By Arnold Kling
You often hear people saying that the crisis has revealed the need for new economic thinking, for new ideas about macroeconomics. Yet the first priority seems to be to resuscitate old ideas. Brad DeLong describes an interview of Larry Summers by Martin Wolf as follows: “Asked to name where to turn to understand what was going on in 2008, Summers cited three dead men, a book written 33 years ago, and another written the century before last.” And in my view, Summers basically got it right.
Thanks to Timothy Taylor for the pointer. The three dead men, by the way, are Walter Bagehot, Hyman Minsky, and Charles Kindleberger.
I have long had a soft spot for Kindleberger. Almost ten years ago, when I was more Keynesian than I am today, I wrote,
Why does aggregate demand sometimes fall short of the level needed to maintain full employment? My beliefs about this issue are influenced to an unusual degree by Charles Kindleberger, who was not considered a macroeconomist.
Kindleberger was an economic historian, who wrote extensively on the Depression and on historical episodes of speculative frenzy. He noted that these episodes, such as the Dutch Tulip Mania in the 1620’s and 1630’s or the South Sea Bubble in England in roughly 1710-1720, had common elements. A country achieved wealth as a result of the combination of winning a war and encountering a new market opportunity. Kindleberger called this process “displacement.” Displacement resulted in early speculators achieving riches, leading masses of people to join in, resulting in overspeculation. This was followed by a panic, a crash, and an economic recession. This model of fluctuations was laid out by Kindleberger in his book Manias, Panics, and Crashes.
I got involved with the commercialization of the Internet very early, in 1994. I saw its resemblance to the Kindleberger model as early as August of 1995, when Netscape Communications became the first Internet company to sell stock to the general public.
I recently re-read CPK and discussed his relevance.
Back to Krugman. He makes three points. One is that the profession should have recognized the housing bubble for what it was. The problem is that you are tempted to explain asset prices, not to cry “bubble.” Just the other day, Krugman himself gave in to that temptation regarding gold. In fact, his rationale for high gold prices is the same as my rationale for high house prices–low real interest rates. What I would suggest is that any time you get the urge to provide an economic interpretation of asset price movements, lie down until the feeling goes away.
The second point is that the profession should have recognized the fragility of the financial system. But that is asking technocratic experts to recognize the fragility of technocratic expertise. Because, contrary to myth, the financial regulators were not swept up in a wave of religious faith in free markets. Rather, they were convinced that with Taylor-rule-based monetary policy and Basel’s risk-based capital regulations, they had built a macroeconomic and financial house that could withstand any storm.
Finally, Krugman complains that the profession forgot about the Keynesian multiplier. That may be true of some economists, but “folk Keynesiansim” has such a strong grip on politicians and the media that I do not think it much matters. I would say that, if anything, the idea that government deficits can create jobs has too much standing in the public debate, not too little.
My candidate for worst macroeconomic idea entered into the debate would be the “liquidity trap,” for which the proponent is none other than Paul Krugman. What the liquidity trap says is that we need fiscal stimulus because the monetary authority cannot debase the currency, no matter how much it wants to. While policy makers certainly can have an argument over whether the monetary authority should want to debase the currency, Krugman has done a disservice by insisting that we are in a trap where debasement is impossible.
Of course, I am not convinced that the old-time religion of aggregate demand is the road to salvation. It is possible that I am wrong, and that aggregate demand is the big issue today. But you will find no mention of it in my jobs speech.