For those of you interested in Economic Theory, Krugman published a brilliant piece in the times, explaining how the different schools of economic approach the economy and why everyone got it so wrong.
Nice thing about this article is that you dont have to have a degree in economics to follow the reasoning.
It is much longer than the one presented here, so click the link. Its absolutely fascnating how wrong, Friedman and Greenspan actually were about the economy.
http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=all
QuoteIt’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes â€" or so they believed â€" were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro†(that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.†The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.†And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,†declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.
Last year, everything came apart.
Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable â€" indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.
And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,†and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.†In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse†of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.
What happened to the economics profession? And where does it go from here?
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets â€" especially financial markets â€" that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.
It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge 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. In practical terms, this will translate into more cautious policy advice â€" and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.
II. FROM SMITH TO KEYNES AND BACK
The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations†in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities†â€" costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical†economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical†predecessors) was that we should have faith in the market system.
This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,†declared Joseph Schumpeter in 1934 â€" 1934! They are, he added, “forms of something which has to be done.†But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.
Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,†as “moderately conservative in its implications.†He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention â€" printing more money and, if necessary, spending heavily on public works â€" to fight unemployment during slumps.
It’s important to understand that Keynes did much more than make bold assertions. “The General Theory†is a work of profound, deep analysis â€" analysis that persuaded the best young economists of the day. Yet the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism and a return to neoclassicism. The neoclassical revival was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953 that neoclassical economics works well enough as a description of the way the economy actually functions to be “both extremely fruitful and deserving of much confidence.†But what about depressions?
I think that most economic theorists from Marx to Hyeck like to think that human beings are economically rational or that even if individuals are not, then the aggregated market is. The Chicago School especially bought into the "rational market" view.
They were/are wrong! We are not rational either individually or collectively. Sorry, Ayn! We are irrational, and emotionally driven. There have even been a number of recent psycho-economic studies recently that illustrate this clearly. For example, it has been shown clearly that we suffer a lot more emotional pain from an economic loss than satisfaction from an economic gain. This tendency alone, and there are other endocrine mediated effects too, distorts both our individual economic decisions and the overall markets in non-rational ways.
One cannot make any accurate economic forecasts or even analysis if you don't take our "monkey" brain as a primary driver of our economic decisions.
Why do people drive Hummers? Rational economic decision? Funniest t-shirt I've seen in years showed a picture of a Hummer with the caption, "Sorry about your penis."
What does it all mean?
The main problems are the Fed and Keynesian economics.
QuoteThe Second Coming of Keynes
Mises Daily by Lilburne | Posted on 7/22/2009 12:00:00 AM
Paul Krugman wants to be our savior. Moreover, he wants to be a specific kind of savior: a magus of the scientific age, a blackboard prophet.
The roots of this curious ambition can be seen in his recent profile in Newsweek:
Krugman says he found himself in the science fiction of Isaac Asimov, especially the "Foundation" series "It was nerds saving civilization, quants who had a theory of society, people writing equations on a blackboard, saying, 'See, unless you follow this formula, the empire will fail and be followed by a thousand years of barbarism.'"
Now here we are at an economic zero hour for the American empire, and perhaps for modern civilization itself, and many in the global urban elite think this establishment triathlete with his Princeton professorship, his New York Times column, and his Nobel Prize, has the equation for salvation. So what is Krugman's formula? What commandments does the magus have scrawled on his blackboard for us, his plebian flock?
To understand that, one must understand Krugman's intellectual heritage, such as it is.
Paul Krugman is a devotee of John Maynard Keynes. He's such a hard core disciple that he was Keyensian when Keynesianism wasn't cool: the period between the 1970s stagflation, which seemed to disprove Keynesian doctrine, and now, when it is groundlessly renascent due to our society's stunted memory span. He himself proudly admits his devotion to Keynes. He has written such headlines as "The Greatness of Keynes" and "Why Aren't We All Keynesians Yet?" But what does it mean to be keen on Keynes? What diagnosis does Krugman's Keynesian economics have for the economic crisis, and what remedies does he prescribe?
The Keynesian Diagnosis: A Deadly Case of Frugality
In the Keynesian whodunit mystery of depression economics, the culprit is nothing other than savings. That's right, savings: that necessary precondition for all capital development, thereby all gains in productivity, and thereby all increases in general human prosperity.
The Keynesian story of depressions in a nutshell is that (1) excessive savings leads to (2) underconsumption which leads to (3) unemployment. Unemployment engenders even more dread savings, completing the loop of a vicious cycle. This theory was a spit in the face of hundreds of years of progress in economic thought. Economists before Keynes painstakingly, analytically, and progressively built up a mighty edifice of knowledge and truth, all of which centered around how markets find optimal prices and equilibrate in response to changing situations. Keynes blithely dismissed it all as "orthodoxy" and falsely characterized the market as an inherently dysfunctional mechanism that tends to seize up into long-lasting depression without intervention from the wise government.
Paul Krugman completely buys the Keynesian story. He wrote recently,
one of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income.
So to Krugman, the road to economic hell is paved with the good intentions of frugality. This "underconsumption theory" is basically what he's talking about whenever you read Krugman warning ominously about "saving gluts," the "paradox of thrift," "consumer capitulation," "insufficient aggregate demand," etc., etc. It's all just adult jargon dressing up a childish theory. As Gary North wrote, underconsumption theories
speak of saving as if it were a system for hiding paper currency under a mattress. They refuse to answer this crucial question: What does the bank do with the money that a consumer deposits instead of spending? Put another way: What analytical or conceptual difference does it make whether a saver deposits a dollar [in] his bank, which the bank will lend, or whether he spends it, enabling the seller to deposit the dollar in his bank, which his bank will lend?
And even if saving were a matter of greenbacks and mattresses, any particular amount of such "hoarding" would not lead to underconsumption, as Murray Rothbard showed in his economic treatise Man, Economy, and State, but merely "an increase in the real value of their cash balances and of the monetary unit." This would depress business revenues in nominal terms, but it would lower business costs as well, leaving businesses just as profitable in real terms as before.
The Keynesian Remedy: Spend Your Way to Riches
Since Krugman has such a backwards diagnosis of depressions, it should be no surprise that his Keynesian remedies would be equally wrongheaded, and disastrously destructive. The Keynesian prescription to ward off depression is government stimulus. This is what Krugman is talking about whenever he calls for "priming the pump." Keynesian stimulus comes in two forms: monetary and fiscal. With monetary stimulus, a central bank (like the Federal Reserve) greatly increases the money supply, which dramatically lowers interest rates, which in turn stimulates spending. This is the "pro-bubble" side of Krugman's economics, which I've written about here and here. His now-notorious prescription of an induced housing bubble was to be accomplished (and was actually accomplished) via monetary stimulus. Krugman said in an interview with Lou Dobbs:
Meanwhile, economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer. (emphasis added)
This was his prescription for the recession in 2001. The rest is housing bubble history.
The ironic thing is that monetary expansion, Krugman's cure for depressions, is the very poison that causes them in the first place. According to the Austrian Business Cycle Theory, which was first expounded in 1912 by Ludwig von Mises, the great Austrian economist who predicted the Great Depression, monetary expansion misdirects resources, causing excessive investment in stages of production that are more removed from the final products. This lengthening of the chain of production is unsustainable, given the actual amount of savings available for continuous investment. Eventually, businesses realize this fact, and that the malinvestments need to be liquidated and resources reallocated toward sustainable projects. Further monetary stimulus (or any government intervention for that matter) only serves to retard that reallocation process and to prolong the depression. For a nice primer on the true story behind business cycles, I recommend this article and this speech (video) by Thomas Woods.
According to Krugman's assessment of the current state of the economy, monetary stimulus has done pretty much all it could do (thank God for that!), and we are now coming upon a Keynesian "liquidity trap," which, as he characterizes it, is "a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero … " What does Keynesian doctrine prescribe in such situations? It calls for massive fiscal stimulus: government spending intended to fill the hole in aggregate demand that underconsumption has left. This is how Krugman himself characterized it in February, according to a University of Pennsylvania e-newsletter:
With monetary policy a non-starter, "That leaves nothing but government spending" to prime the pump, Krugman said. "That's pure Keynes."
Krugman estimated that the "spending hole" in the U.S. economy is $2.9 trillion dollars. Because of that, he complained, President Obama's stimulus package should be over three times its present size!
"It's helpful, but it does not cover even one-third of the gap, so it's disappointing," Krugman said. Out of the $789 billion approved, only about $600 billion adds real stimulus, in Krugman's opinion. "So you've only got $600 billion to fill a $2.9 trillion hole."
The only hole that needs filling is the one in Krugman's understanding. As we have already seen, the notion that stimulus does any good by moving money out of mattresses and bank vaults is fallacious. And as Ludwig von Mises wrote,
a government can spend or invest only what it takes away from its citizens … its additional spending and investment curtails the citizens' spending and investment to the full extent of its quantity.
This leads to the question of whether government spending and investment does more good than private spending and investment. Sound economics answers this question with a resounding "no"; yet we don't even need to consider the question in regards to Krugman's Keynesianism. This is because ultimately, Keynesian fiscal stimulus is not even about the goods and services produced by the additional spending (infrastructure, welfare, etc). You see, the fiscal stimulus might as well be literally filling holes, since according to Keynes's ridiculous understanding of how an economy works, it doesn't matter what the government spends money on; even digging up holes just to refill them would qualify as beneficial stimulus. You might think that this must not be literally true. "Keynes may have been wrong on some things," you may protest, "but no economist as prominent as him would believe something so foolish!" Read the man's words for yourself:
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.
The above passage is not some off-hand note written to a colleague in a fit of academic speculation. It is part of Keynes's chief contribution to economics, upon which his reputation rests: The General Theory of Employment, Interest, and Money. I don't care how prominent, credentialed, or "accomplished" an economist is. If he says that burying cash in the ground can be a boon to society, then he should be immediately dismissed from public and academic discourse.
The simple fact that Krugman regards such a fellow as an exemplar of economic scholarship would be highly telling by itself. "Okay," you might think, "Keynes was a bit extreme. But Krugman himself wouldn't go so far as to believe something like that."
Wrong again. In April, Krugman actually bemoaned the fact that Obama's stimulus projects were under budget.
President Obama hails the fact that stimulus projects are coming in ahead of schedule and under budget. Yay â€" but boo.
Ahead of schedule is good. Under budget â€" well, ordinarily that's a good thing. But the point of the stimulus is to increase spending!
That's right: Krugman would, all other things being equal, prefer government stimulus spending to be inefficient. He then goes on to quote the very same ridiculous passage from Keynes's General Theory, which I quoted above, but favorably. And the title of the piece in which he made this complaint? "Time for Bottles in Coal Mines."
I told you he's hard core.
This brings me to a side point I'd like to make. One might think that in writing in such, let's say "direct," language, I'm needlessly vilifying both Keynes and Krugman. I certainly wouldn't write this way about just anyone who I happened to disagree with. But, as should now be evident, Keynesians are special. Their economic doctrines are so fallacious, and their policies are so destructive that, for the sake of truth and humanity, one cannot be too forthright in denouncing them.
Conclusion
Paul Krugman wants to be our savior. Like a savior, he would perform a miracle for us: that of turning consumption into wealth. But who would accept a messiah with such a John the Baptist as John Maynard Keynes, who proclaimed that credit expansion could perform the "miracle … of turning a stone into bread"? In any case, Krugman is a curious kind of savior: one more interested in exercising his brilliance than in actually helping people. In the Newsweek profile, he said of his policy advocacy,
"I am not overflowing with human compassion. It's more of an intellectual thing."
Indeed, there is something almost calculated in the unblinking wrongheadedness of both Keynes and Krugman. You're not likely to get much notoriety as a public intellectual advocating common sense.
What's more, you can't express common sense in calculus, which is actually useful in the natural sciences, but which only provides a fallacious veil of obscurity and elitism over the social sciences. In other words, sound economics just doesn't make for a cool-looking blackboard. And without a cool-looking blackboard, how could Paul Krugman be the "nerd saving civilization"?
John Maynard Keynes reveled in the ballyhoo over his bold "new economics," even though his doctrines were merely age-old inflationist fallacies dressed up in mathematical jargon. When confronted with the fact that his solutions would never work in the long run, he would dismissively say, "In the long run, we're all dead." But, as Murray Rothbard used to say, now Keynes is dead, and we're all stuck living in his "long run." For our own sake, let's hope Paul Krugman's tenure as an influential economist â€" as well as the current renascence of Keynes he represents â€" is a mercifully short-run affair.
www.mises.org
Ludwig (von Mises, see link above) was also a believer in "rational" markets as are his advocates like the author of the article above.
Planned economies don't work due to lack of feedback information into the economy. Totally unregulated economies don't work either due to the human tendency to act in concert with everyone else whether it is rational or not. You get repeated booms (bubbles) and busts from too much erroneous information; what was famously called "irrational exuberance".
Von Mises and Keynes were two monetarists at the opposite, extreme ends of the philosophical spectrum. They saw the money supply as the controlling mechanism of economic activity.
NOTICE TO ECONOMIC THEORISTS: Humans are not economic mechanisms!
The question seems to come down to what "form" of regulation will best meet the needs of our economy. If it is true, as many believe, that the "irrational exuberance" that led to the current situtation was the result of artifical monetary conditions created by the Fed and massive government interference in certain major market sectors, then we already have a major problem with "regulation". Do we continue with the politicized, fiat money system we now endure or go back to a standard(gold, silver, both?) system? Is there a combination in there somewhere that would leave room for sound decisions based on market conditions and the steadying restraint of some form of standard?
Jax, Going back to a "metal" standard, gold, silver, platinum, etc won't work either. There simply isn't enough of that stuff to support the level of economic activity that exists. Promises-to-pay i.e. gold or silver certificates get less and less of the metal to back them up and they become "fiat" money too.
In a lot of science fiction stories the currency used is called "credits". That would be a lot more accurate than what we call them, "dollars". That fancy, engraved, kool-aide colored, piece of linen paper in your wallet is simply a marker of the promise of goods or services that will be exchanged for it. It works as long as the issuer doesn't let the printing presses run too far ahead of real economic growth.
If you think about it, governments are not even the biggest "printers" of money anymore. Actually your credit card issuer is also in the business of "printing" money. Every time they extend you credit (there's that word again!) they are printing money just as the Federal Reserve does. When you write a check to pay that credit card bill you are also issuing a "promise-to-pay". i.e. "printing" or rather creating money.
The credit crisis that started this recession came about because too many of us issued too many credits (promises-to-pay) backed by the equity in houses which turned out not to be there. All of a sudden the promises couldn't be kept. CRASH! All of the derivative promises-to-pay like credit default swaps turned out to be worthless too since they were ultimately based on our house values.
Regulating financial markets had better be done as carefully as a doctor gives you medicine to regulate your heartbeat. You don't want the medicine to make your heart beat so fast that it fibrillates or so slowly that you cant move. Some of the regulation (root of the word means to make regular i.e. controlled) of the financial markets such as limitations of short selling and closing of markets when they gain or loose X amount in a session are designed to prevent your financial heart from "running away" when people panic. Some of the regulation, like relaxing limits on leveraged purchases, can stimulate activity.
Personally, I think that our recent crisis was a failure by the regulators to limit the creation of the funny "financial instruments" that even the creators didn't fully understand. Do you know what a "credit default swap" is and can you judge the risk that bonded bundles of mortgages present? Me either.
Quote
http://www.telegraph.co.uk/finance/economics/6147211/Barack-Obama-accused-of-making-Depression-mistakes.html
Barack Obama accused of making 'Depression' mistakes
Barack Obama is committing the same mistakes made by policymakers during the Great Depression, according to a new study endorsed by Nobel laureate James Buchanan.
By Edmund Conway
History repeating itself? President Obama has been accused by some economists of making the same mistakes policymakers in the US made in the Great Depression, which followed the Wall Street crash of 1929.His policies even have the potential to consign the US to a similar fate as Argentina, which suffered a painful and humiliating slide from first to Third World status last century, the paper says.
There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the worst economic collapse in recorded history, says the new pamphlet, published by the Institute of Economic Affairs.
In particular, the authors, economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run. They say that by employing deficit spending and increased state intervention President Obama will ultimately hamper the long-term growth potential of the US economy and may risk delaying full economic recovery by several years.
The study represents a challenge to the widely held view that Keynesian fiscal policies helped the US recover from the Depression which started in the early 1930s. The authors say: "[Franklin D Roosevelt's] interventionist policies and draconian tax increases delayed full economic recovery by several years by exacerbating a climate of pessimistic expectations that drove down private capital formation and household consumption to unprecedented lows."
Although the authors support the Federal Reserve's moves to slash interest rates to just above zero and embark on quantitative easing, pumping cash directly into the system, they warn that greater intervention could set the US back further. Rowley says: "It is also not impossible that the US will experience the kind of economic collapse from first to Third World status experienced by Argentina under the national-socialist governance of Juan Peron."
The paper, which recommends that the US return to a more laissez-faire economic system rather than intervening further in activity, has been endorsed by Nobel laureate James Buchanan, who said: "We have learned some things from comparable experiences of the 1930s' Great Depression, perhaps enough to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understanding of what makes capitalism work."