Keynes versus the Classics: Round Two

The economist John Maynard Keynes wrote The General Theory of Employment, Interest, and Money (1936) to “bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory…” Seventy years later, heavyweight economists are still at each other’s throats, in terms almost unchanged from the 1930’s.

The latest slugfest features New Keynesian champion Paul Krugman of Princeton University and New Classical champion John Cochrane of the University of Chicago. Krugman recently published a newspaper article entitled “How Did Economists Get It So Wrong?” There was nothing in mainstream economics, Krugman wrote, “suggesting the possibility of the kind of collapse that happened last year.”

The reason was that “economists, as a group, mistook beauty, clad in impressive-looking math, for truth.” They purveyed an “idealized vision of an economy in which rational individuals interact in perfect markets.” Unfortunately “this sanitized vision of the economy led most economists to ignore all the things that could go wrong.” So now economists will have to accept “the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

Krugman’s heavy pounding of Chicago School economics goaded Cochrane, a professor of finance, into some bad-tempered counter-punching on the university’s Web site, much of which consisted of a personal attack on Krugman’s scientific integrity. When he gets around to economics, Cochrane aims his blows at two points: Krugman’s attack on the “efficient market theory” and his advocacy of “fiscal stimulus” for depressed economies.

Cochrane accuses Krugman of misleading his readers about the efficient market theory, which asserts that, given the available information, financial markets always get asset prices right. Rather than defend that theory, Cochrane admits that “asset prices move more than reasonable expectations of future cash flows.” Unfortunately, “no theory is particularly good at that right now.”

But it’s theoretical nihilism, Cochrane argues, to ascribe these excessive fluctuations to “irrationality” as Krugman does. What Krugman is really after (“though he can’t quite come out and say this”) is for the government to “take charge of the allocation of capital.” And the one thing we do know is that however badly asset markets behave, government control “has always been much worse.”

Cochrane’s heaviest punching is reserved for Krugman’s support for President Barack Obama’s fiscal stimulus. He invokes the hoary old “Ricardian equivalence theorem,” revived by the Harvard economist Robert Barro, according to whom “debt-financed spending can’t have any effect, because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.”

In short, Krugman “has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward” – except that the government should now spend money like a drunken sailor. Far from having too much math, economists need more, in order to “keep the logic straight.”

On the stimulus, though, Krugman achieves a knock-out punch. The view that extra government spending “crowds out” an equal amount of private spending, so that its net stimulus effect is zero, would be true only if the economy were at full employment. Indeed, the Chicago School tacitly assumes that economies are always at full employment. They are unfazed by the fact that America’s economy has shrunk by 4% in the last year and that over 6 million people have been added to the unemployment rolls.

To Chicago economists, an increase in the number of idle workers represents a voluntary choice for leisure. In a concession to commonsense, they concede that people may make mistakes and, to that extent, a stimulus may be beneficial. But they insist that the only stimulus that will work is printing money. This will drive down interest rates and lead to an economic rebound.

Against this view, Keynes pointed out that interest-rate reductions may not do the job, because at zero or near-zero rates investors hoard cash rather than lend it out. Hence, as he put it in 1932, there may be “no escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment” – which is what the Obama administration is rightly doing.

On the question of what caused the crash, the debate is more even. Krugman is hampered by the fact that he attributes the crash to “irrationality,” which, as Cochrane points out, is no theory.

This is because Krugman refuses to take seriously Keynes’s crucial distinction between risk and uncertainty. In my view, Keynes’s major contribution to economic theory was to emphasize the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.

This makes for considerable stability in markets as long as the conventions hold . But they are liable to being overturned suddenly in the face of passing bad news, because “there is no firm basis of conviction to hold them steady.” It’s like what happens in a crowded theater if someone shouts “Fire!” Everyone rushes to get out. This is not “irrational” behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn.

Chicago School economics has never been more vulnerable than it is today – and deservedly so. But the attack on it will never succeed unless policy Keynesians like Krugman are willing to work out the implications of irreducible uncertainty for economic theory.