The Free Thinker

If This is the Best Case They Can Make for Keynesianism...

... it must be even wronger than I thought. Krugman writes:

Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed, relative to what could have happened — an acrimonious failure to agree on anything — the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States.

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed.

Krugman is conflating two quite different ideas here: (a) that the government (or the central bank) has to bail out banks to prevent a collapse of the financial system, and (b) that most governments need to retrench right now. Not only are the two ideas quite separable-- the government could bail out the banks and increase spending; or it could do neither-- but if anything, they are philosophically opposed. A comprehensive interventionist might advocate both; a libertarian would support neither. TARP is at this point not, I think, especially controversial among economists, so it's interesting that Krugman stakes out an anti-TARP position here. I'm glad of it: I think the anti-TARP view deserves more of a hearing than it has gotten. But how he would justify conflating TARP and austerity, I have no idea.

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.

Some economists weren’t convinced. One caustic critic referred to claims about the expansionary effects of austerity as amounting to belief in the “confidence fairy.” O.K., that was me.

But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank, which last year urged all European governments — not just those in fiscal distress — to engage in “fiscal consolidation.”

And when David Cameron became Britain’s prime minster last year, he immediately embarked on a program of spending cuts in the belief that this would actually boost the economy — a decision that was greeted with fawning praise by many American pundits.

Now, however, the results are in, and the picture isn’t pretty.

This is ridiculous. First, one distinction which it's essential to make is that between (a) countries that could have borrowed more, such as the United States, at least in the short run, or Germany; and (b) countries that lost access to financing or were on the verge of doing so, like Greece, Italy, Portugal, Spain, and Ireland. The latter were compelled to adopt austerity, not on their own terms but on those imposed by the markets, and the sovereign debt crisis hurt them in other ways too. The former had flexibility to design austerity in the way that would do them the least harm. So it's fair to use the example of Britain, but not Greece, Latvia, etc.

Second, the results are certainly not in-- yet. The European debt crisis seems to have been resolved, finally, but only just. There's been no time for it to take effect. And in general, austerity is a policy oriented towards the longer term. One doesn't expect it to help over the long term, but over three, five, ten years. In the East Asian crisis of 1998, austerity was pursued, and the recession was very deep and painful; but there was a strong rebound a couple of years later; in Japan after the crash of 1989, Keynesian stimulus was pursued, and the recession became more or less permanent.

It would be much more reasonable to say that "the results are in" on the path that was taken in America, namely, not-austerity, but Keynesian stimulus, "and it ain't pretty." Stimulus has had more time to work. The European sovereign debt crisis is much less of an issue here. And Keynesian stimulus is supposed to work in the short run; that's the whole point. Of course, Krugman claims that America has pursued austerity, but that just underscores the uselessness of this conceptual framework. With deficit spending at 10% of GDP for three years, this is as Keynesian a fiscal policy as we've had in decades. If we were deficit-spending 20% of GDP and it didn't work, the Keynesians could always say, hey, it should have been 30%. Of course, the Keynesians can also deny that it didn't work: they can say it did work, because things would have been even worse. If they were worse, they can say they would have been even worse than that. If we were deficit-spending 20% and unemployment were 15% instead of 9%, well, they could say that if we had been deficit-spending only 10% of GDP, unemployment would have been 20%. Why they expect anyone should believe their counter-factuals when none of them foresaw the crisis is a mystery. More conservative, free-marketeer, rational-expectations type economists are more epistemically modest. All we know is that the economy has a natural tendency towards full employment, and the best bet is that if policy had been neutral (admittedly that's hard to define) it would probably have reverted to trend (admittedly that's also hard to define) in a few years. By that standard, Keynesian stimulus seems to have made things worse, and certainly hasn't helped much; and the marginal effect of Keynesian stimulus would probably have been even more harmful, since the marginal benefit of just about anything falls, and the marginal cost rises, as you get more of it. But that's just the best guess.

Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared.

Maybe the most telling thing is what now passes for a success story. A few months ago various pundits began hailing the achievements of Latvia, which in the aftermath of a terrible recession, nonetheless, managed to reduce its budget deficit and convince markets that it was fiscally sound. That was, indeed, impressive, but it came at the cost of 16 percent unemployment and an economy that, while finally growing, is still 18 percent smaller than it was before the crisis.

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different.

If you’ve been reading accounts of the financial crisis, or watching film treatments like the excellent “Inside Job,” you know that Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

"Iceland let the banks go bust and expanded its social safety net." OK. But far more importantly, to-the-exclusion-of-everything-else importantly, Iceland has a floating currency and could devalue. Real wages could fall. For a tiny economy like Iceland's, trade is crucial. We always knew that improving competitiveness by devaluation can help a lot in a crisis.The East Asians did it in 1998, too. That's monetarism, not Keynesianism.

One supposes Krugman would use the best available arguments in favor of "the path not taken." If this is it, I was right to be dismissive.

The Putinization of American Politics

"Fox Wars: The Obama Administration Wants to Delegitimize Any Significant Dissent" (Charles Krauthammer, 10/23/2009):

Rahm Emanuel once sent a dead fish to a live pollster. Now he’s put a horse’s head in Roger Ailes’s bed.

Not very subtle. And not very smart. Ailes doesn’t scare easily.

The White House has declared war on Fox News. White House communications director Anita Dunn said that Fox is “opinion journalism masquerading as news.” Patting rival networks on the head for their authenticity (read: docility), senior adviser David Axelrod declared Fox “not really a news station.” And Chief of Staff Emanuel told (warned?) the other networks not to “be led (by) and following Fox.”

Meaning? If Fox runs a story critical of the administration — from exposing White House czar Van Jones as a loony 9/11 “truther” to exhaustively examining the mathematical chicanery and hidden loopholes in proposed health-care legislation — the other news organizations should think twice before following the lead.

The signal to corporations is equally clear: You might have dealings with a federal behemoth that not only disburses more than $3 trillion every year but is extending its reach ever deeper into private industry — finance, autos, soon health care and energy. Think twice before you run an ad on Fox...

Fox and its viewers (numbering more than CNN’s and MSNBC’s combined) need no defense. Defend Fox compared to whom? To CNN — which recently unleashed its fact-checkers on a Saturday Night Live skit mildly critical of President Obama, but did no checking of a grotesquely racist remark CNN falsely attributed to Rush Limbaugh?

Defend Fox from whom? Fox’s flagship 6 o’clock evening news out of Washington (hosted by Bret Baier, formerly by Brit Hume) is, to my mind, the best hour of news on television. (Definitive evidence: My mother watches it even on the odd night when I’m not on.) Defend Fox from the likes of Anita Dunn? She’s been attacked for extolling Mao’s political philosophy in a speech at a high-school graduation. But the critics miss the surpassing stupidity of her larger point: She was invoking Mao as support and authority for her impassioned plea for individuality and trusting one’s own choices. Mao as champion of individuality? Mao, the greatest imposer of mass uniformity in modern history, creator of a slave society of a near-billion worker bees wearing Mao suits and waving the Little Red Book?

The White House communications director cannot be trusted to address high schoolers without uttering inanities. She and her cohorts are now to instruct the country on truth and objectivity?

Nationalization of major companies, attempts to muscle out critics in the press, efforts to rewrite history in favor of mass-murdering Communist tyrants... Wow. Note that Obama and Putin go after TV rather than print media; the National Review is safe. It's OK to have small freethinking cliques, but you can't give the other guy access to public opinion. By the way, I made a break with CNN last fall. The last straw was a story last October about people losing money in non-FDIC-insured banks, which was all fine up to the sting: they mentioned that McCain's nephew worked in one of these banks, or something. It was such a low blow. A mere pundit would have been ashamed to make such an ad hominem attack on a candidate's family. I would have been ashamed to see freerepublic.com sink to that level. That was the end. I will simply never watch CNN. I don't think it should be shown in public places, but it doesn't hurt me, because I can look the other way, and I always have an iPod to drown out the sounds. I never watched Fox News either but now I feel guilty about that. If I want to keep my First Amendment freedoms, shouldn't I support the network that is standing up for them, even if I don't like it?

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?

Epistemology and Mapmaking

In a recent debate with (mostly) Joyless Moralist, the subject of epistemology was raised.  I wrote:

It sometimes happens that an advance in epistemology occasions a loss in real insights which were not developed in ways that satisfy new epistemic standards.

To this Joyless Moralist replied:

This is one of the funniest statements I've read on this blog. New epistemic standards? So, it's as though the FESC (Federal Epistemic Standards Commission) passed some new rules, and now earlier insights, even though you admit that they're "real", have to be recalled? Maybe we could bribe the Epistemic Standard Police to look the other way while we sell some on the sly through the philosophy black market.

But seriously. When I say that an insight is "real", I mean that it captures some part of the truth. If you're adhering to an epistemic standard that excludes that, there's a problem with your standard, because the whole point of philosophy and theology is to seek the truth.

So I thought I'd quote one of my favorite sources on the ambiguous role of rising epistemic standards in intellectual history, Paul Krugman's Development, Geography and Economic Theory.  Krugman uses mapmaking as a metaphor:

A friend of mine who combines a professional interest in Africa with a hobby of collecting antique maps has written a fascinating paper on what he calls "the evolution of ignorance" about Africa. The paper describes how European maps of the African continent evolved from the fifteenth to the nineteenth centuries.

You might have supposed that the process would have been more or less linear: as European knowledge of the continent advanced, the maps would have shown both increasing accuracy and increasing levels of detail. But that's not what happened. In the fifteenth century, maps of Africa were, of course, quite inaccurate about distances, coastlines, and so on. They did, however, contain quite a lot of information about the interior, based essentially on second- or third-hand travelers' reports. Thus the maps showed Timbuktu, the River Niger, and so forth. Admittedly, they also contained quite a lot of untrue information, like regions inhabited by men with mouths in their stomachs. Still, in the early fifteenth century Africa on maps was a filled space.

Over time, the art of mapmaking and the quality of information used to make maps got steadily better. The coastline of Africa was first explored, then plotted with growing accuracy, and by the eighteenth century that coastline was shown in a manner essentially indistinguishable from that of modern maps. Cities and peoples along the coast were also shown with great fidelity.

On the other hand, the interior emptied out. The weird mythical creatures were gone, but so were the real cities and rivers. In a way, Europeans had become more ignorant about Africa than they had been before.

It should be obvious what happened: the improvement in the art of mapmaking raised the standard for what was considered valid data. Second-hand reports of the form "six days south of the end of the desert you encounter a vast river flowing from east to west" were no longer something you would use to draw your map. Only features of the landscape that had been visited by reliable informants equipped with sextants and compasses now qualified. And so the crowded if confused continental interior of the old maps became "darkest Africa," an empty space.

Krugman is using this as a metaphor for the recent history of the field of economics:

In these lectures I will present an interpretation of the evolution of ideas in the two fields of development and economic geography. I will argue that in each of these fields, between the 1940s and the 1970s, there was a cycle somewhat similar to the story of how improved mapmaking temporarily diminished European knowledge about Africa. A rise in the standards of rigor and logic led to a much improved level of understanding of some things, but for a time it also led to an unwillingness to confront those areas that the new technical rigor could not yet reach. Areas of inquiry that had been filled in, however imperfectly, became blanks.

Development and economic geography are fascinating subjects and the dissertation I want to write is related to this passage, but economics is not my concern here. Rather, Krugman's mapmaking metaphor may illuminate what JM found so odd in my statement. Socrates and Descartes, those defining figures of ancient and modern philosophy respectively, are notably skeptical; they question and doubt and undermine, and tend towards substituting acknowledged ignorance for claims to knowledge that are exposed as groundless. To focus on modern philosophy, much that the medievals thought they knew the moderns doubted, demanding reasons that could not be given. And when, as I think sometimes or often was the case, what the medievals believed and the moderns doubted contained a good deal of truth, a loss of real insight may have occurred.

If heightening one's epistemic scruples can lead to losses of true insights, why should we ever do it?  Because, of course, credulous people adopt inadequately supported false beliefs as well as inadequately supported true ones.  We sacrifice Timbuktu and the River Niger in order to stop believing in the men with mouths in their stomachs.  More specifically, it seems to me that epistemic scruples are often made more exacting when people encounter disagreement.  If everyone says A, I am satisfied; but if I encounter someone who thinks B instead, I am compelled to look for reasons.  Descartes lived in a world of Catholics, Muslims, Protestants, and Jews: who was right?  Socrates lived in a Greece whose beliefs had been challenged by encounters with foreign cultures and by new currents in philosophy: what was true?  One had to look for a common basis on which to found agreement.  The alternative is not appealing.  It is simply to insist that one's views are right and shout down the alternatives.

There is, however, an important difference between philosophy and mapmaking, which is related to something I discussed in an earlier post, "The Domains of Reason, and of Intersubjectivity."  There are things one can think about quite rationally, but where one can prove little or nothing because one's evidence is internal.  Mapmaking deals only in the intersubjective, but philosophy relies, sometimes, on introspection.  This limits the degree to which consensus can be established by means of academic debate.  The search for truth here ultimately calls for a very different kind of conversation.

Public esteem for economists really ought to fall when they read this from Nobel Prize winner Paul Krugman:

When it comes to domestic policy, there are two Barack Obamas.

On one side there’s Barack the Policy Wonk, whose command of the issues — and ability to explain those issues in plain English — is a joy to behold.

But on the other side there’s Barack the Post-Partisan, who searches for common ground where none exists, and whose negotiations with himself lead to policies that are far too weak.

Both Baracks were on display in the president’s press conference earlier this week. First, Mr. Obama offered a crystal-clear explanation of the case for health care reform, and especially of the case for a public option competing with private insurers. “If private insurers say that the marketplace provides the best quality health care, if they tell us that they’re offering a good deal,” he asked, “then why is it that the government, which they say can’t run anything, suddenly is going to drive them out of business? That’s not logical.”

OBVIOUSLY, the reason a "public option" might drive private insurers out of business is not because of its superior efficiency, but because a government-run health care system would get taxpayer subsidies. If it didn't, it's not even clear in what sense it could be a "public option." This is perfectly consistent with "the government not being able to run anything [well]." An incompetent health care program funded by other people's money might be preferable to a high-quality program you have to pay for yourself.

It's one thing for Barack Obama to make this mistake. Politicians are not known either for their ability to grasp economic principles or for their willingness to honestly articulate even what little they do understand. But for Krugman to give this elementary fallacy as an example of how "Obama's command of policy issues - and ability to explain those issues in plain English - is a joy to behold."

If you're an average college-educated reader and you think you see what's wrong with Krugman/Obama's argument, but you doubt whether you're competent to second-guess a Nobelist in economics... well, don't worry, in this case, you are. (Or maybe you should worry.)

"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.

Here's Paul Krugman's rehash of Keynesian business cycle theory:

So, how does this all end?

I’ve been saying for a long time that this isn’t your father’s recession — it’s your grandfather’s recession. (I actually used the phrase about the last recession, too.) That is, it isn’t something like the 1981-82 recession, which was brought on by the Fed to control inflation, and ended when the Fed decided that we had suffered enough. Instead, it’s like the 1929-33 recession — or the recession of 1873-1879 — a slump brought on by the collapse of an investment and credit bubble...

Maybe it’s time to dust off Keynesian business cycle theory.

Keynes himself actually didn’t have much to do with this theory. In fact, one of the key moves in his development of the General Theory was the decision to focus on how economies stay stuck in depression for extended periods, rather than on the more complex question of explaining the economy’s ups and downs. But he did devote a brief chapter at the end to the subject, and Hicks elaborated on this quite a lot.

What’s notable about this theory is that it made no use of the self-correcting mechanism expounded in every principles textbook, mine included — the mechanism in which falling prices lead to a rising real money supply, which shifts the aggregate demand curve out moves the economy down the aggregate demand curve. Why? Well, as we’ve now learned the hard way, a sufficiently severe bubble-bursting pushes you into the liquidity trap, and makes the aggregate demand curve more or less vertical.

Instead, recovery comes because low investment eventually produces a backlog of desired capital stock, through use, delay, and obsolescence. And eventually this leads to an investment recovery, which is self-reinforcing.

And what do we mean by use, delay, etc.? Calculated Risk had a nice piece on auto sales, which I find helps me to think about this concretely. As CR pointed out, at current rates of sale it would take 23.9 years to replace the existing vehicle stock. Obviously, that won’t happen. Even if the desired number of vehicles doesn’t rise, people will start replacing vehicles that wear out (use), rust away (decay), or just are so much worse than newer models that they’re worth replacing to get the spiffy new features (obsolescence).

As autos go, so goes the capital stock. In the long run, we will have a spontaneous economic recovery, even if all current policy initiatives fail. On the other hand, in the long run …

Note the casual tone here.  That's not just Krugman's style.  It's essential to Keynesianism.  As became clear during the monetarist and new classical (rational expectations) counter-attacks in macroeconomics during the 1960s and 1970s, you can't make Keynesianism rigorous.  You can't base it on rational optimizing agents in competitive markets.  Keynes' original argument relied on various ad hoc behavioral and/or institutional assumptions, and was not always rigorous even when those assumptions are accepted.

Think about the argument here.  A "a backlog of desired capital stock?"  What does that mean?  Surely desire for capital (meaning capital goods, not money) is never in short supply.  I would be glad to have a house and a few cars and some functional machinery to make stuff with!  What limits people's willingness-to-pay (not their desire) for capital is that they expect the returns to be low.  "Obviously, that won't happen," writes Krugman about replacing the nation's stock of cars in 23.9 years.  No, that's not obvious.  If the economy deteriorates enough, we'll use our cars longer, and when they give out we might not replace them, just ride the bus or something.  Yes, the utility of cars rises as they become fewer, so there might be some pickup in demand as more of them fail, but that might just cause another drop in demand for something else (houses, say, or computers) as people cut other expenses to replace their cars.

Krugman diagnoses "an investment and credit bubble."  Something looks like a bubble if it pops.  That is, if variable x drops like a stone this year, x's level last year looks like a bubble.  But it might be, not that x was at an unsustainable level before, but that there was some shock, some disaster that caused it to fall.  Housing was a bubble, yes.  Credit -- maybe.  But investment, no.  First, investment, except residential construction, hasn't been so high for the past few years.  Second, the concept of an investment bubble is problematic.  It's clear what it means to say there's a bubble in, say, tulip bulbs: tulip bulbs are nonsensically expensive relative to other goods.  But investment is just a general term for all the stuff we make today that makes us richer tomorrow.  How can you have too much of that?

There's a much more parsimonious story to be told here.  A story that can be told in non-casual ways and make sense.  In the past few months, there's been an explosion of political risk, resulting in particular from the victory in the 2008 elections of Democrats who want to tax and spend more.  Investors have to think: If I invest, and succeed, how much of my returns will get confiscated by the state?  The answer to that question has just gotten a lot worse, ergo investment has fallen off a cliff.

UPDATE: By the way, for the record, I think Keynes might have been right that in 1936 what the economy needed was massive government spending.  The policy insanity of the 1930s had so devastated investor confidence that moderate measures and efforts to commit to non-expropriation couldn't work, at any rate not while FDR was president.  (If Wilkie had won in 1940, maybe.)  So having the lumbering government force the economy to move may have been the best we could do then.  And that's sort of what happened.  WWII was helpful because it forced a return to some kind of means-ends rationality: we had to make stuff and do things, even if it was just for the sake of killing rather than, say, the good life, and so we had to give doers and makers room and respect.  The 1930s cult of envy and escapism and paranoia withered and we became grown-ups again, and the habits of making and doing, combined with the Red Scare, brought a return of capitalism and prosperity (which WWII was not, despite high GDP numbers).  Keynes had one foot in theory and one foot in policymaking, and while I think the theoretical pretensions of the General Theory are hugely inflated and the biggest misstep in 20th-century economics was to buy into those pretensions, Keynes' advice may well have been largely right in an immediate sense.  Maybe Keynesianism can be compared to feudalism, which emerged during the 9th-century Viking invasions of Europe: it was a crude institution that may have been appropriate for a particular time, but whose continuance was unfortunate later.  Keynes was bad for economic theory but maybe good for economic policy, in the short run.  Today's Keynesian-revivalism, by contrast, is not theoretical improvisation to justify a sound policy hunch, but a bungling application of outworn economic doctrines that were invented for a very different economy, long ago.

UPDATE II: By the way, I was a little unfair above: the explosion of political risk began, not with Obama's and the Democrats' victory, but to some extent with the Bear Stearns bailout earlier this year, and especially with Hank Paulson's ultimatum last October.  Obviously these events were forced by markets to some extent, and there's no way for the authorities to "do nothing" in such cases (although they could have "done less"); since the state is the ultimate guarantor of the contracts of a bewildering web of which the big banks are at the center, it can't not be involved.  Paulson's ultimatum, in particular, was a breaking-point of sorts: I think prior to that moment no one had quite conceived that such a thing-- such a demand for authority, such volumes of money-- could occur.  Everyone's political model of what the government is and does vis-a-vis the market was thrown into chaos.  Obviously that's not Obama's "fault" even if he supported it.

But the handover of power in the wake of the Paulson bombshell was peculiarly unfortunate, because a revolution in the economic constitution was already underway and then was handed off into the extremely inexpert hands of Obama, and the hungry paleoliberal Democrats with their backlog of ancient agendas.  That Obama has capable lieutenants may be of little use.  What is needed is not advice but decisions, or rather, commitments.  Something to fix, and coordinate, expectations, to eliminate the sense of flux, the toxic counter-point of high-stakes grabbing and dreamy improvisation.  

I agree with most of this critique of Krugman (and the "stimulus") but I wanted to quibble with this:

Krugman is very concerned that the liquidity trap we’re arguably in will degenerate into a sticky and persistent deflationary spiral, with far lower output for years to come (an American “lost decade”).

The President faces a different trap. By believing the mathematics and not the people, he’s come out in favor of a huge spending plan that runs deeply counter to what nearly every American now feels deep in her marrow: that this is a time for saving, not for borrowing and spending.

And there’s something very important about this that even an economist needs to account for. Because the overall mood of the country prohibits a quick return to spending and investment, the multiplier effect of the stimulus will be muted. (my emphasis)

Does the mood of the country prohibit a quick return to spending and investment?  I can easily make sense of the idea that people want to spend less.  Apply the following model: People want to consume, annually, a certain percentage of the lifetime net worth.  That net worth has fallen sharply due to reduced housing and stock prices, and also maybe reduced prospective earning opportunities.  So they want to consume less.

But investment is a way of transferring resouces from the present to the future.  You put solar panels in your roof.  Up-front cost now, lower energy bills for years to come.  You build a factory.  Up-front costs now, revenues from the sales of products for years to come.  People should want to do more of this at a time when they are desperate for stronger balance sheets.

I don't think the obstacle to investment is "the mood of the country."  It is (a) the volatility of prices and other macroeconomic variables (employment, GDP) makes it harder to calculate the value stream that investments will generate, (b) increased political risk, as the explosion of present and expected future government interference in the economy in the past few months makes people suspect that their investments will be directly or indirectly expropriated, and (c) the fact that so many investment-type assets are now for sale cheap through the devalued stockmarket (why build a factory or a fleet of trucks when you can buy companies that have these things at half of what they cost two years ago?)

Obama's losing Krugman (and Martin Wolf):

You know, it was widely expected that Obama would have a stimulus plan ready to pass Congress even before his inauguration. That didn’t happen. We were told that this was because the economic team was working flat out on the financial rescue.

In fact, when it comes to bank rescue it’s hard to see much evidence that anything was accomplished during all that time; the team is still — still! — running ideas up the flagpole to see if anyone salutes. And the ideas look remarkably bad. (Welcome to the Ancient and Hermetic Order of the Shrill, Yves.)

Meanwhile, when it came to stimulus legislation, when Obama finally introduced his economic plan he immediately began negotiating with himself, preemptively offering concessions to the GOP, which voted against the plan anyway. (And Obama appears, in the name of bipartisanship, to have thrown away a Senate vote he may well need.)

As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?

While Krugman and I disagree on what kind of activism is likely to help, I'd also like to see more activism.

Krugman doesn't make enough concessions here:

If the government builds a bridge, the boost to aggregate demand comes not because people are “tricked” into feeling wealthier but because the government is building a bridge. The question then is how much of that direct increase in government demand is offset by a fall in private consumption because people expect their future taxes to be higher...

Yes, an increase in government demand could be offset by a fall in private demand because people expect their future taxes to be higher.  Private demand could also fall because an employer who would have hired those workers finds that they're already employed by the government.  Or private demand could fall because the money they would have borrowed to finance a project is instead used to buy government bonds.  There are lots of ways that government spending can crowd out private-sector activity.

And here he seems to suggest that too many tax cuts were part of what caused the Great Depression:

In the United States, the Republican party remains committed to a belief in that old tax-cut magic, with no willingness to rethink its doctrine in the face of catastrophe...  So yes, we can have another depression — because those who refuse to learn from history may be condemned to repeat it.

Herbert Hoover didn't want to run deficits, so he raised taxes: "in 1931-1932 Hoover had proposed -- and a Democratic-controlled Congress had enacted -- a massive tax increase in a desperate effort to balance the federal budget."  I believe the standard Keynesian line has usually been that Hoover's fiscal austerity during a depression was a disastrous mistake.