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Jul 21, 2011

Krugman and Macroeconomics

One of my former students asked me about Pete Boettke's post over at Coordination Problem on a recent Paul Krugman presentation, "Mr. Keynes and the Moderns." Pete does not agree with Krugman, but he likes this particular piece and thinks it must be addressed. Perhaps I'm missing something, but I'm not entirely clear why.

Although I agree with Pete both (a) that it represents Krugman at his least intellectually dishonest and (b) that it makes a useful history-of-thought distinction between Keynesians who focus on Part 1 of The General Theory (Hicks and Samuelson) and those who focus on chapter 12 (essentially post-Keynesians and Leijonhufvud), most of the article merely reiterates the traditional textbook (IS-LM) exposition. There is almost nothing original there, not even with respect to providing an intuitive understanding of Keynesian theory. On the contrary, Krugman displays no explicit appreciation of the fact that a Keynesian divergence between total spending and total income can arise only through a change in the demand for money, or in more straightforward terms, through hoarding (or dishoarding) of cash--in short, through what monetarists refer to as changes in velocity.

Indeed, Krugman's presentation doesn't incorporate any of the more sophisticated arguments about the financial system of such old-line, hard-core Keynesians as James Tobin. He moreover completely ignores any possible complications arising from Ricardian Equivalence, essentially knocking down straw-men objections to fiscal policy. No other Krugman article has come closer to convincing me that John Cochrane is in fact right: Krugman doesn't actually know or understand much modern macroeconomics, as Krugman himself comes close to admitting at the article's beginning.

Which doesn't mean that there is any easy and obvious refutation of Keynesian business-cycle theory, or any short article that will answer Krugman. As I repeatedly point out in my macro classes, all general theories of the business cycle are wrong. None is entirely comprehensive and adequate, which is why economists are as far from a consensus on this issue today as they were during the Keynes vs. the Classics debates. Even some advocates of Austrian business cycle theory, such as George Selgin and Steve Horwitz, incorporate significant Keynesian elements, by giving velocity shocks equal billing with monetary shocks.

Nor do I think, if you really want to get a perspective on Krugman's article, that the way to go is to get into Talmudic distinctions between Say's Law and Say's Identity, as Pete suggests. Instead I would recommend slogging through Don Patinkin's massive classic, Money, Interest, and Prices: An Integration of Monetary and Value Theory, the second edition of which was published way back in 1965. It had become the standard fare in all graduate monetary theory classes before the New Classical revolution swept the profession with dynamic stochastic general equilibrium models. Patinkin actually considered himself a Keynesian, which is why his careful, rigorous, and exhaustive comparisons between classical and Keynesian approaches are so telling and insightful.

For a contrasting instance of Krugman at his most intellectually dishonest that still further confirms Cochrane's evaluation, you might take a look at Krugman's review (co-authored with his wife, Robin Wells) of Jeff Madrick's Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present in the latest (July 14) New York Review of Books. While Bethany McLean and Joe Nocera's All the Devils Are Here: The Hidden History of the Financial Crisis represents the best of what Arnold Kling has called "financial crisis porn," Madrick's book represents the worst. Most of the left-leaning economics writers for The New Yorker or the New York Review of Books usually understand economics, so even though I often disagree with their conclusions, I find their articles interesting and informative. Madrick, who writes regularly for the New York Review of Books, is the only one who seems to be totally ignorant of any serious economic theory or analysis. His book was even too much for the overly kind Tyler Cowen. And yet Krugman and Wells wax enthusiastic about Age of Greed.

Just to give you two examples of Krugman and Wells howlers: (1) "Madrick stresses a key point that is often forgotten or misunderstood to this day: the surging inflation of the 1970s had its roots not in some general problem of 'big government' but in largely temporary events--the oil price shock and disappointing crop yields--whose effects were magnified throughout the economy by wage-price indexation." Does Krugman honestly agree with Madrick that monetary policy played no role in the Great Inflation?

(2) "The transformation of American banking initiated by Wriston arguably began as early as 1961, when First National City began offering negotiable certificates of deposit--CDs that could be cashed in early, and therefore served as an alternative to regular bank deposits, while sidestepping legal limits on interest rates. First National City's innovation--and the decision of regulators to let it stand--marked the first major crack in the system of bank regulation created in the 1930s, and hence arguably the first step on the road to the crisis of 2008." So we could have prevented the financial crisis by going back to a world in which rigid interest-rate ceilings prevented bank depositors from earning market rates of return and in which an entire generation was taught that putting their money in a bank was equivalent to throwing it away? Amazingly, this second sentence runs counter to the more sober analysis Krugman and Wells offered in a prior article for the New York Review of Books of last September 30: "The Slump Goes On: Why?"

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