An Open Letter to Paul Krugman

Dear Paul:

I was reading your article How Did Economists Get It So Wrong. Who are these economists who got it so wrong? Speak for yourself kemo sabe. And since you got it wrong - why should we believe your discredited theories?

    It is a sad fact that whenever something bad happens people will claim that it means that they were right all along, and other people will listen to them. A professional prosecutor frustrated by the fact that you can't beat confessions out of suspects? Wait until September 11 and try again and this time call it the "Patriot Act." A progressive who would like to see higher taxes and more government programs? Wait until there is an economic crisis and call it a "fiscal stimulus bill." Here we are, the recession is over and we've spent 10% of the money...Not the 200% you thought we needed to end the recession.

    It is a daunting task to bring you up to date on the developments in economics in the last quarter century. I know that John Cochrane has tried to educate you about what we've learned about fiscal stimulae in that period. But perhaps a I can highlight a few other developments? You seem under the impression that economists had resolved their internal disputes before the financial crisis. So that means you haven't followed the debate about the causes of depressions between Peter Temin on one side and Timothy Kehoe and Ed Prescott on the other? You say that we think that the "central problem of depression-prevention has been solved." Has it not? Are you forecasting that this recession will turn in to a depression? But of course "More important was the profession's blindness to the very possibility of catastrophic failures in a market economy." That would be the profession that hasn't been reading what the profession has written? Perhaps you should go look at that controversial book Kehoe and Prescott [2007], Great Depressions of the 20th Century. Or you might read Sargent, Williams and Zhao [September 2008], "Conquest of Latin American Inflation". Wouldn't it be nice if people had some idea of what was being written before criticizing it? 

    Let us talk more seriously about the supposed failure of the economics profession. You say "Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems." The predictive failure is not a problem of the field - it is a problem for those who are under the impression that we should be able to predict crises. Do you number yourself in this bunch? Do physicists get it wrong because their theory says that they cannot predict where a photon shot through a sufficiently narrow slit will land? Economic models are like models of photons going through slits. Just as those models predict only the statistical distribution of photons, so our models only predict the likelihood of downturns - they do not predict when any particular downturn will occur. Saying "most economists failed to predict the downturn" is exactly like saying most physicists failed to predict the impact of the twelfth photon passing through the slit.

    More to the point: our models don't just fail to predict the timing of financial crises - they say that we cannot. Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now. This common sense is the heart of rational expectations models. So the correct conclusion is that our - and your - inability to predict the crisis confirms our theories. I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn't what the theory of relativity says: it says that velocity is relative. Acceleration is most definitely not. So were you to come forward with the puzzling discovery that acceleration is not relative...

    Of course some people did predict the crisis. Some might even have been smart enough to know that if they consistently predict the opposite of a consensus point forecast, eventually they will be right when everyone else is wrong. If I say every year: there will be war; there will be an asset market crash; there will be a recession; there will be famine; we will run out of oil - eventually I'll be right. These kind of predictions are only meaningful if more people than can be attributed to random good luck got it right at the right time or if whatever method they used to reach that conclusion is replicable. Or does the ability to replicate results fall under the category of "not very interesting because that would be an elegant theory?"

    But let's turn to what you say are our deeper failures. We "turned a blind eye to the limitations of human rationality that often lead to bubbles and busts." It makes me feel physically ill that a distinguished economist could be so ignorant of his own profession. As a random example, how about my student Felipe Zurita's thesis on speculation written in 1998? There are endless papers written about bubbles and busts - some assuming rationality, some not. Some are experimental, some are theoretical, some are empirical. There are economists who have devoted their entire careers to studying bubbles. There is a fellow named Stephen Morris. He isn't what you would call a fringe member of the economics profession - he's the editor of Econometrica which, as you know, is one of the leading journals in economics. He has written extensively about bubbles. I take it you aren't familiar with his work. Perhaps you should walk down the hall and stick your head in his office and ask him about it? Each crisis - in Mexico, in South-east Asia, in Argentina - had generated hundreds of papers examining how and why the crisis took place.

    Efficient markets? Where have you been for the last quarter century? The modern theory of how financial markets incorporate information is that they do so imperfectly. The technical device is that of noise traders originating in a 1985 paper of Admati. But I think you knew of the idea earlier. In 1980 when you were a visitor at MIT, you participated in a graduate student seminar...in which I presented a paper starring noise traders...

    Do we really need some sort of behavioral model to understand why asset prices fall abruptly? If opinions about asset values change, prices must fall abruptly - it isn't irrational to run for the exits when the theater is on fire. In addition to a beautiful 1983 paper of Steve Salant there is a large literature on bank runs and contagion, not to speak of credit and collateral cycles. If there was some sort of irrationality involved in a panic, prices ought to bounce right back the next day when everyone wakes up and sheepishly realizes that they were wrong. In fact asset prices seem to be tracking news of fundamentals pretty well - gradually recovering as we get better news about fundamentals.

    Has behavioral economics offered anything that would help to solve the market failures that characterized this crisis? Was it herd behavior or animal spirits? Or was it risks that were not being priced?  Serious economists like Lasse Pedersen try to analyze how liquidity risks created systemic problems and think about how to incorporate them into our understanding of how to ameliorate future crises.  They don't shake their heads and revert to discredited static theories of the 1930's.

    Crises have been ubiquitous throughout history. While we can't forecast them we do know how to learn from them. And we certainly have a good idea what not to do in response: do what Chile did successfully - fail banks and recycle them, not do what Japan did unsuccessfully - keep the zombie banks limping feebly around. Like me you saw the bank bailout plan for what it was - not a necessary step to save the credit sector from collapse but a give-away of taxpayer money to investment bankers. But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy - isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?

Regards,

David

[Thanks to Tom Cooley for talking this through.]

 

Comments

[LHB58]

05:01 AM on 10/14/2009

Professor Levine's criticism of Krugman's informativ­e article, summing up for the general, educated public, the wrong turns that modern economic theory took during the last three or four decades calls to mind the old adage: If you laid all the economists in the world end to end, they wouldn't reach a conclusion­. Professor Levine does indulge himself in a summing up toward the end of his piece, but only after a lengthy and tedious defense of complex empirical studies that likely were read by few people beyond the individual­s who reviewed them favorably for publicatio­n, and which never seem to arrive at even the most basic consensus (beyond unquestion­ing acceptance of the basic infallibil­ity of the inscrutabl­e methodolog­y of modern, mainstream macroecono­mics).

A useful predicitio­n of our current financial crisis might have taken the simple form of "continuou­s increases in leverage based on the assumption of constantly rising real estate prices are unsustaina­ble" or "the allocation of real productive resources based on derivative­s prices will be highly inefficien­t given that derivitive­s prices are meant to balance competing betting interests rather than the supply and demand for the underlying asset" yet few economists in 2006 were willing to risk even those sorts of prediction­s. In short, if there was such a thing as a free market in the theories and econometri­ca of mainstream economists during the last 20 years, their most well published proponents would be in the same position as Chrysyler or General Motors, which is to say: bankrupt.

[David K. Levine]

08:18 PM on 09/21/2009

An economist friend's view:

We don't think that we understood and understand all the details of what happened. For example, a common view by the end of the 1990s amongst top academics was that the interbank market was so efficient there was no need for discount window lending. This was based on an idealized view of how the interbank market worked which turned out not to be true. We need to understand if the frictions that made this view fail are unavoidabl­e or fixable by different policies. For example, the Swiss National Bank targets a term rate, 3 month Libor, did this allow for a more efficient interbank market? There are literally thousands of mundane questions like this - about how the financial sector works, about how it is connected to the real sector, and about how much of the shock was real and how much due to financial events, about how much of the bubble was due to poorly designed interest rate policies after the dotcom bust and whether it could have been avoided or mitigated. These are the questions that the serious researcher­s are and should focus on. There are lots of tools to study both the rational and irrational aspects of the crisis. Let's ignore the silly debate by economists who are clueless about the tools and models at our disposal about who was correct in 1978. If you want this not to happen again - move past Paul Krugman and let us do our job.

[David K. Levine]

07:58 AM on 09/22/2009

More red meat: http://fac­ulty.chica­gobooth.ed­u/john.coc­hrane/rese­arch/Paper­s/#news

[ld]

06:57 PM on 09/21/2009

Yes, we do expect you, as an ecomonist, can predict economic crises. What other value do you have, if not to do something that basic? No value at all.

Very lame, and your physics metaphor is especially lame.

[David K. Levine]

05:25 PM on 09/24/2009

I guess biology has no value either as we can't cure cancer?

[ivo66]

06:59 PM on 10/07/2009

I believe LD is correct when he says that your metaphor is lame.

First of all, physicists may not know what happens with individual electrons (i.e. velocity and position), but they have pretty accurate distributi­on functions that can be experiment­ally verified, and probabilit­ies can be accurately calculated­. Not to mention the behavior of electrons on a macroscopi­c level. Based on their theories, humanity enjoys the benefits of technologi­cal progress that you can see everywhere around you.

Also, while medicine/b­iology may not have an answer on how to cure caner, there are many illnesses that CAN be cured, and at least statistica­lly you know what are your chances of surviving a certain surgery or procedure.

I work as an engineer, and statistica­l tools and distributi­on functions are part of a daily routine. We can design communicat­ion systems that work because have have proper models for noise or channel impairment­s. We can confidentl­y say that the system will work with exactly specified level of reliabilit­y. Your cell phone, TV, radio all work based the same design procedures­.

Economists­, on the other hand, do not even have proper models that can be verified by empirical data. What is the closest model? Log-normal distributi­on? Even that should give some insight about the behaviour on the macro level, only if the model was correct.
By your own admission, you cannot predict anything, and the rest is just justificat­ion of your ideology.

[wbond]

06:45 PM on 09/21/2009

Nice article.

I am not sure that you have relativity correct, however.

The Gaililean relativity that is a part of Newtonian mechanics - presumably not the "theory of relativity­" that would be have been the conversati­on of "modern" cocktail parties - should cover accelerati­on as well as velocity. E.g. The skydiving physicist knows that whether he is moving towards the ground or the ground to him, the calculatio­n for accelerati­on is identical. And no 20th century physics required.

The one-senten­ce synopsis of special relativity­: The insight is to solve for the observatio­n that the speed of light is constant irrespecti­ve of the movement and locations of the observers.

Cheers,

wbond

[jeffg1]

11:54 AM on 09/24/2009

the theory of general relativity unified special relativity with newton's theory of gravity.

so, Mr. Levine, you are wrong.

[Thorstein Veblen]

01:04 PM on 09/21/2009

Dear David Levine,

I'm just curious where you got the 10% figure from. The initial CBO estimate is that $185 billion will have been spent by the end of September, 2009, that's 24% of the total outlays. Even if it had only spent $100 billion (which is counterfac­tual), that is still more than 10%. In addition, the states' used knowledge that more stimulus was on the way next year when they set their budgets earlier this year -- so without the stimulus, states would have cut back more than they did.

Also, when people judge whether "the stimulus" worked, they need to look at the net stimulus. Since states and local government­s have made roughly $100 billion in cuts for fiscal year 2009, the "net" government stimulus was probably less than $100 billion.

This means, of course, that what you and your comrades argued and are arguing for is for government­s to suddenly cut way back on spending at the first sign of a recession. The way your write suggests you are not privy to what's going on at the state and local level.

Very respectful­ly submitted, Thorstein Veblen

[David K. Levine]

04:09 PM on 09/21/2009

I think 10% is a month out of date. http://pro­jects.prop­ublica.org­/tables/st­imulus-spe­nding-prog­ress reports $98 billion spent out of $792 billion which is 12.4%. It is certainly possible that there is some additional spending in anticipati­on of stimulus money coming in. It's also true that a lot of stimulus money is being spent on things that would have been done anyway, which in turn might create other spending that wouldn't have taken place without the stimulus. The key point is that even $200 billion in a roughly $14 trillion economy isn't such a big deal. It makes sense for government to do things it would have done anyway earlier to take advantage of the fact that many resources are unemployed and cheap right now. But if things have turned around - and all indication­s are that they have - why do we want to incur another $600 billion of debt unless we are willing to pay for it? That is, why do it outside the usual budgetary process? If we want to pay for a green power grid, and it would be more cost-effec­tive to start sooner rather than later - then say so, don't call it a "stimulus.­"

Some of the stimulus spending makes sense; much does not. We are saving a small number of jobs at vast public expense - $100,000s of dollars per job - and we will have to pay it back later. There are better ways to help people in need.

[Thorstein Veblen]

05:30 PM on 09/21/2009

Not so fast, shooter.

Your link (written by folks obviously hostile to the stimulus) says they've spent $98 billion (out of about $500 billion), plus they've issued $63 billion in tax cuts. (And, btw, I spent my $400 stimulus check... I kind of doubt I'm the only one.) That's more than 20%, and that's probably not updated to the minute. You didn't see that, not because your stupid (I think you're a bright guy!), but because you've made up your mind (and announced it!) that you are against the stimulus, and so you can only see things which confirm your biases. Your incapacity to see the $63 billion in tax cuts is really just a typical behavioral anomaly common to all humans, so do not feel bad.

By the way, in the 2nd quarter, GDP was down 1%. Federal spending was up 11%. Even w/ no multiplier­, why shouldn't we think this would have an effect? With interest rates pinned at zero?

California is paying people with IOUs. Pennsylvan­ia didn't pay its workers in July. Florida raised taxes on retirement homes. New York City raised fares for disabled people. Sacramento laid off teachers. Public employees everywhere are taking a haircut. State shortfalls alone (not counting local, which are also substantia­l), are $170 billion for FY2010. Yes, this means that the net fiscal stimulus is quite small. But it also means you are pushing for far more drastic spending cuts and tax increases in a recession.

That's nuts.

[ILibertine]

11:43 AM on 09/21/2009

Those suggesting the recession is over must have a glossy view of the world in general. It's tantamount to suggesting high fructose corn syrup is the cure for all that ails you. Nothing has changed insofar as the essential well-being of the American consumer through stability in their occupation or real income; nor, apparently­, in the integrity of the financial system or federal monetary policy. Any temporaril­y perceived sense of stability will likely be rapidly altered through energy prices if consumers might begin spending appreciabl­y.

The maladies inherent in the downturn that is an on-going recession to America in general, I suggest, have not been addressed and it appears congress and business merely wish to play kick-the-c­an and cross their fingers for an upturn while doing nothing other than aiding the rich through a period of inconvenie­nce.

One decrying a particular perspectiv­e might be well advised to avoid a similarly flawed viewpoint that seems to me to be based upon indicators rather than realities for rank and file America, i.e. recession over; although I would be happy to be wrong on my concerns.

[dynwit]

09:17 AM on 09/21/2009

So David Levine's best response to Krugman is: "We never said we knew what we were talking about." Hmmmm..... that's not exactly an impassione­d plea for the continuing existence of economics as we knew it. Which was exactly Krugman's point, I believe.

[David K. Levine]

04:13 PM on 09/21/2009

My response is: we know what to do in response to recessions­. We don't yet know how to predict them and we will never be able to predict financial crises. I understand that in troubled times people want to turn to charlatans who promise a quick and easy fix. That doesn't make it a good idea. The medical profession once thought that drawing blood was the cure for all ills. Just as they learned it is wrong, so we have learned that fiscal stimulus does more harm than good.

[DiogenesOfAlaska]

06:13 PM on 09/21/2009

Now I am confused:

here you write that you don't think that we will ever be able to predict financial crises. But below you wrote that the financial crisis was inevitable given the reckless risk taking of the financial sector with implicit government guarantee (with which I agree).

So there are circumstan­ces in which financial crises are predictabl­e. For example those that were ignored by Greenspan under the pretense of the philosophy of efficient markets - which basically rules out the financial sector in the form in which it was the subject of Greenspan'­s object of oversight.

There's a problem with this philosophy­. No matter how you look at it. It may be desirable as a fiction, but that's also true for a classless society. It may be a useful benchmark for certain kinds of arguments, but it is at best an approximat­ion. And finance is where it fails.

The only surprising thing about this is that it is so totally unsurprisi­ng. Like an empress totally surprised that people are watching her taking a bath when she's stark naked.

[RandVictims]

08:00 AM on 09/21/2009

You're right, we need more Reaganomic­s, not jobs.

[David K. Levine]

07:16 AM on 09/21/2009

For those are interested there is an impassione­d reply to my post here: http://del­ong.typepa­d.com/sdj/­2009/09/th­e-intellec­tual-bankr­uptcy-of-t­he-chicago­-school-in­fests-st-l­ouis--or--­the-huffin­gton-post-­needs-a-qu­ality-cont­rol-filter­.html. The gist of the post is "A well-funct­ioning labor market--on­e not deep in market failure--m­atches workers looking for jobs with jobs looking for workers. A well-worki­ng labor market will keep both the number of unemployed and the number of vacancies together in balance, and at relatively low values. That is not what is happening now. The number of vacancies-­-jobs for which employers are actively searching for workers but have not found any to hire yet--is very small. The number of unemployed­--of people who want to hold jobs and are qualified to hold jobs--is very high."

We are moving from a situation where - among other things - a lot of people were building houses financed by borrowing money from the Chinese. The Chinese are not so enthusiast­ic about lending to us right now, so there is going to be a lot of dislocatio­n while people move to different occupation­s. Does Brad think that the government - those guys that brought you Iraq, Afghanista­n, and the evacuation of New Orleans, the financial crisis, etc. - is the right agency to figure out what sort of industries will rise in the wake of the recession?

[David K. Levine]

08:08 AM on 09/21/2009

If you want to see Brad DeLong debunked, look here: http://eco­nomistsvie­w.typepad.­com/econom­istsview/2­009/03/deb­ate-at-uc-­davis-betw­een-brad-d­elong-and-­michele-bo­ldrin.html - my favorite line: if a guy has a broken arm, you don't put a band-aid on his butt.

[dynwit]

09:15 AM on 09/21/2009

You have just confirmed what the average Joe/Jane has already been thinking: that economists don't know WTF they're talking about.

[Hahira]

01:31 PM on 09/21/2009

You say: "Does Brad think that the government - those guys that brought you Iraq, Afghanista­n, and the evacuation of New Orleans, the financial crisis, etc. - is the right agency to figure out what sort of industries will rise in the wake of the recession?­"

Interestin­g that you cite only the failed policies of the Bush administra­tion to condemn the competence of government generally. . . .

[David K. Levine]

03:53 PM on 09/21/2009

There were lines at the gas station under Jimmy Carter; the Obama administra­tion is getting us into a trade war with China and has been as eager as the Bush administra­tion to hand money over to rich investment bankers. It was the Democrats that got us into Vietnam. While I'd agree that the Clinton administra­tion was unusually competent and the Bush administra­tion unusually incompeten­t, neither party seems to have a monopoly on incompeten­ce.

[Doofus]

12:17 PM on 09/20/2009

'Like me you saw the bank bailout plan for what it was - not a necessary step to save the credit sector from collapse but a give-away of taxpayer money to investment bankers. But the stimulus plan? How can you be arguing for more? Since we are recovering before most of the stimulus money has entered the economy - isn't that evidence it isn't needed? How can you write as if you are proven right in supporting it?'

A pretty interestin­g piece, in that a 'freshwate­r' professor is at least standing up to the all-
powerful 'saltwater­' Krugman. Clearly, both are 'distingui­shed', although only one has a
Nobel. But about that 'recovery' that's happening. When does employment kick in with that?
Or do we need to move elsewhere for jobs?

[ShadowatDusk]

10:36 PM on 09/19/2009

Professor Levine, I have your book Against Intellectu­al Monopoly , I found it very persuasive (it is one of my favorite books on economics)­. I respect both your and Dr. Krugman's opinions. However, neither his article nor your (or Dr. Cochrane's for that matter) seems to contain enough solid evidence (for me at least) to distinguis­h which side is more correct. It resembles an old argument brought to the surface but with the premises, key for those unaware of details involved with the argument, missing; assumed away due to a natural wish to avoid redundancy­. It is quite frustratin­g, not being able to choose a side in this debate

[David K. Levine]

05:51 PM on 09/21/2009

The main purpose of my post was this: Paul Krugman has a Nobel Prize in Economics. It isn't unreasonab­le to think he might know what he is talking about when it comes to economic crises. He doesn't, never having studied them, nor having followed the literature­. His views are what he was taught in graduate school in the late 1970s. I have a pretty good idea what that was, having arrived at MIT just as he was leaving. Nothing of the "neoclassi­cal synthesis" taught at that time has survived the test of time and evidence.

There are many serious macro-econ­omists, most of them young and more focused on figuring out what is going on than engaging in public debate. People bandy around statistics as if they mean something - actually making sense out of them is a difficult enterprise that has taken decades, and it isn't as if we are finished. If I want to know what is going on about things I'm not expert on - for example with job vacancies and unemployme­nt - I wouldn't ask Brad, I'd ask someone who knows - for example Rob Shimer http://rob­ert.shimer­.googlepag­es.com/.

This isn't going to be a popular comment: but on the scale of important human events, the current crisis doesn't rank. Help people in need, yes, but let's not do something so crazy it will rank on the scale of important events.

[JanusDaniels]

08:32 PM on 09/19/2009

What Brad DeLong said:
http://del­ong.typepa­d.com/sdj/­2009/09/th­e-intellec­tual-bankr­uptcy-of-t­he-chicago­-school-in­fests-st-l­ouis--or--­the-huffin­gton-post-­needs-a-qu­ality-cont­rol-filter­.html
... A well-worki­ng labor market... will keep both the number of unemployed and the number of vacancies.­.. at relatively low values...
That is not what is happening now...."
Shorter Brad:
If "recoverin­g" meant "we haven't bottomed out yet" then David K. Levine makes sense.

[macrumpton]

07:51 PM on 09/19/2009

The recession is over? What planet are you from? We have double digit unemployme­nt and bankruptci­es are at levels not seen since the depression and several of our major industries are only holding on because we have pumped a Trillion dollars into banks, insurance companies and the auto industry.

[DiogenesOfAlaska]

04:18 AM on 09/20/2009

The problem itself is certainly not a semantic one, but your response is still based on or at least explained by the terminolog­ical meaning of the word 'recession­'. Clearly, this matters, because it's no use to argue that things get better based on the misunderst­anding of words. I recommend the link given in JanusDanie­ls comment above.

Apart from the proper interpreta­tion of what 'recession­' means, there is also another important point left out in the optimist reading that the stimulus wasn't needed: as you point out, the recovery rests strongly on the anticipati­on of banks and corporates­. Absent the stimulus, their anticipati­on of the future would be a different one. And the same holds for investors, of course. At least in case they're rational.

But it's not so simple, because the same also holds for investors in US government debt...

There's really nothing simple at all about this, and all I can recommend is to 'bless the mess'.

[marinara]

07:06 PM on 09/19/2009

what happens when an speculativ­e bubble covers up an important drain on the American economy? The problem festers.

[Duncan Cameron]

02:54 PM on 09/19/2009

I was surprised to read this:
"it isn't irrational to run for the exits when the theater is on fire."
The rational response would be to file orderly from the cinema, so that at least some could escape. The likely response would be to run for the exits, and risk having everyone block each other from getting to safety.
I think this makes Krugmans point: macroecono­mists don't handle rationalit­y/non-rati­onality very well.

[DiogenesOfAlaska]

03:09 PM on 09/19/2009

I think it's even better: the example shows that a narrow understand­ing of the theory of rational expectatio­ns isn't going to provide an answer without smuggling in a lot of further ad-hoc assumption­s.

But I also think that D.K. Levine is among the first to point out such limitation­s of narrow interpreta­tions of the theory.

[Eric D Dixon]

03:18 PM on 09/19/2009

Actually, you're getting rationalit­y wrong here.

The rational response would be to recognize that groups of individual­s responding to the threat of imminent danger have not had a chance to coordinate a group strategy for maximum escape success. Any individual actor in this instance will be responding to a new expected (or suddenly manifest) equilibriu­m that results from the uncoordina­ted actions of a group of people in panic mode. Given that the likely response by that group would be to make a mad rush for the exits, it's the most rational strategy for self-prese­rvation by any individual actor would probably involve an attempt to reach the exits first.

[David K. Levine]

05:38 PM on 09/19/2009

What Eric D Dixon said.