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Please analyze and contrast the Introduction and Literature Review of the articles below. Paul Krugman

by Jason Briggeman30

Paul Krugman (1953-) was raised on Long Island "in a safe middle-class suburb" (Krugman 1995, 30). His career choice grew in part from childhood dreams:

Krugman says he found himself in the science fiction of Isaac Asimov, especially the "Foundation" series—"It was nerds saving civilization, quants who had a theory of society, people writing equations on a blackboard, saying, 'See, unless you follow this formula, the empire will fail and be followed by a thousand years of barbarism'." ...

Social science, he says, offered the promise of what he dreamed of in science fiction—"the beauty of pushing a button to solve problems. Sometimes there really are simple solutions: you really can have a grand idea." (Thomas 2009)

Krugman majored in economics as an undergraduate at Yale, where he became a research assistant to William Nordhaus. He finished in 1974, then in only three years earned a doctorate from MIT; by the fall of 1977, Krugman was back at Yale as an assistant professor. Krugman moved to MIT in 1980, where he would remain for the next two decades, save for two years at Stanford. While at MIT he met his future wife Robin Wells, an economist who has coauthored several textbooks with Krugman (e.g., Krugman and Wells 2006) and often helps to shape his writing (MacFarquhar 2010).31 Since 2000, Krugman has been professor of economics at Princeton.

Between 1978 and 1980, Krugman wrote several papers illuminating phe- nomena in international trade that were not well explained by simple notions of comparative advantage. These successes, Krugman says, effectively assured his place among "the people who get invited to speak at academic conferences, who form a sort of de facto nomenklatura" and "constitute a true, and wonderfully unpretentious, elite" (Krugman 1995, 33-34; cf. Galbraith 2001). But in 1982, at the invitation of Martin Feldstein, Krugman took leave from the academic circuit to join President Reagan's Council of Economic Advisers:

30. Central Texas College, Killeen, TX 76540.

31. "Early on, she edited a lot—she had, they felt, a better sense than he did of how to communicate economics to the layperson. But he's much better at that now, and these days she focusses on making him less dry, less abstract, angrier" (MacFarquhar 2010).

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It was, in a way, strange for me to be part of the Reagan Administra- tion. I was then and still am an unabashed defender of the welfare state, which I regard as the most decent social arrangement yet devised. ...

Washington was first thrilling, then disillusioning. It is the capital of the world, and for a young person it is wonderful to think that you can really have an effect on decisions of global importance. I can still recite from memory the long list of prohibitions on the front page of each classified document ("Secret/No foreign nationals/ No contractors/Proprietary information/Origin controlled"). Some people get addicted to that thrill, and will do anything to stay near the center.

After a little while, however, I began to notice how policy decisions are really made. The fact is that most senior officials have no idea what they are talking about: discussion at high-level meetings is startlingly primitive. (For example, the distinction between nominal and real interest rates tends to be regarded as a complex and useless bit of academic nitpicking.) Furthermore, many powerful people prefer to take advice from those who make them feel comfortable rather than from those who will force them to think hard. That is, those who really manage to influence policy are usually the best courtiers, not the best analysts. I like to think that I am a good analyst, but I am certainly a very bad courtier. And so I was not tempted to stay on in Washington. (Krugman 1995, 34-35)

In the decade following Krugman's year in Washington, he expanded on his previous research in trade theory (Helpman and Krugman 1987) and wrote papers motivated by current policy debates (e.g., Krugman 1991). He also developed a research agenda in economic geography that complemented his early work. The 2008 Nobel Prize was awarded to Krugman "for his analysis of trade patterns and location of economic activity."

Over the same period, Krugman began writing books and articles on economics intended for the general public:

[In Washington] I did, however, discover a new talent: that of writing serious economics in seemingly plain English. I got to practice that talent in writing classified memos, and proved good enough at it that I ended up writing most of the 1983 Economic Report of the President. Ever since, I have used non-technical writing about economics as the basis for a sort of parallel career, one that keeps me on the fringes of the policy world though rarely at its center. (Krugman 1995, 35)

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Krugman's first such efforts were noted (by, e.g., Kuttner 1996) for coun- seling a Stiglerian acceptance of the status quo on a variety of issues. Krugman titled his first popular book The Age of Diminished Expectations (1990); in the next, Peddling Prosperity, Krugman mocked "policy entrepreneurs" who offer "unambiguous diagnoses" and "easy answers" in books with brash titles (Krugman 1994, 11).

The older Krugman, remarkably, has become a leading advocate of a "progressive agenda" that is "clear and achievable" (Krugman 2007a, 272). He has been since 2000 a regular op-ed columnist at the New York Times, where he also maintains a blog of the same title as his 2007 book The Conscience of a Liberal. In 2012, he published a bestseller declaring that Keynesian insights on the business cycle make it possible to End This Depression Now! And through this period, Krugman has continued to be held in very high esteem by many economics professors (Klein et al. 2013, 123).32

Krugman's popular output is vast, rife with pronouncements on policy issues, and yet also often subtle in its analysis and politically astute (Sumner 2010). When one writes with an eye to political impact, one may find it important to play up or play down different matters at different times, even as one's own positions on the underlying issues may remain unchanged. Not surprisingly, there have been shifts in Krugman's discourse that seem driven by the fortunes of the two major U.S. political parties. For instance, in his New York Times columns Krugman largely refrained from criticizing Democratic Party politicians during the Republican administration ofGeorge W. Bush (Waight 2002; 2007; 2008), but since then he has often been critical of President Obama (Thomas 2009).

There is also, obviously, much reason to think Krugman has changed his method in seeking to have an impact on the course of events. The early Krugman saw that he could make an impact by building standing as a dispassionate academic economist;33 the later Krugman believes he can contribute by aiding the better of

32. The older Krugman all but has to be interpreted as bravely attempting to surmount this thicket of difficulties anticipated by the younger Krugman: "A professor can try to play [policy] entrepreneur—after all, the rewards in both money and a sense of importance can be huge. Ultimately, however, she is at a disadvantage, because she is too constrained by her obscure professorly ethics. Some professors manage to transcend these limitations, but in so doing they cease to be professors, at least in the minds of their colleagues. And in general it seems that it is easiest to become a policy entrepreneur if your mind has not been clouded by too much knowledge of economic facts or existing economic theories—only then can you be entirely sincere in telling people what they want to hear. As a result, most of our influential economic policy entrepreneurs, right and left, have their professional roots in journalism or law rather than economics" (Krugman 1994, 12).

33. "Surely as a practical matter the devastating criticism of [Bob] Dole's economic plan from conventional economists has been far more effective than the complaints of the interventionist left. To make that kind of criticism effective, however, you need a certain kind of moral authority—a reputation for intellectual honesty that can only be achieved if you are willing to critique bad ideas on the left as well as the right" (Krugman 1996b; see also Krugman 1998a, 9, 41).

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America's two political parties to electoral victory. Krugman holds that a blunt form of partisanship is necessary, if only temporarily (Krugman 2007a, 272-273), because the contemporary Republican Party is a menace that must be vanquished; as he says, "the madness of the GOP is the central issue of our time" (Krugman 2013c).34 Americans can't, or don't, have a stable political system upon which a leading intellectual can have much positive effect by criticizing, from a point in a multidimensional ideological space, that which is errant in both parties.35 Rather, responsible criticism of the better party should almost always be made from that party's flank, so that no one can interpret the criticism as an expression of sympathy for the worse party.36 The base of the better party will then be encouraged, or inspired, and comforted in its beliefs.37 A Democratic Presidency and majority in Congress are the most important factors in improvement (Krugman 2007a, 272), and thus the role of cheerleader for the better party is an appropriate role for a leading intellectual to take up and maintain.

Krugman and others date his embrace of a crusading partisanship to the early years of the Bush administration (Confessore 2002; Tomasky 2007), and sometimes Krugman has suggested that shift occurred because of his observation of efforts by the Bush administration to mislead (Krugman 2008; 2009; MacFarquhar 2010). Krugman had, however, claimed on several occasions prior to 2001 that dishonesty is endemic to conservative or Republican thinking. Looking back on his time on the Council of Economic Advisers in the early 1980s, Krugman (1995) wrote: "The Reagan Administration was, of course, full of people who hated the welfare state and had very little interest in the truth." In 1996, speaking generally about policy debates of that time, Krugman wrote: "There is...another way to counter the conservative program: by pointing out that it is based on falsehoods, not only about the effect of tax cuts but about the nature of public spending and the realities of income distribution" (Krugman 1996b).

34. Cf. Krugman (2007a, 272): "The central fact of modern American political life is the control of the Republican Party by movement conservatives."

35. "[M]ost conservatives are not libertarians... there are some real libertarians out there, particularly in the realm of economics bloggers, but they have no real power base. ... [T]here is an interesting debate to be had about the proper extent of the public sphere. But that isn't the debate driving our politics; our left-right split isn't nearly that idealistic, or innocent" (Krugman 2013f).

36. Daniel Klein and Harika Anna Barlett (2008) show that, in his New York Times columns, Krugman has only rarely criticized existing government interventions.

37. "Krugman was not, and is not, the only person in America who believes that the Bush administration is in cahoots with interests out to bilk Americans and pervert the political process. But as a Times columnist, closely read by the political elite and syndicated to papers across the country, he has been able to validate the anger of a whole class of angry, frustrated Democrats who feel that he's the only one prepared to describe the world as it really is" (Confessore 2002).

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While Krugman has changed much in how he writes and what subjects he tackles, there are also a few definite shifts in his policy views, though probably not as many as a cursory examination would suggest.

In a 1987 article for the Journal of Economic Perspectives, Krugman expressed the view that "the national interest" should take precedence over any hard-and- fast principle of free international trade. He interpreted new trade theory as having revealed that free trade is not "the policy that economic theory tells us is always right" (Krugman 1987, 132), but said that free trade could still "serve as a focal point on which countries can agree to avoid trade wars" (ibid., 143). Krugman wrote:

Strategic trade policy aimed at securing excess returns for domestic firms and support for industries that are believed to yield national benefits are both beggar-thy-neighbor policies that raise income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many (though not all) cases, a trade war between two interventionist governments will leave both countries worse off than if a hands-off approach were adopted by both. (Krugman 1987, 141-142)

Krugman said, however: "If the potential gains from interventionist trade policies were large, it would be hard to argue against making some effort to realize these gains" (1987, 143).

It seems to me that if Krugman's views on trade have changed, the change is small. In 2010, the New York Times published an editorial criticizing the Chinese government's "economic strategy based on cheap exports." In a blog post later that day, Krugman (2010) praised the editorial and urged the U.S. to threaten sanctions against China. I interpret Krugman as hoping that such a threat would lead to China dropping its interventionist trade policies. Krugman concluded by telling his readers to "bear in mind" that if the threat were instead to set off a trade conflict, large losses could befall China but that the U.S. "may well end up gaining," adding "right now we're in a world in which mercantilism works" (Krugman 2010).

Krugman (2013b) recently endorsed "stricter safety and working conditions standards in third-world apparel producers." He said, "I don't think that's a con- tradiction of my earlier views," explaining:

At this point...there really isn't any competition between apparel pro- duction in poor countries and rich countries; the whole industry has moved to the third world. The relevant competition is instead among poor countries...

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If we do this for Bangladesh, and only for Bangladesh, it could backfire: the business could move to China or Cambodia. But if we demand higher standards for all countries—modestly higher stan- dards, so that we're not talking about driving the business back to advanced countries—we can achieve an improvement in workers' lives (and fewer horrible workers' deaths), without undermining the export industries these countries so desperately need. (Krugman 2013b)

Krugman (2013b) cites an essay from 1997 to represent his earlier views. But in the cited essay (Krugman 1997) he had justified his opposition to "international labor standards" on two grounds, only the second of which was that such standards might stop or "even reverse" industrial growth in developing countries. His other justification was:

First of all, even if we could assure the workers in Third World export industries of higher wages and better working conditions, this would do nothing for the peasants, day laborers, scavengers, and so on who make up the bulk of these countries' populations. At best, forcing developing countries to adhere to our labor standards would create a privileged labor aristocracy, leaving the poor majority no better off. (Krugman 1997; cf. Yglesias 2013b)

Another issue that Krugman has addressed is minimum wage legislation. In a 1998 book review, Krugman criticized "the 'living wage' movement," dismissing its proponents as "basically opposed to the idea that wages are a market price" and asserting that "the broader political movement of which the demand for a living wage is the leading edge is ultimately doomed to failure." In support of his position against much higher minimum wages, Krugman (1998b) brought forth arguments that could also be used against mildly higher minimum wages, or, indeed, against the existence of a minimum-wage policy—but while the overall thrust of the piece seems to run against minimum wages, it does not argue that the minimum wage should be kept at the same level, decreased, or eliminated. Today, Krugman is simply open in his support of a mild increase in the minimum wage (Krugman 2006; 2007a, 261-262; 2013a; see also Briggeman 2013, 8-11; Yglesias 2013a).

Krugman has, perhaps, become more sanguine about government budget deficits and debt (cf. Barkley 2010, 123-128). In The Age of Diminished Expectations, Krugman fantasized about "a day of reckoning" on budget matters:

If there were any justice in the world, there would be a dramatic end to the deficit story: The adverse consequences of the deficit would

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become spectacularly apparent in an economic crisis, and the public would rise up and throw the rascals out. But of course there isn't any justice in the world. While there are possibilities of disaster, they don't have to materialize. It is not only possible but probable that budget deficits at more or less the current level will continue for the rest of the century. There will be costs to these deficits, but they may never reach the crisis stage.

Why can America apparently be so irresponsible fiscally yet avoid drastic punishment? At least part of the answer is that even as short-term politics has come to rule the budget, apolitical pro- fessionals have placed themselves firmly back in control of monetary policy. (Krugman 1990, 77-78)

In the mid-1990s, Krugman criticized certain politicians for being insufficiently concerned about deficits and debt:

True believers [in supply-side economics] like Steve Forbes live in a never-never land in which there are no hard choices or painful tradeoffs, budget deficits will be cured by growth and poverty will vanish as the rising tide lifts all boats. ...

[T]he Republican nominee, whoever he is, will probably run not on the theme of fiscal responsibility but on a Reaganesque program of tax cuts. Such a program would promise growth, but it would deliver new and bigger deficits. ...

[U]nlike Mr. Reagan in 1980, a newly elected President...would find a Government already deeply in debt. Worse yet, the day is approaching when the baby boomers will start to retire and claim the trillions of dollars in Social Security and Medicare benefits they have been promised. (Krugman 1996a)

But in recent years Krugman has often said that politicians are overly concerned with deficits and debt, as here:

Deficit-worriers portray a future in which we're impoverished by the need to pay back money we've been borrowing. ...

Governments don't [have to pay back their debt]—all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation. ...

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When Keynes was writing about the need to spend your way out of a depression, Britain was deeper in debt than any advanced nation today, with the exception of Japan. ...

[D]ebt matters. But right now, other things matter more. We need more, not less, government spending to get us out of our unem- ployment trap. (Krugman 2012b)

Krugman says the policy response to the recession of 2007-2009 was inef- fective, causing him to lose confidence in markets generally:

[W]e need "macroprudential" policies—regulations and taxes de- signed to limit the risk of crisis—even during good years, because we now know that we can't count on an effective cleanup when crisis strikes. And I don't just mean banking regulation; as [Emmanuel Farhi and Iván Werning (2013)] say, the logic of this argument calls for policies that discourage leverage in general, capital controls to limit foreign borrowing, and more.

What's more, you have to ask why, if markets are imperfect enough to generate the massive waste we've seen since 2008, we should believe that they get everything else right. I've always considered myself a free-market Keynesian—basically, a believer in Samuelson's synthesis. But I'm far less sure of that position than I used to be. (Krugman 2013e; see also Quiggin 2013)

It has been said that Krugman is more or less a present-day version of Milton Friedman, though possessed of an ideological stance opposed to Friedman's (Cowen 2013, 173-174; Medema 2013, 197).38 Krugman himself has offered much praise for Friedman (Krugman 2007b; 2013d), whom he sees as having adopted an effective political persona that was, for a time, salutary:

In the aftermath of the Great Depression, there were many people saying that markets can never work. Friedman had the intellectual courage to say that markets can too work, and his showman's flair combined with his ability to marshal evidence made him the best spokesman for the virtues of free markets since Adam Smith. ...

Milton Friedman the great economist could and did ac- knowledge ambiguity. But Milton Friedman the great champion of

38. Cf. DeLong (2010): "He is the closest thing to an heir to John Maynard Keynes we have today."

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free markets was expected to preach the true faith, not give voice to doubts. And he ended up playing the role his followers expected. ...

In the long run, great men are remembered for their strengths, not their weaknesses, and Milton Friedman was a very great man indeed—a man of intellectual courage who was one of the most important economic thinkers of all time, and possibly the most brilliant communicator of economic ideas to the general public that ever lived. ... When Friedman was beginning his career as a public intellectual, the times were ripe for a counterreformation against Keynesianism and all that went with it. But what the world needs now, I'd argue, is a counter-counterreformation. (Krugman 2007b)

What's Wrong with Economics: A Discussion Between Paul Krugman and Jeff Madrick. 

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Jeff Madrick raised several criticisms of mainstream economics in his book, Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World. The Nobelist and New York Times columnist Paul Krugman sat down at the City University of New York Graduate Center to discuss the issues last November. A lightly edited transcript follows. Janet Gornick, a director of the Luxembourg Income Study, where Paul Krugman also does research, moderated the event.

MODERATOR: Good evening, I'm Janet Gornick. I am a political economist and professor of political science and sociology here at the Graduate Center of the City University of New York, and I'm also the director of Luxembourg Income Study Center, with offices in Luxembourg and here at the Graduate Center. The format for the evening is as follows: First, Jeff Madrick will offer some remarks about his new book, Seven Bad Ideas, which talks about how mainstream economists have damaged America and the world. Second, we'll be treated to a conversation between Jeff and Paul Krugman about the book and about whatever else we wish to discuss. Their conversation will be unregulated, in the spirit of the topic. And, for the final part of the evening, we're going to take questions from the audience.

So let me just take a moment to introduce our two speakers. It's really a great treat to have these two guests with us this evening. Few people anywhere have done more than either Jeff Madrick or Paul Krugman to explain contemporary economics to general audiences. Having them here together jointly assessing the state of the economics discipline is really a double treat.

Jeff Madrick is an award-winning economic analyst and journalist. He's a regular contributor to the New York Review of Booksand a former economics columnist for the New York Times. He's also director of the Bernard L. Schwartz Rediscovering Government Initiative at the Century Foundation, where he's also a senior fellow, and several of his colleagues and ours from the Century Foundation are here with us this evening. Jeff is also an editor of Challenge magazine, and he's a visiting professor of humanities at Cooper Union. Jeff is the author of many widely read and much cited books, including Age of Greed, The Case for Big Government, End of Affluence, and Taking America. Jeff's books are notable for attracting diverse audiences, often receiving praise from progressives and the business press alike. This new book, Seven Bad Ideas is, as I think you know by now, an assessment of the ways in which mainstream economics failed to anticipate—and he would argue also contributed to—the economic turmoil of the last six years. And that analysis is rooted, of course, in a larger critique of the economics profession, especially an overreliance on modeling. The book has already attracted considerable attention, much of it positive, and a surprising amount of positive response has come from economists. I for one heartily recommend it, and I might add that one does not have to be an economist to find the book both clarifying and delightfully readable. To the non-economist academics in the audience, you might be pleased to know that in this book Jeff argues that one thing that contemporary economics needs is more engagement with sociologists, anthropologists, and historians. That's not an observation that one hears all that often.

Paul Krugman needs little introduction here. As I think most of you know, Professor Krugman is in transition now, shifting his home institution from Princeton University to here at the Graduate Center of the City University of New York. In the middle of 2014 he joined the List Center and serves there as a distinguished scholar, and in September 2015 he will join the economics faculty at the PhD program here at the Graduate Center. Paul Krugman is known for his extensive body of academic work, for which he has received an enormous array of honors, including in 2008 the big one, the Nobel Memorial Prize in Economic Sciences. He's also known to many of us for his much-read biweekly column in the New York Times and for his lively blog, "The Conscience of a Liberal." He contributes to other publications as well, and he attracted considerable attention last month for his article in Rolling Stone titled "In Defense of Obama." We'll editorialize for a moment: I just have this to say, I wonder what would have happened last week if some key Democrats had taken that article to heart. In any case, we're really delighted to have Paul with us this evening, and I'm especially grateful that he's able to join us as he is just back from a whirlwind trip to Japan, another petri dish for curious macroeconomic thinking, and perhaps this evening he and Jeff will help us make sense of Japan, after they've clarified the state of macroeconomics in the United States. Jeff and Paul, I turn the evening over to you. Welcome.

JEFF: Thank you all very much for coming. A special thanks to Janet Gornick, who you just heard from, who runs the Luxembourg Income Study Center and very generously made all of this available to us. Thanks to the Century Foundation for cosponsoring this. Thanks to Paul for giving his time, and thanks to mainstream economists for making so many mistakes.

Now obviously I have to place a caveat in here. There are many exceptions to the conventional mainstream thinking that I criticize in my book, or what I guess we could call neoclassical economics. Economists would call it more or less economics based on the market itself solving our problems, with a variety of qualifications. But I got an e-mail that said, if you were really an anti-mainstreamer, you would have talked about Marx in the first chapter. And I was a little bit taken aback. I did talk about Duncan Foley of the New School, who is a Marxist. But it occurred to me I'm probably not an anti-mainstreamer in that sense. I'm surely anti-what mainstream became. If neoclassical or mainstream economists were arguing that all we need is a little jolt from fiscal policy or monetary policy and the self-adjusting qualities of the economy would take over, well, I'm not very sympathetic to that. If efficiency is identical to prosperity, which many did argue, I'm not sympathetic with that. If it just means to get rid of the obstacles in the way of a free market working; if labor is getting paid what it deserves, as many neoclassical or mainstream economists contend, I am not sympathetic to this contention. If it means we shouldn't worry about inequality—and a surprising number of mainstream economists talk about how inequality is not their concern, equality of opportunity is their concern—well, I'm not very sympathetic with that, because inequality of outcomes matters a lot. If mainstream economists mean we need only worry about the inflation rate and keeping it at 2 percent a year, well, I'm not very sympathetic to neoclassical or mainstream economics. If it means a low deficit is our first or second priority, as you might guess, I'm not sympathetic. If government's purpose is only to counteract—and this is important—if it's only to counteract market failures, I'm again not sympathetic because market failures are rampant and very hard to define. If it means public investment should be modest, and it often did in the last thirty years, again I'm not sympathetic. If it means you really can reduce the sources of growth to abstractions like technology plus savings plus human capital, I think we've got to be a lot more specific and particular about why economies grow.

What happened in mainstream economics is not that these neoclassical classical tools are bad per se, but that they were abused and they are at their core oversimplified. The pendulum of economics swung to rule-of-thumb ideology and especially antigovernment attitudes. Economics swung with the rest of the nation. And I think I wrote this to be sure that we're not going to repeat the same mistake, but it's not obvious to me we're not. I'm not talking about another bubble, another crash. I'm talking about the same basic assumptions that lead to bad policy.

So I got very frustrated over the years since I've been out of school. We had Walter Wriston fighting Regulation Q well before Regulation Q was eliminated. To some degree Regulation Q had kept a lid on the amount of money you can pay on interest rates to savers. To some degree we had to get rid of that, but we got rid of it in a very haphazard fashion. Walter Wriston lent all that oil money to South America. Probably it should have been an international government agency doing that. He bowled over the Nixon and Ford administrations and took it on his own shoulders. One consequence was repeated financial crises over Latin American debt in the subsequent years. The approbation given to Paul Volcker for his shock therapy, I am just tired of that, but you can't say that without being humiliated by economists for your lack of knowledge of what was necessary at that time. We didn't need that severe a correction. We had rational expectations theorists telling us in 1982 that the recession would not be very steep, we could cut inflation without a severe recession. They're still around, they still are prestigious. We had an astounding S&L, savings and loan, deregulation. I didn't hear that much from dissenting economists in that period. We had Democrats railing against deficits under Reagan using Say's law, which I'm sure Paul and I will talk about a little bit. And we had the Clinton administration placing basically all the surplus revenue into reducing debt, directly or indirectly based on a Say's law argument. We accepted that the Fed could solve just about any problem, we had financial deregulation under Clinton, we had a Boskin Commission, which is too complicated to go into, but it overstated the understatement of inflation due to quality increases in products, a political operation if there ever was one, and then we had the phenomenon of Alan Greenspan, the legend. I'll leave it at that.

That was the preamble of my long speech, and probably if I had a little more time I could clarify all those points, but I do want to make two observations very clear. Where the ideology does damage. The ideology is basically about a free market that solves our problems through the invisible hand, which probably almost everybody here studied at one time or another. The invisible hand in a narrow sense and the invisible hand as an explanation of the entire economy. Now you may think, "Well, economists know better than that," that they know there are lots of exceptions to the invisible hand and to laissez-faire policy. But let me take two cases where a broad spectrum of mainstream neoclassical economists agree. One was something called the great moderation. The great moderation was hailed by economists like Ben Bernanke, the former chairman of the Fed and a very respected and very bright economist from Princeton, and Olivier Blanchard, a former MIT economist with an equal reputation and now head of the economics department of the International Monetary Fund. They said the great moderation was proof we knew how to control the economy. The great moderation meant the economy was stable. GDP, our national income, didn't fluctuate that much. It fluctuated a lot less than it used to. Stability was a goal in itself. Well, stability is useful. For example, we don't want periodic bouts of high unemployment. Sure, stability matters. But the underlying argument was that if we had stability, then the market would basically work well and solve our problems, so stability became an objective in itself. Consider what happened over this period of the great moderation—high levels of debt, soaring inequality, stagnating wages, and one financial crisis after another—I'm going to name the years just for fun: '82, '87, '90, '94 and '97, '98, 2000, and 2008 financial crises under this ideal period of the great moderation based on an ideology that the market would solve the problems as long as the economy was stable.

But number one, and the one that worries me most, is inflation targeting. Both soft inflation targets and hard inflation targets, we've come to an idea that 2 percent inflation was the maximum inflation rate this economy could tolerate. Again it was based on an ideological notion, that if we keep inflation low and very stable, we will remove the uncertainties from the economy that are obstacles to the true functioning of the market, or a general equilibrium, as it's known. That idea still prevails. We do not need a 2 percent lid on inflation, but we get it, and it's determining Fed policy to this day, even under Janet Yellen, who I admire a lot.

So my point is this: ideology is still determining policy in America. There has been a shift, there have been mea culpas, especially with the 2008 crisis. Many of these ideas set the stage for the 2008 crisis. And they permeated the public consciousness and the consciousness of Washington policy makers. Some of that's been reversed, but my argument is that the basic ideology is still with us, and we've got to be aware of it or we're going to make the same mistakes over again, and the best example of that is a 2 percent inflation target. I'm sure Paul has a couple of things to say about this, and then he and I are going to have a good conversation.

PAUL: So I'm actually going to do this a little differently. Because one thing I want to say is that there's a possible takeaway that many people might get from the kinds of things that you're saying, which would be worse descriptions of economics than they should be, is to conclude, "Okay, so economists don't know anything, they're useless, so we've got to turn to smart, successful businessmen like Mitt Romney." What you really don't want is to think that all this economic analysis is useless. There are several scripts that people have in mind. One is, oh, so we're going to show that economics is useless and therefore we're going to turn to practical business people. That's one script. Another one is that the end of the story has to be that we go back to Marx, which is what you ran into, and I don't think either of those is a direction we really want to go. The fact is that business people are actually really lousy macroeconomists on average. They extrapolate from what it's like to run a business, which is nothing like running an economy, and when it comes to Marx, there's no particularly fresh thinking about these issues that should lead you there. But what is true is that economics let us down really badly, which was revealed a lot in the crisis, and I think I want to make a distinction between two kinds of sins here, both of which happened. One is the intellectual sin of basically getting the economy wrong in the models and in the analysis and having the wrong structure of thought, which is a lot of what you're talking about. The other risk is the actual policy, when the moment comes, when something has to be done, choking on what your own analysis says and going instead for conventional wisdom, something that feels plausible to politicians and the political process. I really would like to talk about the way I see what happened.

So something I really got from your book, which I hadn't thought about that clearly, is that we actually had an unintended case of bait and switch in the way that economic analysis was done. In economic analysis we use lots of models, and I'm a big believer in models. You have to use models to discipline your thought. Models are how you tell yourself what the story is, but you should always think of them as being metaphors, guidance, and not truth. There's one model that economists like a lot because it's such an overarching story, the story of competitive markets, rational behavior, and general equilibrium— it all fits together in this wonderful story, and it's a great story. It tells you a lot of stuff. As soon as you start to look at the real world, you realize, wait, people don't actually maximize and markets are not competitive and so there're lots of details here that are not right. There's an answer to this charge you talk about at some length, which is when Milton Friedman said that the precise truth of the model is not critical, you need to look at whether or not it fits reality. Does the behavior seem to be what seems to happen, which is OK, we all do that some? But then having done that, having said, "Well, these models are OK because we can make some use of them even if they're not precisely right," you then turn around and say, "This is the model, and therefore all policy decisions must be based on this model." For example, you say, "I've got this model of maximization and perfect markets and the market is exactly right," and I say, "But people don't actually behave that way," and you say, "That's OK, because it's a good enough prediction," and then I say, "Well, we have this phenomenon out here which is that clearly unemployment does not self-correct," and they say, "That can't be true because of maximization and equilibrium—the model says that can't be true." You've said, reality lets me ignore the fact that the assumption is not true. Well, but the assumptions must be true, and therefore you have to ignore reality, and actually I call it bait and switch in my review. I call it the Chicago two-step in this context. And it has played a very big role in desensitizing economists to the flaws in their view, which were really very severe.

Let me talk just for a second—and I hate to go on at length on one of these points— but let me talk about 2 percent inflation. I actually put in some work on that, because I'm one of those people who're arguing that we need to loosen that up on the upside. I did a paper for a European Central Bank conference this past summer—which, by the way, even though the European Central Bank is not what you would think of as the most wildly radical thought institution, they were certainly willing to let people like me come in and present papers saying you're doing it all wrong, so at least they're willing to hear the criticism. Anyway, I spent some time on the trail: where did that 2 percent inflation come from? How did we get 2 percent inflation? It turns out to be remarkably unscientific. It turns out that it's not a case of people who sat down and really figured out what is the optimal inflation rate. There were several converging strands. There was one strand of people who were said that we should have stable prices, zero inflation, that has to be right thing, and at least there was enough good sense among a number of economists to say, that can't be, that could get us into big trouble. They were afraid that if you started from zero inflation and then there was adverse shock, you would be into deflation, and you couldn't cut interest rates below zero, so what do you do? So you need some leeway, and some historical episodes suggested that if you have 2 percent inflation, that would give you enough room to usually deal with that. So that was kind of one strand. Also, there are always changes— some people's wages go up relative to other people, some go down, and it's very hard to cut wages. So there were some calculations that suggested that 2 percent inflation would give you enough leeway that you could make the necessary wage adjustments without actually having to have a lot of wage cuts. And finally, there were the people claiming that inflation is actually overstated because of quality improvement, and it's possible to argue that 2 percent inflation is actually zero it. That was the Greenspan argument, and these things all converged on 2 percent, which was a number that could make a number of people happy, but then it solidified into a dogma. Everyone was targeting 2 percent inflation so we better target 2 percent inflation, too, and it became respectable to advocate 2 percent and disrespectable to advocate anything higher than that. Now it turns out that everything what people thought is wrong. The idea that 2 percent would be enough of a cushion that you would rarely have episodes when cutting interest rates to zero was not enough. We've now passed the sixth anniversary of the Fed having had interest rates of zero, and it's not been enough, so the idea that that would be a rare phenomenon is clearly not true. The idea that the wage adjustments is not going to be a big deal, I mean, look at what's going on in Europe where we're experiencing year after year of nightmarish unemployment in Spain and Portugal as they try to get their wages down relative to Germany. That minor wage turns out not to be true. But the 2 percent target that emerged from this process sits there now as an unbreachable icon. I've tried to talk to people at the Fed, and they will admit sort of in principle that the case for 2 percent that we used to make is not as good, but we can't change the target because that would hurt our credibility.

JEFF: To me that's the classic example of what's gone on, and as you know, there's no serious empirical evidence that an economy running inflation at 3 or 4 percent will grow more slowly than an economy running at 2 percent.

PAUL: Sure.

JEFF: In fact, even at 6 and 8 percent there's no significant empirical evidence. To say that would be a problem, and yet we stick to this 2 percent rate, and it becomes inviolable, and we have people like economists on the FOMC, such as Jeffrey Lacker, who (even though we haven't reached 2 percent inflation) are still worried that they're stepping on the gas too hard. But people like Lacker would argue, well, it's coming any minute now, and yet wages are not going up, which is the main cost-push element of inflation, but wages are a lagging indicator, so we better get ahead of that. Of course, I've written and Paul has written that these guys had been wrong time and again. Richard Fisher, a great proponent of this idea, wanted to raise interest rates in the middle of 2008 when we were collapsing into the worst economy since the Great Depression. This kind of mythology makes you wonder at these claims that economics is a science when, so easily, 2 percent becomes embedded in a way of thinking and it cannot be violated. The reason people want zero percent inflation is that they believe fully in this perfect market idea, that if you remove all uncertainty so that all participants in the market can make rational decisions, then the market will work itself out, work out our problems, and maximize prosperity.

PAUL: But maybe this is the question— where do we draw the line between economics as a discipline and economics as practiced as policy? It's not the case that papers being published in the Quarterly Journal of Economics make the case that 2 percent is a sacred target. That's not it at all, in fact, if you take the papers that people write on new Keynesian macroeconomics, they definitely don't say that there's anything sacred about that number. And, in fact, if you take the theoretical models seriously, which maybe you shouldn't, but if you take them seriously, they would suggest that given what we've seen, targets should be higher than that. It's in the practice of economics at the central banks that it has become this magical target, so is that a problem with mainstream economics, or is it a problem of the sociology of central banking? I think we may be crossing categories here.

JEFF: But it seems only in the last couple of years that some mainstream economists like Blanchard and Larry Ball are talking about raising the inflation rate, and it's always put in terms of not violating the lower, zero bound.

PAUL: Yeah.

JEFF: And to me, I wondered about your opinion about this. I would like to see—here's heresy for you—something like the Phillips curve come back. George Ackerloff, who is a Nobel Prize winner, has talked about this a little bit. Not only would a 3 percent or even 4 percent target help us avoid the zero lower bound so we could cut interest rates to stimulate the economy again, but it might get the unemployment rate down on a more consistent basis.

PAUL: No, actually that is an argument that's out there. We took this notion that government policy, or demand side policy, can't permanently lower the unemployment rate, and there's a lot of reason to believe that that's true, that raising the inflation rate from 8 percent to 13 percent is probably not going to buy you anything on employment, but that an inflation rate of 4 as opposed to 2 might very well buy you something on unemployment. That is actually not being rejected by the mainstream. By the way, one thing to say is that the people that you're criticizing are all on the good side. I mean Olivier Blanchard and Janet Yellen are good guys in all the current policy debates, they are people who are well to the left or to the activist side of the spectrum, so you have to give some credit, even if you would like to see them be more.

JEFF: I'll always give credit to Janet Yellen, but I'm a little more hesitant about Blanchard. After all, the IMF, I don't know if he was there at the time, was pretty supportive of England's David Cameron. The fact that they reversed their point of view on austerity sometime after the 2008 crash was pretty common across the board and the slightly left-of-center mainstream economic community. They weren't that beforehand, and Blanchard admits it. He says with some shock, we never thought that financial regulation was part of macroeconomic policy. Well, that's quite extraordinary, and very rarely was finance ever part of macroeconomic models, and Hyman Minsky, who became the man of the moment, I remember was pretty highly ridiculed. At one ADA conference, there was a memorial for Minsky sponsored by the Levy Institute, where he worked, and he was just scoffed at.

So, because some economists got religion after 2008 I don't think totally exonerates them for the damage done until 2008. In fact, in Larry Ball's stuff I haven't seen much about if you champion 3 percent or 4 percent inflation targets on the Phillips curve basis—that is, to get unemployment down—it would work.

PAUL: OK, maybe I'm a little too close to it, but I've certainly been making that argument and not getting a lot of pushback, which is kind of interesting. I mean, not getting a lot of pushback analytically. The policy thing is another thing. You can go and talk to European Central Bank senior people, and they'll say, that's an interesting case, and the Fed people will certainly say that, but then they'll say, but of course we can't actually implement that. But that's a little bit less a question of the intellectual structure of economics and more the weird things that happen in policy formation.

Actually, I wanted to talk more about the great moderation—since I've been traveling, I can actually bring it in. So people don't notice, there were papers by, I think it was actually Ben Bernanke, you may have heard of him, and certainly Olivier Blanchard, chief economist of the IMF, who we've mentioned here.

So what Blanchard and others had done was show that, in fact, the wiggles had gotten smaller, that after around 1985 the U.S. economy had seemed to be much more steadily growing than it had been previously, and Ben Bernanke coined a phrase for it, the great moderation, and this was attributed to superior management by central banks. That has always seemed to me to be a really bizarre episode, because although it was true that the U.S. was more stable, there is a rest of the world out there.

I wrote a book in 1999 called The Return of Depression Economics, which was a little ahead of the curve, but then I was able to write The Return of Depression Economics and the Crisis of 2008, that's the second edition. But that was not coming out of nowhere, that was coming out of the fact that Asia had had severe financial crises—it seemed like the end of the world to us then, although it was trivial compared to what came later—and Japan slid into a prolonged stagnation, and it was amazing to me that people did not take that as a lesson, did not take that as an indication that we do not have this thing under control. It's not a problem exactly that the models didn't allow for it, because we had the model even before Japan, but it was this weird sense that won't happen here in the U.S.

JEFF: Well, I do quote Milton Friedman telling Charlie Rose in 2005 that the American economy has never been more stable and isn't that great. It was something of a charade, and I think what's mostly aggravating to me about it is that economists manufactured their own criterion of success, so inflation targeting thus worked, and it was sort of the single policy lever that was adopted. Keynesian as a fiscal policy was by and large shoved aside and put in the back seat of the car. There was a single policy lever, which they said worked like magic, and in this period, which you do call bizarre, we have all kinds of things going on, and it happens that the Fed got us out of serious trouble in '97 and '98 and in 2000 and 2001 again, only to lead to the 2008 debacle. People took it as a kind of law; I think mainstream economists said the Fed could by and large always save the day. There was worry about the so-called Greenspan Put or moral hazard, but there was no great uprising by economists, and I think there could have been. I would call it two kinds of errors but somewhat different than yours. One is errors of commission, and one was errors of omission. Economists who made errors of omission failed to analyze and be up in arms about Wall Street, because there were conflicts of interest, there seemed to be monopoly profits like crazy, there was manipulation of markets, and there was no transparency of information in derivatives whatsoever. Economists weren't up in arms. One can say, well, what power do economists have, but, my gosh, they have power in free trade arguments. They certainly were up in arms about that. So where were they about these conservative invisible hand violations of the market, where were economists at that point? We hardly even saw studies, maybe you know more than I, studies about what Wall Street did. They began to come out later, but only a couple.

PAUL: Now actually this is an interesting thing, because there were certainly studies. I mean, I'm not going to try and do biographical stuff here, but I remember back around 2000 we were already getting some papers that were looking at the way hedge fund managers are compensated—2 percent commission and 20 percent of profits, which you don't have to give back if then everything goes to hell, and pointing out that all the incentives were there to basically leverage up, borrow as much money as possible, take big risks, and then it's heads, you win, and tails, your investors lose. The incentives were clearly there for unproductive, risk-increasing behavior. So there were papers out there, and the question is, why didn't people make this a cause? Why were people so willing to accept that the market was working? Partly it's don't rock the boat, it's very hard to argue with success. I think these things are actually interactive. The notion that we had it all under control—what's really amazing, how could we have gotten all the way to 2008, and then suddenly said, oh, we have a problem with finance, because there was actually a terrifying crisis in '98, the Asian crisis, which was very much a prefiguring of what happened 10 years later. But there was also Long-Term Capital Management, and I happen to have been in a briefing by a senior Fed official, right after Long-Term Management went under, and they were describing the collapse of transactions— essentially the financial markets had just frozen—and after this pretty grim description, somebody asked, "So what do we do?" And this senior official said, pray. What actually happened was that Alan Greenspan and Robert Rubin gave a press conference and sounded very confident, and magically the markets thawed out, but that should not have been a lesson saying that we have this thing under control, that should have been a My God, we don't know how we pulled out of that one, and yet it was ignored and I think that's a very big story. It's not exactly a problem with economic doctrine, it's a problem of what does it take to get people's attention.

JEFF: Well, I wrote a piece that if we saved Lehman Brothers, what would have happened? There's a good chance we would have had a less serious recession, but we probably would not have gotten Dodd-Frank. We had had a vicious crisis with Long-Term Capital Management. Greenspan and the folks rounded up the banks and basically forced them to put capital into Long-Term Capital Management to keep it afloat, or at least pay off the creditors, and stop the run. But no financial regulation came out of that episode because we got out of it. The same thing probably would have happened if we saved Lehman Brothers this time around, we might not have gotten anything like Dodd-Frank, we may have pushed catastrophe back that much farther, and I think it's something about the sloppy thinking, or at least the failure to address public issues, or the reality of the economics profession, or their duty to inform people that there's something wrong here. It is a bloodless profession, and it lacks red corpuscles, and the methodology allows economists to distance themselves from the problems. There was a lot of work about corruption, but it didn't really get to the heart of the matter, and I just don't understand how people like Greenspan got away with so much with so many allegedly good economists out there.

PAUL: I'm introspecting a little bit here because even though I had written about Depression economics, and even though I invented the academic literature of currency crises, I was caught completely by surprise by the severity of the financial crises. How did that happen? Partly was that I just wasn't paying attention. I had no idea that more than half of our banking system were no longer banks and therefore had none of the safety nets, none of the regulations. Part of the problem, I think, is that the world is a big, complicated place, and nobody is going to keep track of it. There were people for whom financial markets were their specialty, and there is where I think you get into issues of cooptation, and in some cases corruption.

JEFF: We should talk a little bit about that, because there is an ethics issue here.

PAUL: Yeah, there was no question of that. By and large, people who were actually doing finance or actually studying what Wall Street did also tended to be, and continue to be, rather close to Wall Street. There are various levels—I mean, there are some actual plain hired guns—but there's also a broader thing, which is if you're studying financial economics and you're busy saying the end is nigh and this is a corrupt field, then you're probably not going to get a whole lot of invitations to Wall Street-sponsored conferences. You're not going to get a lot of consulting gigs for sure, so there is probably something going on there. And people who did not have stake in that—good macroeconomists—would have been pretty much unaware because it's somebody else's subfield and they just didn't know. Again, I'm being self-justifying to some extent, but also I just had no idea. I had no idea what the financial system as of 2008 looked like until it came crashing down.

JEFF: The scarier thing, I think, is that it seemed like the New York Fed had too little an idea, and they didn't look under the hood of collateralized debt obligations, for example. They didn't try to, they didn't begin to understand what was going on until the market started coming apart. Now how could this be anything except an ideological attitude? Maybe I oversimplify here, but I don't think so. There's the idea that things can't get too out of hand if a market is operating well. If something is priced too high, some smart person will sell it, and if something is priced too low, some smart person will buy it, and the correct prices will be reached. That became an underlying assumption, certainly of Greenspan, who became a kind of ideologue, I'd say, as he gained more and more confidence in himself. But I think it existed in many regulatory agencies, manned by good economists, or at least well-trained economists.

PAUL: Could we actually have had for a long time mainstream economic models that tell you that an unregulated financial system can be highly fragile? As soon as Lehman fell and everything, you could wander around the corridors of Princeton, and there were people muttering because we had that model. As soon as you said, oh wait, these are banks, even though they aren't banks, but they don't have capital requirements, then immediately it's slotted in, so the analytics were there, but no one who knew enough to know what was actually going on was willing to apply those analytics. So some of it is maybe free market ideology but applied in a place where standard economics itself says free market ideology is not right. Standard textbook economics says that banks need to be regulated. Adam Smith said the banks need to be regulated—right, one of the places where he really takes steps away from laissez-faire in the Wealth of Nations is when he says banks need to be regulated and that you may say this is an unwarranted intrusion on freedom, but it is no more so than requiring firewalls in housing, so something else is going on. It's not the inherent model, it is maybe libertarian ideology, which is not mainstream economics but affects Greenspan. He's not an economist, he's an Ayn Rand follower, and I would say mostly it's soft corruption, but sometimes not so soft.

JEFF: Yeah, soft corruption can lead us down the wrong road, too.

PAUL: The specific problem with finance, I just want to say, is bigger even than other stuff, like if you're dealing with the oil industry, for example, there is lots of money and corruption. The thing about Wall Street is that they tend to be smart, impressive people. You're going to have a hard time arguing down these Wall Street guys, they come in to a room, they act like they know what they're talking about, and they seem like they know what they're talking about. They're rich, they have great tailors, they're often funny so they're impressive, and it's very hard to get past that.

JEFF: I don't see why that would bother a scientist, though. Let me bring up an example where I think you may be giving the profession too much credit: efficient markets theory. It's a very good example, it's one of my Seven Bad Ideas that was valuable when it started because it taught us that many managers had a very hard time beating the market. Now, that was extrapolated into claiming the market was so efficient that the actual stock price was right, it reflected the future value of the company, and therefore speculative bubbles could happen, but they would be temporary and not very dangerous, and you could motivate CEOs by giving them stock options and their performance would be rationally rewarded by rising stock price because it would reflect the value of the company. But when Bob Schiller tried to upset the capital apple cart created mostly by Chicago, but also MIT economists, he had a hard time making his argument heard by these people. He showed pretty clearly that there were serious stock market bubbles, but the stock price wasn't right over time, and he had to beat them. I admire him a lot, but he's forgotten. He was a little more tentative in the early years of his work gives, because he was knocking on a door that was so solidly closed to him, and pretty soon his ideas prevailed, at least to some degree in the profession, but they mostly prevailed after stock market crashes, not before. So that was an example of efficient markets—free market theory that got carried away ideologically.

PAUL: A couple of stories on that, because one of the things you're overly optimistic about is that you think that Schiller has won. Not a chance. A friend of mine got me to be on a panel at the International Finance Association Meeting, I guess this was two years ago, and they had several eminent finance theorists, and the question was "Has the financial crisis led you to think that we need to revise anything?" and the answer was no, no problem. These are people who have advocated for efficient market theory, and they saw no reason to change their views, so they were waving it off, saying that it was other stuff and maybe it's all Obamacare or something.

For the sake of clarification, what Schiller did was, several decades ago was to calculate a maximum estimate of how much fluctuation in stock prices could be accounted for by fundamentals, like the growth of dividends and earnings. It was clear the fluctuations in stock prices were too great, it was as if even if you had known everything that was going to happen, he showed that the actual fluctuation of stock prices was much greater than that. That says, there have to be herd-behavior bubbles going on. Compelling overwhelming demonstration, mostly rejected by people. But now the interesting thing is, one person took this kind of argument very seriously and wrote some very strong, caustic condemnations of efficient markets— Larry Summers. So Larry Summers in the eighties wrote the ketchup paper. Larry took on the alleged demonstrations that the markets are efficient by using arbitrage strategies that will work. Larry said that it's like looking at the market for ketchup and finding that two quart bottles of ketchup always sell for twice the price of one quart bottle of ketchup and concluding from that that the price of ketchup is therefore always right. Now what's interesting is this same person becomes a senior administration official and is a strong advocate of financial deregulation, that financial markets do set the right price.

JEFF: But he's my representative character, actually, in my book because he was a shape shifter, given his past.

PAUL: But it's interesting, in his analytical work, never. His analytical work has always been critical of efficient markets and so on, but in positions of influence, he's often been part of the ongoing policy consensus, which doesn't necessarily have very much to do with what the economics literature says.

JEFF: Well, he certainly utilized his reputation as a man who knew economics to wage his influence there. But I did work on efficient markets in school, but it's interesting that those in the Shiller camp and perhaps including Summers didn't prevail at all in that argument for quite a while.

PAUL: I would say still have not. I would single out actually the financial piece of the profession as being the part that performed worst and had reformed least, and it's quite amazing when you talk to people there.

JEFF: There's nothing I would fear more than being called an optimist, but we are getting government capital requirements out of this to some degree, which is recognition that there are bubbles. We are getting people talking about it, at the IMF, the OECD, the Fed, and this is an important issue. For a while people thought the only lever to control bubbles would be interest rates, and then Greenspan appeared, and Janet Yellen is talking about capital requirements, capital controls, and actual regulation like what I would call the good ol' days. So I think that's some progress, and in the academic field it's so easy to rationalize the efficient markets theory. There's always an alternative explanation that the bubble is actually rational.

PAUL: Yes, that's the..., well, certainly some of the people start yelling at you if you even use the word bubble.

JEFF: Right.

PAUL: There are no bubbles.

JEFF: It's a title, by the way, of one of my chapters. One thing I would like to tell the audience about a little bit, and I would love to hear your thoughts about, is economists' attitudes toward government, because the best mainstream economics calls for government to intervene only when there are market failures, and I find the definition of market failures way too ambiguous. It narrows the definition of what government should do and I think that's harmed us a lot. It's by and large the best there is—maybe interventions for asymmetric information, sometimes behavioral economics, but I don't think that's gotten far enough given that we know how irrational people can be. I wondered if you thought a little bit about that, because I think government is the sideshow in mainstream economics, and government is not a sideshow, in the economy or in our economic history.

PAUL: Yeah, I was thinking about that a bit. I think the problem here is to show how you do it, and it's the way that textbooks do it, even the very best textbooks like mine. You start with this beautiful model of the perfectly efficient free market economy and then you say OK, now we're going to talk about deviations from that model, and you actually have two kinds of deviations. One is that markets may not work right for a variety of reasons—pollution, externalities, asymmetric information, if buyers don't know as much as sellers do, whatever—so that's one kind of source for government intervention. The other is that, at least if you say the market outcome has no moral significance and there is reason to believe that it's fair or acceptable, if you wanted to help the poor, we could certainly have a valid role of public policy in helping the unfortunate or unlucky. But you're always starting from the baseline position that the economy gets it all right, the market gets it right, and we're working at the edges. And you can certainly argue that that's really wrong, that markets are full of market failure, full of ways in which they don't actually fit that model. Actually real economies have big governments, and it's funny how the textbook approach is one in which the government is kind of a marginal factor there. Yet even in the United States, 30+ percent of the economy passes through the government, and in other advanced countries it's closer to 50, and government obviously regulates a lot of stuff. Now the question is, "So how do you do that?" Jamie Galbraith and I have this conversation fairly often. He says we should start from a paradigm which doesn't have perfect market as the baseline, and I said OK, but how do I actually teach it that way? I don't even know how to make the argument. I mean, the trouble is that starting reality-based is not easy. I guess I believe that you're always going to be doing models that are somewhat abstracting from reality, so I'm waiting for somebody to come up with a way to do this.

JEFF: This is a key point, I think, and one of the key points I make in the book. Because it's hard to do, we often don't do it, and that just doesn't cut it. What you get is a propensity, and Paul has written about this in other contexts, a propensity to do what I would call clean economics in a very dirty world. And in my view, there are ways to think about economics at least in policy terms that deal with the specific problems of the time in context, as opposed to shoehorning in rule-of-thumb answers to all policy questions. I think there's been a strong tendency in mainstream economics to shoehorn in these rule-of-thumb policy answers, and I think that economists have to deal with that even though it becomes a sloppy, dirty profession as a consequence.

PAUL: I'm [thinking] of an old joke about the drunkard looking for his lost keys under the streetlamp, and they say, did you actually drop them here, and he says no, but I can see here, there's light. But I think actually the situation is more like you're not actually sure where you dropped the keys, and so you look under the light hoping that you dropped them there.

JEFF: This is a big issue that I think has to be first.

PAUL: Yeah, let's put it this way: my advice to a young mainstream economist would be not throw it all out, if only for your personal career, but to...

JEFF: ... and not always.

PAUL: ... always be aware. At the very least, you should be aware that there is this strong bias in the way we tend to do economics that is pushing you toward understating the possible role of government, overstating how well markets work; and at least remember that that is just a model, and it's not a model that has actually been borne out by lots of real-world experience.

JEFF: Well, let me challenge you as a textbook writer, and I do this to some degree in the book as well. Why not tell people how the invisible hand works—freshman in college—and then immediately tell them it doesn't work, and here are the problems with it. It's increasingly happening, I think, in textbooks, but not nearly enough to be valid.

PAUL: Yeah, we try. But actually there is also, I have to say this, the equivalent—maybe this is soft corruption—you do want the textbook to be used, and that partly means that some really overstretched person teaching six sections of a course at a community college has to have a book that is not too different from the way her notes look, and it's going to be something that can be adopted. So there is some shading, but I guess the point is always you have to fight the easy path, which doesn't mean jumping completely away from the way everybody does it, but means pushing the environment a little bit.

JEFF: Probably Janet wants to allow you all to ask some questions. But I just want to say one last thing because my own platform for America, my own agenda, would be far more public investment than this deficit, these deficit fears, allow; a significantly higher inflation target; and a lot more fiscal stimulus. I think to some degree Paul agrees with that.

PAUL: Yeah.

JEFF: My view is that mainstream economics inhibits especially the role of government as always defined by the amount of borrowing it can do, the deficit.

PAUL: Yeah.

[Questions from the audience]

TIM McGUIRE: Thank you, this has been very interesting. My name is Tim McGuire and I have a degree from this place. What bothers me is that within the last fifty years, with the decline of labor unions and other institutions, there were no institutions to push back on prevailing establishment ideas about economics. We've lived with a stagnating economy where kids are graduating with debt between $40,000 and $100,000 and end up back stocking shelves in a supermarket, and nobody sees that as a crisis. I don't understand how that can be allowed to happen.

JEFF: I think a lot of people think of it now as a crisis. There is some disagreement about what to do about it. I think on this stage we both agree that there's a lot more room for fiscal stimulus to get economic growth going, and economic growth in itself could start to raise wages and create more jobs. There may be a globalization issue on top of that, of course, but—and I may disagree a little bit with Paul on this—people are talking about secular stagnation at a time when we really haven't used the tools at our disposal to get our growth rate going again. So maybe there's some historical secular stagnation, but I think people are very concerned. I don't think it's fair to say they're not concerned. There's disagreement about what to do, and I think Republicans did so well in this election because they had a very simple and very wrong answer—you get growth by cutting back government spending and government regulation and getting business motivated again. That's not what's missing in this economy.

PAUL: Secular stagnation is an old idea that has come back. It was rejected as being wrong because markets get it right, but it's coming back. And, again, the leading proponent is Larry Summers. What secular stagnation states says is that there are environments in which the economy wants to be depressed and it requires much more activist government policies to fight it, so it's not actually a contradiction. What we're saying is that we're actually in an environment where just having the Fed do its normal thing is not enough to produce consistent, full employment, where we need higher inflation targets and public investment. So there's not actually a contradiction here. Now the thing is, it's always political, so how do we get people to do this stuff? The great frustration I've had is that the pro-government spending, anti-tight money forces have won every argument. They have won on the facts and have made the other side look ridiculous again and again, yet nothing changes in the political sphere, nothing changes in the policy, and that, I guess, is not a problem with mainstream economics exactly, but a problem with life, the universe, and everything.

JEFF: I just want to say this about secular stagnation, because it's come up repeatedly in economic history, especially after the Great Depression. A lot of people claim that technological advancement just runs out of gas.

PAUL: That's a different story. That's not what I mean by that, and it's not what Larry means by referring to that.

JEFF: Anyway, we should move on.

DAVID LEMPER: My name is David Lemper, and I'm a senior international economist at the IRS and a 2014 graduate of the economics program here at the Graduate Center. I'm an especially big fan of Krugman, I've read all your books, and I'm sorry I'm missing you joining the department, but I'm glad to be done. Six years while working full time, it was rough. My question has to do with the critique of inflation targeting, that sort of religion of a 2 percent inflation targeting. Obviously I was in graduate school during an economic environment of financial crisis and very weak demand, and we have interest rates at zero, so how relevant is the religion of the 2 percent inflation targeting? What is your critique of it in the current environment where they don't have to really worry so much about inflation targeting? If anything, we really need to pump the economy by keeping interest rates as low as possible.

PAUL: The first point is if we had had 4 percent inflation instead of 2 percent coming in, then interest rates probably would have been about 2 percentage points higher to start with, so there would have been an extra 200 basis points of interest rate to cut. So the point is that if we had not been so good at achieving price stability, we would have had more room to deal with this crisis as it happened. And then to some extent looking forward, if you can convince people that there's going to be inflation, you can convince people that borrowing more is not a bad thing and that sitting on cash is a bad thing. What the Japanese are trying to do right now is to create a self-fulfilling prophecy that inflation will end, they will do whatever it takes. Unfortunately, they're saying to get it up to 2 percent when it really should be 4 percent. So the point is, yeah, the inflation target has not been a constraint, but we would have been in much better shape had we had a higher inflation target in the past. And, arguably, getting out of where we are now, convincing people that we were in fact raising the inflation target, would—even though it wouldn't be operational for a few years—help us bootstrap ourselves out of where we are. Now if the Fed were to announce that we've decided that 2 percent was too low a target and we're going to move it up to 3 percent, that would be a tremendously shocking announcement, which is a good thing. We want people to be shocked and to change their expectations.

JEFF: It's remarkable to read the minutes of the FOMC about this because they do hold 2 percent as inviolable, and even people who might agree with this argument that it should be 3 or 4 percent have to work within the constraint of that. I think they've talked a little bit about going above 2 percent. A couple of the gentlemen who run the Boston Fed talk about going over 2 percent, so I'm sure deep down, Janet Yellen feels we should be above 2 percent. But when you read the arguments and the FOMC minutes, especially when they come out five years later, it's disheartening to say the least, and it's ideologically biased. I mean, the same people who have said inflation is coming back every year in a big way for five years are saying it again and making public speeches about it, which the media, who are not uncomplicit—to coin a word—in all this, pick up as if there's some special knowledge these people have.

SEYMOUR AMMON: My name is Seymour Ammon. I'm a retired television executive. Full disclosure, I'm a neighbor of Dr. Krugman's. My question is addressed to both of you. Given that we live in a global market economy fueled by consumer demand, when a large proportion of households (I would estimate in the U.S. it's somewhere between 15 and 25 percent) have little or no discretionary income—how can we possibly have a thriving or growing economy, and why do most economists ignore this problem?

JEFF: Well, I think fewer economists are ignoring that problem, and I think it's getting more attention. Part of it is this new attitude about inequality that's receiving more and more attention among a wide, broader number of economists. It used to be that even Bernanke would make comments that inequality didn't matter, but more people are claiming that inequality does matter because low-wage people tend to spend more, and they're spending less. It's not obvious that America is saving too much if you look at the big numbers.

PAUL: Yeah.

JEFF: I think this is a point you make, Paul. But I, for one, think that higher wages are stimulative. That's another thing you don't talk much about in mainstream economics. In mainstream economics, for the most part, higher wages have been a cost that reduces profits and may even increase inflation, the bugaboo of 2 percent inflation. So I think you're right, an economy that doesn't have strong wages is in trouble. An economy that doesn't have domestic demand that's not dependent on huge bubbles and consumer borrowing, which was the case obviously in the 2000s with the mortgage boom, is an economy in trouble. So I think with the Washington policy establishment that sits on government spending and apparently will continue to do so no matter what, low wages are not rising, and if they are, it'll take some time for them to come back—and we've got a central and tragic problem.

PAUL: It's not quite as simple as the story that the middle class and below doesn't have enough income and therefore we don't have enough consumer demand. In fact, consumer spending as a share of GDP has been relatively high all throughout all of this stuff, by historical standards. What is more arguable is that the extremely skewed income distribution has been sustained by rising debt, which then leads you to a crisis, but that's not as solid, the evidence for that is not as strong as I'd like. I would say that inequality is a problem for a number of reasons, and this is maybe not the most important of them. And if you ask what the problem is with the world economy as a whole, what's actually is the case right now is that investment is low; it's not actually that consumer demand is low. Right now what's holding us back is that investment is low, and some of that is residential investment, which still has not recovered, but also that corporations are sitting on cash which they don't see much reason to spend because growth is slow. It's kind of a self-fulfilling pessimism here. Additionally, I think if you try to ask what you need to do, the answer would be that there are multiple reasons for wanting to raise wages. There are multiple reasons for wanting to do what you can to reduce income inequality, and there's a huge case for more public investment as well. The thing is, none of this is actually particularly hard or mysterious. Borrow money to build infrastructure considering that inflation (index bonds) has essentially zero percentage, so it doesn't actually cost anything. Print some money, that's supposed to be fun, right? But what happens is that we can't, the political system stands in the way of doing all of the stuff that's supposed to be an irresistible temptation and turns out to actually be impossible to get happening.


IRENE COPLEY: My name is Irene Copley. I'm retired from several activities. And what I'm going to say is really bigger than economics, and I'm taking the opportunity to discuss this with you, because I'm scared. Just plain scared. Paul Krugman, I have the highest regard for you when I hear you say you had no idea that there were organizations acting as banks but they weren't banks, you had no idea. And I have this innocent notion that economists know everything about everything, but I understand that you can't. And then you mention ideologies, and I was reading Erwin Chemerinsky's book, The Case Against the Supreme Court, which you talked about in today's column, Paul Krugman. And if they are corrupt and if people in government are corrupt and Republicans talk about climate hoax, and the NRA, and the path to oligarchy that we are in—and when we talk about 2 percent inflation, that seems to be an itty-bitty question, because what it all depends on is who is in charge. Now Republicans have taken over 2014. If they win the presidency, where am I going to move to? I'm scared.

JEFF: One issue we've addressed to some degree, but maybe not enough, is this issue of capture and ethics and revolving doors in Washington, or people going to Washington as a means to get a better job elsewhere in the economy. It's not only Wall Street, it's the defense industry and it's the health industry. We can argue that to some degree there's a similar ethics problem in economics. People want to get grants, they want to rise in their universities, they want consulting jobs, they want to get a government post so they can get a better university position and then more consulting jobs. It's become a career, a very lucrative career for some economists. We do have a serious issue here, but it's hard to regulate. I'm a fan of regulation, but it's hard when people stop believing in the rule of law or think that the way you make money or the way to get ahead in life is to find the loopholes. There's an argument especially prevalent among economists that says, no matter how you regulate, Wall Street is going to find the loophole, but I'm not sure this was always the case. I think there was once a kind of attitude, a sensibility, that to some degree you have to abide by the law and not just find a way to get around the meaning and spirit of that law, and I think that we've lost that to some degree. In fact, I think one reason why we've lost it is this emphasis on the idea that when the market is working, everything is right with the world and the market works best with minimal government interference. Government as a moral force has been minimized in America, and I think that affected this campaign. Those who run for office talk about it as a moral force only in terms of eliminating it, or certainly minimizing it. We face a serious uphill battle both morally and in economic theory and practice.

PAUL: I would say if you're not frightened by some of these things, then you're not paying attention, and of course it's scary. Now all you can say is that there have been dark moments in U.S. history and world history, worse moments, and some of them have turned out right in the end, or at least something was worked out on the specific issue of financial regulation. I don't believe that Wall Street can find its way around anything. and in fact Wall Street doesn't believe that, or they wouldn't have campaigned so furiously against Dodd-Frank, or firms that are being designated as strategically important and therefore subject to extra regulation wouldn't be fighting so bitterly not to get that designation. So these things matter. On other issues, sure, climate is a very scary thing. The fact that the head of the Senate Environment Committee is likely to be James Inhofe, who thinks that there's this vast conspiracy of scientists who perpetrate a hoax about the climate—that's pretty scary stuff. But you keep on plugging. I've been writing a column for the New York Times now for fourteen years, and in 2004 it was all over. It was "Liberalism is dead, and there's conservatism domination of everything forever." In 2008 it was "The Democrats have won, and it's the end of conservatism." In 2010, it was "There's no way that Obama could be reelected after this." So nothing is permanent except mass extinction, which we may be working on. But I think the point is that we just keep on plugging, and you have to work. You can't only work on the big issues. I mean, in some sense climate change swamps everything, but meanwhile you dohave to worry about inflation targets.

JEFF: Well, I think one reason to be a little more pessimistic is that money talks louder than ever now in politics. So I don't think it's a matter of cyclical history anymore.

PAUL: Well...

JEFF: Arthur Schlesinger Jr. talked about that all the time, the cycle swings back and forth. I hope that's right.

PAUL: Well, and yet...

JEFF: There's an argument for it.

PAUL: Strange fact: the most expensive presidential election as a share of GDP was 1896. So, you know, it's not as if we haven't had previous eras when money talked.

JEFF: Yup. We needed quite a revolution to come out of the mess of that period.

IRA KRISTADULU: My name is Ira Kristadulu. I'm a retired executive. This question is primarily to Professor Krugman. Professor, you mentioned that large complex systems are inherently fragile and by extension this also means large economic and large financial systems. Now there's a new book, Fragile by Design by Professor Charles Calomiris and another gentleman from Columbia. In fairness to the book, only one piece of it is what I want to focus on, which is really that the reason for the 2008 crisis is due primarily to the Fannie Mae and Freddie Mac problem lending—or in effect, giving—subprime mortgages to the wrong people, namely the poor who couldn't pay them back. Now, I wanted to ask you, Professor Krugman, if you agree with this, because there is the counterargument on the other side that is called "the big lie." He calls this the big lie. And if you don't agree with it, it seems amazing to me that six years after the crisis, if science is the basis for economics, that the tools don't exist to put this question to rest once and for all and not have a high-level disagreement by a person like Charles Calomiris and the other side arguing about such a basic point about what caused the crisis. Thank you.

PAUL: OK. The answer is it is a big lie, and the tools do exist, and it has been totally refuted. The vast bulk of bad loans were made by private lenders, not by Fannie Mae and Freddie Mac. And in any case, Fannie Mae and Freddie Mac did not collapse. They were not part of the financial crisis. The attempt to claim that they were involved in lots of subprime lending and other high-risk categories was sleazy because it turns out it wasn't actually high risk, and this whole story that the government "did it" has been completely refuted. And among other things, there's this claim that all of this was happening because Barney Frank was forcing the government and forcing banks to make all of these bad loans at a time when Republicans controlled the House of Representatives. How is this supposed to have happened? Now the question you have to ask is why some well-known economists would buy into this. A lot of them, well-known economists, endorse this thoroughly refuted theory. Well, we've been talking about some of the incentives going on there, but it's astonishing. There was one review of that book that says it is a tour de force, and I mean that in the worst way. It's incredible that they would go with that lie. It just makes no sense at all, given everything we know.

JEFF: This a highly ideological debate supported by vested interests in well-financed think tanks.

PAUL: Yeah. It's like the proposition that tax cuts for the wealthy yield enormous economic growth. Why haven't we been able to put that away? Well, the answer is that wealthy people who want tax cuts finance an unquenchable faith in that view, no matter what the evidence is.

MODERATOR: It is my grave duty to bring the evening to a close. But before we do, let me just ask Jeff and Paul if you each would like to make a final comment before we send our guests out into the night.

JEFF: Well, I think this is an uphill battle. I hope economists engage more faithfully and maybe I shouldn't use the world intelligently, but more sincerely in this battle. I think economics has become subject to careerism. Economics has been simplified in order to make career advancement easier. And I think it's time to recognize that it's an academic discipline full of the difficulties and dirtiness of the real world, and it's time to make it less antiseptic, to make it less distanced from reality, and to make it flow with red blood again.

PAUL: I'm not sure about the sanguinary metaphors, but there's a lot to be upset about and depressed about when it comes to the state of economics. But good work continues to be done. Particularly there are younger people in the field—for example, I was at a dinner with a mix of Wall Street economists—good guys, actually, there are some—and academics, but there were also some of the younger macro people there, and I came away enormously encouraged, that there is still hope. The new thing now is for us to grapple with reality. Let's grapple with what actually happens and not be too constrained by what was supposed to happen. Will we see complete redemption? Will we get anybody who got it wrong admitting that they got it wrong? Probably not. But you don't give up hope. I think the answer is not to burn down the whole structure and start over, so you work on what you can work on, and books like Jeff's are helpful. If they make people feel guilty, if they make people in the profession feel worried, that's the first step toward redemption.

JEFF: I hope so.

MODERATOR: On that note...


... buy some books on the way out.

JEFF: OK, Paul, thanks.

PAUL: Thanks a lot.



John H. Cochrane

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This article is a response to Paul Krugman's New York Times Magazine article, 'How Did Economists Get It So Wrong?' Krugman's attack on modern economics - and many adhominem attacks on modern economists - display a deep and highly politicised ignorance of what economics and finance is really all about, and a striking emptiness of useful ideas.

Keywords: Paul Krugman, stimulus, Keynes, efficient markets.

Many friends and colleagues have asked me what I think of Paul Krugman's New York Times Magazine article, 'How Did Economists Get It So Wrong?'2

Most of all, it is sad. Imagine this were not an economics article. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid-1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programmes, presented at its conferences, summarised in its graduate textbooks, and rewarded with the accolades a profession can bestow (including multiple Nobel Prizes) is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be an AIDS-HIV disbeliever, a creationist or a stalwart that maybe continents do not move after all.

It gets worse. Krugman hints at dark conspiracies, claiming 'dissenters are marginalised'. The list of enemies is ever- growing and now includes 'new Keynesians' such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he uses out-of-context second-hand quotes from media interviews. He even implies that economists have adopted ideas for pay, selling out for 'sabbaticals at the Hoover institution' and fat 'Wall Street paychecks'.

This approach to economic discourse is a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

Indeed, this is the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused the financial and economic problems that culminated in the crash of 2008, what policies might have prevented it, or what might help us in the future.

But maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I think Keynesian economics was such a wrong turn. So let us take a quick look at the ideas.

Krugman's attack has two goals. First, he thinks financial markets are 'inefficient', fundamentally due to 'irrational' investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge 'fiscal stimulus' provided by multi-trillion dollar deficits.

Market efficiency

It is fun to say that we did not see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going - neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is rehash his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer. It makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn't see the crash coming.

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and believers in efficient marketers have just

© 2011 The Authors. Economic Affairs © 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

ignored it all these years. This is a canard that Krugman should know better than to pass on, no matter how rhetorically convenient. There is nothing about 'efficiency' that promises 'stability'. 'Stable' price growth would in fact be a major violation of efficiency as it would imply easy profits. Data from the Great Depression have been included in practically all the tests of efficient markets. Proponents of the theory have not forgotten its lessons. In fact, a great puzzle in efficient markets theory is that the large equity risk premium suggests that, if anything, stock markets do not seem risky enough.

It is true and very well documented that asset prices move more than is justified by reasonable expectations of future cashflows, discounted at a constant rate. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people's willingness to take on risk varies over time, and is lower in bad economic times. As Eugene Fama pointed out in 1970, these are observationally equivalent explanations. Unless you are willing to elaborate your theory to the point that it can quantitatively describe how much and when risk premiums, or waves of 'optimism' and 'pessimism', can vary, you know nothing. No theory is particularly good at that right now.

Crying 'bubble' is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low-risk premiums and crying wolf too many years in a row. Krugman rightly praises Robert Shiller for his warnings over many years that house prices might fall. But advice that we should listen to Shiller, because he got the last call right, is no more useful than previous advice from many quarters to listen to Alan Greenspan because he got several forecasts right. Following the last mystic oracle until he gets a judgment wrong, then casting him to the wolves, is not a good long-term strategy for identifying bubbles. Krugman likes Shiller because he advocates behavioural finance ideas, but that is no help either. People who say they follow behavioural finance have just as wide a divergence of opinion as those who do not. Are markets irrationally exuberant or irrationally depressed today? It's hard to tell.

This difficulty is no surprise. It is the central prediction of free-market economics, as crystallised by F. A. Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what 'fundamental' value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, then communism and central planning would have worked. More deeply, the economist's job is not to 'explain' market fluctuations after the fact or to give a pleasant story on the evening news about why markets went up or down.

The case for free markets is not justified by the belief that markets are 'perfect'

But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.

In effect, Krugman is arguing that the government should massively intervene in financial markets and take charge of the allocation of capital. He cannot say this explicitly, but he does

say, 'Keynes considered it a very bad idea to let such

markets . . . dictate important business decisions', and 'finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a "casino" '. Well, if markets cannot be trusted to allocate capital, it's a fair to conclude Krugman thinks only the government can.

To reach this conclusion, you need evidence, experience or some realistic hope that the alternative will be better. Remember, the US regulator, the SEC, could not even find Bernie Madoff when he was handed to them on a silver platter. Fannie Mae, Freddie Mac and Congress all did a dreadful job of managing the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? Government regulators failed just as abysmally as private investors and economists to see the storm coming.

In fact, if you take it at all seriously, the behavioural view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman's words, 'idiots', then so must be the typical Treasury secretary, Fed chairman and regulatory staff. Most of them are ex-bankers! Furthermore, regulators act alone or in committees, without the discipline of competition, where behavioural biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.

Careful behaviouralists know this, and do not quickly run from 'the market got it wrong' to 'the government can put it all right'. Even my most behavioural colleagues Richard Thaler and Cass Sunstein in their book Nudge go only so far as a light libertarian paternalism, suggesting good default options on US personal pension accounts. (And even here they're not very clear on how the Federal Nudging Agency is going to steer clear of industry capture.) They do not even think of jumping from 'irrational' markets, which they believe in deeply, to government control of stock and house prices and allocation of capital.


Krugman is a strong supporter of fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of 'mistaking beauty for truth'. He is not clear on what the 'beauty' is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Krugman's Keynesian economics requires that people make logically inconsistent plans to consume more, invest more and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don't think about the future in making decisions today. Logical consistency and plausible foundations are indeed 'beautiful' but to me they are also basic preconditions for 'truth'.

In economics, stimulus spending ran aground on Robert Barro's Ricardian equivalence theorem. This theorem says that

© 2011 The Authors. Economic Affairs © 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

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debt-financed spending cannot have any more effect than spending financed by raising taxes. People, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? It is a logical connection from a set of 'ifs' to a set of 'therefores'. Not even Krugman can object to the connection.

Therefore, we have to examine the 'ifs'. And those 'ifs' are, as usual, obviously not true. For example, the theorem assumes lump-sum taxes, not proportional income taxes. Alas, when you take this consideration into account, we are all made poorer by deficit spending, so the multiplier is most likely negative. The theorem (like most Keynesian economics) ignores the composition of output; but surely spending money on roads rather than cars can't greatly affect the overall level of output.

Economists have spent a generation tossing and turning the Ricardian equivalence theorem, assessing the likely effects of fiscal stimulus in its light, generalising the 'ifs' and figuring out the likely 'therefores'. This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why and how it is false.

Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today's consumption and so on.

For example, most Keynesians think the Ricardian equivalence theorem fails because people don't rationally anticipate the future taxes that must pay off today's debt. OK, but what's good for the goose is good for the gander: if sometimes people pay too little attention to future taxes, at others they pay too much, so stimulus has a negative effect. The latter seems at least plausible now! It is the logically consistent conclusion from Krugman's views. He thinks deficit concerns are just Tea Party hysteria. OK, but if so, the voters are overestimating future taxes, not ignoring them. Furthermore, if 'stimulus' is rooted in people ignoring future taxes, then it makes no sense whatsoever to advocate 'stimulus' today but loudly announce the future taxes in 'deficit reduction'!

Last, when you find 'market failures' that might justify a multiplier, optimal-policy analysis suggests fixing the market failures, not their exploitation by fiscal multipliers.

This is how real, thoughtful, logically consistent analysis of fiscal stimulus proceeds. Nobody ever 'asserted that an increase in government spending cannot, under any circumstances, increase employment', any more than (I presume) Krugman would assert that more government spending always helps (Greece? Zimbabwe?). This statement is unsupportable by any serious review of professional writings, and Krugman knows it. But thinking through this sort of thing and explaining it is much harder than just tarring your enemies with out-of-context quotes, ethical innuendo or silly cartoons.

The 'crash'

Krugman's New York Times article is supposedly about how the crash and recession changed our thinking, and what

economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.

There was a financial crisis, a classic run on the shadow banking system, and near collapse of the large commercial banks. The centrepiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated banks. A generation of economists has thought really hard about these kinds of events: Diamond, Rajan, Gorton, Kashyap, Stein, Duffie and so on. They have thought about why there is so much short-term debt, why people run on banks, how deposit insurance and credit guarantees can help to stop runs, and how they give incentives for excessive risk-taking, why brokerage and derivatives contracts are prone to runs, what's wrong with bankruptcy law and how to fix it.

If we want to think about events and policies, this seems like more than a minor detail. The hard and central policy debate over the last year was how to manage this financial crisis. Now it is how to set up the incentives of banks and other financial institutions so that another financial crisis or sovereign-debt crisis does not happen. There is a lot of good and subtle economics here that New York Times readers might like to know about. But, sadly, Krugman says nothing about these things.

Krugman does not even have anything to say about the Federal Reserve Board (Fed). Ben Bernanke did a lot more in 2007-08 than set central bank interest rates to zero and then go off on vacation and wait for fiscal policy to do its magic. Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy US government bonds in exchange for reserves, it essentially sold government bonds in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitised-debt spreads, and intervened in those markets. There is no such thing as 'the' interest rate anymore: the Fed is attempting to manage all interest rates.

Monetary policy now has little to do with 'money' versus 'bonds' with all the latter lumped together. Monetary policy has become wide-ranging financial policy. Does any of this work? What are the dangers? Can the Fed stay independent in this new role? These are the questions of our time. Paul Krugman has nothing to say about them.

To Krugman, the crash was caused by 'irrationality'. To Krugman, there is one magic cure-all for all economic problems: fiscal stimulus. It's really a remarkably empty view of the world.

Krugman claims a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis. Alas, that won't stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular to anything with a serious intertemporal dimension. Krugman's simple Keynesianism has dominated policy analysis for decades and continues to do so. Policy-makers just add up consumer, investment and government 'demand' to forecast

© 2011 The Authors. Economic Affairs © 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

output and use simple Phillips curves to think about inflation. If a failure of ideas caused bad policy, it's Krugman's simple-minded 1960s Keynesianism that failed.

The future of economics

How should economics change? Krugman argues for three incompatible changes.

First, he argues for a future of economics that 'recognises flaws and frictions', and incorporates alternative assumptions about behaviour, especially towards risk-taking. This is what macroeconomists have been doing for a generation. Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescott's 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviours (especially new models of attitudes to risk) and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same. My own research includes work on 'habits', a mechanism by which people become more risk averse as values fall.

Second, Krugman argues that 'a more or less Keynesian view is the only plausible game in town', and 'Keynesian economics remains the best framework we have for making sense of recessions and depressions'. One thing is pretty clear by now, that when economics incorporates flaws and frictions, the result will not be to rehabilitate an 80-year-old book. As Krugman bemoans, the 'new Keynesians' who did just what he asks by putting Keynes-inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism. A science that moves forward almost never ends up back where it started: Einstein revised Newton, but did not send us back to Aristotle.

Third, and most surprising, is Krugman's Luddite attack on mathematics: 'economists as a group, mistook beauty, clad in impressive-looking mathematics, for truth'. Models are 'gussied up with fancy equations'. I am old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize. The old guard tut-tutted 'nice recreational mathematics, but not real-world at all'. He once wrote eloquently about how only mathematics keeps your ideas straight in economics. How quickly time passes.

Again, what is the alternative? Does Krugman really think we can make progress in economic and financial research (understanding frictions, imperfect markets, complex human behaviour and institutional rigidities) by reverting to a literary style of exposition and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavour is there any real hope that this will work in economics?

The problem is that we do not have enough mathematics. Mathematics in economics serves to keep the logic straight, to make sure that the 'then' really does follow the 'if ', which it so frequently does not if you just write prose. The challenge is that it is hard to write down explicit artificial economies with these novel ingredients and actually solve them in order to see what makes them tick. Frictions are just hard with the mathematical tools we have now.

ieaeconomic affairs june 2011 39 The insults

The level of personal attack in the New York Times article, and the fudging of the facts to achieve it, is simply amazing. As one little example, take my quotation about carpenters in Nevada. Krugman writes: 'And Cochrane declares that high unemployment is actually good: "We should have a recession. People who spend their lives pounding nails in Nevada need something else to do." Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada?'

I did not write this. It is an attribution, taken out of context, from a article, written by a reporter with whom I spent about 10 hours patiently trying to explain some basics, and who also turned out only to be on a hunt for embarrassing quotes. Nevertheless, I was trying to explain how sectoral shifts contribute to unemployment. I never asserted that 'it takes mass unemployment across the whole nation to get carpenters to move out of Nevada'. You cannot even dredge up an out-of-context quote for that monstrously made-up opinion.

What is the point in conducting debate this way? I do not think that Krugman disagrees that sectoral shifts result in some unemployment, so the quote actually makes sense as economics. The only point is to make me, personally, seem heartless - a pure, personal, calumnious attack, which has nothing to do with economics.

It goes on. Krugman asserts that I and others 'believe' 'that an increase in government spending cannot, under any circumstances, increase employment' and that we 'argued that price fluctuations and shocks to demand actually had nothing to do with the business cycle'. These are just gross distortions, unsupported by any documentation or the lightest fact-checking, let alone by examination of any professional writing. And Krugman knows better. All economic models are simplified to exhibit one point; we all understand the real world is more complicated. Krugman's job as a professional economist with a newspaper column is supposed to be to explain that to lay readers. These quotes about academic opponents would be rather like somebody looking up Krugman's early work (which assumed away transport costs) and claiming in the Wall Street Journal, 'Paul Krugman believes ocean shipping is free, how stupid'.

The idea that any of us do what we do because we are paid off by Wall Street banks or seek cushy sabbaticals at Hoover is ridiculous. Indeed, believing in efficient markets disqualifies you for employment in hedge funds and many other financial institutions. Nobody wants to hire somebody who thinks you cannot make any money trading!

Krugman is supposed to read, explain and criticise things economists write. This should be real professional writing: not interviews, opeds and blog posts. At a minimum, Krugman's style leads to the unavoidable conclusion that he is not reading real economics anymore.

How did Krugman get it so wrong?

So what is Krugman up to? The only explanation that makes sense to me is that Krugman isn't trying to be an economist: he is trying to be a partisan, political opinion writer. This is

© 2011 The Authors. Economic Affairs © 2011 Institute of Economic Affairs. Published by Blackwell Publishing, Oxford

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