Paul Krugman draws strong reactions. You either admire the guy or you despise him; there doesn't seem to be any middle ground. Let's look at Krugman's view of the economy. To have a proper understanding of how the economy works is of paramount importance to investors, and the outspoken Krugman provides a nice focal point.
We will address these issues in a couple of articles. We'll start with describing two fundamental views of the economy, those that argue that the economy is self-stabilizing and will return to full-employment equilibrium in due course, and those (like Krugman), who argue that these self-stabilizing forces can be overpowerd by forces that keep the economy into a prolonged recession.
The relevance to investors is not hard to explain. If Krugman is right, growth and full employment will not return automatically, and sooner or later corporate earnings will also suffer. So for the prospects of the stock exchange, it matters a great deal what your fundamental view of the economy is.
"Freshwater" Versus "Saltwater" Economics
At the core lie different views of how the economy works, whether it is self-stabilizing or whether it can veer off into an abyss, and what is the role for economic policy.
Krugman's main opponents are so called "freshwater economists" (as they mainly teach at universities in the heartland of the US, while the Keynesians like Krugman mainly populate faculties on the US coast, hence "saltwater economists"). These freshwater economists argue that the economy is self-stabilizing and no policy interventions are needed to achieve a full-employment equilibrium.
Where is Krugman?
Since there are some misconceptions about where Krugman is actually situated in the economic spectrum, he can best answer that himself:
The brand of economics I use in my daily work - the brand that I still consider by far the most reasonable approach out there - was largely established by Paul Samuelson back in 1948, when he published the first edition of his calssic textbook. It's an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, wich emphasizes the way the economy can develop magneto trouble, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment: only once that can be taken as given do the usual virtues of free markets come to the fore.
Now, for the present economic predicament, there are at least four important differences between the freshwater (or general equilibrium) and saltwater economists like Krugman:
- Explaining recessions
- Explaining the persistence of recessions
- Explaining why interest rates are so low, despite record public deficits and debts (in part II)
- Explaining why inflation is so low, despite record base money creation (in part II)
The freshwater economists argue that the economy as a whole functions like individual markets (the "microeconomics" part mentioned by Krugman above). Individual markets more or less clear instantly, that is, supply will tend to equal demand pretty fast. Using the tools of micro economic analysis for the economy as a whole has significant advantages in rigor and ability to apply complex mathematics.
The freshwater approach is deductive, starting from a number of assumptions like assuming perfectly rational, optimizing agents, the absence of transaction cost, and perfectly competitive markets. Although not any of these assumptions is anywhere near realistic, Milton Friedman has countred that critique by arbuing that realism of the assumptions doesn't matter as long as the model has predictive value.
If, as the freshwater economist argue, markets always clear more or less instantly, the economy at large will quickly restore full-employment equilibrium. However, they have a bit of a problem explaining prolonged slumps in economic activity. Some markets must fail, apparently.
Here is an important representative of that school, Robert Barro asking:
Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?
And here is Krugman's riposte:
There’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did three and a half years ago despite population growth and advancing technology.
Larry Summers, another notable saltwater economist, adds:
Summers asserted, the dynamic stochastic general equilibrium models used by many economists, which often assume the economy will naturally return to a basic equilibrium with full employment, have been of little value in these complex times. “In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought,” Summers said, adding: “I think the profession is not entirely innocent.”
And here is Krugman again:
It helps to understand the origins of the freshwater-saltwater divide, which actually began as a dispute about monetary policy. Lucas said that monetary policy could have real effects only as long as workers and firms were confused about whether a shortfall in demand was economy-wide or specific to them. This view proved unsustainable because recessions last too long, and also because rational observers could figure out what’s going on by looking at interest rates and other asset prices. So the real business cycle theorists came in and said that technology shocks were driving the cycle, and money had nothing to do with it. But what the data actually say — see Romer and Romer lecture 3 (pdf) — is that changes in monetary policy have large and sustained effects on output and employment. This tells us right off the bat that equilibrium macro is wrong, which is presumably why Sims says that the New Keynesians are the ones actually trying to come to grips with the data. By the time this reality was clear, however, a large part of the macro field was committed, ideologically and professionally, to an anti-Keynesian view. It was not acceptable even to consider the possibility that they were on the wrong track. Hence models must be calibrated, not tested.
Economic booms and busts have basically occurred since time immemorial, so they must be an integral part of how economies work. Yet the freshwater "dynamic stochastic general equilibrium model" has basically no room for them -- that's where the stochastic part comes from; recessions occur as a result of an outside shock to the system.
Like jelly, when moved from the outside, the economic system wiggles, but in ever smaller amounts, sooner or later equilibrium is restored, meaning the economy returns to its previous growth path with resources essentially fully employed.
In the general equilibrium models, economies move back to full employment through wage and price flexibility and a rise in the real money supply (the so called Pigou effect, the fall in prices cause the purchasing power of money to increase).
Explaining the Recession in Terms of Aggregate Demand
Saltwater economist like Krugman explain the recession in terms of a lack of aggregate demand, something that cannot really happen in the general equilibrium world. But take that mythical creature, the American consumer, he has taken quite a few hits lately:
Or read the Sentier research:
For the entire period from December 2007 to June 2011, real median annual household income has declined by 9.8 percent. A decline of this magnitude represents a significant reduction in the American standard of living.
Not only wages took a large hit, something like six million jobs were lost too:
Not to mention the wealth destruction for households:
Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs. [Martin Feldstein]
You have to realize, it's not only the $9T in wealth that has been lost, mortgage debt hasn't fallen by nearly as much. There are 11 million mortgage holders underwater -- that is, the value of their mortgage exceeding that of their house.
While Krugman has posted hundreds of blog posts on the topic, it's best summarized by Larry Summers:
“No thoughtful person can look at the U.S. economy today and believe that the principal constraint on expansion of output and employment is anything other than the lack of demand experienced by firms,”
Considering the magnitude of the wages/employment/balance sheet shock to consumers, it's pretty hard to escape that conclusion. It is really notable as well, that many other constraints on business seem to be rather absent:
- Interest rates have never been lower
- Profits have never been higher
- Corporate balance sheets have never been in better shape.
The general equilibrium models favored by freshwater economists stress the self-restoring nature of the economic system. This makes it hard to explain the endurance of the recession.
For the saltwater economist like Krugman, this isn't so problematic, as there are possible negative or self-reinforcing feedback mechanisms operating in the economy which, rather than restore full-employment equilibrium, tend to move it further away from that (or at least overwhelm the self-restoring or positive feedback mechanisms of the general equilibrium models).
The multiplier. A fall in demand means a fall in income for someone else in the economy, who might very well respond to that by cutting back spending himself. In this way, the original shock, rather than dampen, can be exacerbated.
Falling wages and prices. The favorite equilibrium restoring mechanism of the freshwater general equilibrium models. Lower demand should lead to lower prices and wages, which should boost demand and and restore full-employment equilibrium. If there is high unemployment this is simply a sign that wages are too high, according to the freshwater economists.
However, cutting wages is difficult (here is one of the ad-hoc market imperfections Keynesians rely upon) due to worker resistance, contracts, or even the law. Cutting wages might reduce demand further, and if prices fall as much as wages, labor cost doesn't change. After all, it's real wages that matter.
Falling prices might have their own problems. In the 1930s, prices and wages did fall considerably but rather than restoring full employment, the economy moved deeper into a funk as deflationary expectations rooted and people expected prices to be lower still in the future, reducing spending.
Fisher's debt deflation. Falling prices, rather than restoring full-employment equilibrium, could under some circumstances take it further away from it. Irving Fisher explained in the 1930s how falling prices cause the real value of debt to increase, leading to forced asset sales and even lower asset prices, worsening balance sheets further, leading to more bankruptcies and further reductions in spending and production.
It is mainly this spectrum of a debt deflationary vicious cycle taking hold in the economy that informs the likes of Bernanke to pull all (or at least most) of the plugs on monetary policy in preventing this from happening. We know from Japan that once deflation takes hold, it's very hard to get rid off.
It is also the reason that some, like Krugman, argue that the present recession is at least in part a so-called balance sheet recession caused by financial over-leverage and excessive debt, which has to be worked off.
Keynes paradox of thrift. Keynes argued that in a recession, it might be rational for individuals and firms to reduce spending because of a fall in income, but taken together, this tends to reinforce the economic problems.
Loanable funds. Equilibrium economist argue that if consumption demand falls, the interest rate will fall as to spur a rise in investment to compensate for the fall in consumption (in equilibrium, savings equal investments).
One problem is that interest rates are already at record lows and this hasn't spurred a rise in investments. Also, as Krugman argues, much of the adjustment that equate savings to investment works via changes in economic output, especially at very low interest rates.
Liquidity trap. Freshwater economists like Milton Friedman argued that monetary policy is able to stabilize the economy (and it should do this by rule, rather than discretionary policy changes). However, following Keynes, Krugman has argued that monetary policy loses much of its traction at very low interest rates. This happened first in Japan in the 1990s, and now it is happening in the US as well.
This theorema is known as the liquidity trap. Krugman's explanation relies on the role of expectations, discussing Japan in the 1990s:
No matter how much Japan increases the monetary base now, expectations of future money supplies won’t move if people believe that the Bank of Japan will move to stabilize the price level as soon as the economy recovers. And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.
Zimbabwe wouldn’t have this problem: people believe that any money it prints will stay in circulation. But the likes of Japan, or the United States, print money for policy purposes, not to pay their bills. And that, perversely, is what makes them vulnerable to a liquidity trap.
He arrived at a rather controversial conclusion:
Back in 1998 I argued that the Bank of Japan needed to find a way to “credibly promise to be irresponsible.”
The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices.
These explanations (and you'll have to bear with us, in the space here we can barely scratch the surface) have a considerable ad-hoc quality and are far removed from the rigorous, consistent, deductive optimizing world of general equilibrium economics, but we will shortly show that there is, in fact, a surprising amount of evidence in support.
What the Different Models Can and Can't Explain
Krugman's neo-Keynesian view of the world, although not nearly as consistent or rigorous as the general equilibrium approach, nevertheless seems to have less problems explaining the incidence and persistence of recessions.
Since there is no place for these in general equilibrium models, freshwater economist have to invoke exogenous ad-hoc explanations like government policies (regulatory burden) for explaining recessions and their persistence.
It is a bit of a stretch to explain the biggest and most persistent recession since the 1930s on too much regulation, especially given that the US remains one of the least regulated economies in the world, or reverting to the so-called real-business cycle theories when productivity growth has become pro-cyclical.
What's more, Krugman can take considerable comfort for being able to explain a couple of phenomena that seem to completely vex his opponents, the record low interest rates in the face of record high budget deficits and debts, and the lack of inflation in the face of unprecedented base money creation, we'll look into that in part II of this article.
Krugman admits that his brand of economics isn't as consistent as the general equilibrium models:
For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential.
A whole new brand of economics has risen to solve these inconsistencies ("New Keynesian economics"). However, Krugman himself isn't overly concerned about these. Asked about why he believes in Keynesian models, he replied:
We have a model of the way the world works, and the world does indeed seem to work that way.
It seems to pass Milton Friedman's smell test, at least so far.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.