the fact that there is a
general recession for several years in a row! Thus, Lucas' model was not accepted as a
general model of recessions. Instead, what Krugman calls the "true believers"
turned to the theory of the real business cycle. On this theory slumps and booms in
economic activity reflect changes in productivity (following natural, political and
technological shocks) which are amplified through the choices of workers to work more or
less depending on their productivity. People take holidays when their productivity is low,
and work more when their productivity is high - just like a farmer would stay indoors when
the weather is bad, and work long hours when the weather is good (p. 203-204). However,
this theory has few supporters since it too seems to be contradicted by historical
experience. As Krugman writes: "... was the Great Depression really just an extended,
voluntary holiday?" (p.204)
Still, the Keynesians have to explain why prices and wages are slow to adjust after a
shock. Lately the New Keynesians have developed several theories to explain this.
Inflexible wages are explained by the theory of efficiency wages, norms of justice,
insider-outsider theories and hysterese. Inflexible prices can be explained by menu-costs,
imperfect competition and less than perfect rationality (Krugman makes quite a lot of the
argument that near-rationality produces very different results than perfect-rationality in
aggregate. See p. 206ff).
I am less than convinced by the power of some of these theories to explain long run
inflexibility. At least, menu costs do not appear to be strong enough to produce seriously
inflexible prices over time. Moreover, I do not think Krugman managed to explain exactly
how small errors (near-rationality instead of perfect rationality) may produce large
aggregate recessions. Still, although there are no widely accepted theory which explains
price inflexibility, we might simply point to actual experience to prove that prices are
only slowly flexible. To cite Krugman again: "If the evidence of the business cycle
were not enough, powerful evidence of the inflexibility of prices has come from another
source: the movement of exchange rates" (p. 217). If prices were perfectly flexible,
"a 10 percent depreciation of the dollar should lead to a mix of U.S. inflation and
German deflation just sufficient to leave the real exchange rate unchanged" (p. 217).
However, actual experience tells us that this is not the case. So, we may not have a
complete theory of why prices are inflexible, but experience tell us that they are!
It is time to close the argument on Keynes. Overall I found Krugman's presentation to
be convincing. I think there is little doubt that shocks can cause shortfalls in demand
which in turn cause recessions; that prices and wages are slow to adjust; and that central
intervention can improve the situation by increasing the money supply (open market
operations). [2] This, of course, does not mean that there are no supply constraints or
that increasing the money supply is the answer to all our problems. No serious economists
would argue that the economy can be made to grow forever simply by increasing the money
supply, or that painful adjustments do not have to be faced (e.g. a decrease in real wage
after an increase in the oil price). However, I do believe that some recessions are caused
by insufficient demand resulting from the attempt of many people to increase their
reserves, which in turn leads to unemployment, and that the process of re-adjusting to the
new situation can be made easier with an increase in the money supply.
Policy entrepreneurs: Supply siders and strategic traders
A second major theme in Krugman's book, is that "there are two different kinds of
'economists.' We can call them professors and policy entrepreneurs; politicians,
unfortunately, nearly always prefer the latter" (p. 6).
One difference between professors and policy entrepreneurs, is that entrepreneurs often
avoid close scrutiny of their ideas by publishing in the popular press, as opposed to
professors who present their theories to well qualified academic colleagues in established
journals (and, they are therefore less likely to get away with inconsistencies). Moreover,
entrepreneurs are often distinguished by professors in terms of background. Entrepreneurs
are often journalists, working in think-tanks, or some other non-university institution.
Entrepreneurs also prefer to present their ideas in metaphors (e.g. sunrise industries and
the US as a corporation). Lastly, entrepreneurs are much more willing to give clear policy
advice, having much greater faith in the reliability of their advice than the always
sceptical professor.
I am unsure about the utility of Krugman's distinction between entrepreneurs and
professors. Clearly, the labels should not be used to dismiss a person's argument -
labelling a person as a policy entrepreneur is no way to discredit his ideas - only
arguments beat arguments. Moreover, there is no clear-cut distinction. Economists come in
all kinds of shades - willingness to translate theories into policy advice and willingness
to present this advice as reliable and revolutionary - exist to various degrees in all
economists. Nevertheless, I agree with Krugman that there are mechanisms which leads good
economic research to be transformed into bad economic policies - bad ideas crowd out good
ideas.
One example of this process, was the growth of supply side economics. All economists
would agree that it is important to increase the capacity of the economy (potential
output). However, the defining feature of supply-side economists, was that they thought
that a reduction in taxes and regulation would create great economic growth - even to the
extent that a cut in taxes would lead to an increase in tax-revenue because of the
increased activity (the Laffer curve). This message, of course, sounded like music in the
ears of politicians: Here is a theory that tells us that we can reduce taxes (good),
increase growth (good) without increasing the deficit (good). Thus, although only a few
people really promoted this theory (Irving Kristol, Martin Anderson, Jude Wanninski,
Robert Bartley), it gained great prominence by virtue of its political appeal. The
consequence of these policies was large budget deficits and growing inequalities. Some
economists claim that the policies also increased growth, but as Krugman shows the
policies did not increase the rate of growth of the productive capacity of the economy (as
opposed to the rate of growth of the GDP). Altogether, it represented a bizarre episode in
which ideas which were distrusted by the great majority of economists - left and right -
became government policy since it provided the tempting promise of providing many benefits
and no costs.
A second example of an equally bizarre policy, is that of the strategic traders.
Respectable modern trade theory has suggested that in some cases industrial policy might
have beneficial effects (e.g. supporting Boeing against Airbus). However, politicians in
search for answers which do not exists, have seized on a distorted version of this idea.
The distortion builds on the image that the US is a giant corporation which competes
against the other countries. To compete effectively, the US government has to intervene to
protect the US from unfair competition (firms which charge lower prices than US firms for
their goods!). Most economists recognize this as nonsense. Free trade is almost always
economically beneficial; the idea that we somehow could loose if a foreign firm sells it
good 'too cheaply' is almost always wrong. We want goods to be cheap! Still, the policy of
the strategic traders has influenced policy because it gave the left ideas which they
could use to get elected (they appeared to have an answer to what appeared to be a
problem), as well as to justify interventionist policies. In this way, the ideas of the
few (Robert Reich, Lester Thurow, Bruce Scott, George Lodge, Robert Kuttner) became
government policy, despite the overwhelming consensus in the academic community against
these ideas. The need for an answer and a vision proved to be stronger than wisdom of the
many.
In sum, wishful thinking, the desire to get the best of all worlds and the need to have
answers inspired government policy, while good economics - economics which not always
translated neatly into policy advice but which nevertheless was explanatory - continued to
be done by the professors. (See also p. 177-178 for a good example of how wishful think
lead to the adoption of wrong policies.) This is unfortunate, not only for the reputation
of economics as a subject, but also because it leads to harmful policies.
Economic myths
There are a number of myths - beliefs that are wrong but hard to change - that exist. Some
of these myths are about economics. For instance, the already mentioned image of the US as
a giant corporation competing against the world is such a myth. Equally persistent, and
related, is the myth that free trade is not beneficial [3]. In addition to these myths,
Krugman deals effectively with the mistaken belief that de-industrialization is a fact and
a problem. First, it is not true that industrial production has decreased in absolute
terms - only that its share of GDP has decreased since the service sector has
grown. Second, even if the industrial sector has grown at a slower speed than the service
sector, this is no problem. As people become richer they want more services to a greater
degree than they want more industrial goods, thus the changes in the market reflect
people's desires. Hence, in the same way that nobody today seriously complains about
"de-agriculturalization", it is nonsense to complain about
"de-industrialization."
Another persisting myth, is that the US deficit is threatening to cripple its economy.
Today this myth is maybe not as popular as it was (remember Ross Perot), but it still
exists. Contrary to the myth, Krugman argues that the deficit is only a modest drag on the
US economy. The reason is simple. Money borrowed by the US government, could instead have
been used for private investment to increase productivity. However, compared to the size
of the US economy the amounts "missed" are relatively small. One might also
argue, but Krugman does not mention this, that the projects financed by the deficit also
increased productivity (e.g. spill-overs from military research). Of course, the debt is
also a problem in the sense that it has to be repaid, but as the US economy grows, this
burden is reduced. Overall, the problem of the debt exists, but it does not imply that the
US is heading towards an economic catastrophe.
Conclusion
In conclusion, I can only agree with Marc Levinson (Newsweek) who in his review of Peddling
Prosperity wrote that: "In ten lively chapters, Krugman traces how loose economic
thinking has repeatedly led to wrongheaded policies. In the process, he offers the bet
primer around on recent U.S. economic history" (backcover).
ENDNOTES
1 Curiously, Krugman does not argue that intervention might also reduce the NAIRU level of
unemployment. Recently this has been a widely discussed topic. See, for example, an
article in The Economics (Economic focus) which argues that the left has captured
the conservative NRU idea and used it to justify intervention (such as job-training for
the long-term unemployed).
2 There is an additional question: Exactly how does open-market operations increase (or
decrease) economic activity? By buying US bonds, the Fed gives private individuals more
money. However, does this necessarily increase economic activity? Only if people who buy
bonds will change their behaviour (invest the money, or consume more). The idea of
Richardian equivalence suggests that the expansion will not translate into increased
economic activity since expectations about future tax-increases will eliminate the effects
of increased spending. Once again, empirical experience discredits this argument. See also
S. Sheffrin's Rational Expectation for some theoretical arguments against
Richardian equivalence.
3 The persistence of some of these myths - like the belief that free trade reduces
American wealth by destroying American jobs - suggest that wrong beliefs may live on for a
long time despite theoretical proofs and empirical evidence that the beliefs are in fact
wrong. This is in itself an interesting topic: Why do people continue to hold mistaken
beliefs? At least in the example concerning free trade, I believe a mechanism opposite to
wishful thinking takes place. One might call this the "zero-sum" bias - the
belief that if something benefits me, then it does not benefit you. (One might also try to
examine why people tend to believe in this "zero-sum" system.) There are also
many other mechanisms which contribute to the continued existence of these myths. For
example, the negative effects of foreign competition are often concentrated (whole
communities are hit), while the benefits are widely distributed; Also, some politicians
may exploit the myth in order to get elected or to justify some policy, even if he knows
that the myth is false.
Note: Keynesian policies have also been dismissed as wishful thinking (see Krugman,
page 33: Roosevelt reportedly dismissed monetary expansion as a way to fight the
depression as "too easy.") One might argue that it is inconsistent to dismiss
supply side policies as wishful thinking while denying that Keynesian policies are
wishful-thinking. After all, both promise to give something at almost no cost. The
difference, however, is that supply-side policies were based on a false premise - that
cutting taxes would increase activity so much that it would increase revenue - while
Keynesian policies do work (Krugman would argue). Beliefs are not wishful just because
they promise to give you something at no, or low, costs - they must also be false. For
example, to believe that free trade is beneficial to both parties is not wishful thinking
since it is true.
[Note for bibliographic reference: Melberg, Hans O. (1997), Economic sense and
nonsense - A review of Krugman's Peddling Prosperity, http://www.oocities.org/hmelberg/papers/970714.htm]