I Agree with Krugman

Paul Krugman argues that President Obama should just let the tax cuts expire and I agree.

Democrats have tried to push a compromise: let tax cuts for the wealthy expire, but extend tax cuts for the middle class. Republicans, however, are having none of it. They have been filibustering Democratic attempts to separate tax cuts that mainly benefit a tiny group of wealthy Americans from those that mainly help the middle class. It’s all or nothing, they say: all the Bush tax cuts must be extended. What should Democrats do?

The answer is that they should just say no. If G.O.P. intransigence means that taxes rise at the end of this month, so be it.

Krugman thinks it is a bad deal. I think they should just let them expire based on budget realities. What would be best would be to couple this with a cut in payroll taxes. That would lower the cost of employing people and would mitigate any effect on unemployment.

But I expect the President will give in to satisfy his campaign pledge about not raising taxes on the middle class.

Rajan's Reply

Ragu Rajan replies to Krugman and Wells attack on his book Fault Lines. The book is excellent, no time to discuss it now. The reply is devastating and valuable.

Here is a small taste (but important point):

Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.” Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

Read the whole thing.

Krugman, Maddow Smackdown

Jack Shafer takes down Paul Krugman and Rachel Maddow for their alarmist warnings of the unpaving of American highways. What Krugman and Maddow see as the decline of western civilization may just be a rational response to lack of use and alternative routes:

A strong case can be made that North Dakota and maybe a few other states are now paying the price—or not paying the price, as it were—for having overbuilt their road systems. The most recent federal numbers show that North Dakota has 86,842 miles of road, compared with next-door-neighbor Montana's 73,202 miles. Montana is similarly rural, but it's twice the size of North Dakota and has a 50 percent greater population. If Montana can function with 13,000 fewer miles of road than North Dakota, then North Dakota can unpave or abandon several thousands of miles of road without disintegrating. Montanans even drive more rural miles (PDF) than North Dakotans. South Dakota, which has about 25 percent more people than North Dakota, gets by with just 83,744 miles of road!

Krugman and China

Paul Krugman has been calling for a surcharge on Chinese imports of 25% as a response to currency manipulation. He wants a tough policy because he believes they will not respond otherwise. Scott Sumner does a pretty nice job dealing with the hubris part of this argument. In a second column Krugman does a better job of explaining the economics:

Let me start with a proposition: the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.

Although people don’t always think of it this way, what the Chinese government is doing here is engaging in massive capital export – artificially creating a huge deficit in China’s capital account. It’s able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.

Now, bear in mind the two basic balance of payments accounting identities:

Capital account + Current account = 0

Current account = Domestic savings – Domestic investment

By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.

This is a good way to think about the problem, but it does not necessarily support Krugman's policy preference. He argues that if China appreciated the yuan or if the US slapped a tariff on Chinese exports these would reduce the current account surplus of China. He starts from the macro balances but then comes back to the currency value being the exogenous driving force. He is reading his two equations from the top down. Why does it not work from the bottom up?

Suppose that China stopped purchasing foreign assets and let the yuan appreciate. Then we are to suppose that Chinese savings will necessarily fall. Presumably this arises because the movement in the exchange rate makes imports more expensive.

But why do we believe that the current account will adjust in this manner. Can't we read the CA equation the opposite way? If Chinese households and corporations want to save over 50% of GDP there will still be an excess of savings over investment (see this article for some evidence on the distribution of Chinese savings by type). So something else must give. What? Presumably the price level. Since net exports fall due to the currency intervention aggregate demand is lower. This puts downward pressure on the price level. This offsets the impact of the currency change on the real exchange rate. China is just as competitive as before.

For a currency surcharge or revaluation to reduce the Chinese current account surplus it has to change the savings/investment balance. It is not clear how that will happen until something changes the desires of Chinese corporations to hoard savings and Chinese households to save. There may be government policies that China can pursue to achieve this, and they would likely improve welfare (for example a retirement system), but it is not at all clear that they will be implemented in response to tough talk from US Congressman about the yuan.

Health Bill

Paul Krugman criticizes those who are unhappy about the Senate's passage of health care. In the spirit of the holidays he updates Dickens:

It begins with sad news: young Timothy Cratchit, a k a Tiny Tim, is sick. And his treatment will cost far more than his parents can pay out of pocket.

Fortunately, our story is set in 2014, and the Cratchits have health insurance. Not from their employer: Ebenezer Scrooge doesn’t do employee benefits. And just a few years earlier they wouldn’t have been able to buy insurance on their own because Tiny Tim has a pre-existing condition, and, anyway, the premiums would have been out of their reach.

But reform legislation enacted in 2010 banned insurance discrimination on the basis of medical history and also created a system of subsidies to help families pay for coverage. Even so, insurance doesn’t come cheap — but the Cratchits do have it, and they’re grateful. God bless us, everyone.

Of course, one might also note that somebody must pay for the increased coverage. Perhaps as the tale proceeds, Cratchit loses his job as Scrooge goes out of business.

Krugman does not consider that because he has his own straw men to consider. He divides opposition to the health bill to three groups: irrational tea baggers; "Bah Humbug" fiscal scolds; and disappointed progressives. Obviously the only sensible reason to be unhappy is if you are disappointed that we are not enacting a single payer system, but you have to be realistic.

There are reasons to be unhappy with the bill that does not fall into his three categories. The fiscal impact of the bill that Krugman is so happy about depends on Congress carrying out commitments that all know they won't follow. Even supporters like Ezra Klein believe that the individual mandate in this bill is a sweetheart deal. The penalty for not buying insurance is so small that for many the best option will be to just pay the penalty and sign up for insurance only after you need it. But someone will have to pay the cost of this, will they not?

The most pressing problem, perhaps, is that the bill does not allow competition across state lines. Krugman never discusses this issue. The exchanges are set up on a state level, and private insurers cannot compete. Given that the bill limits administrative costs, small insurers will likely go out of business -- they cannot spread the fixed costs sufficiently -- so in some states the number of options will decrease under this bill. As Richard Epstein argues, the current bill turns health insurance into a regulated public utility.

I suppose that Krugman really approves of this but he never discusses it. He cannot. This argument does not fall into any of his straw man categories.

Levine Responds to Krugman

David Levine writes an open letter to Paul Krugman on the state of Macroeconomics. At one point he notes:

our models don't just fail to predict the timing of financial crises - they say that we cannot. Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now. This common sense is the heart of rational expectations models. So the correct conclusion is that our - and your - inability to predict the crisis confirms our theories. I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn't what the theory of relativity says: it says that velocity is relative. Acceleration is most definitely not. So were you to come forward with the puzzling discovery that acceleration is not relative...

Read more at: http://www.huffingtonpost.com/david-k-levine/an-open-letter-to-paul-kr_b_289768.html

Levine is being coy here. Without mentioning it, he is trying to outline Krugman's own model of first-generation exchange rate collapses. But not exactly. For in Krugman's model there is a fundamental that is driving the currency collapse. Excessive money growth is driving down reserves, so in Krugman's rational expectations model, investors do not wait for all reserves to be evaporated before selling the currency, they do so at the first moment that an attack is feasible. Krugman's model ties down the timing of the attack exactly, even though it is based on rational expectations (indeed that is the novel point). Thus, I suppose one could argue that with better models of fundamentals we would know more about the timing of crashes.

I should have linked earlier to John Cochrane's response to Krugman. It is long, but well worth reading.

Meanwhile, Gilles Saint-Paul provides a modest defense of the economics profession.

Economics and the Crisis

Paul Krugman has a long article discussing the role of economists in the crisis. Krugman argues that macroeconomics has gotten it very wrong. His basic indictment:

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, thatstocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

The explanation is becoming fairly conventional. The problem is that mathematization of the field.

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.

The article is worth reading in full, but Krugman's attack lacks focus I think. His attack is too broad, and thus the worthy parts are offset by the desire to blame everything he does not like.

For example, it is just not fair to argue that economists accepted the efficient markets hypothesis or the belief in market efficiency for personal gain:

The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

What about the evidence from financial markets that demonstrates the difficulty of beating the market? Most empirical studies, especially the early ones, were quite clear on this (see, for example, here). This is especially true for the weak form of the hypothesis that says that asset prices incorporate all publicly available information.

Krugman also mis-characterizes why fresh-water and salt-water economists reconciliated. He writes:

Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.

This misses the story. What happened is that fresh-water economists started to incorporate market frictions in their models, especially those that come from search. Meanwhile, salt-water economists adopted the methodology, using dynamic models with optimizing agents to study economies with other types of market frictions. An agreement to study the quantitative effects of policies made it easier for macroeconomists to talk. This is much closer to what happened.

How about Krugman's claim that macroeconomists should have predicted the crisis?

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst.

Of course it is not really clear that Shiller actually predicted that housing prices would decline nationally, as Falkenblog has noted. Moreover, a bubble continues precisely because the belief that asset prices follow a bubble is not common knowledge. Once it becomes common knowledge traders sell against the bubble. The bubble continues precisely because nobody knows when enough agents realize this. This is the important lesson from Abreu and Brunnermaier (the latter is Krugman's colleague, so he should be aware of this). Now suppose that there is a difference of opinion concerning the likelihood we are on a bubble path. What are policymakers to do? If they try to prick the bubble they will be blamed for the consequences. There is a political agency problem here.

The person who gets the most credit for predicting the crisis is Nouriel Roubini. He did predict crisis, the one that many economists did expect. But that was a currency crisis due to our excessive current account deficits. This was quite a rational fear. As for the excessive risk in the banking system, it seems that Raghuram Rajan was the only major economist who talked about this (there was some very good work at the BIS that was also ignored). And as Krugman notes in his article, when Rajan made these warnings even Larry Summers belittled him. Why was this the case? I suspect that most economists understood the basics of securitization, but could not believe how much of the CDO's banks were keeping on their books or in special investment vehicles they were responsible for. Since the latter are off-balance sheet, they are precisely organized to fool analysts.

What economists did miss is an important point made by Posner in his book, A Failure of Capitalism. Suppose we have regulations that prevent some type of crisis. Over time, if the policies are successful, the likelihood of seeing a crisis will recede. So the benefits of the regulations will be less apparent. But the costs of the regulation will not be reduced. So a cost-benefit analysis of beneficial regulations will seem to signal inefficiency. This increases the political support for eliminating the beneficial regulations. And this will make a crisis more likely.

This leads to another interesting point about economics. Normally economics works through negative feedback loops. When demand for a good falls so does its price. The fall in the price reduces the extent of the fall in sales and signals producers to produce other things. Negative feedback is what makes the equilibrium hypothesis useful. But what happens when the economy is so far out of kilter that we have positive feedback loops? This is what happened when the housing bubble burst. The fall in asset prices led to a deterioration of bank balance sheets and less lending. This hurt investment and production and incomes declined. So people could not purchase homes that were much cheaper. This is positive feedback, and it is what turned the asset bubble into the great recession.

Notice that after many asset bubbles burst negative feedback loops operated. Think of the 1987 crash or the end of the tech bubble. These had little economy-wide effects because of negative feedback. But in rare cases we do get positive feedback. Yet if these cases are so rare most of the data we operate with will not display it. So most of our experience, and most of our analysis will be conducted using data generated by negative feedback behavior. It is not surprising that we are not well-prepared for positive feedback loops. If we were it would mean we had experienced many more crises.

One could then blame economists for focusing so much on normal times and ignoring how the economy works outside the corridor (see my previous post on the Corridor hypothesis). But given how rare depressions have been was this such an unwise strategy?

Another important point Krugman makes is that macro failed to incorporate finance sufficiently. This is an important criticism, but I doubt the reason is the efficient markets hypothesis. It stems much more from the use of representative agent models. These make it hard to model finance. I think it is the complexity rather than the obtuseness of economists that led to this result.

Efficient Markets Again

Paul Krugman reviews several books in the New York Times, especially Justin Fox's book, The Myth of the Rational Market. But I wonder if Krugman actually read his own article. He reviews the development of modern finance theory, and especially emphasizes efficient markets (EMH) and the capital asset pricing model, CAPM. He then argues that this is what created the financial crisis.

Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy.

Doesn't this seem strange? If Wall Street bought the ideas of the efficient markets hypothesis why would invest so much in complex trading strategies? If they believed CAPM, they would know that they could only earn more return by taking on more risk. Isn't it more correct to argue that they did not believe in the EMH and the CAPM?

P.S. Today, Falkenstein likes Krugmans review no more than I, and is much harsher.