[Y]ou might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians... didn’t think fiscal policy... was needed.... They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed... all you need to avoid depressions is a smarter Fed. And as long as macroeconomic policy was left in the hands of the maestro Greenspan, without Keynesian-type stimulus programs, freshwater economists found little to complain about. (They didn’t believe that monetary policy did any good, but they didn’t believe it did any harm, either.) It would take a crisis to reveal both how little common ground there was and how Panglossian even New Keynesian economics had become.
In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted.... Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.” How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities. But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed”... the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place. Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?
Between 1985 and 2007 a false peace settled over the field of macroeconomics.... But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever. Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero.... The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero. But zero, it turned out, isn’t low enough.... Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending.... Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious. For 25 or so years they tolerated the Fed’s efforts to manage the economy, but a full-blown Keynesian resurgence was something entirely different. Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown. And so Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” (It’s a mark of how deep the division between saltwater and freshwater runs that Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard.)
Meanwhile, saltwater economists, who had comforted themselves with the belief that the great divide in macroeconomics was narrowing, were shocked to realize that freshwater economists hadn’t been listening at all. Freshwater economists who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who had no idea what Keynesian economics was about, who were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound.... [T]he Chicago school’s... current stance amounts to a wholesale rejection of Milton Friedman’s ideas, as well. Friedman believed that Fed policy rather than changes in government spending should be used to stabilize the economy, but he never asserted that an increase in government spending cannot... increase employment.... And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy.... Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.
Yet... the crisis... has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models... get anything like the current slump... [only by] some kind of fudge factor.... And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?... Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch....
Probably the most influential paper in this vein was a 1997 publication by Andrei Shleifer of Harvard and Robert Vishny of Chicago, which amounted to a formalization of the old line that “the market can stay irrational longer than you can stay solvent.” As they pointed out, arbitrageurs — the people who are supposed to buy low and sell high — need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral. The spread of the current financial crisis seemed almost like an object lesson in the perils of financial instability. And the general ideas underlying models of financial instability have proved highly relevant to economic policy: a focus on the depleted capital of financial institutions helped guide policy actions taken after the fall of Lehman, and it looks (cross your fingers) as if these actions successfully headed off an even bigger financial collapse.
Meanwhile, what about macroeconomics? Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector. There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change...
When senators return to Washington on Monday after a short recess, they will be facing their first vote on a jobs bill worth $15bn, proposed by Harry Reid, leader of the Democratic majority in the Senate. But even aides on Capitol Hill working for lawmakers supporting the measure privately concede that it is a modest package in terms of its economic impact – in stark contrast to the pledge only a few weeks ago by Barack Obama, US president, to make job creation his top domestic priority this year...
Thomas Friedman told readers that: "But now it feels as if we are entering a new era, 'where the great task of government and of leadership is going to be about taking things away from people,' said the Johns Hopkins University foreign policy expert Michael Mandelbaum." Unfortunately, Mr. Friedman apparently doesn't talk to anyone who has ever taken any economics. There are no serious forecasts that do not project that productivity will continue to grow for the indefinite future, and many project that productivity will grow at a more rapid pace than it did in the years from 1973-1995. This means that there is no reason, except incompetent economic management and/or the continuing upward redistribution of income, why the vast majority of the population should not experience improvements in living standards. This would mean an increase in both public and private services.
Left Behind: Latin America and the False Promise of Populism: The political and economic history of Latin America has been marked by great hopes and even greater disappointments. Despite abundant resources—and a history of productivity and wealth—in recent decades the region has fallen further and further behind developed nations, surpassed even by other developing economies in Southeast Asia and elsewhere.... Sebastian Edwards explains why the nations of Latin America have failed to share in the fruits of globalization and forcefully highlights the dangers of the recent turn to economic populism.... He begins by detailing the many ways Latin American governments have stifled economic development over the years through excessive regulation, currency manipulation, and thoroughgoing corruption. He then turns to the neoliberal reforms of the early 1990s, which called for the elimination of deficits, lowering of trade barriers, and privatization of inefficient public enterprises—and which, Edwards argues, held the promise of freeing Latin America from the burdens of the past. Flawed implementation, however, meant the promised gains of globalization were never felt by the mass of citizens.... [H]e argues, the way forward for Latin America lies in further market reforms, more honestly pursued and fairly implemented. As an example of the promise of that approach, Edwards points to Latin America's giant, Brazil, which under the successful administration of President Luis Inácio da Silva (Lula) has finally begun to show signs of reaching its true economic potential.
Week 1.5: Utilitarianism: After the showstopper that is Arrow’s Theorem, we could just throw in the towel. The motivation for studying social welfare functions was to find a coherent standard by which to judge institutions and to propose policies. Now we see that there is no coherent standard. Well, sorry students we are not getting away so easily here in the second week of the class. We will accept that we must violate one of the axioms. Which one do we choose? A lot of normative economic theory is implicitly built upon one of two welfare criteria, either Pareto efficiency or utilitarianism. While it is standard to formally define Pareto efficiency in an undergraduate micro class, utilitarianism is often invoked without explicit mention. For example, we are implicitly using some form of utilitarianism when we talk about consumer and producer surplus. And to argue that a monopoly is inefficient in a partial equilibrium framework is a utilitarian judgment (absent compensating transfers.) So I make it explicit. And I take the time to formally define utilitarianism, explain where it applies and what justifies it and I point out its limitations. In terms of Arrow’s theorem I tell the students that we are dropping the axiom of universal domain (UD.) That is, we are not requiring our social welfare function to apply in all situations, only in those situations in which there is a valid measure of welfare that can be transferred and/or compared inter-personally. In this class, that measure of welfare is willingness to pay, and it applies when there are monetary transfers available and all agents value money in equal terms, i.e. quasi-linear utility.
These lectures contain one important formal result. In the quasi-linear world with monetary transfers utilitarianism coincides with Pareto efficiency. So these two common welfare standards are the same. (Any utilitarian improvement can be made into a Pareto improvement with judiciously chosen transfers and any Pareto improvement is a utilitarian improvement.)
6) DELONG SMACKDOWN OF THE DAY: John Emerson: DeLong / Krugman smackdown:
How flawed is economics? How deep does the problem go? I can’t prove anything, but we need to consider the possibility that the problem goes all the way down. Everyone except Eugene Fama knows that there’s a serious problem, but they’re mostly trying small tweaks and trying to make sure that their faction comes out on top. I’m suggesting that the larger claims of the science of economics are fundamentally unjustified. One comparison is with alchemy and astrology. There was a great deal of truth in those sciences and they provided the foundations for chemistry and astronomy, but their largest claims were flatly wrong.... The second problem with economics is related to the first. Even within the orthodox schools (after excluding Austrians, Marxists, and other alleged fossils) there’s incredibly wide disagreement about critically important questions. You can always get an economist to say what you want them to say. (No, this is not true of climatologists). They don’t have to be fake economists, and no one is ever disbarred, defrocked, or expelled. When economics is being taught in the schools there are definite right and wrong answers, and economics is made to seem like a coherent system. But the minute that something important and real is discussed, economists start mumbling around and arguing. In a science you have a large area of agreement and small areas in dispute, mostly at the frontiers of the discipline. But in economics almost everything is up for grabs. It’s like the days when naturopaths, homeopaths, osteopaths, chiropractors, herbalists, allopaths, and Christian Scientists all contended on equal terms.
What economics really is is a form of expert advocacy.... No one says lawyers don’t know anything. They’re very bright and knowledgeable and, in the context of our society, necessary and powerful. They do know a lot, but no one calls them scientists..... Economists are highly skilled mercenary advocates within an sloppy, open system which is always in the process of redefining itself. And like most mercenaries, economists are most sympathetic to those who can afford them. (“The Magnificent Seven” was a myth. The samurai never protected the peasants, any more than economists or lawyers work for you and me).
7) GRAPH OF THE DAY: Convergence in the OECD Over the Thirty Glorious Years:
8) BEST NON-ECONOMICS THING I HAVE READ TODAY: Zbigniew Brzezinski: How Jimmy Carter and I Started the Mujahideen: Interview of Zbigniew Brzezinski, Le Nouvel Observateur (France), Jan 15-21, 1998, p. 76:
Q: The former director of the CIA, Robert Gates, stated in his memoirs ["From the Shadows"], that American intelligence services began to aid the Mujahadeen in Afghanistan 6 months before the Soviet intervention. In this period you were the national security adviser to President Carter. You therefore played a role in this affair. Is that correct?
Brzezinski: Yes. According to the official version of history, CIA aid to the Mujahadeen began during 1980, that is to say, after the Soviet army invaded Afghanistan, 24 Dec 1979. But the reality, secretly guarded until now, is completely otherwise: Indeed, it was July 3, 1979 that President Carter signed the first directive for secret aid to the opponents of the pro-Soviet regime in Kabul. And that very day, I wrote a note to the president in which I explained to him that in my opinion this aid was going to induce a Soviet military intervention.
Q: Despite this risk, you were an advocate of this covert action. But perhaps you yourself desired this Soviet entry into war and looked to provoke it?
Brzezinski: It isn't quite that. We didn't push the Russians to intervene, but we knowingly increased the probability that they would.
Q: When the Soviets justified their intervention by asserting that they intended to fight against a secret involvement of the United States in Afghanistan, people didn't believe them. However, there was a basis of truth. You don't regret anything today?
Brzezinski: Regret what? That secret operation was an excellent idea. It had the effect of drawing the Russians into the Afghan trap and you want me to regret it? The day that the Soviets officially crossed the border, I wrote to President Carter: We now have the opportunity of giving to the USSR its Vietnam war. Indeed, for almost 10 years, Moscow had to carry on a war unsupportable by the government, a conflict that brought about the demoralization and finally the breakup of the Soviet empire.
Q: And neither do you regret having supported the Islamic [integrisme], having given arms and advice to future terrorists?
Brzezinski: What is most important to the history of the world? The Taliban or the collapse of the Soviet empire? Some stirred-up Moslems or the liberation of Central Europe and the end of the cold war?
Q: Some stirred-up Moslems? But it has been said and repeated: Islamic fundamentalism represents a world menace today.
Brzezinski: Nonsense! It is said that the West had a global policy in regard to Islam. That is stupid. There isn't a global Islam. Look at Islam in a rational manner and without demagoguery or emotion. It is the leading religion of the world with 1.5 billion followers. But what is there in common among Saudi Arabian fundamentalism, moderate Morocco, Pakistan militarism, Egyptian pro-Western or Central Asian secularism? Nothing more than what unites the Christian countries.
9) STUPIDEST THING I HAVE READ TODAY: Jackson Diehl of the Washington Post, as observed by Brad of "Sadly, No!":
The Washington Post has many, many bad columnists. Jackson Diehl often gets overlooked among the Krauthammers, Samuelsons, Gersons, Wills and Kagans, but he’s still very, very bad....
Two Americans who understand how big the stakes are — U.S. Ambassador Christopher Hill and top commander Gen. Raymond Odierno — were in Washington last week to explain. Iraq’s March 7 election and what follows it, Hill said, will “determine the future of Iraq... and also the future of the U.S. relationship with Iraq.”... The survival of Iraq’s democratic system, Odierno said, could have a far-reaching impact on regimes across the Middle East. “Some of them,” he added, “don’t really want the democratic process to succeed because of the pressure it might put on their own government.”... First among these is Iran, which has a simple strategy for the coming months: Turn the elections into a bitter sectarian battle — and thereby ensure that the next government will be led by its hard-line Shiite allies. To an alarming extent, the campaign is succeeding. Tehran’s leading agent, as both Hill and Odierno noted, is Ahmed Chalabi...
So wait. Wuh-wuh-wait.
We now have to stay indefinitely in Iraq in order to thwart the guy who convinced us to occupy Iraq in the first place? This brings new meaning to “clusterf---,” people. We might as well rename everyone in the United States military “K” and send them on a serious of vague, ill-defined missions in Eastern European villages where their objectives are wholly revised by soulless bureaucrats on a daily basis and where they are constantly thwarted by their failures to properly fill out confusing paperwork. I don’t think it could be any crazier than asking them to put their lives on the line just to stop Ahmed Chalabi.
Chalabi aims to become prime minister of the next government, which would be a disaster for Iraq and for Washington.
The kicker will be if Chalabi does get elected prime minister and Diehl then says we have to remain in the country to prevent him from getting weapons of mass destruction. Only then will the circle be complete!...
10) HOISTED FROM THE ARCHIVES: DeLong (August 2002) Fog of Wargames: A Cautionary Tale:
British Admiral Sandy Woodward -- commander of the Falklands naval battle group during Britain's war with Argentina in the 1980s -- tells the story of a pre-Falklands naval exercise in which he, with one British destroyer, three frigates, and four Exocet missiles, 'sank' the US fleet carrier Coral Sea. A cautionary tale:
I was clear in my mind what I wanted to practise: the US battle group, with all its escorts and aircraft, was to take up positions well out to sea. Their job was to stop my force from getting through their guard to 'sink' their carrier before they 'sank' us. Admiral Brown was happy enough with that -- if you had been in his position, you would have been too. He could spot an enemy surface ship more than two hundred miles away, track it at his leisure, and strike it at a comfortable range with any six of his missile-launching attack aircraft. And that was only the first layer of his defence. By any modern military standard, he was well-nigh impregnable. I had Glamorgan and three frigates, plus three Royal Fleet Auxiliary ships, two of which were tankers and the third, a stores ship. The frigates were all anti-submarine ships and not capable of doing serious harm to an aircraft carrier, short of ramming it. Only Glamorgan, with her four Exocets and effetive range of twenty miles, could inflict real damage on the Coral Sea, and Admiral Brown knew this.... We were due to start not a moment before twelve noon and not a mile less than 200 from the American carrier. She sat in the middle of this vast stretch of clear blue water, under clear blue skies -- effective visibility: two hundred and fifty miles. Admiral Brown was, so to speak, at the centre of a well-defended exclusion zone and I did not even have the benefit of a cloud bank, let alone fog or rain or heavy seas. No cover. No hiding place. No air support of my own either.
I ordered my ships to split up and take positions all around the two-hundred-mile perimeter by 1200 and then to hurry in as best they could -- a sort of maritime Charge of the Light Brigade from all directions. Three-quarters of an hour before we were due to start, bless my soul if a US fighter didn't appear, spot us, identify us and hurry home to tell the boss what he had found, where it was and where it was going. We couldn't 'shoot it down' -- the exercise had not yet begun! But we may just have lost this one before the starting gates were open. Stand by for a decisive American airstrike against Glamorgan, just as soon as they can lay it on. However, you have to keep on trying.... This basically involved reversing course.... Three hours later, we heard the US strike aircraft go in 100 miles west of us. They found nothing and went home....
[T]he sun set over the Arabian Sea and night began to stream in, Glamorgan turned into the two-hundred-mile zone. The dusk faded to darkness and I ordered every light in the ship to be switched on, plus as many extras as we could find. I intended that from any distance we should look like a cruise liner.... We barrelled on through the tense night, in toward the USS Coral Sea, listening all the time to the International Voice radio frequencies. Sure enough, eventually one of the American destroyer captains came on line, asking us to identify ourselves. My in-house Peter Sellers imitator, already primed for the job, replied in his best Anglo-Indian: 'This is the liner Rawalpindi, bound from Bombay to the port of Dubai. Good night, and jolly good luck!' He sounded like the head waiter at the Surbiton Tandoori. But it was good enough. The Americans, who were conducting a 'limited war', were rather obliged to believe us and let us through while they thought about it. Vital minutes slipped by until we were eleven miles from their carrier, with our Exocet system locked on to her. They still thought are splendid display of lights was the Rawalpindi on her innocent business.
Doubt, however, began to enter their minds... two of their big destroyers managed to 'open fire' on each other.... Then one of my officers calmly called the carrier to break the appalling news to Tom Brown that we were now in a position to put his ship on the bottom of the Indian Ocean and there was nothing he could do about it. 'We fired four Exocets twenty seconds ago,' he added for good measure, knowing this gave them about forty-five seconds to hit the deck... the American knew as well as we did that he was effectively non-operational. He has lost his 'mission critical' unit and with it his air force.
Understandably, we were all elated, but also a little embarrassed.... Tom Brown had a serious and proper preoccupation with the real world, and that our own particular brand of carefree 'cheekiness' was undoubtedly born of the unarguable fact that we knew that we weren't really going to be sunk no matter what happened, were we? A debriefing along these lines very soon restored our sense of proportion....
It was nonetheless an important exercise for me because it taught me two vital lessons. The first was to beware of becoming over-engrossed in one area of operations at the risk of ignoring another. The second was that, in a limited war, in perfect weather, under the cover of darkness, one fairly old destroyer or crusier, or whatever, is capable of getting right up to within eleven miles of a modern strike carrier in a full battle group.... Six months on, I was to face a very similar sort of situation, this time for real. And thanks to those few hours with the Coral Sea, I would have a clearer idea of how to proceed...
From Sandy Woodward (with Patrick Robinson) (1992), One Hundred Days: The Memoirs of the Falklands Battle Group Commander (Annapolis: Naval Institute Press), pp. 64-66.
Addenda: Two things come to mind. The first is that this passage has one of those 'there will always be an England' qualities. I mean, embarrassment as your emotional reaction... 'Frightfully sorry, chap. I don't know what to say. I'm so embarrassed. I didn't mean to sink your carrier in the midst of its sea and air escorts with one destroyer and three frigates...'
The second is something that my brother knew (and I did not) and that he pointed out to me: the name Rawalpindi has significance: the British auxiliary merchant cruiser Rawalpindi took on and was destroyed by the Nazi battlecruiser Scharnhorst southeast of Iceland in November 1939. Anyone in the Coral Sea's Combat Information Center who had been marinated in naval history (more than I have been) would have heard alarm bells ringing in his head at the name 'Rawalpindi'. Woodward and his people gave the Coral Sea and its battle group extra clues as to what was going on.