Krugman on "Weaponized Keynesianism"

Here is the key bit from a post by Paul Krugman on his NY Times blog:

And the evidence clearly shows that weaponized Keynesianism works – which means that Keynesianism in general works.

So why do politicians and their hired economic propagandists say differently? On reflection, I think it’s a bit more complicated than I suggested in my previous post on this topic, because there’s a strong element of cynicism as well as genuine intellectual confusion.

What kind of cynicism am I talking about? First, there’s the general fear on the part of conservatives that if you admit that the government can do anything useful other than fighting wars, you open the door to do-gooding in general; that explains why conservatives have always seen Keynesianism as a dangerous leftist doctrine even though that makes no sense in terms of the theory’s actual content. On top of that there’s the Kalecki point that admitting that the government can create jobs undermines demands that policies be framed to cater to all-important business confidence.

That said, there’s also the Keynes/coalmines point: there’s a strong tendency to take any spending that looks like a business proposition – building bridges or tunnels, supporting solar energy or mass transit – and demanding that it appear to be a sound investment in terms of its financial return. This makes most such spending look bad, since almost by definition a depressed economy is one in which businesses aren’t seeing good reasons to invest. Defense gets exempted because nobody expects bombs to be a good business proposition.

The moral here should be that spending to promote employment in a depressed economy should not be viewed as something that has to generate a good financial return; in effect, most of the resources being used are in reality free.

I wonder if we’ll ever have a political system mature enough to understand this.

The political right in the US has gone beyond simply proposing bad policies, it is actively destroying the country. That people vote for a political party whose agenda is to destroy the country seems unreal, but that's exactly what the Germans did in 1932 when they voted the Nazis into a plurality position. The average German voting for the Nazi party obviously didn't think it was a vote for six years of war and the utter destruction of his country, but in effect that was the political effect of his vote. Similarly Americans who vote for the Republican party may not think they are voting for the destruction of their country, but in effect their votes enable political radicals to take obstructionists positions that are literally destroying the US.

The current Republican party is to the right of McCarthyism and the 1960s John Birch Society. It is a party of fanatics and radicals intent on destroying America. Sadly, the electorate is unable to think through the political confetti on offer by that party and see the reality behind it. Similarly the Germans didn't see through the strong "nationalist" ranting of the Nazis to realize they were electing a government intent on absolutely destroying their country, a party capable of crimes against humanity of unspeakable dimensions and a party whose leader who would demand, as he prepared for his own suicide, that Germans "fight to the last man" and utterly, utterly destroy their country in an insane war for a political party that was corrupt and vicious and determined to go down in bloody defeat. A political party completely unwilling to compromise with political rivals and intent on policies that superficially called for "the greater good of Germany" but which, by attacking all of its neighbors, was singularly intent on committing political suicide.

But the German people voted in that party.

And the Americans have learned nothing from history.

Krugman Identifies the Real Radicals

From Paul Krugman's NY Times blog:

The Amnesiac Economy

Mark Thoma sends us to John Cassidy on the absence of really new ideas in this crisis — largely because we didn’t need new ideas, all we needed for the most part was to remember things that we somehow forgot.

This is a theme dear to my heart. The crisis we’re in is not something unprecedented. It’s a close cousin to the Great Depression — milder, but recognizably the same sort of thing. And we understand — or used to understand — how the Depression happened, and what to do in such a situation. Most of what’s required are fairly straightforward translations of existing concepts. For example, we have a pretty good understanding of bank runs; extending that framework to shadow banking requires little more than the understanding that repo and other kinds of short-maturity obligations are, from an economic point of view, more or less equivalent to deposits.

So how is it that policy is so confused and lost?

I’ve been arguing for a while that much of the economics profession has lost its way, recapitulating old errors because it made a point of unlearning what Keynes taught. But it’s not just economists who willfully threw away hard-won insights.

On Monday night we had a panel discussion of the euro crisis at Princeton — me, Chris Sims, Hyun Shin, Markus Brunnermeier. I was struck by some of what Sims had to say. He pointed out that central banks have always had a wider mandate than simply guaranteeing price stability; they’ve always served as lenders of last resort, including having a standby capacity to finance the government in times of need. And there are good, well-understood reasons for this wider mandate. Yet the creators of the euro essentially threw away hard-won wisdom — stuff that Bagehot knew in the 19th century! — to create a stripped-down central bank without the powers or flexibility that history has shown are necessary. What were they thinking?

The result of all this is that the supposedly sober, serious people are actually radicals insisting that we can make the economy work in ways that it has never worked in the past — hence the embrace of magical thinking on expansionary austerity and the power of structural reform. Meanwhile, the irresponsible bearded professors are actually the custodians of traditional wisdom.

And those who are determined to forget the past run a high risk of reliving it — which is why we’re in the state we’re in.

The similarity of the arrogance shown by many "economists" and the EU bank is the same kind of arrogance shown by the neo-cons and Donald Rumsfeld. It is a willful rejection of the past and a claim to "superior" knowledge that is based not on fact and theory but on a willful distortion to fit a preconceived ideology. History is replete with this kind of "radical" taking control and wrecking things while claiming "superior knowledge".

Stable societies have traditions and accreditation requirements put in place to prevent these usurpers from taking control and wrecking things. Private business faces a similar problem with psychopaths take high positions. These are individuals with no regard for others an an overweening sense of self that lets them wreck everything about them for their own gratification or sense of self importance.

Paul Krugman Despairs the Economics is Not a Science

Paul Krugman has devoted his career to economics and has won a Nobel Prize, but he fells that he is living through a "Dark Age" in which economics has unlearned the lessons of the past. He is really despondent. Here is the relevant piece from a post on his NY Times blog:

I’ve never liked the notion of talking about economic “science” — it’s much too raw and imperfect a discipline to be paired casually with things like chemistry or biology, and in general when someone talks about economics as a science I immediately suspect that I’m hearing someone who doesn’t know that models are only models. Still, when I was younger I firmly believed that economics was a field that progressed over time, that every generation knew more than the generation before.

The question now is whether that’s still true. In 1971 it was clear that economists knew a lot that they hadn’t known in 1931. Is that clear when we compare 2011 with 1971? I think you can actually make the case that in important ways the profession knew more in 1971 than it does now.

I’ve written a lot about the Dark Age of macroeconomics, of the way economists are recapitulating 80-year-old fallacies in the belief that they’re profound insights, because they’re ignorant of the hard-won insights of the past.

What I’d add to that is that at this point it seems to me that many economists aren’t even trying to get at the truth. When I look at a lot of what prominent economists have been writing in response to the ongoing economic crisis, I see no sign of intellectual discomfort, no sense that a disaster their models made no allowance for is troubling them; I see only blithe invention of stories to rationalize the disaster in a way that supports their side of the partisan divide. And no, it’s not symmetric: liberal economists by and large do seem to be genuinely wrestling with what has happened, but conservative economists don’t.

And all this makes me wonder what kind of an enterprise I’ve devoted my life to.

I'm stunned that the field has shown itself that incompetent in the face of the 2008 financial crisis. But the academics fell in love with their models, the math, and the simplifying assumptions required to make the math and the models work. They took their eye off what is critical to any real science: the facts. They've turned economics into a branch of theology where the divines of the field debate the number of angels dancing on the head of a pin. They've gotten away from the hard insights of Keynes from the Great Depression. Tragic.

Krugman's Speech at Cambridge on Keynes' 75 Anniversary

This speech by Paul Krugman celebrates the 75th anniversary of Keynes' "General Theory of Employment, Interest and Money. He reinterprets the key part of Keynes applicable to today:



I particularly like this lecture because Krugman takes on Keynes' critics and discusses how they are misreading keynes and why their criticisms are wrong. Krugman is not deifying Keynes. He is willing to admit that Keynes has been superceded by new economics (see 30:00 into the lecture), but there is a substantial truth in Keynes which has been forgotten by far too many right wing economists and ideologues.

Sadly the politicians and gatekeepers of the Federal Reserve and the banks simply "don't get Keynes" so the Great Recession is going to be longer and worse than it needed to be. Tragic!

And... for those who want something more relevant to the current situation, here is the Q&A that took place after the lecture:

John Quiggin's "Zombie Economics"

I had high hopes for this book. It did cover the problems with economic theory over the last 40 years, but it wasn't as readable or as memorable as I would like. The book was aimed a little high for a general reader and the style was a slog. Too bad academics don't realize that style and wit are important in keeping their reader alert and interested. I found myself dozing off in too many places. This should have been a very important book. It is, but not for the general reader. That is a tragedy.

Chapter 1 covers the deceptive economic performance from 1985 until the bank panic of 2008 and how this "Great Moderation" seemed to verify the right wing (fresh water) economists which he calls "market liberals".

Chapter 2 talks about the absurd simplifying assumptions of right wing economics with absurdities like the "efficient market hypothesis".

Chapter 3 covers the DSGE models used by right wing economists to create a completely unrealistic theory for macroeconomic "policies" which basically come down to "the market knows best" so "hands off" and let it do its magic.

Chapter 4 reviews the elites constant claim that if you let them prosper, then everybody else will prosper, i.e. the "trickle-down economics" touted so popularly by Ronald Reagan.

Chapter 5 explores the deceptive claim the "privatization" would have magical benefits of downsizing government, while returning loads of booty to the government treasury, and unleashing the dynamism of private ownership to cause the economy to soar. As Quiggins points out, almost all of the big privatizations over the last 30 years have failed miserably. He says that in a mixed economy there is a place for some privatization, but right wing economists sold politicians a pig-in-a-poke.

These are all great topics to educate the broad public on. And I admit that if you are diligent you will get the necessary information. But sadly the presentation and style just aren't conducive to educating somebody outside the magic circle of economists.

Here is an example of him skewering DSGE models:

People are not, and cannot be, the infinitely foresightful, unbounded rational utility maximizers assumed in DSGE models. On the contrary, economic behavior, even that of highly sophisticated actors like the "rocket scientists" who design financial instruments for investment banks, is inevitably driven by a partial view of the world. Heuristics and unconsidered assumptions inevitably play a crucial role. For finite beings in a world of boundless possibilities, nothing else is possible.

That is a proper dressing down of DSGE models, but the general reader won't understand all the technical terms and the inside jokes about "rocket scientists with partial views" unless they have been doing a lot of reading. The text simply demands too much from an average reader.

There is a lot of material in this book which the broad public should know. Until this information is widely disseminated, the right wing economists (and politicians) can fool people into thinking that the disaster of 2008 didn't really happen and that it really wasn't because of their failed economic theories. That is dangerous. The world needs to steer away from the crazy radicalism of the freshwater theorists.

The chapter on "trickle-down economics" ends with three paragraphs that raise good questions but don't provide an answer:

All of this analysis is merely a preliminary to the big question: how can the growth in inequality be reversed and the more egalitarian society of the Great Compression be restored? Some steps, such as restoring progressivity to the tax system, seem obvious.

Even these obvious steps must confront the political realities of a system in which political power has shifted overwhelmingly to the wealthy. A study by the Center for Responsive Politics showed that about two-thirds of U.S. senators were millionaires in 2008. There are similar trends in other countries.

Improving the taxation system is a comparatively easy response. The decline in union membership has almost certainly played a substantial role in promoting inequality in market incomes, not to mention the removal of checks to the power and prerogatives of managers. But,how, if at all, can this decline be reversed? This is one of many questions we need to look at with fresh eyes.

The book is well worth reading, but be warned. It is a hard slog. And you won't feel as satisfied as you should that you understand how economic theory went off the rails and what needs to be done to get it back on track.

Excellent Article on Paul Krugman

The New York Magazine has an excellent article about Paul Krugman written by Benjamin Wallace-Wells that starts:

If you are looking not only for clues into Barack Obama’s character but for a definition of what his presidency will mean to the country, then the speech on fiscal policy that he delivered at George Washington University the Wednesday before last is the most significant one he has ever given. It is, in its own way, an astonishing document, alive with the themes that undergirded his Philadelphia speech on race and his Nobel Prize acceptance, on the tragic enmeshment of American limitations and American strength. Obama was responding mostly to the Republican budget plan, and he understood exactly what its author, Representative Paul Ryan, had in his sights: “This vision,” Obama said, “is less about reducing the deficit than it is about changing the basic social compact in America.”

And yet, having defined the fight so starkly, Obama delivered a plea for compromise. He ended a stirring defense of the welfare state by explaining his plans to gut it. Then he said that even this proposed $2 trillion cut in government spending was only a starting point for negotiation: “I don’t expect the details in any final agreement to look exactly like the approach I laid out today,” he said. “This is a democracy; that’s not how things work.” There were notes of deference, and passivity: If Obama believed that his vision of society was at stake, why place it so squarely on the partisan bargaining table—or why not at least begin with a stronger gambit? This was, at any rate, the point of view of one particular strain of liberal reaction, whose position was summed up with poignant resignation by New York Times columnist Paul Krugman. “I could live with this as an end result,” he wrote. “If this becomes the left pole, and the center is halfway between this and Ryan, then no.”

For the first two years of the Obama administration, Krugman has been building, in his columns and on his blog, not just a critique of this presidency but something grander and more expansively detailed, something closer to an alternate architecture for what Obamaism might be. The project has remade Krugman’s public image, as if he had spent years becoming a chemically isolate form of himself—first a moderate, then an anti-Bush partisan, and now the leading exponent of a kind of liberal purism against which the compromises of the White House might be judged. Krugman’s counterfactual Obama would have provided far more stimulus money and would have nationalized Citigroup and Bank of America. He would have written off Republicans and worked only with Democrats to fashion a health-care reform bill that included a so-called public option. The president of Krugman’s dreams would have made his singular long-term goal the preservation of the welfare state and the middle-class society it was designed to create.

This purism is not a role Krugman is altogether comfortable with, but it is one he has sought: His blog is titled The Conscience of a Liberal. He uses it as a kind of workroom for his column, and it is now, according to Technorati, the most popular single-author blog online—a more statistically rigorous counterpart to Rachel Maddow’s show and the Huffington Post. The comment section has become a repository for a certain form of liberal anguish, and a community unto itself: “His campaign promised a better, more equitable America. Those who believed him feel betrayed,” wrote one commenter in regard to a recent column titled “The President Is Missing.”And another: “Come on, Professor Krugman, will you lead the people out?”

Go read the whole article.

I view Krugman as the modern equivalent of those old Israelite prophets. His message is unpopular, but it is the voice of Truth and Justice. Sadly the people would rather chase after their false gods of Money and political Ideology. Nobody expects the Hand of God to come crashing down to punish the stiff-necked people, but I'm pretty sure that the current path of US politics will lead to a crack-up and crash in the society. The best days of America are behind her because she is unwilling to face up to the terrible path the country is on. That is a "Hand" of something which will sweep across the country and bring the high and proud down to punish them for their stiff-neck refusal to hear the plea for justice and greater social equity.

This bit from the article is very poignant:

You could see something else in the data, too. From 1979 to 2004, the income of the richest one percent of Americans grew by 176 percent, that of the richest one fifth of the country by 69 percent, and that of everyone else by less than 25 percent. Working through the numbers, Krugman came to believe that “only a fraction” of the change was compelled by global forces, which had been the standard explanation. The rest, he concluded, was political.

It was Krugman’s Princeton colleague Larry Bartels who made the critical connection, in research Krugman devoured and still cites. Perhaps the most important influence on income inequality, Bartels argued, was something economists had not ­emphasized: whether a Democrat or a Republican was in the White House. Since World War II, Bartels found, wealthy families in the 95th percentile in income had seen identical income growth under both parties. But for families in the 20th percentile, the difference was astonishing: Under Democratic presidents, their income grew at six times the rate it did under Republican ones. There was, for Krugman, a kind of radicalization implied in this.

What worries me is that the greed of the wealthy and powerful will cause a class war to break out as the last ditch attempt of the dispossessed to get a fair shake in the society. Don't expect this to break out during the Great Recession. No. It will come when the economy rebounds, when people once again feel a chance for a better life, but see it being snatched from them -- yet again -- by the wealthy and powerful. This kind of rising up of the downtrodden occurs when there is hope but those at the bottom see their chances being taken away from them.

The political divide in the US is the most bitter since the divide prior to the American Civil War. When I hear Republicans say that they will refuse to increase the debt limit unless Obama agrees to the cuts they demand, this strikes me as the same absolutist stands that the Southerners took on the issue of extending slavery into the new territories. The lack of real compromise (and a path into the future) is what brought about that great war and all that bloodshed.

The Economics of Debt 101

In his NY Times blog, Paul Krugman provides a very simple statement of fact to bring home the difficulty of repairing the current financial mess:

The background to the world economic crisis is that we went through an extended period of rising debt. Now, one person’s liability is another person’s asset, so rising debt made the world as a whole neither richer nor poorer. It did, however, leave the borrowers increasingly leveraged. And then came the Minsky moment; suddenly, investors were no longer willing to roll over, let alone increase, the debts of highly leveraged players. So these players are being forced to pay down debt.

The process of paying down debt, however, must obey two rules:

1. Those who pay down debt must do so by spending less than their income.
2. For the world as a whole, spending equals income.

It follows that

3. Those who are not being forced to pay down debt must spend more than their income.

But here’s the problem: there’s no good mechanism in place to induce those who can spend more to do so. Low interest rates do encourage spending; but given the size of the debt shock, even zero rates are nowhere near low enough.

Since people who don't have excessive debt are very unwilling to spend to make the basic accounting equation work, this is the role of government. This is the Keynesian solution. The government is the agent of last resort. It can spend when agents in the private economy are unwilling to do the right thing.

Ignorance at the Top

Here is the start of an excellent article by Dean Baker published in the Guardian newspaper:

John Maynard Keynes explained the dynamics of an economy in a prolonged period of high unemployment more than 70 years ago in The General Theory. Unfortunately, it seems very few people in policymaking positions in the United States or Europe have heard of the book. Otherwise, they would be pushing economic policy in the exact opposite direction than it is currently heading.

Most wealthy countries have now made deficit reduction the primary focus of their economic policy. Even though the US and many eurozone countries are projected to be flirting with double-digit unemployment for years to come, their governments will be focused on cutting deficits rather than boosting the economy and creating jobs.

The outcome of this story is not pretty. Cutting deficits means raising taxes and/or cutting spending. In either case, it means pulling money out of the economy at a time when it is already well below full employment. This can lower deficits, but it also means lower GDP and higher unemployment.

Do yourself a favour and read the whole thing. Do everybody a favour: read this, fully comprehend it, then agitate to get governments to follow a Keynesian approach. Otherwise we are all back to Hoovervilles and bread lines hoping that a new Hitler will come along to kill maybe 200 million people this time but give governments an excuse to give their economies a real Keynesian boost through military spending that will get us out of the ditch.

I never cease to be amazed that people are more stupid than I think possible. And sure enough, they prove that even my low expectations are far too high. I once again must lower my expectations about intelligence in government.

Slaves of Defunct Economists

Daniel Gross writes articles for Slate magazine and has just published a book Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation that discusses the financial crisis. The following material from his book was published on Slate. I've pulled out the best bits, but you should read the whole thing. There's lots more detail there:

Which profession bears more blame for the global credit meltdown and its ensuing gazillion-dollar bailouts: bankers or economists?

This isn't a trick question.

So far, bankers have been getting most of the opprobrium. Yes, there are a few solid bankers who didn't destroy their firms. But pretty much all the prominent bankers failed. And their failures are writ large on the pages of the Wall Street Journal every day. They've been hauled before Congress, been deposed and fired, lost vast fortunes, and been the targets of populist rage. By common consensus, bankers (and by this I mean the term as it's used in the tri-state metro area: to describe anybody who works at a relatively high level in the financial services industry) blew it.

But they couldn't have created the Dumb Money debacle without a substantial assist from economists. Toiling in government and academia, at trade groups and Wall Street firms, practitioners of the dismal science provided the intellectual ballast and justification for much of the insanity of this past decade. At every step of the way, as an Era of Cheap Money devolved into an Era of Dumb Money and then into an Era of Dumber Money, Ph.D.s led the cheers. And when things started to go bad, they failed to grasp just how bad things would get. ...

In February, I recounted some of the economists' most egregious errors. Alan Greenspan, chairman of the Federal Reserve System, was easily the most influential economist of the last quarter-century. His intellectual virtues were many. So, it turns out, were his intellectual sins. Greenspan spent his career evangelizing for the Holy Trinity of low interest rates, deregulated markets, and the ability of financial innovation to insulate markets from calamities. Oops! The persistence of low interest rates sparked a speculative orgy in securities and derivatives. The tools that were supposed to help people manage risk instead created systemic risk. And deregulated, free, and open markets blew up so badly they required massive government interventions. The disaster was a feature of the financial operating code Greenspan had helped write, not a bug. (Bonus Greenspan screw-up: telling borrowers in February 2004 that adjustable-rate mortgages could help people save money—just as he was about to start boosting short-term rates.) ...

While the performance of many prominent economists during the boom was poor, their performance after it ended may have been worse. As a class—again, with significant exceptions—they failed to recognize that the fall of housing, which started in the summer of 2006, would have negative effects on the economy ("The worst may be over for housing," Greenspan declared on Oct. 9, 2006) and on the financial system. In November 2007, Bernanke estimated the losses stemming from subprime as being "in the ballpark" of $150 billion. (Must have been a really big ballpark.) Neither of the nation's chief economists, despite spending their days poring over economic data and meeting with professional economists inside and outside the Fed, seemed to have a clue that the virus of bad lending had spread far beyond subprime and far beyond housing and far beyond America's borders.

Economic forecasting is hard. But the dismal scientists collectively did a horrific job of prognostication as the economy shifted into recession and then plummeted into a sharp contraction. The recession, we now know, started in December 2007. The Blue Chip forecasters surveyed by the Philadelphia Fed in the fourth quarter of 2007, when the recession was about to start, projected the economy would grow by 2.5 percent in 2008 and the economy would add more than 100,000 jobs each month in 2008. (Instead, the economy lost jobs every month in 2008 and ground to a halt.) In the middle of the fourth quarter of 2008, one in which the economy was shrinking at a 6.3 percent annual rate, they took down their forecast for the quarter from 0.7 percent growth to a decline at a 2.9 percent annual rate. They projected the unemployment rate would be 7 percent in the first quarter of 2009. By March 2009, it was up to 8.5 percent.

Clearly, economic forecasters weren't asking the right questions, or looking at the right indicators. ...

So, back to our original question. Bankers or economists?

Bankers have clearly suffered more financial damage—they had a lot more to lose. But when it comes to reputation, I think it's a draw. One similarity between the two professions' reactions to the meltdown is that it doesn't seem to have occasioned much self-examination. The best Greenspan could muster was that he had "found a flaw" in his theories.

This all goes to show that Keynes was right when he said:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

Finding the Middle Way

Moderation, pragmatism, scientific rationalism, democracy are the guideposts that I use to find my way through life. Any idea or institution that rests on these has my support. Any that claims that these are "soft" and not shaped for the perils of "our times" loses my support.

Robert Shiller follows the theme of moderation in an article in the Financial Times entitled "A Failure to Control the Animal Spirits". (Shiller has just published a book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism written by George A. Akerlof and Robert J. Shiller.) Here are key bits from the article:

Lydia Lopokova, wife of the economist John Maynard Keynes, was a famous ballerina. She was also a Russian émigré. Thus Keynes knew from the experience of his in-laws the horrors of living in the worst of socialist economies. But he also knew first-hand the great difficulties that come from unregulated, unfettered capitalism. He lived through the British depression of the 1920s and 1930s. Thus Keynes was inspired to find a middle way for modern economies.

...

Keynes’s middle way would avoid the unemployment and the panics and manias of capitalism. But it would also avoid the economic and political controls of communism. The General Theory became the most important economics book of the 20th century because of its sensible balanced message.

In times of high unemployment, creditworthy governments should expand demand by deficit spending. Then, in times of low unemployment, governments should pay down the resultant debt. With that seemingly minor change in procedures, a capitalist system can be stable. There is no need for radical surgery on capitalism.

Adherents to Keynes’s message were so eager to get this simple policy implemented, on both sides of the Atlantic, that they failed to notice – or perhaps they intentionally disregarded – that the General Theory also had a deeper, more fundamental message about how capitalism worked, if only briefly spelled out. It explained why capitalist economies, left to their own devices, without the balancing of governments, were essentially unstable. And it explained why, for capitalist economies to work well, the government should serve as a counterbalance.

The key to this insight was the role Keynes gave to people’s psychological motivations. These are usually ignored by macroeconomists. Keynes called them animal spirits, and he thought they were especially important in determining people’s willingness to take risks. Businessmen’s calculations, he said, were precarious: “Our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing.” Despite this, people somehow make decisions and act. This “can only be taken as a result of animal spirits”. There is “a spontaneous urge to action”.

...

There is a broader moral to all this – about the nature of capitalism. On the one hand, we want to take advantage of the wisdom of Adam Smith. For the most part, the products produced by capitalism are what we really want, produced at a price that we are willing and able to pay. On the other hand, when confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.

It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards for our financial assets make as much common sense as the standards for the food we eat, or the purchase medicine we get from the pharmacy. But we do not want to throw out the good parts of capitalism with the bad. To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government to see that those who can and want to produce what others want to buy can do so. It is the role of the government, through its counterbalancing fiscal and monetary policy, to maintain full employment.

The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well.

That is the role of government. Its role is to ensure a “wise laisser faire”. This is not the free-for-all capitalism that has been recommended by the current economic theory, and seems to have been accepted as gospel by economic planners, and also many economists, since the Thatcher and Reagan governments. But it also is a significant middle way between those who see the economic disasters and unemployment of unfettered capitalism, on the one hand, and those who believe that the government should play no role at all.

The idea that unfettered, unregulated capitalism would invariably produce the good outcomes was a wrong economic theory regarding how capitalist societies behave and what causes their crises. That wrong economic theory fails to take account of how the animal spirits affect economic behaviour. It fails to take into account the roles of confidence, stories and snake oil in economic fluctuation.

Keynes Diagnoses the 21st Century Malady

The following is extremely interesting because it shows how perceptive Keynes was in understanding the intellectual forces leading up to the "modern" situation. I've included only section one of the essay because it is truly relevant. The rest of the essay attempts to look into the future (from 1926) and unfortunately Keynes is less of a prophet than he was of a key analyst of our intellectual history). The other sections are interesting and I generally agree with his view that some social institution between individual and state need to be born to bridge the gap, but the particulars of that part of his argument is less interesting.

The arugment which comprises section one of the essay is exceptionally good and understanding the intellectual movements leading up to the modern situation. As I read it the voices of conservatives and liberal and socialists and libertarians are all there. He has show how they all thread together in leading to the modern situation. It is well worth reading the following. I am indebted to Brad DeLong for putting this piece, John Maynard Keynes: The End of Laissez Faire (1926), on his Egregious Moderation blog:

The disposition towards public affairs, which we conveniently sum up as individualism and laissez-faire, drew its sustenance from many different rivulets of thought and springs of feeling. For more than a hundred years our philosophers ruled us because, by a miracle, they nearly all agreed or seem to agree on this one thing. We do not dance even yet to a new tune. But a change is in the air. We hear but indistinctly what were once the clearest and most distinguishable voices which have ever instructed political mankind. The orchestra of diverse instruments, the chorus of articulate sound, is receding at last into the distance.

At the end of the seventeenth century the divine right of monarchs gave place to natural liberty and to the compact, and the divine right of the church to the principle of toleration, and to the view that a church is 'a voluntary society of men’, coming together, in a way which is 'absolutely free and spontaneous' (Locke, A Letter Concerning Toleration). Fifty years later the divine origin and absolute voice of duty gave place to the calculations of utility. In the hands of Locke and Hume these doctrines founded Individualism. The compact presumed rights in the individual; the new ethics, being no more than a scientific study of the consequences of rational self-love, placed the individual at the centre. ‘The sole trouble Virtue demands', said Hume, 'is that of just Calculation, and a steady preference of the greater Happiness.' (An Enquiry Concerning the Principles of Morals, section LX).

These ideas accorded with the practical notions of conservatives and of lawyers. They furnished a satisfactory intellectual foundation to the rights of property and to the liberty of the individual in possession to do what he liked with himself and with his own. This was one of the contributions of the eighteenth century to the air we still breathe.

The purpose of promoting the individual was to depose the monarch and the church; the effect - through the new ethical significance attributed to contract - was to buttress property and prescriptions. But it was not long before the claims of society raised themselves anew against the individual. Paley and Bentham accepted utilitarian hedonism from the hands of Hume and his predecessors, but enlarged it into social utility (‘I omit’ says Archdeacon Paley, 'much usual declamation upon the dignity and capacity of our nature, the superiority of the soul to the body, of the rational to the animal part of our constitution; upon the worthiness, refinement, and delicacy of some satisfactions, and the meanness, grossness, and sensuality of others: because I hold that pleasures differ in nothing but in continuance and intensity' - Principles of Moral and Political Philosophy, Book 1, chap. 6). Rousseau took the Social Contract from Locke and drew out of it the General Will. In each case the transition was made by virtue of the new emphasis laid on equality. 'Locke applies his Social Contract to modify the natural equality of mankind, so far as that phrase implies equality of property or even of privilege, in consideration of general security. In Rousseau's version equality is not only the starting-point but the goal.' (Leslie Stephen, English Thought in the Eighteenth Century, II, 192).

Paley and Bentham reached the same destination, but by different routes. Paley avoided an egoistic conclusion to his hedonism by a God from the machine. 'Virtue', he says, 'is the doing good to mankind, in obedience to the will of God, and for the sake of everlasting happiness' - in this way bringing I and the others to a parity. Bentham reached the same result by pure reason. There is no rational ground, he argued, for preferring the happiness of one individual, even oneself, to that of any other. Hence the greatest happiness of the greatest number is the sole rational object of conduct - taking utility from Hume, but forgetting that sage man's corollary: 'Tis not contrary to reason to prefer the destruction of the whole world to the scratching of my finger.' 'Tis not contrary to reason for me to choose my total ruin to prevent the least uneasiness of an Indian, or person totally unknown to me ... Reason is and ought only to be the slave of the passions, and can never pretend to any other office than to serve and obey them.'

Rousseau derived equality from the state of nature, Paley from the will of God, Bentham from a mathematical law of indifference. Equality and altruism had thus entered political philosophy, and from Rousseau and Bentham sprang both democracy and utilitarian socialism.

This is the second current - sprang from long-dead controversies, and carried on its way by long-exploded sophistries - which still permeates our atmosphere of thought but it did not drive out the former current. It mixed with it. The early nineteenth century performed the miraculous union. It harmonised the conservative individualism of Locke, Hume, Johnson, and Burke with the socialism and democratic egalitarianism of Rousseau, Paley, Bentham, and Godwin. (Godwin carried laissez-faire so far that he thought all government an evil, in which Bentham almost agreed with him. The doctrine of equality becomes with him one of extreme individualism, verging on anarchy. 'The universal exercise of private judgement’ he says, 'is a doctrine so unspeakably beautiful that the true politician will certainly feel infinite reluctance in admitting the idea of interfering with it' - see Leslie Stephen, op. cit. II, 277).

Nevertheless, that age would have been hard put to it to achieve this harmony of opposites if it had not been for the economists, who sprang into prominence just at the right moment. The idea of a divine harmony between private advantage and the public good is already apparent in Paley. But it was the economists who gave the notion a good scientific basis. Suppose that by the working of natural laws individuals pursuing their own interests with enlightenment in condition of freedom always tend to promote the general interest at the same time! Our philosophical difficulties are resolved-at least for the practical man, who can then concentrate his efforts on securing the necessary conditions of freedom. To the philosophical doctrine that the government has no right to interfere, and the divine that it has no need to interfere, there is added a scientific proof that its interference is inexpedient. This is the third current of thought, just discoverable in Adam Smith, who was ready in the main to allow the public good to rest on 'the natural effort of every individual to better his own condition', but not fully and self-consciously developed until the nineteenth century begins. The principle of laissez-faire had arrived to harmonise individualism and socialism, and to make at one Hume's egoism with the greatest good of the greatest number. The political philosopher could retire in favour of the business man - for the latter could attain the philosopher's summum bonum by just pursuing his own private profit.

Yet some other ingredients were needed to complete the pudding. First the corruption and incompetence of eighteenth-century government, many legacies of which survived into the nineteenth. The individualism of the political philosophers pointed to laissez-faire. The divine or scientific harmony (as the case might be) between private interest and public advantage pointed to laissez-faire. But above all, the ineptitude of public administrators strongly prejudiced the practical man in favour of laissez-faire - a sentiment which has by no means disappeared. Almost everything which the State did in the eighteenth century in excess of its minimum functions was, or seemed, injurious or unsuccessful.

On the other hand, material progress between 1750 and 1850 came from individual initiative, and owed almost nothing to the directive influence of organised society as a whole. Thus practical experience reinforced a priori reasonings. The philosophers and the economists told us that for sundry deep reasons unfettered private enterprise would promote the greatest good of the whole. What could suit the business man better? And could a practical observer, looking about him, deny that the blessings of improvement which distinguished the age he lived in were traceable to the activities of individuals ‘on the make’?

Thus the ground was fertile for a doctrine that, whether on divine, natural, or scientific grounds, state action should be narrowly confined and economic life left, unregulated so far as may be, to the skill and good sense of individual citizens actuated by the admirable motive of trying to get on in the world.

By the time that the influence of Paley and his like was waning, the innovations of Darwin were shaking the foundations of belief. Nothing could seem more oppose than the old doctrine and the new - the doctrine which looked on the world as the work of the divine watchmaker and the doctrine which seemed to draw all things out of Chance, Chaos, and Old Time. But at this one point the new ideas bolstered up the old. The economists were teaching that wealth, commerce, and machinery were the children of free competition - that free competition built London. But the Darwinians could go one better than that - free competition had built man. The human eye was no longer the demonstration of design, miraculously contriving all things for the best; it was the supreme achievement of chance, operating under conditions of free competition and laissez-faire. The principle of the survival of the fittest could be regarded as a vast generalisation of the Ricardian economics. Socialist interferences became, in the light of this grander synthesis, not merely inexpedient, but impious, as calculated to retard the onward movement of the mighty process by which we ourselves had risen like Aphrodite out of the primeval slime of ocean.

Therefore I trace the peculiar unity of the everyday political philosophy of the nineteenth century to the success with which it harmonised diversified and warring schools and united all good things to a single end. Hume and Paley, Burke and Rousseau, Godwin and Malthus, Cobbett and Huskisson, Bentham and Coleridge, Darwin and the Bishop of Oxford, were all, it was discovered, preaching practically the same thing - individualism and laissez-faire. This was the Church of England and those her apostles, whilst the company of the economists were there to prove that the least deviation into impiety involved financial ruin.

These reasons and this atmosphere are the explanations, we know it or not - and most of us in these degenerate days are largely ignorant in the matter - why we feel such a strong bias in favour of laissez-faire, and why state action to regulate the value of money, or the course of investment, or the population, provokes such passionate suspicions in many upright breasts. We have not read these authors; we should consider their arguments preposterous if they were to fall into our hands. Nevertheless we should not, I fancy, think as we do, if Hobbes, Locke, Hume, Rousseau, Paley, Adam Smith, Bentham, and Miss Martineau had not thought and written as they did. A study of the history of opinion is a necessary preliminary to the emancipation of the mind. I do not know which makes a man more conservative - to know nothing but the present, or nothing but the past.

The Logic of Make-work Projects

Mark Thoma has a blog entry addressing an article by Samuel Brittan in the Financial Times. I wan't particularly impressed by Brittan's material, but I did enjoy this observation by Mark Thoma:

Keynesians also note that even if the government spending has zero value initially, e.g. paying half the idle workers to dig ditches, and the other half to follow behind and fill the ditches in again, as those workers spend their new income in the community it will generate productive private sector activity. Thus, even if the initial projects are of little or no value, it can still be the case that we are better off having the government intervene than we would be if we did nothing at all. The government should do everything that it can to pursue the highest value projects, but the fact that there may be some waste in the process does not, in and of itself, mean that we'd be better off leaving those resources completely idle and doing nothing at all.

A Voice From Christmas Past

Here is a good article by Martin Wolf of the Financial Times. I've marked in bold bold the part that I think is most important:

The ghost of John Maynard Keynes, the father of macroeconomics, has returned to haunt us. With it has come that of his most interesting disciple, Hyman Minsky. We all now know of the “Minsky moment” – the point at which a financial mania turns into panic.

Like all prophets, Keynes offered ambiguous lessons to his followers. Few still believe in the fiscal fine-tuning that his disciples propounded in the decades after the second world war. But nobody believes in the monetary targeting proposed by his celebrated intellectual adversary, Milton Friedman, either. Now, 62 years after Keynes’ death, in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant in his teaching.

I see three broad lessons.

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”.

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand. An individual may not spend all his income. But the world must do so.

The third and most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

Sensible Actions from an Senseless Administration

Paul McCulley from Pimco presents the sensible actions that the US federal government has to do to get the country out of its current mess:

...the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets. ...

Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. ...

As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation. ...

Fortunately, Congress is finally grappling with this reality, as it moves towards passage of Mr. Paulson’s plan for backstopping Fannie and Freddie with taxpayer funds. It’s not a fun thing to do, particularly following the use of $29 billion of taxpayer funds to facilitate the merger of Bear Stearns into JPMorgan. But it is the right thing to do. And it is further the right thing that Congress is doing it, not the Fed under Section 13(3), except as a possible bridge to Treasury authority.

Note: for those of you who are allergic to reading, here is the video version available on Bloomberg.

McCulley has it right. This action is necessary. Instead of the non-response of the Bush Administration to Katrina, this catastrophe is on a scale and at a scope that simply won't allow the "no government is the best government" ideology of the Bush administration to continue to be applied.

Instead, this calls for Keynes. Just like the Great Depression, the current situation is one of those classic economic catastrophes where government has to step in and act as the economic agent of last resort to save the capitalist system from itself. The good news is that there are enough capitalists with common sense to realize this. Sure, there will be the odd ideologues over the next two or three generations who will grumble and complain just as they do over FDR's efforts to save the capitalists from themselves. But sensible people will applaud sensible actions even when it is done to save a fool from his own foolishness!

Hang on...

Before I get too rapturous with praise for the Bush administration, I should point out that there are voices crying in the wilderness telling us that all is not sweetness and light. Here is Dean Baker from the American Prospect:

BIll That Will Cause 140,000 Homeowners to Face Second Foreclosure Passes Congress

Okay, that would not have been my headline, but when all the news accounts keep saying that the bill will "help" 400,000 homeowners, this fact really does deserve some attention. Just to remind everyone, the bill allows the banks -- not the homeowners-- to decide which loans get placed in the program.

If you are a troubled homeowner with the sheriff at the door with the eviction papers, this bill does nothing, as in zero, as in nada, for you, unless you can persuade your lender to take part in the program. The Congressional Budget Office expects that lenders will only place their worst loans into the program and that 140,000 of the homeowners who get new mortgages issued under the program will subsequently face foreclosure a second time. This means that only 260,000 homeowners will on net be able to keep their home as a result of this program, based on the CBO estimates. This is approximately 5 percent of the 5-6 million foreclosures expected over 2008 and 2009.