Interesting Critique of Krugman

There is an interesting article by Brink Lindsey of the Cato Institute (a right wing think tank). I generally avoid these right wing web sites because they seldom have anything interesting to say. Cato is libertarian which is a flavour of right wing that is more tolerable to me than the dogmatic conservative, neocon, or ideologically atavistic political sites. I share a desire for minimal government, but unlike libertarians I accept a need for government and want it to be "right" sized not "downsized". As for Lindsey, this bit from the Wikipedia article on him explains why I find him more palatable than most: "Lindsey, a registered Republican, has endorsed Sen. Barack Obama during the 2008 presidential campaign. A self proclaimed "Obamacon", Lindsey expressed his frustrations with the current state of the Republican Party in a June 17, 2008 BloggingHeads.tv diavlog, A Real Live Obamacon."

This article entitled "Nostalgianomics" is interesting and worth reading. Here are the key bits:

“The America I grew up in was a relatively equal middle-class society. Over the past generation, however, the country has returned to Gilded Age levels of inequality.” So sighs Paul Krugman, the Nobel Prize–winning Princeton economist and New York Times columnist, in his recent book The Conscience of a Liberal.

The sentiment is nothing new. Political progressives such as Krugman have been decrying increases in income inequality for many years now. But Krugman has added a novel twist, one that has important implications for public policy and economic discourse in the age of Obama. In seeking explanations for the widening spread of incomes during the last four decades, researchers have focused overwhelmingly on broad structural changes in the economy, such as technological progress and demographic shifts. Krugman argues that these explanations are insufficient. “Since the 1970s,” he writes, “norms and institutions in the United States have changed in ways that either encouraged or permitted sharply higher inequality. Where, however, did the change in norms and institutions come from? The answer appears to be politics.”

To understand Krugman’s argument, we can’t start in the 1970s. We have to back up to the 1930s and ’40s—when, he contends, the “norms and institutions” that shaped a more egalitarian society were created. “The middle-class America of my youth,” Krugman writes, “is best thought of not as the normal state of our society, but as an interregnum between Gilded Ages. America before 1930 was a society in which a small number of very rich people controlled a large share of the nation’s wealth.” But then came the twin convulsions of the Great Depression and World War II, and the country that arose out of those trials was a very different place. “Middle-class America didn’t emerge by accident. It was created by what has been called the Great Compression of incomes that took place during World War II, and sustained for a generation by social norms that favored equality, strong labor unions and progressive taxation.”

The Great Compression is a term coined by the economists Claudia Goldin of Harvard and Robert Margo of Boston University to describe the dramatic narrowing of the nation’s wage structure during the 1940s. The real wages of manufacturing workers jumped 67 percent between 1929 and 1947, while the top 1 percent of earners saw a 17 percent drop in real income. These egalitarian trends can be attributed to the exceptional circumstances of the period: precipitous declines at the top end of the income spectrum due to economic cataclysm; wartime wage controls that tended to compress wage rates; rapid growth in the demand for low-skilled labor, combined with the labor shortages of the war years; and rapid growth in the relative supply of skilled workers due to a near doubling of high school graduation rates.

Yet the return to peacetime and prosperity did not result in a shift back toward the status quo ante. The more egalitarian income structure persisted for decades. For an explanation, Krugman leans heavily on a 2007 paper by the Massachusetts Institute of Technology economists Frank Levy and Peter Temin, who argue that postwar American history has been a tale of two widely divergent systems of political economy. First came the “Treaty of Detroit,” characterized by heavy unionization of industry, steeply progressive taxation, and a high minimum wage. Under that system, median wages kept pace with the economy’s overall productivity growth, and incomes at the lower end of the scale grew faster than those at the top. Beginning around 1980, though, the Treaty of Detroit gave way to the free market “Washington Consensus.” Tax rates on high earners fell sharply, the real value of the minimum wage declined, and private-sector unionism collapsed. As a result, most workers’ incomes failed to share in overall productivity gains while the highest earners had a field day.

That is a fair statement of Krugman's position.

Lindsey offers this criticism:

The Treaty of Detroit was built on extensive cartelization of markets, limiting competition to favor producers over consumers. The restrictions on competition were buttressed by racial prejudice, sexual discrimination, and postwar conformism, which combined to limit the choices available to workers and potential workers alike. Those illiberal social norms were finally swept aside in the cultural tumults of the 1960s and ’70s. And then, in the 1970s and ’80s, restraints on competition were substantially reduced as well, to the applause of economists across the ideological spectrum. At least until now.

The economic system that emerged from the New Deal and World War II was markedly different from the one that exists today. The contrast between past and present is sharpest when we focus on one critical dimension: the degree to which public policy either encourages or thwarts competition.

There is an element of truth in this criticism, but I think Lindsey misrepresents the "benefits" from laissez-faire run rampant. For example, here are the particulars on his complaint about how the Treaty of Detroit "strangled" the finacial industry:

Comprehensive regulation of the financial sector restricted competition in capital markets too. The McFadden Act of 1927 added a federal ban on interstate branch banking to widespread state-level restrictions on intrastate branching. The Glass-Steagall Act of 1933 erected a wall between commercial and investment banking, effectively brokering a market-sharing agreement protecting commercial and investment banks from each other. Regulation Q, instituted in 1933, prohibited interest payments on demand deposits and set interest rate ceilings for time deposits. Provisions of the Securities Act of 1933 limited competition in underwriting by outlawing pre-offering solicitations and undisclosed discounts. These and other restrictions artificially stunted the depth and development of capital markets, muting the intensity of competition throughout the larger “real” economy. New entrants are much more dependent on a well-developed financial system than are established firms, since incumbents can self-finance through retained earnings or use existing assets as collateral. A hobbled financial sector acts as a barrier to entry and thereby reduces established firms’ vulnerability to competition from entrepreneurial upstarts.

Well, we can see just how wonderful a world the "liberalized" financial regulation has given us: economic collapse.

I can accept, and I'm petty sure Krugman would accept, most of the complaints that Lindsey lays on the Treaty of Detroit era. But Lindsey is strangely oblivious to any faults in his Washington Consensus world. The fact is: you need elements of both. You need regulation, you need social safety nets, you need competition, you need innovation. The trick is to get the recipe right. I think Krugman is a better chef than Lindsey. I would be more willing to enter a world the Krugman constructed than Lindsey. I'm not nostalgic for a fantasy world. I'm nostalgic for a world in which the great mass of people got a fair shake from the economic system.

For me, the following is a statement of the absolute unreality of Lindsey:

The highly progressive tax structure of the early postwar decades further dampened competition. The top marginal income tax rate shot up from 25 percent to 63 percent under Herbert Hoover in 1932, climbed as high as 94 percent during World War II, and stayed at 91 percent during most of the 1950s and early ’60s. Research by the economists William Gentry of Williams College and Glenn Hubbard of Columbia University has found that such rates act as a “success tax,” discouraging employees from striking out as entrepreneurs.

The joke is that the economy was far more dynamic and delivered for more economic well being in the 1950s and 1960s than it ever did in the 1980s, 1999s, and 2000s. In the Washington Consensus only the billionaires really got to party through the night.

Here is a point that I would agree with Lindsey. He argues that the cultural mores of the 1950's conformity and "organizational man" gave way to a focus on individual freedom (1960s), "me first" ego building (1970s), and individual greed (1980s):

Indeed, the relevant changes in social norms were led by movements associated with the left. The women’s movement led the assault on sex discrimination. The civil rights campaigns of the 1950s and ’60s inspired more enlightened attitudes about race and ethnicity, with results such as the Immigration and Nationality Act of 1965, a law spearheaded by a young Sen. Edward Kennedy (D-Mass.). And then there was the counterculture of the 1960s, whose influence spread throughout American society in the Me Decade that followed. It upended the social ethic of group-minded solidarity and conformity with a stampede of unbridled individualism and self-assertion. With the general relaxation of inhibitions, talented and ambitious people felt less restrained from seeking top dollar in the marketplace. Yippies and yuppies were two sides of the same coin.

I think he has a point. Culture and economics drive each other.

While Lindsey's article is seductive, he never strays too far from "party line". Here is the parting shot in his article:

The rise in income inequality does raise issues of legitimate public concern. And reasonable people disagree hotly about what ought to be done to ensure that our prosperity is widely shared. But the caricature of postwar history put forward by Krugman and other purveyors of nostalgianomics won’t lead us anywhere. Reactionary fantasies never do.

I got a good chuckle out of Lindsey calling Krugman a "reactionary". That is precious. It is tempting to call this an example of a pot calling a kettle black but Krugman is not a reactionary. Krugman is pointing to the past to identify lessons learned then forgotten that we need to re-learn. Lindsey is in love with the recent past and, I would guess, love to go live in the 1980-2008 "Washington Consensus" era from here to kingdom come.

In summary, I think people should read Lindsey's article. It is interesting. It is thought provoking. But I warn people to take a lot of it with a pinch of salt. You need to check facts and think hard about life in the Treaty of Detroit era versus the Lindsey wonderland of the Washington Consensus era.