The glorious irrelevance of Paul Krugman

The economic crisis that started in 2007 exposed deep flaws in conventional macroeconomics. This was wonderfully exposed by Adair Turner, as I have posted before. But many of the macroeconomics’s big beasts seem to plough on regardless. Most shameless of these is Nobel Laureate and New York Times columnist Paul Krugman. This has become apparent in the latest kerfuffle to take the world of macroeconomists: the idea of “secular stagnation”.

This can get very technical very quickly (indeed the technicality of it is something of a hiding place), and I will try to spare my readers of these technical details. The idea of secular stagnation that is the natural rate of interest in many developed economies is less than zero, and has been for some time; since about 2003 according to some, or the 1990s to others. The natural rate of interest is that which is required to balance the supply of savings with their consumption in investment projects. If this rate is negative, then actual interest rates are doomed to be above this rate, and hence not enough investment happens. And because of this, growth rates are dragged down to stagnation levels, while the surplus savings are pumped into assets, creating bubbles, or else excessive debt-fuelled consumption occurs. If you want to read more about there is this excellent article by Gavyn Davies in the FT. This is behind the FT paywall. More accessible in is the speech by Larry Summers, another big beast of old macroeconomics, that set the whole fuss off, which is on YouTube. Unfortunately this takes quite a bit of reading between the lines to understand its implications. And then there is Mr Krugman, who weighs in after the speech with this blog post. This much the most accessible article in all senses – Mr Krugman is one of the best people at explaining economics ideas there is.

Mr Krugman says that his idea encapsulates what he has being saying or feeling for years; and having read him for years, I have no reason to doubt him on that. mr Krugman’s main interest is in an  old battle: that between his own liberal-inclined system of “Neo-Keynesian” theory, and the “Neo-Classical” approach favoured by conservatives. To him the crisis and its aftermath simply proves that the Neo-Classicists were wrong. He is right there, but that’s a very old story.

The interesting point is that neo-Keynesianism failed too. It failed for two main reasons. First was that it ignored the implications of the financial system, and levels of debt, in particular. And second it stuck to a theory of money and monetary policy that had barely moved on from the days when most transactions were settled in notes and coins. This blinded them to the scale of the crisis that was building, and blinds them still to the effectiveness of different policy options. In particular they place too much faith in the usefulness of a loose monetary policy, and an obsession with the rate of inflation. Their support for loose fiscal policy is much better grounded. There is not a hint of these problems in Mr Krugman’s writing.

There is something very striking about Mr Krugman’s article. He doesn’t seem that bothered about the forces that driving the economic statistics. There is a bit of speculation that it is something to do with an aging population, but no attempt to get behind the implications of this. Instead he obsesses with good old-fashioned fiscal and monetary policy: the idea being that we need to fix short term problems, and that the more fundamental, structural issues, such as inequality, finance and the efficiency of government, can be fixed in due course later. His signature policy idea is that the rate of inflation should be raised deliberately so that negative real interest rates can rise, which will then help the economy back to growth. Mr Krugman has long advocated just such a policy for Japan and feels entirely vindicated that the Japanese Prime Minister Shinzo Abe is now following his advice.

This insouciance towards the details of what is happening to economies is quite wrong-headed, though. He is right that growth rates in the developed world are stagnating, and that this problem dates back to well before the crisis of 2007. But we need to have a better idea of why. If it is for fundamental reasons, such as demographics and the changed nature of technological innovation, what is the point trying to take the economy to a place that it cannot go sustainably? And surely policy solutions must be sensitive to the complexities of an evolving economy? If labour markets work in a very different way, thanks to technological change and globalisation, then the old assumptions about inflation could be wrong. We are in danger of misreading the implications of a low inflation rate, and policies designed to increase its level could have malign effects. In Japan, employers are refusing to raise wages in the face of increased inflation expectations, so Mr Abe’s policy is starting to unravel.

Mr Krugman comes through as gloriously irrelevant to modern policymakers. Right some of the time, wrong on other occasions, and with nothing to say on many crucial questions, his ideas are so disconnected from the realities of the modern economy that they have become quite useless. Macroeconomics needs to learn and move on. The likes of Mr Krugman and Mr Summers should either embrace new ideas or bow out.


What is neoliberalism? The left’s muddle does not help reverse its progress

Political movements tend to be united by what they oppose, rather than any positive things they stand for. Today the political left unite against a universal enemy, which they name “neoliberalism”. The word is bandied about much as “socialism” is by the political right. But what is it? And is it a useful descriptive term? I believe it is, but that the left is muddled by what it is and is not.

According to Wikipedia neoliberalism started its life in the 1930s as a middle path between classical liberalism on the one hand, and the state planning ideologies of fascism and communism on the other. Classical liberalism advocated a minimal state, and, in practice, a world in which big capitalist corporations could thrive. It was widely blamed for the economic catastrophe that followed 1929 in capitalist economies. Neoliberalism stood for something called a “social market”, backed by a strong state. Nowadays, the left make no real distinction between  classical liberalism and neoliberalism. This speech by Susan George in 1999, and posted recently on Facebook by a friend, illustrates this quite well – a lot of what she rails at should in fact be defined as classical liberalism. This is interesting, and not necessarily wrong. Neoliberal ideas have provided cover for a lot of classical liberal ideas – and neoliberals have seen state socialism as their main enemy, rather than unfettered capitalism.

I think it is best to understand neoliberalism in terms of three core ideas:

  • Markets are an unbeatable information exchange. Markets are idolised, because they are seen as the most efficient possible way of reconciling the masses of information that modern societies require to keep moving. This idea of the market as an information exchange, famously advanced by Freidrich Hayek, is a very powerful one, and an advance on the rather abstracted ideas of classical economists.
  • People respond to incentives. Pretty much all human behaviour, good or bad, can be understood as a response to external incentives. This is often developed into the idea of all people being independent agents rationally responding to the opportunities around them according to a set of pre-defined preferences – often referred to as homus economicus. However, the idea is deeper and stronger than this theoretically convenient way of looking at things.
  • Direct state management is inefficient. This actually follows from the previous two ideas, but takes on a life of its own in the minds of its followers. The state is incapable of processing information about people’s wants and needs with the efficiency of a market; the state’s officers generally respond to their personal incentives, often simply to secure a stable and easy job. Result: gross inefficiency. When any of the known theoretical weaknesses of markets are presented to neoliberal advocates, their response is often to accept them, but to point out that to try and solve them through a state managed solution would make things even worse.

There is a general view, supported by Ms George’s speech, that neoliberalism took hold in the 1980s, under Britain’s Margaret Thatcher and America’s Ronald Reagan’s political leadership, and the economist Milton Freidman providing theoretical heft. From these beginnings it developed into an orthodoxy across the developed world that, according to the left, still grips the political establishment today. The financial crisis of 2007-09 has not drained it of power, as the left thinks it should have done.

There is some puzzlement on the left as to how this neoliberal takeover happened. Ms George paints a glowing picture of the Keynesian consensus that preceded it, and derides any idea that neoliberal ideas had any real persuasive power in their own right. She resorts to a sort of conspiracy theory of coordinated and determined vested interests. Well, I was there, and voted for Mrs Thatcher in 1979 (though not afterwards), and find the rise of neoliberal ideas entirely unsurprising. Britain, in particular, was in a miserable state: and the “Keynesian” consensus was an evident failure. It had failed to respond to the changed world that followed the oil crisis, resulting in unemployment and inflation. We were surrounded by national bureaucracies and nationalised industries of an inefficiency that today people would find unbelievable. Much of what they said, especially about state directed solutions, rang true. Many politically powerful vested interests opposed the change – but the neoliberals were pushing at an open door in the world of ideas.

Trying to put all this in perspective is made harder by the following things that have accompanied the rise of neoliberalism:

  • There has been a dramatic change to the industrial and economic base to developed societies since 1945 (well since long before that, of course). In the first phase manufacturing industry advanced, in such a way that much of the capacity built to support the war effort could be readily redeployed (in contrast to what followed the 1914-18 war); this was the basis of an unambiguous economic miracle that lifted many out of poverty. In the second phase, from the 1980s, manufacturing industry became much more efficient, while the appetite for its production hit saturation; the economy switched to services. This has created huge dislocation, and, more recently, the disappearance of mid level jobs. It has driven overall growth in wealth, but also tended to increase inequality. Neoliberal policies have helped this transition forward, but were not the underlying cause of it.
  • Capitalist corporations have remained as strong as ever, and have grown increasingly able to press forward their interests in the political system, especially in America. They are not fundamentally neoliberal in outlook (their aim is to rig markets and not empower them, but they usually camouflage their lobbying in neoliberal terms. We should be careful not to exaggerate their power though. The corporations have not had it all their own way: their life expectancy has dramatically reduced over the period. Neither are these faceless corporations entirely managed for the benefit of a small elite; they have also benefited armies of employees, and their institutional shareholders are often pension funds that likewise transmit their gains to ordinary people.
  • A lot of theoretical economists have got carried away with their models based on homus economicus, and these have become a soft target for neoliberalism’s critics. But often these criticisms amount to criticising the tactics and not the strategy: about how people respond to incentives, and not the idea that incentives drive behaviour.

Ms George manages to be muddled by all of these things, leading to a speech that can only be called paranoid. I suspect many on the left share her views, though, and feel that they have been vindicated by the events of the decade and a half since. This muddle, and their failure to clear identify and advocate alternative approaches to the neoliberal consensus, means their persuasiveness is doomed to be very limited.

Meanwhile political centrists seem to be trying to recover something of the original neoliberal outlook: the social market. The use of market mechanisms within a society that is still dominated by the state. As somebody who tends to the political centre I would like to say that this offers the most constructive way forward. But I have to  point out that the great financial crisis of 2007-09 resulted from the collapse of just such a middle way philosophy, in the world of finance and banking. While the left blames it on rampant capitalism and greed, cack-handed state intervention was just as much of a problem, and the combination was lethal. It was a neoliberal project in the original sense of the word.

Where does that leave us? A lot of what neoliberals say is true. We need to grow up and recognise that. But a lot of it isn’t; and its failures are currently more important that its successes. Our societies’ institutions have not kept pace with the changed nature of society and the economy. But it will require a large dose of state direction, especially in education and housing, to fix this.

The Twitter launch tells you all you need to know about financial markets

Yesterday Twitter launched itself onto the financial markets by offering a small proportion of its share for sale. The company sold them for $26 each. By the close of the day they were being sold for $44; during the day they had been even higher. Last week The Economist carried out a sober assessment of what they thought the shares were worth. They thought that investors should not pay more than $18. So what is going on?

No new information was revealed last week that might raise the share valuations. Instead we get a lot candyfloss arguments about why investors should buy the shares: arguments that taste sweet but disappear as soon as you try to digest them. There is talk of growth potential and strategic value – but studious avoidance of how much these are already built into the price. For those of us brought up to believe that share values reflect the discounted value of future cash flows this sobering. But serious money is behind the price movements. Who is buying at these stupid prices?

The answer is that people are buying because they think they will increase in value in the short term, and that they can sell out at a profit before any trouble starts. They are not watching long term value; they are watching the other guy. This logic may make some sense for an individual investor (or perhaps more correctly “trader”), but collectively it is madness. It simply leads to asset price bubbles. And there is a lot of it about.

This leads to a massive source of instability at the heart of the world’s financial system. But what to do about it? The first thing to say is that the world’s central bankers should stop treating asset price bubbles as a minor aberration of the system whose damaging effects can be contained. They are the big deal: a more important source of instability than the consumer price inflation that they still tend to focus on. Such policies as quantitative easing should be assessed in that light.

You can’t and shouldn’t stop people speculating on financial assets with their own money. Ultimately this leads to more realistic prices. What fuels bubbles is when people speculate with other people’s money: “leverage” in the jargon. Banks and financial institutions should lend money for proper investment projects, and a modest amount for purchases of existing property for people to live in or use productively. They should not be lending to speculators. Since 2008 people are more aware of the dangers. Alas we have a long, long way to go.

Labour can win in 2015. A disaster beckons in 2020.

Is it just me, or can I see a certain spring in the step of Britain’s national politicians? Ever since the party conference season last September they have been focusing on one thing above all: winning the General Election due in May 2015. The perplexing state of the country is now simply a source of ammunition to batter the other side. Actually solving the problems can be left until afterwards. What a relief!

The Labour leader, Ed Miliband, is having the better of it, if the relentlessly superficial media chatter is to be believed. This is quite a turnaround, since the same chatterers had him as toast as late as August. He has abandoned his party’s “too far, too fast” criticism of the government’s austerity policies, which helped rally the faithful (and rattle Lib Dem activists) but cut little ice with the country at large. The recovery of the country’s economic statistics has not invalidated their argument, but it has made it far too complex a proposition to argue, especially since their rhetoric had placed far too much reliance on these “flatlining” statistics in the first place. Instead they are focusing on living standards, and things, like fuel bills, which affect them.

From a campaigning perspective, this change of tack is astute on at least two counts. First, it appeals to direct personal experience, rather than the ephemeral world of economic statistics, to which the country’s GDP growth statistics belong. Second, it is such an intractable problem that the government is unlikely to be able to neutralise it. All that remains is to find some eye-catching policies to embarrass the government and keep the political debate on their ground. The centrepiece of this is the pledge to freeze energy prices for two years if Labour takes power, while they put in place a longer term fix to limit the damage inflicted by the greedy energy businesses they blame for the problem. A second push has been to enforce a “living wage” significantly higher than the legal minimum wage, through government procurement, and a tax break for employers who raise their wages.

In this line of attack Mr Miliband is the first of our national politicians to make political capital out of one of the most important developments in the British economy, along with many other developed economies, notably America’s. For the majority of people, wages are not keeping up with growth in the wider economy. In Britain this trend was clearly established, I read in this piece by Chris Giles in the FT, 2003/04; since 2010 (i.e. when the current government took over) wages have not even kept up with average prices. The benefits of growth are going to mainly to a privileged elite, while government interventions tend to be focused on the other end of the spectrum: the very poor. While the main economic issue is slow growth of pay, the main flashpoints are in taxes (especially for things like fuel) and energy costs.

There is, however, a snag. How on earth to actually fix it? This does not seem to bother Mr Miliband too much. His policy proposals are at best ineffectual, and at worst will actually make things worse. In the field of energy Britain is being overtaken by a crisis, as old nuclear and coal-fired power stations are shut down, and replaced by renewable energy sources that place wholly different strains on infrastructure. What the country badly needs is investment, in new capacity, and, especially, in distribution infrastructure (e.g. moves towards a “smart grid”). Just how Labour’s attack on the energy companies is going to solve this problem is, to say the least, unclear. And, if some of what I read is true, the pressure will break out into real problems in two or three years time. Labour’s living wage policies are no better thought through. Using government procurement to do heavy lifting in this area, along with many others, risks weighing it down with compliance costs – a process that tends to push out smaller businesses, as well as inviting scandal and fraud. The tax break looks totally unsustainable and an invitation to unscrupulous companies to manipulate the system.

The Conservatives are planning their counterattack. There is growing talk of 1992 (which this blog has long been banging on about), when a well-funded late campaign destroyed what had seemed to be an inevitable Labour victory. They will focus, probably, on frightening voters about the economy and taxes; their newspaper allies will concentrate on personal attacks on Mr Miliband to undermine his credibility as a prime minister. The Lib Dems are crafting a “centre ground” campaign, no doubt hoping to benefit from the damage the big parties will do to each other.

I have urged my readers not to underestimate the Conservatives. That advice still applies. But my current instinct is the Labour will weather the storm enough to form a minority government. That is when Mr Miliband’s problems will start. The country will face electricity shortages; clever schemes to enforce the living wage will unravel; living standards for the majority will stay under pressure; Labour activists and trade unionists will be on the government’s case to raise benefits and expenditure. The calamity that has struck Nick Clegg and the Lib Dems will visit Labour, for very similar reasons. I understand Labour’s strategy for winning in 2015; how on earth are they going to win in 2020?

What went wrong with economics?

It is commonplace to suggest that economics, as taught in our schools and universities, badly failed prior to the great financial crisis of 2007/08. But beyond this, things get a lot less clear. People tend to pipe up and attack aspects of the discipline that they have never liked; in the circles I move this tends to be the “neoliberal” ideas of well-functioning markets. This does not seem to be based on any real analysis, though. And universities plough on teaching the same old stuff as if nothing had happened, no doubt because nothing particularly coherent has replaced the old models. It is worth looking at the substance behind the remarkable failure of this discipline, which attracts so much intellectual heft in our era.

The failure of economics, and the imperious discipline of macroeconomics in particular, has been described brilliantly by Adair Turner in a recent lecture. I have already referred to this in an earlier post, but now I have been able to lay my hands on a copy of the text. It’s a challenge to read the 38 pages if you don’t have an academic economics training; but it’s well worth a try if you are not too daunted by this.

My personal perspective comes from the fact that I was a mature student on the BSc undergraduate course in Economics at UCL in the years 2005-08, just as the boom years were coming to an end, and the crisis started to develop, though before the seminal bankruptcy of Lehman Brothers, and the full blown crisis that followed in its wake. We were taught the standard macroeconomic model, referred to as the neo-Keynesian model, which nearly comprised a consensus at the time, although our lecturers were not beyond a little healthy scepticism.

Three related failures stand out. The first was an indifference to the potential macroeconomic impact of finance, and debt in particular. The fact that debt levels were exploding did not affect the models at all. You may think that economists are obsessed with money, but they treat it as a veil, and they try to see through it to a “real” economy of people and things. Finance is just tactics; a means to and which should not bother the imperial-level grand strategists too much. Besides, debt is two sided; for every debtor there is a creditor, and it all cancels out. If Matthew lends Mark £100, who in turn lends it to Luke, who in his turn lends it to John, who actual invests it in something, what has happened? £100 of debt has turned into £300 but there is still only £100 of investment. The bottom line is that Matthew lent £100 and John spent it; Mark and Luke are where they were beforehand. Do the machinations of intermediaries really matter?

This was much too complacent. Suppose Matthew, Mark, Luke and John are financially stretched, and a £100 loss will push them over the edge. If John’s investment fails, and he goes bust; he can’t pay Luke, who can’t pay back Mark, who can’t pay back Matthew. All four go bust, whereas just two would have done if Matthew had lent directly to John. The more overall levels of debt ramp up, the more likely it is that such contagion effects occur. I remember British policymakers expressing disbelief that a little trouble in the U.S. subprime property market could possibly have such a big global impact. And it isn’t just bankruptcy that is the issue; financial difficulties could simply cause a reduction in consumption – which would cause excessive saving in the economy at large, with bad macroeconomic effects, which can be very widespread from a rather small proximate cause.

The second problem was the fact that so little of the borrowing was invested in new investment projects, as theory supposed, with the majority being directed towards buying existing assets, and some to support additional consumption based on increased asset values. Hyman Minsky long ago pointed out that this type of investment simply led to asset price bubbles. And even if it had been directed towards “proper” investment, a similar bubble effect can occur. The latter was a point made by Friedrich Hayek. In spite of these warnings, the possibility of asset price bubbles, and what to do about them, was widely ignored.

The third problem centred on monetary policy. Economists used a theory of money that  had scarcely moved on from the use of notes and coins. They assumed that bank money works in an equivalent way; that banks only lend money that has already been deposited, and that the whole money creation process is controlled by the central bank. Over a century ago the Swedish economist, Knut Wicksell pointed out the absurdity of this. Commercial banks effectively have the power to create money out of nowhere. And in any case, it really isn’t possible to distinguish the “transaction money” on which the theory depends, from other sorts of money, for example that being held just for safekeeping. I have frequently blogged about this blindness of conventional economists, shown by their frequent references to non-existent printing presses, and talk of throwing bundles of banknotes out of helicopters. This is almost as nonsensical as a metaphor as it is literally, and shows an utter failure of imagination.

The outcome of these failures was that most economists thought that high levels of debt, and the possibility of asset price bubbles, were just details that should not detain the grand strategist, and that the main thing was for central banks to watch consumer price inflation, while finance ministers should simply keep budget deficits small.

So, as the world’s finance sector boomed, finding ever cleverer ways to hide slimmer margins by increasing leverage, and debt levels exploded in many developed economies, the world’s policymakers looked on without too much concern. Inflation and budget deficits looked fine; everything else would sort itself out in due course. Indeed, since the world economy was delivering steady growth, many thought they had found the answer to life, the world and everything. If it ain’t broke, don’t fix it. And many economists made a fortune from the finance boom. Most of the students on my course chose it as a path to get rich via investment banking or management consultancy.

It is, incidentally, easier to say that economists were wrong, than it is to say that the disaster was their fault. If more economists had piped up to sound warnings, the political pressures to ignore them would have been overwhelming. If they had been heeded, then maybe banking would have been a bit less out of control. But there were other factors driving the instability, including the huge export surpluses of China and oil exporters – which pumped money into the developed world financial system, creating near-on insoluble problems. The situation would have been a bit like global warming – strong awareness from the academic community quite unable to stop overwhelming global political forces and the power of sheer human greed.

Still, the discipline of economics has been left in a sorry state. As Lord Turner points out, in the 1950s they had all the knowledge and insights needed to take it in a less blinkered direction. Wicksell, Hayek and Minsky were all highly respected economists; Maynard Keynes highlighted all the issues lucidly in his General Theory. But instead economists went up a forty year blind alley, becoming more sophisticated with the detail even as the fundamentals became more and more unrealistic. East coast liberals were as badly off track as Chicago supply-siders. It’s no wonder that so many are still in denial and still teaching the discredited models, as if only a few details here and there need to fixed. How can you discard such a huge volume of thinking in one go?

But the economic disaster is too big to be glossed over. Whether or not economic theory has caught up, policymakers understand that the banking system is a major problem, and that you can have too much debt. The last time such a disaster hit economics was in the stagflation era of the 1970s; let’s hope economists’ response to this crisis is more robust than that one!