Cul-de-Sac-Enomics

Paul Krugman takes the freshwater economists of my alma mater to the woodshed, in the process of laying out the current state of macroeconomics following a half century of retreat from Keynesianism.

This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in.

Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious. For 25 or so years they tolerated the Fed’s efforts to manage the economy, but a full-blown Keynesian resurgence was something entirely different. Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown. And so Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” (It’s a mark of how deep the division between saltwater and freshwater runs that Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard.)

Meanwhile, saltwater economists... were shocked to realize that freshwater economists hadn’t been listening.... Freshwater economists [like Lucas, Prescott, Fama, Cochrane, Mulligan, Zingales, Boldrin, etc.] who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who... were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound. And it wasn’t just Keynes whose ideas seemed to have been forgotten. As Brad DeLong of the University of California, Berkeley, has pointed out in his laments about the Chicago school’s “intellectual collapse,” the school’s current stance amounts to a wholesale rejection of Milton Friedman’s ideas as well. Friedman believed that Fed policy rather than changes in government spending should be used to stabilize the economy, but he never asserted that an increase in government spending cannot, under any circumstances, increase employment. In fact, rereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems.

Brad Delong comments:

I remember October of 1987. We--that is me, Andrei Shleifer, Larry Summers, and Robert Waldmann--had what we regarded as a very nice paper about the instability of irrational agents' beliefs as itself a powerful barrier to arbitrage. We then watched the stock market crash by 25% in one day. And we thought that we had won the argument: that the efficient market hypothesis couldn't come back from a 25% market collapse on a day when absolutely nothing fundamental happened.

But then we were told that something fundamental had happened: there had been a sudden shock to the required expected rate of return on equities and the market had reacted efficiently to that shock. However, when I tried to process this, I could not understand it other than as an assertion that the market had gone down for no reason and would eventually recover--but that this was not a problem because it was consistent with the efficient market hypothesis...