Tuesday, March 22, 2011

DeLong and Krugman Don't Get It

For a wealthy, high status man, Krugman sure sounds angry much of the time. Here's his response to those who don't buy DeLong and his solution of more government spending (on what is not important, highlighting how absurd this solution is):
if you’ve reached the point where you don’t pay attention to anything that might disturb your orthodoxy, you’re not doing science, you’re not even pursuing a discipline. All you’re doing is perpetuating a smug, closed-minded sect.

Yet merely two weeks ago Krugman was bragging about how pointless it was for him to hear from those he disagrees with:
Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously.

A principle is something you apply to your own disadvantage, and so I wouldn't call 'balance' one of Krugman's principles. Because he never engages in real arguments but rather ad hominem and straw men, his adversaries are unpersuaded, which makes him even angrier.

If you read Brad DeLong's post that Krugman is referencing, you see this gem by DeLong:
I firmly believe that I am right. I firmly believe that I am right almost as firmly as I believe that the sun will rise in the east tomorrow.

It's a strange lack of self awareness to find one's certainty interesting to others, because of course everyone believes he in right, otherwise he wouldn't believe what he believes, but it seems DeLong and Krugman simply think everyone else is merely a duplicitous shill or moron.

Let's consider what 5 generations(!) of Harvard book learnin' can do to one's cognitive ability, as Bradford DeLong lays out his diagnosis and cure for our economy in powerpoints, indistinguishable in tone and substance from an earnest senior thesis in this Lecture. I put his PowerPoint statements in bold, my comments in non-bold.

Sources of the Downturn:
1) Irrational Exuberance

My problem with this is it is all ex post. Of course we invested too much in housing and everything related to it. But why? Every recession involves discovering one invested too much in something that was unwise: oil, commercial real estate, technology, cotton. That phrase doesn't explain anything, it is true by definition for a recession.

2) Overleverage
ORLY? Then why were relatively low-leveraged commercial banks like WaMu, Wachovia, and National City also destroyed? The ridiculous levels of leverage at investment banks may have been high, but on average they weren't much different than in the early 1990s. The performance of banks in the recession was pretty independent of their leverage (see here). As recessions are invaribly financial events, they necessarily imply 'overleverage'. Again, this doesn't explain, it is true by definition for a recession.

3) Misregulation.
Here DeLong focuses upon the lack of capital for investment banks, which was incidental to the general glut of housing that would then ripple through the economy. He neglects to mention that these same regulators were threatening banks that did not comply with new 'innovative' underwriting standards pioneered by Bill Syron to increase home ownership among the 'traditionally underserved communities'. Once you create all this crap it has to go somewhere, which is why I think low underwriting standards are the dog and leverage/CDO/copulas are the tail. Today the FHA dominates (90%+ share) the under $300k mortgage market because they are the only one giving out loans on 3.5% down payments, highlighting they still don't think this had anything to do with the 2008 crisis, so it's not like giving them more authority back it 2005 would have lessened the amount of NINJA loans--probably the reverse. Leverage, meanwhile, would not have saved Lehman, Bear, or Wachovia at any conceivable level of regulation people were talking about if you try to estimate some kind of relation between leverage and financial performance.

Consequence: flight to quality. Excess demand for high-quality assets.
Again, true by definition in a recession.

This produces a 'general glut": shortage of demand for goods and services.
Well, when you discover 5% of your workforce is engaged in unsustainable activities, they are now unemployed, have no income, and need to find new work. Their reduction in consumption and savings will adversely affect other sectors, but it is hardly 'general', rather highly specific.

Total spending Y=C+I+G+GX-IM falls short of the amount needed for full employment.
This is backwards. Full employment was at an unsustainable, nonequilibrium level due to all sorts of wishful thinking about giving away homes to poor people and thereby giving them all sorts of neat demographic qualities just like homeowners. People involved in this unsustainable activity now need new jobs, and it will take some highly decentralized introspection to reposition these workers in their best niche.

The Right Cure for the Great Recession
Regulatory Reform

Frank-Dodd? What part, exactly? The Home Affordable Modification Program? Most of this bill just gives regulators greater authority to do something, and like the CFPA, they are busy creating a bigger bureaucracy but thus far nothing really meaningful, which is my 'best case scenario'.

Goverment spending when the private sector stops:
Well, DC has already turned this dial to '11', pushing our deficit to Macedonian levels. Further, the idea that 'government spending' and 'private spending' are substitutes is ridiculous: one pays for the other, an important distinction.

DeLong then mentions the importance of providing liquidity, ie, monetizing the deficit, Fannie and Freddie's losses. The Romans often tried to solve fiscal problems debasing their currency and it never worked, and led them to angry reactions as seemingly greedy merchants would then have the gall to raise prices. Perhaps they just needed to double down?

Cure for the Great Recession: Fiscal Policy, ΔG.
He then lists the standard Keynesian Multiplier, which posits government expenditure as a free lunch via the fact that the money is then spent by someone else, who spends it again, etc. The net effect is to spend $1, create $2 in income, which taxed at 40% pays for itself like a dewdrop in terrarium. There's just one problem: where do you get the $1 in the first place?

As per confronting his critics, he ignores anything about his model and simply criticizes their solution, which is a caricature of Milton Friedman circa 1981. There aren't many hard core monetarists out there arguing the solution to our problems is a monetary growth rule which would eliminate all recessions, but the whole point is simply to set up a straw man and smash him down.

My alternative to DeLong's solution--which has been applied vigorously over the past 2 years without effect--is to reduce the size and scope of government. People left to their own devices will innovate, find their best niches, and create wealth without ethanol and wind programs. Such activities are sustainable because they come from myriad voluntary decisions by other free men, not someone spending someone else's money on a project for someone else, the ultimate in whimsical expenditure. Consider that the economy grew to its heights without much guidance just fine (look at the US up to WW1, the Asian Tigers, China post-1978, Adenauer's West German), and precisely because no one person understands it is why top-down solutions hinder growth.

In the 1987 movie Broadcast News, the insufferable Jane Craig (played by Holly Hunter) is remonstrated by her boss:
Boss: It must be nice to always believe you know better, to always think you're the smartest person in the room.
Jane Craig: No. It's awful.

As Krugman's dyspeptic disposition highlights, being certain you know better can not only be bad epistemologically, but make you feel bad too. This is usually because such people unfortunately '100% believe' their misconceptions of their opponents, and then become frustrated when these straw men don't spontaneously admit to being frauds and fools.


Anonymous said...

I read all three, and disagree with you most a on politics. But I enjoy your wit and insight into capital markets.

I guess I have to much empathy for those who struggle to help themselves and no faith in a corporation's interest to provide for them.

Anonymous said...

Another fool leftist commenter who believes in killing freedom and prosperity, and concludes it is because he is a better person than others.

Jim Glass said...

I really enjoy the juxtapostition...

"I firmly believe that I am right. I firmly believe that I am right almost as firmly as I believe that the sun will rise in the east tomorrow."

"if you’ve reached the point where you don’t pay attention to anything that might disturb your orthodoxy, you’re not doing science, you’re not even pursuing a discipline. All you’re doing is perpetuating a smug, closed-minded sect."


Anonymous said...

Another excellent piece and particularly refreshing to see such a knowledgeable commentator find the contradictions and dissect Krugman (and DeLong's) hopelessly broken models of economic theory. Thank you!

dmfdmf said...

The dangerous fact is that important people listen to asses like Krugman and DeLong. People are soothed and attracted to their "certainty" in uncertain times, especially unqualified frauds who are in over their heads like Obama.

The reality is that we need a massive recession to reset investment and the price system after a credit induced boom. It would be painful but survivable and would be short-lived if the government stayed out of the way. But this is politically impossible and politicians would literally rather destroy the dollar than take responsibility and do what is necessary.

Thus Keynesian ideas are being used and just like in the 1930's it will make things worse and ultimately weaken the dollar. Once that happens their policy options will be limited which is why Krugman, et. al., want to "double-down" now. Unfortunately, the dollar is no longer backed by gold so confiscating gold will not save it as that was a one-time trick.

The dollar is backed by debt and they need someone to buy it other than the Fed (and it appears the Japanese won't be buyers now). But the clock is running out on the Fed check-kiting scheme known as QE2 (to be followed by QE3, QE4,,,QEn) and when the inevitable bond crisis comes the government will force some or all the retirement money into US debt. Soon after that the dollar will be toast.

Anonymous said...

"Your attitude towards something is way more important than the facts. See no matter how difficult that facts are it is not as important as your attitude towards it. In other words, your attitude determines whether or not you overcome or are defeated."

HookahBoy said...

You cannot just simply assume away over-leverage. Your example of WAMU and NatCity goes against you, since the mis-marking of assets implied they were far more leveraged than they or their regulators (OTS in one instance). The investment banks were clearly over-leveraged but had more of a liquidity (run on the bank) mishap.

So over-leverage and funding mis-matches were clearly a key part in the crisis, you cannot simply ignore them and say they are tautological. They have a very causal nature to them. The question then for historians of the crisis is to understand why certain institutions allowed themselves to become over-leveraged or run funding mis-matches despite the fact that in many instances, through insider holdings of shares etc, they were clearly exposed to large potential wealth destruction in the event of a negative shock. I think we'll be spending the next century trying to figure that out.

Anonymous #5 said...

Krugman doesn't refuse to listen to conservatives on principle, he's just saying that he thinks that they are morons.

If someone had asked me which conservative blogs are good to read, I would have recommended this one, although I find the frequent "the only people who can be blamed for not seeing the housing bubble are community activists" and "Jonah Goldberg makes a great point about how Democrats are just like Nazis if the Nazis weren't evil" posts pretty discouraging.

Todd said...

"...Krugman sure sounds angry much of the time..." Hah! V funny....I guess it takes anger to recognize anger...

For someone who parses Krugman's every word, I would have expected you to respond to his "Mind Changing Events" post. http://krugman.blogs.nytimes.com/2011/03/19/mind-changing-events/

Krugman has submitted a big part of his macro view to falsification. Have you? Surely that's a good thing, no? What would make you change your mind about how the economy works?

Eric Falkenstein said...

Todd: thanks for the link. His change of thinking is sort of like if a conservative gave up thinking that the Post Office was an exception to governmental ineptitude. To wit, he now thinks monetary policy is insufficient to eliminate recessions, a standard Keynesian thought, so it just means he's even more conventional. As per adopting capital controls like Malaysia in 1996, again, a standard Keynesian solution. He seems to have been unimpressed by non-Keynesian lessons, such as the failure of the various Japanese fiscal stimulations, or how China market oriented policies led to greater growth. So, as an intellectual journey, he simply has become more mainstream, less eclectic.

As per submitting a big part of his macro view to falsification, I don't know what prediction you are referring to.

Dave said...


What of Krugman's argument about the economic weakness in Britain after its government implemented fiscal austerity policies recently? Would your response be that we ought to compare the British and American economies again in a few years (at which point, presumably, the benefits of their austerity policies will be more apparent?)?

BTW, your Chayefsky quote reminds me of another one (from "The Hospital"):

"It's hard for me to take your despair very seriously, Doctor. You obviously enjoy it so much."

Anonymous said...

A depression is a problem of people rationally deciding not to spend or invest given that other people are not spending/investing. Everyone is waiting for everyone else to go first. It's a collective action problem - exactly the sort of problem that government and only government can solve. Your question, "where will government get the money?" is gold standard thinking. We've been on a pure fiat money system since 1971.

Todd said...

Krugman: "What would it take for me to decide that I needed another major rethink? A major surge in domestically-driven inflation — in particular, a surge in wages — would do it."

Eric, Krugman's big thesis the past two years has been the ineffectiveness of monetary policy--conventional and unconventional--at the zero bound. Absent immense fiscal stimulus, domestically-driven inflation is highly improbable. The rise of inflation strike me as a credible falsification of his macro view.

" he now thinks monetary policy is insufficient to eliminate recessions, a standard Keynesian thought, so it just means he's even more conventional..." Could you provide the quote for this? I've follow Krugman's blog, and your description doesn't jibe with his ad nauseum emphasis on the ZIRP constraints of the current crisis. I don't recall him ever stating that "monetary policy is insufficient to eliminate recessions". To the contrary.

And again, which of your core beliefs are you prepared to submit to falsification?

Eric Falkenstein said...

sure, if government was nearly as efficient as the private sector when they compete (eg, construction, post office, education), or when they offer advice (regulators often being totally clueless, fixated on irrelevancies), or if increases in government spending correlated with stronger productivity growth...I'd be for it...

Anyway, the Keynesian idea that monetary policy is insufficient is in the famous analogy of 'pushing on a string', or search for the phrase 'nonlinear liquidity effect'. In the 1960s Monetarists argued that monetary policy was more important, Keynesians that fiscal policy was. It's in the General Theory, a big pre-occupation of the initial Keynesians.

But the idea that current deficits are somehow neutral I find incorrect. There has been a huge fiscal and monetary stimulus, and neither have worked. I would say that's because they have merely delayed the essential reallocation of capital and labor from non-sustainable activities such as housing into other activities. These millions of decisions are made on case-by-case basis, often only when money runs out. Extending unemployment insurance, propping up housing, merely delays the inevitable.

Todd said...

Okay. So you're an Austrian.

"...I would say that's because they have merely delayed the essential reallocation of capital and labor from non-sustainable activities such as housing into other activities. These millions of decisions are made on case-by-case basis, often only when money runs out. Extending unemployment insurance, propping up housing, merely delays the inevitable."

And how would you falsify that claim?

Anonymous said...

"There has been a huge fiscal and monetary stimulus, and neither have worked."

So in your view, the government should have responded to the crisis with a massive tax increase and spending cut (to eliminate the non-working stimulus of deficit spending)?

I'm not sure what to call that idea except "scorched earth economics". The housing sector got too big, so we have to completely wreck the economy and rebuild from scratch.

Dave said...

"And how would you falsify that claim?"

In his column Friday, Krugman repeated his argument that the austerity policies implemented by Portugal, Ireland, and Britain haven't worked. Would that count as a falsification of the austerity first model?