James K. Galbraith’s Washington Monthly piece “No Return to Normal” is a mix of the completely sensible (propping up bad banks is a recipe for further looting by insiders and more stupid risk-taking) and a totally crazy conviction that modern states are economically magical institutions. That is, it is a James K. Galbraith piece. Here is some crazy:

Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

Yes, 401(k)s are down, and Galbraith’s thesis seems to be that they always will be unless… guess what? But, okay, suppose he’s right and there is no recovery if we fail to embrace James K. Galbraithianism. In what crazy world does the economy both (a) fail to recover and (b) the government make good on already completely infeasible entitlement commitments? And how bizarre is it to say in the space of two sentences that a source of wealth is “real and inalienable” just as long as benefits are not cut through the democratic process — which of course they can be and probably must be if Galbraith is right about the likelihood of a no-recovery future. If voters can lose some portion of future government transfers by voting for politicians who vote them away, then those transfers are obviously alienable. (The courts clearly say there is no legal right whatsoever to these transfers.) And alienable future transfers from the government that are conditional on political will and economic feasibility are about as “real” as my future lovechild with Gisele Bundchen. Does anyone have an interpretation of Galbraith’s passage that makes sense?

He later goes on to claim, amazingly, that increasing spending on Social Security is “an economic recovery ace in the hole.” So the best I can do is guess that Galbraith is incoherently shuffling back and forth from a scenario in which we don’t use his “ace in the hole” (investments and home values worthless forever!) and one in which we do (Social Security checks good as gold.) But that’s hardly fair, is it? 

A main theme of Galbraith’s article is that things are so bad that mainstream economics can be of no assistance, so you’ve got to go heterodox. But he says nothing to clarify why, if we must abandon the consensus views of professional economics, one should prefer Galbraithianism over other departures from othodoxy. He seems to infer his own views from the alleged failure of standard views. It is rather gentle to note that that doesn’t follow. For example:

In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.

I largely agree about the inapplicability of many models, but it’s not at all obvious that the experience of the Great Depression is more rather than less applicable than those models. The Depression was a long time ago. The economy was a lot different then. If one is going to do “qualitative and historical analysis” then it seems that recent collpases in the financial systems of other countries are rather more germane. Why not look at those instead of reaching back “past the postwar years”? Because there’s some ineffable but essential Americanness to the American economy? Galbraith actually seems to think so, which is why one must look away from the examples of Argentina and Indonesia! This seems arbitrary and I don’t get it. Of course, if we go back to the Great Depression, we just become mired in competing “qualitative and historical” analyses, which in reality tends to sound a lot like “Must destroy Amity Shlaes!!!” And that’s obviously a lot more intellectually rigorous and helpful than stupid mainstream economists with their stupid mainstream models.

Russ Roberts rightly says “no,” and also strikes the right note of professional modesty:

So it’s a time for humility rather than hubris in my profession. Obama’s economic team, for all its brain power and good intentions, is in uncharted territory. There’s no recipe or manual or roadmap for getting the economy back on track. No one is quite sure how to correct imbalances in financial markets and the housing market. And no one knows how to create confidence, the biggest element lacking in the current economic climate.

No man or woman runs the economy. No man or woman or team of people can possibly plan the evolution of the economy in the coming months. America will come out of the recession but the time and pace are unknown. Obama can help. But he can just as easily slow down any recovery. Some part of the current mess we’re in is the result of erratic government policy that has added to the uncertainty facing consumer, investors, and entrepreneurs.

I certainly don’t mind aggregate demand economics as long as folks realize the limits of the stuff. I take it that one of the main lessons of living macro is that a stable framework of well-wrought rules tends to do better in the long run than periodic attempts to trick folks with the government’s amazing money-printing and money rearranging powers. I think this sort of thing would get through to people better if it were possible to to communciate the economy’s strategic micro-foundations: an economy is a massive, immensely complex coordination game. Maybe we’d like to think that there are Big Chiefs with scalpels and tweezers for fingers, but the fact is Big Chiefs have hams for hands. If the economy is a glassed-in ant colony and a recession is a confusion of non-connecting tunnels then “corrective” government intervention is banging the glass with a fat fist, like Fonzie banging a Jukebox. Barack Obama may be one cool cat, but the government ain’t no Fonzie. Mostly you get disoriented ants.

I’m not sure how to link soley to John Cochrane’s contribution to the Delong v. Zingales Economist.com debate, so I’ll just reprint it here:

Nobody is Keynesian now, really. Keynes distrusted investment and did not think about growth. Now, we all understand that growth, fuelled by higher productivity, is the key to prosperity. Keynes and his followers famously did not understand inflation, leading to the stagflation of the 1970s. We now understand the links between money and inflation, and the natural rate of unemployment below which inflation will rise. A few months before his death in 1946 Keynes declared:¹ ”I find myself more and more relying for a solution of our problems on the invisible hand [of the market] which I tried to eject from economics twenty years ago.” His ejection attempt failed. We all now understand the inescapable need for markets and price signals, and the sclerosis induced by high marginal tax rates, especially on investment. Keynes recommended that Britain pay for the second world war with taxes. We now understand that it is best to finance wars by borrowing, so as to spread the disincentive effects of taxes more broadly over time.

Really, the only remaining Keynesian question is a resurrection of fiscal stimulus, the idea that governments should borrow trillions of dollars and spend them quickly to address our current economic problems. We professional economists  are certainly not all in favour. For example, several hundred economists quickly signed the CATO Institute’s letter²opposing fiscal stimulus. 

Why not? Most of all, modern economics gives very little reason to believe that fiscal stimulus will do much to raise output or lower unemployment. How can borrowing money from A and giving it to B do anything? Every dollar that B spends is a dollar that A does not spend.³ The basic Keynesian analysis of this question is simply wrong. Professional economists abandoned it 30 years ago when Bob Lucas, Tom Sargent and Ed Prescott pointed out its logical inconsistencies. It has not appeared in graduate programmes or professional journals since. Policy simulations from Keynesian models disappeared as well, and even authors who call themselves Keynesian authors do not believe explicit models enough to use them. New Keynesian economics produces an interesting analysis of monetary policy focused on interest rate rules, not a resurrection of fiscal stimulus. 

Our situation is remarkable. Imagine that an august group of Nobel-prize-winning scientists and government advisers on climate change were to say: “Yes, global warming has been all the rage for 30 years, but all these whippersnappers with their fancy computer models, satellite measurements and stacks of publications in unintelligible academic journals have lost touch with the real world. We still believe the world is headed for an ice age, just as we were taught as undergraduates back in the 1960s.” Who would seem out of touch in that debate? Yet this is exactly where we stand with fiscal stimulus. 

Robert Barro’s Ricardian equivalence theorem was one nail in the coffin. This theorem says that stimulus cannot work because people know their taxes must rise in the future. Now, one can argue with that result. Perhaps more people ignore the fact that taxes will go up than overestimate those tax increases. But once enlightened, we cannot ignore this central question. We cannot return to mechanically adding up today’s consumption, investment and export demands, and prescribe the government demand necessary to attain some desired level of output. Every economist now knows that to get stimulus to work, at a minimum, government must fool people into forgetting about future taxes, an issue Keynes and Keynesians never thought of. It also raises the fascinating question of why our Keynesian government is so loudly announcing large and distortionary tax increases if it wants stimulus to work.
 
There is little empirical evidence to suggest that stimulus will work either. Empirical work without a plausible mechanism is always suspect, and work here suffers desperately from the correlation problem. Quack medicine seems to work, because people take it when they are sick. We do know three things. First, countries that borrow a lot and spend a lot do not grow quickly. Second, we have had credit crunches periodically for centuries, and most have passed quickly without stimulus. Whether the long duration of the great depression was caused or helped by stimulus is still hotly debated. Third, many crises have been precipitated by too much government borrowing. 

Neither fiscal stimulus nor conventional monetary policy (exchanging government debt for more cash) diagnoses or addresses the central problem: frozen credit markets. Policy needs first of all to focus on the credit crunch. Rebuilding credit markets does not lend itself to quick fixes that sound sexy in a short op-ed or a speech, but that is the problem, so that is what we should focus on fixing. 

The government can also help by not causing more harm. The credit markets are partly paralysed by the fear of what great plan will come next. Why buy bank stock knowing that the next rescue plan will surely wipe you out, and all the legal rights that defend the value of your investment could easily be trampled on? And the government needs to keep its fiscal powder dry. When the crisis passes, our governments will have to try to soak up vast quantities of debt without causing inflation. The more debt there is, the harder that will be.

Of course we are not all Keynesians now. Economics is, or at least tries to be, a science, not a religion. Economic understanding does not lie in a return to eternal verities written down in long , convoluted old books, or in the wisdom of fondly remembered sages, whether Keynes, Friedman or even Smith himself. Economics is a live and active discipline, and it is no disrespect to Keynes to say that we have learned a lot in 70 years. Let us stop talking about labels and appealing to long dead authorities. Let us instead apply the best of modern economics to talk about what has a chance of working in the present situation and why. 

Here is some Keynesian wisdom I think we should accept. 

“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

“How can I accept the doctrine, which sets up as its bible, above and beyond criticism, an obsolete textbook which I know not only to be scientifically erroneous but without interest or application to the modern world?”

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I think Cochrane is right about bizarre denialist flavor of the recent vogue for undead Keynesianism and — about  most other stuff, too. But I’d also like to see him acknowledge the limits of post-Lucas macro modeling as well. I think the lesson for the economics profession is now pretty clear. Macroeconomics that is useful for policymaking needs to (1) include a lot more political economy and (2) work from more empirically-grounded behavioral assumptions. That is to say, it would be nice to see more top-flight economists like Cochrane acknowledging that macro policy is politics and that people act like people. I suppose doing this would make the math seem impossible, but nobody ever said science was easy.

David Frum’s new column for The Week nicely lays out what the chair of the White House Council of Economic Advisors really thinks of the administration’s economic policy: 

Invited by a reporter Monday to criticize President Obama’s economic plans, the chair of the White House Council of Economic Advisers, Christina Romer, naturally brushed the question aside. “You want me to tell you what’s wrong with the fiscal stimulus package?” she said. “SO not going to do that!” 
 
Too late! As it happens, the lecture Romer had just finished delivering at the Brookings Institute on Monday afternoon was criticism enough. 
 
An expert on the Great Depression, Romer organized her lecture around six lessons distilled from the era. The administration she serves seems to be disregarding every one of them. 

Read the rest for the lessons.

Brad DeLong and Luigi Zingales debate it at Economist.com

DeLong’s opening statement too effectively arrays a huge amount of intellectual firepower against him. If he could persuasively cut this team of giants down to size, it would be a killer opening. But his response to the challenge he erects seems to amount to the contention that this squad of bona fide geniuses are really benighted halfwits guilty of an elementary error. That’s pretty hard to swallow. Meanwhile, Zingales handily hops over the bar he sets for himself. I liked Zingales’ analogy:

[E]ven the third interpretation of the house statement—that we should follow Keynesian prescriptions to combat the current economic crisis [the interpretation DeLong wants to defend]—is false. I am not disputing the idea that some government intervention can alleviate the current economic conditions, I am disputing that a Keynesian economic policy can do it. With a current-account deficit that in 2008 was $614 billion, a budget deficit that was $455 billion and military expenditures of $731 billion, it is hard to argue that the government is not stimulating demand sufficiently. The current crisis is not a demand crisis, it is a trust crisis. Bad corporate governance coupled with bad government policies has destroyed the financial sector, scaring investors and freezing lending. It is as if a nuclear bomb had destroyed all roads in America and we claimed that to alleviate the economic impact of such an event we should invest in banks. It is possible that eventually the effect will trickle down. But if the problem is the roads, you want to rebuild roads, not subsidise the financial sector. And if the problem is the financial sector, you want to fix this and not build roads.

So far, DeLong is getting crushed in the voting, though he’s working the audience hard in the reader comments. Is that allowed? 

Also, here is Brad debating Michele Boldrin. I haven’t listened yet.

Matthew Yglesias’ posts emphasizing the interconnectedness of the global economy and the need for coordination, like this one, are quite correct in pointing out that economies are not contained in little national boxes with policy levers nation-states can pull to goose aggregate demand, brake the rate of job loss, and so on at will. Indeed, having a sound sense of the extent of global economic interconectedness is tantamount to admitting rather hard limits on the ability of national monetary and fiscal interventions to fix things.

Suppose Matt is right when he says:

The economy is very global, and it’s extremely difficult to see it pulling short of a depression if the European Union and Japan are twiddling their thumbs. Beyond that, if there isn’t meaningful global coordination of stimulus efforts then protectionist pressures are going to become harder-and-harder to resist in China and the United States to prevent free riding. That, in turn, would buy some short-term assistance at the cost of really hobbling the prospects for recovery down the road. 

That is to say, given globalization, effective stimulus is a lot like effective carbon-reduction policy: it requires overcoming incredibly difficult international coordination problems. One might argue that the global policy coordination problem is easier to solve if the U.S. is willing to be the first mover. But then one should also admit that the domestic efficacy of American stimulus is conditional on things beyond the control of American policymakers and that the odds of success are rather lower than most progressives have so far been willing to admit.

If I were a Democratic strategist, I would, like Matt, be broadcasting the importance of global coordination in order to prepare Americans for the possibility that domestic stimulus proves ultimately impotent in the face of a broader global decline. Democrats will then be able to say “At least we tried and it would have been worse if we hadn’t” in reply to Republicans keen to capitalize on the failure. If I were a Republican strategist, I would be pointing out how convenient it is for Democrats to have failed to mention the importance of perhaps unattainable global coordination when pushing through their plan. As it happens, I’m neither, so maybe I’m just concern trolling.

Here’s Ed Glaeser:

Yet there are many Americans who spent the last eight years living within their means, and have plenty of resources left. For those Americans, the ones with cash in their bank accounts, this is the time to spend.

Cracking open the Champagne does not exactly feel in tune with today’s spirit of national austerity, but recessions get worse when prosperous people do not spend. In fact, if you can afford it, then this is exactly the moment to redo your kitchen or buy a car. Not only will you be able to get a good deal, but your spending will help revive the economy. The economist John Maynard Keynes convincingly argued 70 years ago that thrift was no virtue during a recession.

Despite the strength of the economic logic urging spending during a downturn, powerful psychological forces push in the opposite direction. America is hurting; thousands are losing their jobs. In today’s political climate, public displays of prosperity are the kind of thing that gets you lambasted by a Senate subcommittee.

I made a similar argument on Marketplace just before Christmas. Here’s what I said:

Most of us won’t lose our jobs, won’t face a pay cut. Yet we tighten anyway. Dollar-stretching tips circulate even among the most comfortable. But if your paycheck’s intact and you’re still cutting back, you may be part of the problem.

When home values surge, we tend to feel richer and spend a bit more, even if we don’t plan to sell the house. Economists call this “the wealth effect,” and it’s got a recessionary flip side. So when our 401(k)s dive as the economy hits a rough patch, we feel a bit of a pinch and rein in consumption — even when our incomes and the long-term value of our investments hasn’t changed a bit. In short, we don’t always look to our personal financial fundamentals when choosing whether to splurge or scrimp.

But just as “irrational exuberance” can keep a speculative bubble afloat, equally irrational anxiety, and the ethos of austerity it produces, can trap us in the doldrums. So maybe you went a bit crazy during the boom, and now’s the time to return to financial sanity. Good! But if you were living comfortably and responsibly within your means last year, you probably don’t need to cut back now. 

You know what? This argument DRIVES PEOPLE CRAZY. Check out Glaeser’s comments, and mine, which tend to confirm that there is in fact a Keynes-ish sort of pack psychology about appropriate consumption behavior. It’s funny that people get upset by a recommendation to do things that are both individually prudent (it’s just good financial stewardship to buy things when prices are low) and that have larger than ususual positive spillover effects. I doubt people really think it’s better to leave yourself and everyone else worse off. My diagnosis is that most people either don’t get the idea of periodic downturns and recoveries and so tend to suspect  with each serious recession that this time everything may go to shit permanently (which is true, it might, but what are the odds?) and to infer that prudence demands hoarding. My biggest worry about things going to shit is that government profligacy may leave us with a worthless dollar. But then why not spend all your dollars now on durable stuff!  I recently put a lot of my savings into a diamond ring, which I’m now thinking turned out to be fairly savvy move in several different ways.

I just stumbled on this, and don’t think I’ve seen it anywhere else, so I offer for your consideration economics Nobel Laureate Robert Mundell on the stimulus in a January 9th Turkish TV interview :

Ipek Cem: There is talk of a stimulus package in the US. We also know that the average US citizen is highly leveraged as a consumer. And when we talk about stimulus we are also talking about consumer pending. How to make the two of them, you know work hand in hand?

Robert Mundell: Well there’s a lot of questions about “What a stimulus package really is?” And I don’t think the major has been taken called a stimulus package are going to be much of a stimulus. To a certain extent, monetary policy, an easy monetary policy, is stimulating for us. But that’s not the pack what we mean by a “stimulus package” because “Federal Reserve” can always do that. What they mean by that is government spending. But government spending doesn’t have that bigger effect. If you have a big increasing government spending, without monetary expansion, they have to finance that deficit by bringing bonds. So while the spending adds to demand, the selling of the bonds, takes away the demand. So if there’s a multiplier in one process, there is a negative multiplier with the other process. And the other fact is that the exchange rate is flexible. So if you sell more bonds with a stimulus pending interest rates rise a little bit. And the capital comes in, the current account deficit increases. The trade deficit increases. So a good part of that stimulus package goes to the rest of the world.

Ipek Cem: So what kind of policy measures would you be advocating at a time like this?

Robert Mundell: Well I think that the difficulty of all the banks, they need to recapitalize the bank, which everybody says it’s necessary. And is also true with corporation you need to recapitalize the corporations like “General Motors”, “Ford” and “Chrysler”. The glories, what used to be glories of American capitalism in the 20th century. American manufacturing. They need to be recapitalized, too. And instead of the government taking its stimulus package, the bailout package, recapitalizing, buying stocking these banks, it is much more important to look at what’s happenning right now, what the goverment is doing today to economy. What the government does to the corporation today is take thirty five percent of the profits of the corporation. And without putting anything in. So with the 35 percent of corporate tax, they take all that, draining the corporation from that, without putting anything in. And so what the best thing to do for stimulus is to reduce or eliminate the corporation tax. It is a double taxation anyway, because the capital pays the tax to the corporation and the profits are taxed at the corporate level after 35 % is taken out. And then there are also tax in the individual level. So eliminate it. By the way the revenue isn’t going to be very much because the corporate tax used to earn 5 % of GDP in revenue. It’s gone down about 1,5 % of GDP. So it doesn’t add too much. And in a recession period there won’t be any profits and tax, so the revenue will be very little. So you don’t loose too much, but you would, if you stimulate economy all the other taxes will increase. And the revenue then from the tax cuts of corporations will increase the tax of every other corporation. Just recently, Germany has cut it it corporation tax from 25 % to 15 %. That’s a very good move and that’s what the United States should do. I think, I was going to say from 35 % to 20 %, but it would be even better if they do it to 15 %.

Recap: Bond-financed spending doesn’t much help. Recapitalize banks and eliminate radically reduce the corporate income tax.