The Free Thinker

The Keynesian Fallacy

"Debt alarm over stimulus spending":

The enormous public cost of fighting the global crisis is haunting governments and unnerving investors.

Even as President Barack Obama declared Tuesday that the United States must continue to “spend our way out of this recession,” international ratings agencies sent shivers through markets with warnings that spiralling budget deficits and soaring debt levels are putting sovereign ratings at risk.

Analysts do not expect a return to fiscal stability soon, and some countries continue to rely on stimulus spending to support fragile economies.

"To support fragile economies."  The Keynesian fallacy has become embedded in the language.  We passed the stimulus, unemployment rose, and yes the economy recovers a bit, as it always tends to do with or without "support," but weakly and not before sinking further.  You'd hope this experience might induce journalists to rephrase a bit, to write, say, that "some countries continue to burden fragile economies by increasing spending."  But the Keynesian fallacy is too embedded in the language.

It should be noted that the only real empirical "success" of Keynesianism is that military spending does seem to raise GDP.  But there's no need to appeal to a Keynesian model to explain that.  Suppose the government spends $X in a purely wasteful manner: will you work more or less?  Probably more, because since the government, now or later, is going to take some more of your money to pay for the $X expense, you're prospectively poorer, so your marginal value of money relative to labor rises and you work more.  War makes us poorer but raises GDP because we have to produce more to make up for what we destroyed.  Keynesian macro is theoretically flawed and has scant if any empirical support.  But how do we purge it from casual journalistic language?

Monasticism

My article, "The Economics of Monasticism," was just published at the ARDA Working Paper Series, see here: http://www.thearda.com/workingpapers/monasticism.asp.  Here's the abstract:

Since their emergence in ancient times, Christian monasteries have proven to be among the most durable of all human institutions, and in the medieval centuries made enormous contributions to the emergence of Western civilization. They are organized internally on socialist lines: monks own no property and owe total obedience to the abbot, making the monastery a miniature ‘centrally planned economy.’ A puzzling contrast exists between the longevity of monasteries and the transience of secular socialist communes. This paper presents a theoretical model which shows why voluntary socialist communes might be viable despite ‘shirking’ problems, yet fail due to turnover, and how worship, which induces people with high ‘spiritual capital’ to self-select into the monastery and then grows that spiritual capital through ‘learning-by-doing,’ can solve the turnover problem and make a worship-based socialist commune—a monastery—stable. Monasticism, like the market, is a form of ‘spontaneous order,’ but unlike the market, it does not depend on third-party enforcement (e.g., by a state) to function: this explains why monasticism (unlike capitalism) was able to thrive in the anarchic Dark Ages. Monasteries, in principle and largely in practice, are a form of society based on consent of the governed, unlike liberal states which preach but do not practice consensual governance, and it is interesting to juxtapose the real, live ‘social contracts’ of the monasteries with the notional social contracts of liberal political theory.

At the heart of the paper is a fairly simple economic model of monasticism.  It starts from individual utility maximization, and builds up to show (on certain assumptions) why monasteries can "compete" for members with "the world," and why only voluntary socialist communities with a religious basis are likely to prove stable, which is consistent with the facts.  And yet the paper is very ambitious in a vague and somewhat noncommittal way.  If you wanted to take a maximalist interpretation of its message it suggests that everything that sets the West apart from the rest, technology and economic growth and political freedom, is an effect of Christianity in general and in particular the nexus of monasticism that lay at the heart of it for over a thousand years.  Though I don't use the phrase, it expresses an idea that has haunted me for a long time, the Christian republic, an entity that is even in a sense political-- it has laws, loyalties, and leaders-- yet wholly, or if not wholly then at least typically and characteristically, noncoercive, and prophecied in various sayings of Our Lord: "My kingdom is not of this world"; "Upon this rock I will build My church, and the gates of hell will not prevail against it"; "Heaven and earth shall not pass away, but My words will not pass away."  And indeed, so it has turned out.  Yet it is in the nature of monasticism to flee from the world, and if the Church doesn't exactly do that, nonetheless if one looks at it from the point of view of secular history, it never has as high a profile as the conquerors who have come and gone while the Church remains.  And it is in the monastic rules that order without coercion is embodied par excellence.  I think one could read my article and even agree with my hypothesis without accepting either the truth or the importance of Christianity... but I think the paper just my shake an agnostic's faith slightly.  However, at this point it's at the level of theory.  How I would like to use the theory as a means of writing a history of monasticism!  Someday...

Publicity for "Economic Contractions in the United States: A Failure of Government"

From my co-author Charles Rowley, in the Daily Telegraph: "Adam Smith would not be optimistic in today's economic world: Adam Smith once commented that "there is a great deal of ruin in a nation". He meant that bungling governments imposed only a limited check on the economic performance of a Great Nation."  This article accompanies the launch of Economic Contractions in the United States.  For regular readers of this blog I'll stop to point out my... differences of emphasis... as appropriate:

As Nathanael Smith and I show in our study of US economic contractions, Adam Smith would be much less sanguine were he confronted by today's financial crisis and the US government's response. Indeed, it is not impossible that the US will experience the kind of economic collapse from first- to third-world status experienced by Argentina under the national socialist governance of Juan Peron.

"Not impossible" is so weak that it makes the claim innocuous, I suppose, but this seems like an exaggeration, and it seems to conflict with the 7th chapter of Economic Contractions, where we predict that "profligate deficit-spending and interventionism" will produce disillusionment and a conservative revival (p. 97)-- a prediction that events seem to be bearing out.

The US economy suffers from a growing culture of indebtedness that has increasingly contaminated the federal government since 2001 and has spilled over dramatically into private household behaviour. The combination of the ill-conceived fiscal-furnace fired by President Bush and the US Congress and the reckless monetary-furnace fired by Alan Greenspan and Ben Bernanke throughout the period 2001-2007, created unsustainable housing market and stock market bubbles whose collapse brought on the financial crisis and economic contraction of 2008-2009.

I would put the charge in more measured terms.  Fiscal policy under George W. Bush was less expansionary (smaller deficits as a share of GDP) than under Ronald Reagan, even though the US was at war in the Bush years and not in the Reagan years.  (At a time when Obama and the Democratic Congress are redefining "reckless" in the upward direction at a rate of $100 billion a month or so, it seems strange to use the term for the Bush administration, though the Bush administration should certainly have known better.)   And while interest rates stayed low in 2003-04 for too long after recovery had begun, they then rose steeply, so "throughout the period 2001-2007" seems to make the charge too broad.  Even the low interest rates of 2003-04 seem more like a serious technical mistake combined with having the wrong Fed policy rules-- housing should have been included in the CPI-- than "reckless."  And dating the problems to 2003-04 would seem to absolve Bernanke and concentrate responsibility on Greenspan. 

What led to the bubble was that (a) fiscal and monetary policy were expansionary at the same time for the first time since the 1970s, and (b) house prices were-- we argue, mistakenly-- excluded from the price index, causing the Fed to see "low" inflation at a time when house prices were rising at well over 5% per year.  What I find ironic is that, in a sense, the crisis is Osama bin Laden's revenge.  Bin Laden wanted to deal a devastating blow to the US economy.  Determined to deprive him of this victory, Bush and Greenspan adopted expansionary fiscal and monetary policies that lifted the economy out of what could, and maybe should, have been a deep recession in 2001.  As a result, they inflated a debt bubble and made the next crisis sooner and deeper.  Fortunately, al Qaeda was ruined by the war in Iraq, so bin Laden's victory is Pyrrhic.  But if the government had let the 2001 recession play itself out naturally, there might not have been any 2008 crisis.

The policy responses to the debt bubble demonstrate crude political consideration rather than economic understanding. If excessive government indebtedness is a major source of the problem, why increase the government debt? Why encourage households to go yet further into debt?

The prognosis is catastrophic if projected government policies are not cut back. According to the White House's own estimates, the federal budget deficit in 2009 will be $1.6 trillion, approximately 11.2pc of the overall economy, the highest on record since the end of the Second World War. In 2019, the national debt will represent 76.5pc of the US national economy, the highest proportion since just after the Second World War. In such circumstances, the international reserve status of the US dollar will not survive. As it fades, so interest rates on government securities will rise and the real burden of servicing the debt will increase. In such circumstances, the US economy will teeter on the edge of a black hole.

Hmm... why bring in "the international reserve status of the US dollar?"  I don't remember anything about that in the monograph.  Do we have-- does anyone have-- a theory relating government debt to the viability of a reserve currency?  Personally, if there were some way to transition out of a dollar regime without global chaos, I think it might be nice not to own the world's reserve currency: I think being able to print the world's reserve currency causes a form of "Dutch disease," undermining the competitiveness of our industries and fueling excessive growth of government.  Also, why would more debt cause the US economy to "teeter on the edge of a black hole," rather than, say, acting as a drag on growth and depressing living standards for decades-- as it has arguably done in Japan?  Government debt in Japan and Italy is way above 76.5% of GDP; both countries have suffered malaise rather than crisis.

Prosperity and full employment in the US will only be restored by a return to laissez-faire capitalism. Our study outlines a radical, but politically feasible, approach. Monetary policy should be expansionary. But, on the micro-economic side, tariffs and other trade barriers should be repealed unilaterally; a "Right-to-Work" Act should reduce the minimum wage and curtail the powers of unions; and business regulation should be reduced. Individual banks and their counterparties should not be bailed out, although the system should be protected by ensuring that failing banks are wound up in an orderly fashion – this is the only way to restore market discipline.

A little late not to bail out individual banks, no?  Rather say that laws and policies should be rewritten so as to prevent future bailouts (except of insured deposits through the FDIC).  And is it really "politically feasible" for "tariffs and other trade barriers [to] be repealed unilaterally?"  Maybe!  I wouldn't rule out the possibility that bold, visionary political leadership can make the politically impossible possible -- after all, Obama seems to have made people dislike unions and appreciate the health care status quo! -- but that is as much as to say that the range of the "politically feasible" is very broad.

Rowley and I found enough to agree on to put a book together, but he might have a tendency to overclaim. 

MORE: "Barack Obama accused of making 'Depression' mistakes: Barack Obama is committing the same mistakes made by policymakers during the Great Depression, according to a new study endorsed by Nobel laureate James Buchanan." (Daily Telegraph):

"Endorsed by Nobel laureate James Buchanan."  That's brilliant marketing.  But it's not false advertising, for here is Buchanan's Frontispiece:

A comprehensive and coherent assessment of the current economic contraction, one that largely rebuts attribution of failure to capitalism or the market. The targets become practicing politicians of all parties, whose cumulative mistakes have now hurt us all. We have learned some things to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understand of what makes capitalism work.

Anyway, here's what Edmund Conway of the Telegraph has to say:

His policies even have the potential to consign the US to a similar fate as Argentina, which suffered a painful and humiliating slide from first to Third World status last century, the paper says.

There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the worst economic collapse in recorded history, says the new pamphlet, published by the Institute of Economic Affairs.

In particular, the authors, economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run. They say that by employing deficit spending and increased state intervention President Obama will ultimately hamper the long-term growth potential of the US economy and may risk delaying full economic recovery by several years.

Excellent.  The title of the Telegraph piece may slightly overplay the 'Depression' analogy -- while we do identify some similarities with policies from the Depression era, monetary policy is (no thanks to Obama) just the opposite, and we haven't seen anything like the crazy tax hikes of Hoover and FDR yet though there are some ominous signs -- but this last paragraph nicely captures a central argument of the book.  Conway continues:

The study represents a challenge to the widely held view that Keynesian fiscal policies helped the US recover from the Depression which started in the early 1930s. The authors say: "[Franklin D Roosevelt's] interventionist policies and draconian tax increases delayed full economic recovery by several years by exacerbating a climate of pessimistic expectations that drove down private capital formation and household consumption to unprecedented lows."

Heh.  If Rowley and I get credit for debunking the myth that FDR's Keynesian New Deal got us out of the Great Depression, that would be as unfair as Columbus getting credit for debunking the myth that the world is flat.  To our cost, this myth remains potent at the popular level, but among economists I don't think even Paul Krugman would defend it.  Rather, Keynesians claim that WWII got us out of the Great Depression.  This is also debatable -- "GDP" grew, but should bombs and guns and tanks count as GDP, when they don't contribute to human happiness; or if they do count as GDP, don't we need some more appropriate way of measuring the economy's contribution to human well-being, which would likely put paid to the odd notion that WWII was an economic golden age? -- but it has no bearing on the episode Rowley and I deal with, namely the 1930s.  It's rather odd that at this late date anyone can make headlines with what ought to be a truism, namely that the New Deal exacerbated, rather than "got us out of," the Great Depression, but if that's still news to a lot of people, then those headlines need to be made.  Conway continues:

Although the authors support the Federal Reserve's moves to slash interest rates to just above zero and embark on quantitative easing, pumping cash directly into the system, they warn that greater intervention could set the US back further...

And then proceeds with quotes from Rowley and Buchanan, already quoted above in this post.  I'm glad that the message is clear that we support quantitative easing.  On that point we're basically Milton Friedman-type monetarists.  Too bad our advocacy of immigration reform and Social Security reform doesn't seem to be making it into the reviews so far!

How Keynesianism Survives

"Why the Stimulus is Helping the Economy, But Not Obama" (Time)

Proving a negative is always a challenge, but there's mounting evidence that the controversial $787 billion stimulus bill is achieving one of its major goals: shortening the recession. Economists at Goldman Sachs say that the bill, officially called the American Recovery and Reconstruction Act, has resulted in a 2%-3% boost to annual GDP in the second and third quarters of this year, turning what could have been a worsening recession into potential growth. For President Barack Obama, whose poll numbers have dropped precipitously from around 65% to around 50% as Americans have become worried about government spending and health-care reform, that should be good news: he fought hard against Republican opposition to push the bill through Congress as one of his first legislative acts, and the fact that it's working should be a vindication.

But it's not that easy. Recent polls show widespread disapproval of the stimulus bill: 51% of Americans polled last month by USA Today and Gallup said they thought the government should be spending less under the plan, while 44% said they thought the government was spending the right amount, or should be spending more. If anything, it seems, the stimulus plan is hurting the President even as it helps the country.

The most obvious reason for that disconnect is jobs: despite the signs of a turnaround, unemployment remains stubbornly high at 9.7%, with employers cutting 216,000 jobs in August. While jobs always trail economic rebounds, the unemployment number is higher than economists thought it would be, even in the worst case scenario forecast by the Treasury department's "stress tests" last spring. The point is not lost on Republicans, some of whom have argued lately that no more of the stimulus money should even be spent. "The metric of this bill was job creation," says Don Stewart, spokesman for the Senate's top Republican, Mitch McConnell, "and it hasn't done that."

Still, one would think that the mere infusion in six months of $88 billion into the economy — that's how much the government has spent so far...

Journalists, it goes without saying, are not very smart (maybe they suppress it because it impedes their ability to slice a complex world into neat stories) but a cruder, more flagrant example of the post hoc ergo propter hoc fallacy would be hard to find than the above.  It seems quixotic, or Sisyphean, to remind people of the truism of economic history that it's normal for the economy to recover, that it always does so, even-- nay, especially-- when the government does nothing.  The last time the US government did nothing in a recovery-- in the recession of 1920-21-- the recovery was especially robust.  Again, in 1997-8, when the IMF forced East Asia to adopt austerity measures in the midst of recession, it earned itself the contempt of East Asians but rapidly restored growth to its former booming rates for another decade.  By contrast, Keynesian policies failed in the US in the 1930s, in Japan in the 1990s, and dragged post-WWII Britain down from being the world's economic leader to a desperate, stagflation-ridden basketcase in the generation after the British economics profession surrendered to Keynes, before it was rescued by Thatcher.

So how does Keynesianism survive?  Because of articles like the above, because of journalists committing the post hoc ergo propter hoc fallacy, while economists like Brad DeLong and Paul Krugman, who want bigger government because their values are different from the mainstream and want to use their technocratic credentials to sell big government to people who would not support it if they understood its true effects, back them up.  Keynesian economics is like fortune-telling: shrewdly vague, it exploits a perennial fallacy, namely people's chronic inability to understand that the economy can recover on its own.

In this case, the journalist provides the key fact that makes the "stimulus worked" case implausible: only $88 billion has been spent, just over 10% of the whole stimulus package, and only about 0.6% of GDP, and all of that after the worst of the crisis-- October 2008-- had already been mitigated.  By contrast, Ben Bernanke's Fed has bought hundreds of billions of dollars of private and federal debt, and the Bush administration "spent"-- albeit with a fair prospect of recovering-- $700 billion or so through the TARP program.  If any stimulus is working, it's that of Bernanke and Paulson, which was not mere Keynesian spending-for-spending's-sake but a timely intervention by highly competent technocrats (we won't see such expert competence from neophyte Obama, but fortunately, we might not need it) targeted to the specific problems at the heart of systemic failure.  That's not to give unqualified approval to Paulson.  He's a tragic hybrid of hero and anti-hero: he probably did save the US from a more shattering crisis, but the fallout from the Paulson Plan is likely to be a more politicized financial sector and hugely increased incentives and opportunities for rent-seeking for years or decades to come.  There's something to be said for the House GOP who voted against him, too.

For now, the American people seem to be displaying a sensible incredulity about the "stimulus is working" message.  But don't count on it to last.

Stylized Effects of Immigration

I put the chart below on the final exam for my Econ 309 class:

It represents international migration.  The vertical axis represents the wage of labor, the horizontal axis, the quantity of labor.  There are six curves in wage-quantity space.  Three are labor demand curves, D-North, D-South, and D-World, which is the sum of D-North and D-South.  Three are labor supply curves, S-North, S-South, and S-World, the sum of S-North and S-South.  Three wages are shown.  P-North is the wage that will prevail in the North (a rich country) under closed borders.  P-South is the wage that will prevail in the South (a poor country) if North closes its borders.  P-World is the wage that will prevail in both countries if North opens its borders.

The chart is a bit misleading.  It assumes a sort of "law of one wage," but in reality there are huge differences in wages in the economy, from retail workers at minimum wage to CEOs earning millions.  Still, even if the labor market is segmented, you might get a similar effect within each sector, in varying degrees.  Also note that the chart does not say simply "Southerners win, Northerners lose" from open borders.  Northerners lose out as workers, but they will benefit as capitalists, landowners, and consumers.  It depends on what factors of production comprise most of your lifetime wealth.  It used to be the case that most people's main asset was their labor, but that's less true than it was.  A lot of people have a lot of equity in houses and a lot of money in 401(k)s.  

Is this a pro-immigration or an anti-immigration chart?  My immediate reaction is: Great, you can equalize wages, and increase the total surplus.  Some students reacted with horror at the drop in North's wages.

Is this really what's at stake in the immigration debate?  Mostly yes, I think.  People talk about "culture" and "community"-- especially debate-savvy people who have a PR instinct-- but we don't ordinarily regard cultural engineering as a legitimate government function, and would reject arguments of this kind outside the immigration debate.  But of course, you can't be sure what's really motivating them.

Paul Krugman is something an unusual: a brilliant economist who can be relied upon to throw economic reasoning out the window whenever it gets in the way of toeing the Democratic party line.  Here, in an attack on the Blue Dogs, he supports a key argument for the public option:

Finally, there would be a public option: a government-run insurance plan competing with private insurers, which would help hold down costs...

There has been a lot of publicity about Blue Dog opposition to the public option, and rightly so: a plan without a public option to hold down insurance premiums would cost taxpayers more than a plan with such an option.

This argument is framed in terms that mimic the appeal of standard free market arguments.  Competition is good, right?  You can't hurt people by giving them more choices.

But there already is competition in the health insurance industry: Aetna, Blue Cross Blue Shield, CIGNA, UnitedHealth Group, and WellPoint, to name the top five.  It is an abuse of the theory of competition to treat the entry of a new supplier into an industry that is already competitive as necessarily a good thing.  If there are increasing returns to scale, as there typically are in insurance, it may be more efficient to have a small number of firms rather than a large number.  If the health insurance industry is competitive already, which the number of suppliers suggests that it is, premiums are already held down to marginal cost, and the entry of a new supplier could not force current suppliers to lower premiums. 

If the health insurance industry is not competitive, one of the following situations must obtain: (a) health insurance is a natural monopoly, or (b) there is some kind of collusion going on.  The idea that health insurance is a natural monopoly is hard to reconcile with the existence of multiple suppliers.  In any case, it would be absurd, under that supposition, to introduce another supplier, because the definition of a natural monopoly (think of an electricity distribution network) is that it is inefficient to have more than one supplier (to have two sets of power lines running to the same house).  If health insurance is a natural monopoly, the government should either take over or regulate the premiums for the entire industry.  If there is collusion, the Department of Justice should break it up.  Under no set of assumptions is it a reasonable policy for the government itself to enter the industry as a supplier and compete with private insurers.

The silliness of this argument becomes immediately evident if we think about some other industry, say, restaurants.  Suppose people are complaining that restaurant prices are too high, and a politician proposes to start a government restaurant chain that will compete with the private sector restaurants and bring down prices.  I think it's obvious enough what's wrong with that.  If the government restaurant chain somehow has completely separate finances from the government-- in which case it's not clear in what sense it is a government restaurant chain-- then perhaps there is no objection to the policy except that it is very odd.  But presumably the government restaurant chain will get some kind of taxpayer subsidy or other privilege (e.g., an implicit guarantee of its debts, or favorable treatment by regulators) that gives it an unfair advantage over the private sector restaurants.  It will then become a means of redistribution, from the general taxpayer to the patrons of the government restaurants.  Presumably state eateries will be less efficient, as theory and practice tell us (theory tells us that the absence of market discipline takes away the incentive to exert effort and make sound decisions).  So there will be losses to society as a whole, as well as redistribution.  Non-patrons of state restaurants, and private restaurateurs, will suffer, while frequent patrons of state restaurants may benefit, although their gains may not be enough to offset losses from higher taxes and crowding out of private restaurant options.  The objections to a "public option" in health care are exactly the same.

But isn't health care different?  Doesn't free-market economics somehow fail to apply to health care?  Maybe so, in some ways.  The reasons to think health care is different are basically three.  (1) The high degree of uncertainty about health care needs means that payment systems, to be efficient, probably need to involve insurance, and insurance markets create special kinds of agency problems.  In this respect, health care resembles auto repairs or disaster relief.  (2) Patients are unusually ignorant, relative to doctors, about their needs in health care markets: my stomach pain (say) might, for all I know, require treatment by a $1 box of pills or a $100,000 surgery.  In this respect, health care might resemble any kind of consulting service or, again, auto repair.  (3) Health care is considered by some to be a merit good, which everyone "deserves" (whatever that means) regardless of ability to pay.  Few would object if poor people don't have access to jet skis or Hawaiian shirts or iPods or pineapples, but some feel it is wrong for anyone to die just because they cannot pay the doctor's bill.  None of these peculiarities of health care have any bearing on the market structure of the industry or give the argument for the public option as competition any of the validity that it so obviously lacks in the case of the restaurant industry. 

There are many questions in economics that are to a large extent unresolved or mysterious, where there is large scope for valid differences of opinion.  If I were to ask why some countries are so much richer than others, you could give many different and contrasting, to some extent even contradictory answers, and it would count as good economics.  The validity of the Krugman/Obama argument for the public option is not one of those questions.  It IS WRONG.  The argument is a simple fallacy.  An attempt to clarify its logic with a model would have laughable results.  If a student were to make this argument on an exam it would be a professor's duty to mark him down, on the grounds that he doesn't understand the basics of how markets work.  It is the kind of argument the absence of which defines the writings of a great economist, at least when he is not degrading his intellect to peddle propaganda.

What is especially sinister about this argument is that it mimics free-market language in order to appeal to people who are vaguely sympathetic to the free market without understanding it.  There are sensible grounds for supporting a public option.  One might want it as a means to subsidize cheap, low-quality health care for the poor and indigent while leaving the existing system in place for the middle class.  Or, one might want to subsidize the state system in order to drive private health insurance companies out of business and move to socialized medicine.  To state those reasons, though, would make enemies.  The Krugman/Obama argument is a way to trick people who don't want a health welfare program or socialized medicine into thinking of the public option as a way to improve efficiency and lower costs while leaving the current system in place.  Krugman at least is surely aware that the argument is spurious. 

How long will the public tolerate the economics profession when our Nobel laureates choose not to avoid the most elementary fallacies?

"History lessons for economists in thrall to Keynes" (Niall Ferguson, FT)

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that “the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds” was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a “painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year”.

De haut en bas came the patronising response: I belonged to a “Dark Age” of economics. It was “really sad” that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes’s General Theory was published), much less its zenith in 2005 (the year Mr Krugman’s macro-economics textbook appeared). Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates.”

Keynes had some genuine, albeit marginal, contributions to make, but where he posed as an antagonist of traditional economics, tradition was generally vaguely right and Keynes was generally guilty of logical or empirical errors.  That economists made Keynes the most influential economist of the 20th century was just a mistake on their part.  Yes, deficits do raise interest rates.

The Economics of Monasticism

Just turned this in...

Why are there monks and nuns?  Why do some men and women under the influence of this motive take vows of poverty, chastity (celibacy) and obedience?  Why do communities of such people adopt peculiar economic arrangements which prohibit individual private property?  And why have such institutions been so successful historically, lasting for generations, sometimes under such adverse circumstances that few or no other institutions have been able to survive, and made wide-ranging contributions to learning and law, agriculture and architecture, and technology?  Clearly, the quintessential motive for a monk or nun is to worship God.  But simply to say monks and nuns exist because people want to worship God is an incomplete explanation, for two reasons. 

First, that human beings desire to worship is not a phenomenon that can be readily explained in terms of biological motives, as for example, human desires for food, sex, or shelter, can be.  So one might ask: Why do humans want to worship God?  That, however, is not a question for an economist.  Economists generally treat what people want as an exogenous factor.  Since the desire to worship God, or some other supernatural entity or entities, is not limited to monks and nuns but is felt (applying the method of “revealed preference”) by most human beings, we may take it as a given part of the human “utility function.”  Following Becker and Stigler (1977), differences in taste for worship can be accounted for in terms of different endowments of a special kind of “capital,” which can be called “spiritual capital.” 

The second problem is that, granting that people want to worship God, it is far from obvious what connection there might be between the worship motive and the monastic lifestyle.  Why do some adopt celibacy for God’s sake, while other people, in some cases probably just as devout, choose to marry instead?  Why is celibacy correlated with the practice of eschewing worldly occupations, even as devout religious householders pursue them?  And why do celibate religious communities adopt economic constitutions which internally abolish private property?  Questions like these deal with the links between “micro-motives and macro-behavior,” and thus seem especially suited to economic analysis.

Some readers may think there is an obvious non-economic explanation of monasticism: religious authority.  People adopt the monastic lifestyle because the Church tells them that God wants them to.  By this account, monasticism would have its origins in the religious doctrines and hierarchies that tell the faithful what God wants, and the individual’s role would consist not so much of choice but obedience.  The appropriate mode of explanation would consist of an examination of the theology and doctrine of the Church to see why the monastic lifestyle was adopted as an ideal, and/or a psychological study of why people believe in and submit to religious authority.  By this account, to treat monks and nuns as rational agents, faced with choices, maximizing utility, subject to cost and opportunity constraints, like consumers in a market, would be to misconceive the problem.

There are (at least) two problems with a theory of this kind.  First, religious people often fail to do what the Church tells them, and they (say they) believe, is God’s will, when faced with incentives to do otherwise.  There are Mormons who drink alcohol, Amish who drive cars, Hindus who eat beef, Muslims who eat pork, and Catholics who divorce or abort babies.  Given the infinite promises (Heaven) and threats (Hell) that religions offer to motivate believers, one might expect believers to have what economists call ‘alphabetic preferences’ for doing God’s will, but it appears that at least many of them do not.  And given that religious people sometimes break the rules, it seems legitimate to take into account normal economic factors of cost and benefit as potential influences on whether and when they do so.  A man who believes God forbids him to hire a prostitute may still be more likely to hire her if her price is low than otherwise.  Likewise, a man who believes that entering a monastery is his surest way to salvation may still be more likely to do so if by doing so he gets some of the things that ordinary men value in life: adequate food, music, study, sleep, economic security, and easy labor. 

Second, at least if we focus on the Christian case, the monastic way of life was not originally imposed by Church authorities or present ab initio in sacred scripture.  Nothing like a plan for a monastery appears in the Bible, although monasticism did emerge from the efforts of devout people to live by Gospel teachings.  Nor did popes or bishops invent the monastic life and prescribe it to their flock.  Odd as it may sound, given monks’ reputation for hierarchical organization and rigid discipline, monasticism is a case of what the Austrian school of economics calls spontaneous order.  It emerged in Egypt in the 3^rd century B.C. when hermits like St. Anthony fled to the desert and attracted followers, then it evolved and spread throughout the Christian world and beyond.  Monasticism was first lived, then codified, most famously but not only in the Rule of St. Benedict, and thereafter remained dynamic, with new monastic orders appearing and competing with each other.  No one planned monasticism.  It was a pattern emerging without design from individual choices, as a price emerges in the marketplace.

Some features of monastic life, especially the absence of internal private property, resemble the ideas of modern socialism.  That is not to say that monasteries resemble Communist states like the Soviet Union, but rather that they bear some resemblance to small, voluntary socialist communes, like the utopian experiments at Brook Farm and New Harmony in the United States, or the Israeli kibbutzim.  This similarity is puzzling, because secular socialist communal experiments have generally been transient, dissolving within a few years or at most after a generation.  Monasteries, by contrast, have exhibited a durability which virtually no other human institution, apart from the Christian Church itself, can match, often lasting for centuries, with some stretching back more than a millennium. 

The perennial irony of monasticism is that monks are always fleeing the world, while the world is always following them.  Or, to state the point more tendentiously, monasticism is frequently corrupted by the prosperity which its piety creates, and then reformed from within by zealots who want to recover pristine ideals.  For example, the late medieval Cistercians, who sought agricultural self-sufficiency by fleeing ‘the world’ into the uncultivated wilderness, ended by acquiring large holdings of land, and became some of Europe’s leading sheep farmers, viticulturalists, and builders and operators of water-mills, the great power source of that time.  They engaged in international trade and even developed a reputation for wealth and greed.  To an economist, this is a record to inspire admiration.  To historians sympathetic to the pristine ideals to which the early Cistercians aspired, as well as to some later monastics in the Cistercian and other orders, the same process may seem like a sad story of decline.  However it is evaluated, monasticism’s capacity both to endure, to achieve success in almost every field of human endeavor, to preserve and advance civilization in manifold ways, calls for explanation.

A further characteristic of monasticism is of special interest.  Political philosophers for centuries, especially John Locke, Thomas Jefferson, and James Buchanan, have imagined a “social contract” as the basis for the legitimacy of government, and the virtue of “consensual” government is habitually acknowledged by modern liberalism.  Yet no modern democracy actually asks the consent of its subjects (individually, that is) to govern them; no one really signs a social contract.  Citizenship in a modern democracy, and subordination to its laws, is not based on consent; but membership in a monastery, and subordination to its rules, is, being a result of an explicit vow made by a consenting adult.  It is interesting, therefore, to contrast the real social contracts of monasticism with the fanciful ones of the philosophers.

That's the intro...

The Future is Unknown

"A talent for missing trends" (Richard Rahn):

Did you notice that the major economic forecasters, both private and government, totally missed the global credit crisis and size of the recession?

The mainstream consensus economic forecasts made in December 2007 for the year 2008 for the United States, Europeand Japan predicted roughly twice as much growth as actually occurred. You may recall that a year ago, when oil prices were racing toward $147 per barrel, the high-paid wizards at Goldman Sachs were projecting it to go over $200 per barrel - it is now $40-something a barrel. A few economists claim to have forecast this great recession, but most have been pessimists for years, and predicting nine out of the last three recessions is not really an example of forecasting brilliance.

The foreign policy/political forecasts were even worse. A year ago, as the presidential nominees of both parties were being selected, the widely held belief was that the great issue would be Iraq. The Democratic establishment believed Senate Majority Leader Harry Reid's words, "the war is lost."

Because of that belief, the Democrats selected their most antiwar candidate, Barack Obama. The Republicans nominated John McCain, who was the champion of winning the war, in part, through the "surge," which indeed did work.

Each candidate had essentially sewed up his respective party nominations before the extent of the economic problems became clear. In retrospect, it is unlikely Mr. Obama and Mr. McCain would have become the nominees given what we know now about the economic situation. Each party had other candidates with stronger economic credentials who would have been more credible.

In the mid-1990s, when the fear of global warming was first becoming fashionable, the global warming theorists said we had only 10 years to make fundamental changes with carbon dioxide (CO2) emissions or the planet was doomed (i.e. the "hockey stick" thesis).

Well, it has now been more than 10 years. and the planet has actually been getting cooler over the last decade, which was not forecast by a single major climate model (oh, well). Also the polar ice cap has not disappeared, and the polar bear population is getting bigger, not smaller! It seems those who claim the variable output of the sun (sun spot theorists) has more effect on Earth temperature than CO2 might just be right.

The public tends to think economists are supposed to be able to predict what will happen to the economy.  We really can't.  It's a little embarrassing.  But I guess we're in good company, or at any rate, in a lot of company.

Theories with Holes: The Paradox of Thrift

Matt Yglesias tries to explain the "paradox of thrift," a key concept in Keynesian economics:

[I]t’s probably worth attempting a layman’s explanation of “the paradox of thrift” in the current situation. So here goes:

I get a paycheck direct deposited into my bank account every two weeks, which is my salary less deductions for taxes and less money diverted into retirement savings. And every month, about as much money comes out of that account—to pay the mortgage, to pay utility bills, to pay credit card bills, and as ATM withdrawals for cash that I spend. I also have coming in a less-regular flow of checks for various freelance assignments I pick up here and there. Those freelance assignments don’t come with taxes deducted, so I always winding up owing money when I do my taxes so I try to make sure I have money saved to pay that off when April comes around. Beyond that, I’m usually saving up some money to take a trip (to Spain, for example) or to buy something somewhat expensive (a new Macbook, for example). But those kind of savings are a pretty small portion of the overall pie. The money I’m not saving for taxes or MacBooks gets spent on goods and services. That spending provides jobs for other people around the world. And those people, in turn, probably spend most of the money they make on other goods and services thus providing more jobs.

So what happens if I decide to cut back and save more, maybe because I want to buy a car or just because I feel a bit nervous and want to build up a cushion? Well, if there’s some particular business that depends crucially on my patronage, that might be bad news for them. But even though the economy as a whole depends on consumers like me spending me, my personal decision to cut back shouldn’t particularly have any macroeconomic impact. And not just because the amount of money is small. It won’t have much impact because if I increase the amount of money I have in my savings account, the bank can increase the amount of money it lends out. And just as my spending led to economic activity and jobs, whatever it is other people borrow money from the bank to do will also generate economic activity.

Why is it that the bank can lend out more money when Matt saves more?  It has the cash, yes, but where does the borrower come from?  Implicit here-- take note-- is an assumption of some kind of capital market, where prices, namely in this case interest rates (which is a kind of price), or perhaps some kind of credit rationing, equalize supply and demand for loanable funds.  Yet the next step in the argument is to assume that this market breaks down:

But now suppose a bunch of people lose their jobs in the construction business and start spending less money. And also a bunch of people in finance lose their jobs and start spending less money. And some restaurants and bars that catered to the finance crowd start having less business so they employ staff for fewer hours and those guys all start spending less money.

Now it’s not just me looking to build a bigger cushion by cutting back on spending, it’s a whole bunch of people looking around and feeling nervous and deciding to cut back. Well, with all that cutting back there’s a lot less stuff flying off the shelves. So retailers start laying off workers (who need to reduce spending and whose friends start feeling nervous and reducing their own spending) and discounting the merchandise. Maybe the sales are so impressive that everyone changes their mind, decides that the bargains are too good to pass up, and goes and buys a bunch of stuff rather than increasing savings...

Well, yes.  That's how the price mechanism works: prices rise or fall to whatever point equilibrates supply and demand.  What's needed to make the story work here is an ad hoc assumption that for some reason the price mechanism doesn't work well here.  But if you adopt ad hoc assumptions like that there are a lot of stories you can tell.

If so, the economy just had a minor hiccup and life goes on. But maybe the accelerating wave of discounts just makes people feel more nervous. And maybe I see all this discounting and decide not to buy that new MacBook after all, because it’s not on sale yet and I’m betting it will be soon.

Now we’ve entered “paradox of thrift” territory. People are saving more. And the increased saving isn’t being cycled back into the economy as new investment...

This assumption that savings does not get cycled back into the economy as new investment is crucial.  If banks will lend out the new money to entrepreneurs, who invest it, there is no paradox of thrift, just a re-allocation of resources from consumption to investment.  So it's important to figure out why this crucial market mechanism is supposed to fail.

In part, that’s because of problems in the financial system...

It occurs to me that the banks are simultaneously being berated for making bad loans before and for not lending out more money now.  It's not surprising that they're reluctant to lend when not only has their past lending worked out badly, but they're being blamed for it on all sides.  I suspect the banks are being excessively scapegoated here.  It's not their fault that housing prices were allowed to soar to unsustainable levels and then allowed to drop.  And it's not exactly their fault, either, when sub-prime borrowers walk away from their homes.  To compel people to honor their contract agreements is generally thought to be the government's job.  If anti-bank populism makes the banks especially risk-averse, it's doing harm to the economy.

But in part, it’s because with short-term demand slumping so much, there’s not a lot of worthwhile investing to be doing...

STOP!  What does short-term demand have to do with it?  Investment is often or even typically geared towards the long term.  Few investments pay off in the next year, or the year after.  It's not clear why an investment project that is expected to pay off over the course of, say, the next thirty years, should care about a slump in short-term demand.  If they do, it's for other reasons.  For example, businessmen might be confident that demand will come back, but be unsure what customers, after regaining their confidence, will want to buy.  Or businessmen might be concerned about increased expropriation risk due to a sudden vogue for economic populism resulting from the recession-- or perhaps the possibility of pro-union legislation which will make it easy for organized labor to steal or destroy any value streams that investors create. 

To say that slumping short-term demand means there's no worthwhile investing does not, in itself, make sense.  To make it make sense would require some other theory, which would likely have quite different policy implications.  If investors are wary because of an increase in perceived political risk, government would be wise to minimize uncertainty by either doing nothing, or by doing things that were clearly temporary and wouldn't change anything in the long run-- and the worst thing politicians should do is to talk about unspecified but seemingly radical "change."  If investors are wary because they rely on short-term demand as an indicator of the trajectories of long-run demand and don't know what to invest in when short-term demand is slumping, the best policy might be to put money into consumers' pockets fast-- doesn't much matter whose-- and let them buy whatever they now think most worthwhile, to signal to business to make more of it.  Matt continues:

The economy needs someone to decide to borrow some money and start a new firm that employs these newly unemployed people. But with the volume of consumption going down so rapidly, nobody’s really in the mood to start a new business...

"In the mood."  This is the problem with Keynesianism: it alternates between rational rigor and ad hoc behavioralism.  What do "moods" have to do with it?  If money's cheap because everyone's scrambling to save, and meanwhile there are lots of unemployed workers to hire, that's a great time to do your long-term investment.  If you're expecting Project X to pay off starting three years from now, and to go on paying off for another thirty, you don't care if demand will be weak in 2009-2010.  You'll invest now and make money later.  As long as you assume people behave rationally, you can at least develop the logic of your models pretty rigorously, with well-defined and well-motivated, if not 100% realistic, assumptions about the roots of human action.  When your theory is relying on moods (or "animal spirits," as Keynes said) to explain phenomena, you're on much shakier ground.

And existing businesses are busy scaling back production, not interested in borrowing money to ramp it up. The result of this is an overall fall in the average level of income. And that means that even with the share of income being saved going up, the actual level of savings can be going down and we can truly end up in the toilet.

It's not clear why Matt thinks it's a problem that the level of savings is falling if it can't be channeled into investment anyway.  But if the price mechanism does its work, even if the dollar value of savings does fall, it should be able to buy a lot more of certain key inputs, say labor, or gasoline. 

The ultimate point of a fiscal stimulus policy is to avoid that toilet scenario. To get money flowing in the economy again, so that savings gets translated into investment which gets translated into jobs which pay salaries which, in turn, are spent and saved in ways that create jobs.

But of course, a fiscal stimulus policy also involves the government borrowing a lot of money, and the government is competing with private corporations for the same stock of loanable funds.  That stock of loanable funds isn't necessarily fixed: government spending could feed back into the supply of loanable funds positively (e.g., if an unemployed worker gets a government job and decides to save more) or negatively (e.g., if the increased government debt spooks some investors and causes them to abandon projects, and not pay workers, who then don't have money to save).  So it's not a logical impossibility that government spending might occur without crowding out private investment.  But if it does crowd out private investment-- and it seems very likely that it will, and to me not at all unlikely that it will crowd it out on a more than one-for-one basis-- the stimulus will boost GDP in the short run, if at all, only at the expense of making us poorer in the long run.  (Hat tip: Tyler)