Choose Your Heterodoxy: Farmer vs. Krugman
Paul Krugman digs in in defense of old economic thinking: behavioral finance to explain bubbles, money illusion plus anchoring to explain wage and price inertia, and then the three-commodity–outside money, bonds, and currently-produced goods and services–temporary-equilibrium model of Hicks and Metzler to provide the backbone of a useful macroeconomics:
…here when he says:
There are still a number of self-professed Keynesian bloggers out there who see the world through the lens of 1950s theory…
And it’s true!… Farmer wants us to think in terms of models with:
an infinite dimensional continuum of locally stable rational expectations equilibria…
a continuum of attracting points, each of which is an equilibrium…
But why, exactly? Saying that it’s ‘modern’ is no answer; so, for a while, was real business cycle theory, which proved to be a huge wrong turn. In part, I think, Farmer is trying to explain an empirical regularity he thinks he sees, but nobody else does — a complete absence of any tendency of the unemployment rate to come down when it’s historically high….
Farmer wants to preserve rational expectations and continuous equilibrium, while introducing multiple equilibria. That strikes me as a bizarre choice. Why not appeal to behavioral economics, behavioral finance in particular, to make sense of bubbles? Why not appeal to the clear evidence of price and wage stickiness — perhaps grounded in bounded rationality — to make sense of market disequilibrium?
The 1950s theory Farmer derides actually follows more or less that agenda…. Economists who knew their Hicks have actually done extremely well at predicting the effects of monetary and fiscal policy since the 2008 crisis, whereas those who sneered at this old-fashioned stuff have been wrong about almost everything. I’m all for new ideas, indeed for radical heterodoxy, if it solves some problem. Attacking ideas that seem to work pretty well simply because they’ve been around for a while, not so much.
I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.
(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)
To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.
When Paul says that standard Hicks-Metzler macro has done well, he means that, since the end of the 2008, given the magnitude of the leftward shift in the IS curve then experienced, Hicks-Metzler has given the right answer to four important questions:
Will extraordinary expansion of the outside money base by the Federal Reserve have powerful effects boosting the economy even after short-term safe nominal interest rates hit zero? No, because such central banking operations are essentially swaps of assets that are nearly perfect substitutes in investors’ portfolios, and expectations of higher future inflation are not easily generated out of thin air but require facts on the ground that can be pointed to.
Will expansionary fiscal policy be counterproductive because it will lead to a crisis of confidence and to a spiking of interest rates? No, not as long as the central bank can and does create the safe high-powered monetary asset that underpins the economy.
Will expansionary monetary policy trigger stagflation–high unemployment and accelerating prices? No, because, once again, expectations of higher future inflation are not easily generated out of thin air but would require the facts on the ground of full recovery to trigger their appearance.
Will the economy quickly recover back to its old normal? No, absent the working-out of bad debt and deleveraging of the economy needed to reverse the large leftward shift of the IS curve.
Giving the right answers ex ante to these four questions was a powerful victory for Hicks-Metzler macro. Judging that the housing price rise was a bubble, the popping of which would create risks, and that wage and price inertia would make recovery without truly extraordinary demand stimulation very painful are also powerful victories. Those who understood the behavioral finance of bubbles and the institutional psychology of wage-price inertia could see and think where others were blind or insane.
But it seems to me that Roger Farmer has empirical victories too. From today’s perspective, the things I used to teach before 2008 about how the American economy had a strong tendency to return to a full employment equilibrium with a 1/e time of two years seems simply wrong: rapid recovery in the past, looking back, seems to have depended on aggressive policy rather than on any natural equilibrating economic process. And I would have given very long odds that $500 billion of sectoral overinvestment, even overleveraged overinvestment, would not take down the U.S. and the world economy.