Back to Keynes

Paul Krugman is at it again. His column asks a good question: How Did Economists Get It So Wrong? Alas, rather than run to one of the economists who actually got it right, Krugman finds another way to offer a paean to Lord Keynes. It's getting so mind-numbingly predictable that Jeffrey Tucker of Mises economics blog has simply thrown up his hands at Krugman's latest drivel.

I have neither the time nor the inclination to produce a complete take down here, but I want to highlight a couple of problems with this piece. Essentially, Krugman divides economists into two camps: freshwater and saltwater. The former are variously described as monetarists, adherents of Milton Friedman's Chicago school, and "neoclassical purists"; they believe that the market should be trusted, but that a central bank should be used to inject liquidity into a lagging economy by lowering the interest rate. The latter are New Keynesian, and believe that in addition to manipulating the interest rate, Government should also augment unemployment by increased spending. Obviously Krugman is a member of the later camp.

The thrust of his argument is leveled at those who believe that markets are infallibly rational: "But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient." This is apparently the explanation for the economic crisis.

His dichotomy allows him to insist that the freshwater economists are the champions of the free market. Moreover, freshwater theories failed to predict the current problem and are powerless to reverse the current recession. This is because one cannot raise interest rates below zero, and, as Krugman avers, "But zero, it turned out, isn’t low enough to end this recession."--which is true from a monetarist perspective. The implication seems to be that, unregulated capitalism having failed, we can now turn to government stimulus to end the current recession.

However, he fails to note that there is another school of economic thought, namely the Austrian, which rejects both freshwater and saltwater assumptions, and whose theories predicted the current crisis. The difference between libertarian philosophy and Krugman's Big Government are sufficiently obvious, but there is a considerable chasm between Friedman and the Austrians as well, which Murray Rothbard explains here:

[W]e must recognize that this "purely monetarist" approach is almost the exact reverse of the sound – as well as truly free-market – Austrian view. For while the Austrians hold that [Benjamin] Strong’s monetary expansion made a later 1929 crash inevitable, Fisher-Friedman believe that all the Fed needed to do was to pump more money in to offset any recession. Believing that there is no causal influence running from boom to bust, believing in the simplistic "Dance of the Dollar" theory, the Chicagoites simply want government to manipulate that dance, specifically to increase the money supply to offset recession.

It is difficult to see how the market can be seen as free if the State can at anytime create money out of thin air. In fact, Austrians see this as the very cause of the business cycle. I've covered this at least briefly in my review of Meltdown, so I'll not return to it here. Suffice it to say that, however small its number of adherents, and however marginalized its members, the Austrian school did see this coming. For that reason alone, their theories require our attention, if not our allegiance.

Returning to the piece in question, Krugman writes: "To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?"

He's absolutely right that the models are flawed, but the solution isn't to introduce a fudge factor: the models should be scrapped altogether. As Ludwig von Mises pointed out long ago, economics is a science, but it is a qualitative one, not a quantitative one. We can derive general trends from economics, but we cannot make any reliable quantitative predictions. Thus we know that unemployment will increase if the minimum wage is raised beyond that which the market can support, but we are powerless to assert how much unemployment will be created, or in what sectors of the economy. As Mises writes in Human Action:

There are, in the field of economics, no constant relations, and consequently no measurement is possible. If a statistician determines that a rise of 10 per cent in the supply of potatoes in Atlantis at a definite time was followed by a fall of 8 per cent in the price, he does not establish anything about what happened or may happen with a change in the supply of potatoes in another country or at another time. He has not “measured” the “elasticity of demand” of potatoes. He has established a unique and individual historical fact. (pp. 55-6)

And again:

The [mathematical economists] devote all their efforts to describing, in mathematical symbols, various “equilibria,” that is, states of rest and the absence of action. They deal with equilibrium as if it were a real entity and not a limiting notion, a mere mental tool. What they are doing is vain playing with mathematical symbols, a pastime not suited to convey any knowledge. (p. 251)

Whatever the criticisms of Mises, it cannot be argued that he was unaware of a reliance upon economic models.

Krugman naturally advises a return to Keynes, but he seems oblivious to the reasons his favorite economist fell out of favor with those of his profession. Given the implications of Keynesian theory--spend as much as you want, at least during a recession--there is no reason the State would ever dismiss him if they weren't absolutely required to do so. Indeed, whatever the actual economic ideas upon which are elected leaders draw, they champion something of an implicit Keynesianism.

I haven't the time to go into this here, but the stagflation of the 1970's did significant damage to Keynesian orthodoxy. When your theory says that something can't happen, and then it does, it's time to change the theory. Given the inadequacies of the monetarist position, it's not surprising that Keynes is back in vogue. But Krugman would do well to realize the tenuousness of his own position. If Keynes has failed before, he can fail again. Perhaps this time we will realize that there is another game in town.