Must-Read: Dani Rodrik: When Economics Works and When it Doesn’t

Must-Read: I wonder: There is an awful lot of bad right-wing economics. There is much less bad left-wing economics. But if the left wing were stronger as a political movement–as strong as the right wing–would there be as much bad left- as right-wing economics. I suspect not, but that is merely a guess. But if it is a correct guess, the next question is: “Why?”

Mark Thoma sends us to Dani Rodrik: When Economics Works and When it Doesn’t: “If we take as our central model one under which the efficient markets hypothesis is correct…

…in the run-up to the financial crisis… the steady increase in house prices or the growth of the shadow banking system… wouldn’t have bothered you at all. You’d tell a story about how wonderful financial liberalisation and innovation are…. But if you took the same [set of] facts, and applied the kind of models that people who had been looking at sovereign debt crises in emerging markets had been developing… you’d get a very different kind of story. I wish we’d put greater weight on stories of the second kind rather than the first. We’d have been better off if we’d done so…

Must-Read: William Poole: Don’t Blame the Fed for Low Rates

Must-Read: You know, given the demographic headwinds of this decade, the consensus of economic historians is likely to say that job growth under Obama was not weak, but quite possibly the second-strongest relative to baseline since the Oil Shock of 1973–somewhat worse than under Clinton, a hair better than under Carter or Reagan, and massively superior to job growth under either Bush:

Graph All Employees Total Nonfarm Payrolls FRED St Louis Fed

William Poole: Don’t Blame the Fed for Low Rates: “Long-term rates reflect weak job creation and credit demand, both a result of President Obama’s poor economic stewardship…

…The frequent claim that Federal Reserve Chair Janet Yellen and her colleagues are responsible for continuing low rates of interest may be correct in the small, but not in the large…. The real villain behind low interest rates is President Obama. Long-term rates reflect weak job creation and credit demand…. The real rate of interest, currently negative for short-term interest rates and only slightly positive for long rates, is a consequence of non-monetary conditions that have held the economy back….

Disincentives to business investment deserve special notice…. The Obama administration has created one disincentive after another… the failure to pursue tax reform… insistence on higher tax rates… environmental activism… growth-killing overreach in the Affordable Care Act and Dodd-Frank to the Consumer Financial Protection Bureau, the Environmental Protection Agency and the Labor Department….

The Fed is responsible, however, for not defending itself by explaining to Congress and the public what is going on. The Fed is too afraid politically to mention any details of its general position that it cannot do the job on its own. Yes, there are “headwinds,” but they are largely the doing of the administration…. The Obama administration didn’t create Fannie Mae and Freddie Mac, for instance, or the government’s affordable-housing goals—both of which fueled the 2008 financial crisis. But the Obama administration has failed to correct the economic problems it inherited. It has simply piled on more and more disincentives to growth. These disincentives have kept long-term rates low.

It seems to me that very little of William Poole’s argument makes any sense at all.

If the factors he points to were there and were operating, they would operate by lowering the future profits of both new capital and old capital. They should thus produce both (a) a fall in interest rates and (b) a fall in the equity values of established companies. We have the first. We do not have the second. Thus I find it very hard to understand in what sense this is made as a technocratic argument. It seems, instead, to be some strange fact-light checking off of political and ideological boxes: Obama BAD! Federal Reserve GOOD!!

Must-Read: David Leonhardt: ‘Chicagonomics’ and ‘Economics Rules’

Must-Read: David Leonhardt: ‘Chicagonomics’ and ‘Economics Rules’: “Adam Smith’s modern reputation is a caricature…

…He was a giant of the Enlightenment in large part because he was a careful and nuanced thinker. He certainly believed that a market economy was a powerful force for good…. Yet he did not have a religious faith in the market…. Lanny Ebenstein’s mission, in ‘Chicagonomics,’ is to rescue not only Smith from his caricature but also some of Smith’s modern-day acolytes: the economists who built the so-called Chicago school of economics…. Ebenstein argues that the message of the Chicago school has nonetheless been perverted in recent years. Many members of the Chicago school subscribed to ‘classical liberalism,’ in Ebenstein’s preferred term, rather than ‘contemporary libertarianism.’…

Dani Rodrik… has written a much less political book than Ebenstein has, titled ‘Economics Rules,’ in which he sets out to explain the discipline to outsiders (and does a nice job)…. Rodrik has diagnosed the central mistake… [of] contemporary libertarians have made… conflat[ing] ideas that often make sense with those that always make sense. Some of this confusion is deliberate… act[ing] as a kind of lobbyist working on behalf of the affluent…

What is the free-market solution to a liquidity trap? Higher inflation!

Three seventeen-year old quotes from Paul Krugman (Paul R. Krugman (1998): It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap, Brookings Papers on Economic Activity 1998:2 (Fall), pp. 137-205):

Suppose that the required real rate of interest is negative; then the economy ‘needs’ inflation, and an attempt by the central bank to achieve price stability will lead to a zero nominal interest rate and excess cash holdings…


In a flexible-price economy, the necessity of a negative real interest rate [for equilibrium] does not cause unemployment…. The economy deflates now in order to provide inflation later…. This fall in the price level occurs regardless of the current money supply, because any excess money will simply be hoarded, rather than added to spending…. The central bank- which finds itself presiding over inflation no matter what it does, [but] this [flexible-price version of the liquidity] trap has no adverse real consequences…


A liquidity trap economy is “naturally” an economy with inflation; if prices were completely flexible, it would get that inflation regardless of monetary policy, so a deliberately inflationary policy is remedying a distortion rather than creating one…

Thinking about these three quotes has led me to change my rules for reading Paul Krugman.

My rules were, as you remember:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).

They are now:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).
  3. And even if you thought Paul Krugman was right already, go reread and study him more diligently–for he is right at a deeper and subtler level than you would think possible.

Let us imagine a fully-flexible distortion-free free-market economy–the utopia of the Randites. Let us consider how it would respond should people suddenly become more pessimistic about the future.

People feel poorer. Feeling poorer, people want to spend less now. However, today’s productive capacity has not fallen. Thus the market economy, in order to incentivize people to keep spending now at a rate high enough to maintain full employment, drops the real interest rate. It thus makes the future more expensive relative to the present, and makes it sufficiently more expensive to incentivize keeping real spending now high enough to maintain full employment.

The real interest rate has two parts. It is equal to:

  1. the nominal interest rate,
  2. minus the inflation rate.

If money demand in the economy is interest elastic, the fall in the real interest rate will take the form of adjustments in both pieces. First, the free-market flexible-price distortion-free economy’s equilibrium will shift to drop the nominal interest rate. Second, the equilibrium will also shift to drop price level will drop immediately and instantaneously. Then the subsequent rebound of the price level back to normal produces the inflation that is the other part of The adjustment of the real interest rate.

If money demand takes the peculiar form of a cash-in-advance constraint, then:

  1. the interest elasticity of money demand is zero as long as the interest-rate is positive, and then
  2. the interest elasticity of money demand is infinite when the interest-rate hits zero.

In this case, the process of adjustment of the real interest rate in response to bad news about the future has two stages. In the first stage, 100% of the fall in the real interest rate is carried by a fall in the nominal interest rate, as the price level stays put because the velocity of money remains constant at the maximum technologically-determined rate allowed by the cash-in-advance constraint. In the second stage, once the nominal interest rate hits zero, and there is no longer any market incentive to spend cash keeping velocity up, 100% of the remaining burden of adjustment rests on the expected rebound inflation produced by an immediate and instantaneous fall in the price level. These two stages together carry the real interest rate down to where it needs to be, in order to incentivize the right amount of spending to preserve full employment.

The free-market solution to the problem created by an outbreak of pessimism about the future is thus to drop the nominal interest rate and then, if that does not solve the problem, to generate enough inflation in order to solve the problem.

Now we do not have the free-market distortion-free flexible-price economy that is the utopia of the Randites. We have an economy with frictions and distortions, in which the job of the central bank is to get price signals governing behavior to values as close as possible to those that the free-market distortion-free flexible-price economy that is the utopia of the Randites would produce.

In particular, our economy has sticky prices in the short run. There can be no instantaneous drop in the price level to generate expectations of an actual rebound inflation. If the central bank confines its policies to simply reducing the nominal interest rate while attempting to hold its inflation target constant, it may fail to maintain full employment. Even with the nominal interest rate at zero, the fact that the price level is sticky in the short-run may mean that the real interest rate is still too high: there may still be insufficient incentive to get spending to the level needed to preserve full employment.

A confident central bank, however, would understand that its task is to compensate for the macroeconomic distortions and mimic the free-market flexible-price full-employment equilibrium outcome. It would understand that proper policy is to set out a path for the money stock and for the future price level that produces the decline in the real interest rates that the flexible-price market economy would have generated automatically.

Thus a confident central bank would view generating higher inflation in a liquidity trap not as imposing an extra distortion on the economy, but repairing one. The free-market flexible-price distortion-free economy of Randite utopia would generate inflation in a liquidity trap in order to maintain full employment–via this instantaneous and immediate initial drop in the price level. A central bank in a sticky price economy cannot generate this initial price-level drop. But it can do second-best by generating the inflation.

All of my points above are implicit–well, actually, more than implicit: they are explicit, albeit compressed–in Paul Krugman’s original 1998 liquidity trap paper.

And yet I did not come to full consciousness that they were explicit until I had, somewhat painfully, rethought them myself, and then picked up on them when I reread Krugman (1998).

On the one hand, I should not feel too bad: very few other economists have realized these points.

On the other hand, I should feel even worse: as best as I can determine, no North Atlantic central bankers have recognized these points laid out in Paul Krugman’s original 1998 liquidity trap paper.

Central bankers, instead, have regarded and do regard exceeding the previously-expected level of inflation as a policy defeat. No central bankers recognize it as a key piece of mimicking the free-market full-employment equilibrium response to a liquidity trap. None see it as an essential part of their performing the adjustment of intertemporal prices to equilibrium values that their flexible-price benchmark economy would automatically perform, and that they are supposed to undertake in making Say’s Law true in practice.

But why has this lesson not been absorbed by policymakers? It’s not as though Krugman (1998) is unknown, or rarely read, is it?

It amazes me how much of today’s macroeconomic debate is laid out explicitly–in compressed form, but explicitly–in Krugman’s (1998) paper and in the comments by Dominguez and Rogoff, especially Rogoff…

Must-Read: Steve Pearstein: The Value and Limits of Economic Models

Must-Read: Let me agree with Steve Perlstein here: the economics that the very sharp Dani Rodrik praises is not the strongest current, outside of our liberal-arts non-business school ivory towers, and not always even in them.

Steven Pearlstein: The Value and Limits of Economic Models: “The alleged failings of economics are now widely understood…

…except perhaps by economists themselves. You hear that economics is ideology masquerading as hard science. That it has become overly theoretical and mathematical, based on false or oversimplified assumptions about the ways real people behave. That it systematically misunderstands the past and fails to anticipate the future. That it celebrates selfishness and greed and values only efficiency, ignoring fairness, social cohesion and our sense of what it is to be human. In his latest book, ‘Economics Rules,’ Dani Rodrik tries to bridge the gap between his discipline and its skeptics….

What economists forget, Rodrik says–or even worse, what they never are taught–is that the answer to most important questions is “It depends.” What’s right for one country at one time may not be right for another country or another time. Context matters. And because context matters, he argues that too much of the focus in economics has been on developing all-encompassing models and grand theories that can be applied to every context, and too little on expanding the inventory of more narrowly focused models and developing the art of knowing which ones to use….

Rodrik no doubt set out to offer an evenhanded view of modern economics, [but] in the end he winds up delivering a fairly devastating critique. “The discipline hobbles from one set of preferred models to another, driven less by evidence than by fads and ideology,” he writes. He despairs that his profession has become one that values “smarts over judgment,” has disdain for other disciplines and is content to produce mathematically elegant research papers that few outside the guild will ever use or understand. The standard economics course offered to undergraduates, he rightly complains, winds up presenting nothing more than “a paean to markets” rather than a “richer paradigm of human behavior.” Rodrik’s plea is for economics to be practiced with a bit more humility both by those who extol free markets and those who would tame them. Economics, he argues, is less a hard science capable of producing provable truths than a set of intuitions disciplined by logic and data and grounded in experience and common sense…

Weekend Reading: Diane Coyle (2012): Do Economic Crises Reflect Crises in Economics?

Diane Coyle (2012): Do Economic Crises Reflect Crises in Economics?: “The problems with economics: (1) Theory…

…There is a well-known joke about economic methodology. Two friends are walking along when one spots a €50 note on the floor. “Look!” he says, “Let’s pick up the money.” His friend, an economist, replies: “No, don’t bother. If it were really there, somebody would have picked it up already.” The joke of course is about the lack of realism in the assumptions economists conventionally make in order to analyse the real world….

In practice, the version of this assumption used in applied analysis is rarely as strong. In practice, it is more like: given the limited information available to them, and the various transaction costs they face in taking certain courses of action, and given that the future is very uncertain, we’ll assume people act broadly in their self-interest, however they would define that. I would strongly defend the use of this contingent version of the standard assumption as it’s a powerful analytical tool…. Modern institutional economics, which is a thriving area of research, is founded on the use of the rationality assumption as a tool of analysis. If people do not seem to be making the rational choice, then looking at the difference between what would happen if they did so and the reality is instructive….

I would defend using the assumption of rational choice as long as one realises that it is not a description of reality. But there is one area where for 30 years economists – and others – have been making that mistake. That is, unfortunately, of course, in the financial markets. Practitioners and policy makers acted as if the strong form of the Efficient Markets Hypothesis held true – in other words that prices instantly reflect all relevant information about the future – even though this evidently defies reality. What’s more, a political philosophy valuing limited government leapt on what was taken as proof that markets left to themselves deliver better economic outcomes. This was translated as the deregulation of markets, especially financial markets, and became entwined with the growing importance of the finance sector in the economy globally. So politics fed the trend. The computer and communications technologies fed the trend as well, by making more and more financial transactions possible.

I think an honest conventionally-trained economist has to at least acknowledge that we grew intellectually lazy…. A particular ideological version of economics became the framework for analysing public policy, and very few mainstream economists challenged that. We got on with our work and ignored the importance of the public rhetoric….

A looser version is that a public sphere founded on the world view of narrow, rational choice economic models has over time led people to behave like the selfish, calculating beings assumed in those models. If regulations assume that you are going to behave in a certain way, there must surely be a temptation to live up to the assumption. I don’t know if this theory of economic performativity is true; perhaps the causality runs the other way, and a period of free-market politics especially in the US and UK changed the character of economics? We can’t test these alternatives, but this criticism is worth considering….

The financial and economic crisis [thus] spells a crisis for certain areas of economics, or approaches to economics. Financial economics and macroeconomics are particularly vulnerable. They are the subject areas where the consequences of the standard assumptions have been most damaging, because they are actually least valid. Financial market traders are not remotely like Star Trek’s Mr Spock, making rational calculations unaffected by emotion or by the decisions of other people. Macroeconomics – the study of how millions of individual decisions aggregate into economy-wide measures – is essentially ideological. How macroeconomists answer a question like ‘What will be the effect of cutting the budget deficit on growth next year?’ depends on their political views. This is not remotely a scientific area of the discipline….

I can’t omit here a few other problems with economics as it has been practised… the economics curriculum in universities… gives too much time to macroeconomics, on which as I just argued there is no professional consensus…. They have little sense of economic history…. Students are also not systematically taught new aspects of the subject…. Undergraduates are also taught as if they are all planning to go on to study for a doctorate and become academic economist…. Finally, many of these under-cooked economics graduates go on to work in government…. There are some good reasons for this special status – I’m about to come on to those – but the influence economists have in government needs seasoning with a corresponding degree of humility. One side-effect of the crisis may be to make economists a bit more humble, which would be a good result.

Must-Read: Marshall I. Steinbaum and Bernard A. Weisberger: Economics was Once Radical: Then It Decided Not to Be

Must-Read: Marshall I. Steinbaum and Bernard A. Weisberger: Economics was Once Radical: Then It Decided Not to Be: “When it was first formed in 1885, the AEA was a radical challenge to the orthodoxy of classical, free-market economics…

…A generation of young American economists trained at German research universities in the 1870s returned to find their field dominated by an establishment largely confined to Harvard and Yale…. Richard Ely, an avowedly Christian Heidelberg-trained professor at Johns Hopkins with a calling to make economics a friend of the working man…. As originally drafted, the opening platform of the AEA declared ‘We regard the state as an educational and ethical agency whose positive aid is an indispensable condition of human progress. While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals,’ and it went on to excoriate ‘the conflict of labor and capital.’ The mission of the new organization was to promulgate empirical economics research, including the nascent concept of peer review, a powerful weapon in asserting the scientific superiority of the new school over the establishment’s dry, unshakable orthodoxy….

[But] university presidents seeking stature for their institutions appealed to rich donors among the period’s Robber Barons, and that appeal was unlikely to be successful when rabble-rousers in the economics department were questioning the foundations of American capitalism…. Economists realized there was much to be gained in terms of professional stature and influence from making themselves appealing to the establishment, so they banished those elements that tainted them by association…. Even Ely himself eventually came around after his own notorious trial before the Wisconsin Board of Regents in 1894…. The economic tracts of that era began to enshrine the perfectly competitive market at the center of the intellectual firmament in economics…. It’s hard to escape the conclusion that in choosing to sideline left-wing elements among their own, economists gave up important if inconvenient empirical insights in favor of intellectual self-promotion, and that left them blind to the realities of inequality…