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February 8, 2009
David Warsh, Proprietor


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More Than Two Aspirin

There is a widespread sense that Barack Obama has gotten off on the wrong foot with the stimulus debate – not that he’s mistaken in urging that emergency measures be taken quickly, but that he has hasn’t been clear about the Why, the How and the What Next? In short, he has lost control of his conversation with the American people.

 

I think I know why.  I believe that Obama has been led by the economists whom he hired just after the election to adopt a strange mechanical story about the nature of this severe recession, its causes and consequences, a story which the overwhelming majority of Americans do not find convincing.  No wonder, then, that the public is skeptical of his ability to deal with the problem efficiently and effectively.

 

Many people have noted the remarkable resurgence of appeals to the authority of John Maynard Keynes, and to the desirability of deficit spending that he advocated as an antidote to the Great Depression of the 1930s. Indeed, rote comparison to the Great Depression has become common in some quarters, even though the current contraction, though memorable, is not expected to be much worse than that of 1981-82, at least as long as stimulative measures are taken promptly (around an expected 24 months in the current episode, instead of 16 months then; unemployment expected to top out in the vicinity of 8 percent this year, as opposed to10.5 percent in 1982).

 

But most people are not very knowledgeable about the inner logic of the Keynesian story of the business cycle. They are even less familiar with the details of the principal alternative to it – which happens to be the preferred explanation among most ordinary citizens. (Many economists subscribe as well.)

 

Call this widely-held alternative “the hangover theory.” That’s the name given to it by Paul Krugman, the indispensable New York Times columnist and Princeton University professor, in the course of explaining why he thinks it is all wet. Krugman is not a member of the administration, it is true, but his views are broadly in line with those of the “new Keynesian” economists who have been appointed, including National Economic Adviser Lawrence Summers and Council of Economic Advisers chair Christina Romer. Chances are they reject the hangover theory too.

 

All three are informed by a view of the business cycle first propounded with great urgency seventy-five years ago by John Maynard Keynes, and considerably elaborated in the years since.

   

The hangover theory of the business cycle, on the other hand, is associated with a pair of Austrian theorists in the 1930s, Friedrich Hayek and Joseph Schumpeter, and their intellectual descendants. It has many business adherents as well.  I will rely on an article that Krugman wrote for Slate in 1998 to set out both views.

 

The heart of hangover theory, wrote Krugman, is the idea of overinvestment — “the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession are the price we pay for the excesses of the previous expansion.”

 

The hangover story, Krugman wrote, is about excess.  It always goes something like this:

In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity – of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes—investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Laymen find the hangover explanation comforting, he continued, because it is a saga of hubris and downfall. It also offers adherents, conservatives especially, “the special pleasure of dispensing painful advice with a clear conscience, not heartless, but practicing tough love.”  Moderates and liberals often surrender to its “deductive charms” as well, because “it gives them a chance to lecture others on their failings.”

 

But there is a crucial defect with the hangover theory, Krugman declared, with the air of a detective about to direct the attention of his audience to a completely overlooked possibility.  It doesn’t explain why the collapse of a bubble – a decline in investment in one sector or another – might cause the entire economy to slump.  “Why should ups and downs in investment cycles lead to ups and downs in the economy as a whole?”

 

Leave aside that disqualifier for a moment. If booms don’t necessarily entail recessions, then what causes them?

 

Here Krugman was a little less clear. “[T]he explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.” The discovery that “excess demand for money” is the root of the problem “makes nonsense of the whole hangover theory.”

 

If the problem is too many people chasing too little cash, why not simply print more money?  That may help, he wrote, but it may not to be enough to get things moving again.  Junk the bad investments. Write off the bad loans. “But why should perfectly good productive capacity be left idle?”  What is inevitably needed is fiscal stimulus – enough government spending to jolt those private hoarders out of their preference for cash over investment.

 

It’s more complicated than that, of course.  Krugman left out the various frictions that Keynesians think prevent the economy from adjusting smoothly to changing conditions – in particular, the reluctance of workers to see their wages fall – but then he wasn’t writing a textbook in that one slim piece. Mainly he was interested in excoriating those foolish enough to subscribe to the hangover theory (a theme to which he returned on his blog in December):  “liquidationists,” he called them, believers in “Austrianism.”  He might as well be debating the phlogiston theory of combustion, he wrote.

 

Still, “whatever causes them” isn’t much of an explanation, either. So what do modern macroeconomists think causes recessions?  The answer most of them would give is “shocks” – sudden changes in expectations about the general state of demand or supply. It seems fair to say that the alternative to the hangover theory is shock theory, at least in Krugman’s terms, though in his introductory text the word shock is neither defined in the glossary or indexed; instead it is illustrated, by the rubbernecking that takes place at the scene of an highway accident, causing traffic to backup for miles. The role of shocks has been carefully and intricately elaborated by economists, Keynesians and non-Keynesians alike.

 

Krugman’s article appeared ten years ago. Does it still describe what he views as the state of play in economics?  To judge from the way he dismissed in December the notion that “a recession is somehow a necessary…part of the process of ‘adapting the structure of production,’” the answer is yes. But his is surely a minority view.

 

Never mind the many first-rate economists who subscribe to some version of the hangover theory.  Leave the technical arguments for another day.  The more significant fact, politically speaking, has to be that hangover theory has become more popular, not less, with the general public, especially since both recessions of the last decade have been associated with the collapse of bubbles – first the relatively short, shallow recession of 2001, eight months following the collapse of the dot.com mania in 2000, then the much more serious present event, associated with the collapse of residential housing prices and the bloated US banking and financial system.

 

There is no shortage of lucid expositions of the hangover theory.  Perhaps the best known, thirty years after it appeared, is Charles P. Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises – not exactly what macroeconomists mean by macroeconomics, but surely more widely read in connection with recent events than any elementary economics text. The most recent is last year’s The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy, by George Cooper, a London-based bond analyst with a novel take on how central banks inadvertently increase oscillations rather than damp them (he appends the physicist James Clerk Maxwell’s 1868 paper from the Proceedings of the Royal Society, “On Governors.”)

 

What both books have in common is that they take as their starting point the work of the late American economist Hyman Minsky, for many years a fixture at Washington University, in St. Louis. Minsky was a macroeconomist, with models to prove it, and a particularly lugubrious view of the future of modern capitalism, to boot. Temperament aside, Minsky’s analytic insight was one that most Americans probably intuitively share: stability breeds instability.

 

Which brings us back to the current situation. Obama was elected at least partly on the strength of his willingness to recognize that Ronald Reagan did something in 1980 that needed doing. At one point Obama put it this way: “I think Ronald Reagan changed the trajectory of America in a way that Richard Nixon did not and in a way that Bill Clinton did not. He put us on a fundamentally different path because the country was ready for it. I think they felt like with all the excesses of the 1960s and 1970s and government had grown and grown but there wasn’t much sense of accountability in terms of how it was operating…. [H]e just tapped into what people were already feeling, which was, We want clarity, we want optimism, we want a return to that sense of dynamism and entrepreneurship that had been missing.”

 

In order to do it, Reagan endured a recession at the start of his presidency – a massive hangover engendered by thirty years of steadily accelerating inflation. Conservatives today sometimes argue that no federal stimulus was required to recover from the W-shaped recessions of 1980 and ’81-82. That is because Federal Reserve chairman Paul Volcker had only to take his foot off the monetary brakes and the economy rumbled into gear.  High interest rates and pent-up demand left plenty of room for monetary policy to operate.

 

Obama’s recession, on the other hand, comes after thirty years of running the economy increasingly flat out, while starving public investment.  Not much margin of safety exists – certainly not in monetary policy, with interest rates near zero and bank lending recovering only slowly from paralysis.  Hence the need for plenty of federal spending, and the expectation that even with such a jump-start, there will be several sub-prime years before the economy returns to its normal rate of growth.

 

Nor is stimulus a simple matter. It is necessary also to address the solvency problems that lie ahead.  Economist Willem Buiter, a member of the Bank of England’s Monetary Policy Committee and a persistent critic of US monetary policy over the last several years, put it this way last fall: “The US government is ill-placed, financially and fiscally, to engage in short-term fiscal heroics.”  He expanded on his warning to good effect last week.

 

The point is that President Obama can’t make a credible case for any of this without the hangover story – a narrative that his technical economists are ill-equipped to provide Excellent technicians, they know the How but not the Why.  Volcker, on the other hand, is intimately familiar with the hangover theory, having put it to work during eight years at the helm of the Fed in order to bring inflation under control.

 

That’s why tension surfaced last week as Volcker complained that Summers was dragging his feet bringing Volcker’s advisory council into being. The president responded with a naming ceremony the next day. Now there’s a situation that bears watching!

 

It’s going to take a lot more than a couple of aspirin to work off the results of a dozen years of increasingly imprudent policies. The denunciations of the lack of regulation and Wall Street excesses are a good start – very much a part of the hangover interpretation.  But the president will have to go much farther than that. And, all the while, he’ll need to continue to address himself to the middle.

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