On Paul Krugman and His "Notes on the Floating Crap Game": Live from Crows Coffee

Paul Krugman appears to be suffering a crisis of confidence with respect to the value of the economics Academic "meritocracy" he surveys from his position at its peak:

Paul Krugman:
Notes on the Floating Crap Game (Economics Inside Baseball):
"Reading Fourcade et al....

...may explain one of the things that has puzzled me in the disputes over macro policy--namely, the seemingly unquenchable certainty among some of the freshwater guys that Keynesians are stupid. Again and again...freshwater macroeconomists declare that New [and old] Keynesians... don’t get some basic point... accounting identities [among others: Fama, Cochrane]... Ricardian equivalence [among others: Lucas, Cochrane, Lin, Prescott, Zingales, Boldrin]... the Euler condition [this seems to be Cochrane alone] (plus)... the Fisher equation [among others: Kocherlakota (but years ago), Williamson, Cochrane, Schmidt-Grohe, Uribe, Cowen, Andolfatto].

Each time it has turned out that the Keynesians understood the concepts perfectly well, and that it was the anti-Keynesians, in their haste to cry ‘Gotcha!’, who were making elementary logical errors or suffering failures of reading comprehension. You would think that at some point they’d catch on.... If your worldview says that Stan Fischer and Olivier Blanchard must be dumb, you have a problem. But they never do seem to learn. Why?... [Perhaps it is] economists’ reputation-based hierarchy interacting with the insularity of the freshwater macro school. People in that camp tuned out alternative views more than 30 years ago, so all they observe is their own repetitional universe....

The structure of academic economics. It’s hierarchical.... Are the reputations deserved? I used to think so. Hey, it worked for me. But the macro wars have been revealing: we’ve seen quite a few highly successful academics, with lots of widely cited papers, prove remarkably dense... people with big reputations who can push equations around but don’t seem to have any sense of what the equations mean. And they don’t even seem to know what they don’t know.... I guess I hope that these things are outliers. But if you feel cynical about economics after reading Fourcade, you may be right.

I find myself both less depressed about economics and more depressed about political economy than Paul Krugman is.

I find myself less depressed about economics because it seemed to me from 1980 on that both new-classical and real-business-cycle macro were unsustainable bubbles, largely for the reasons given by Ken Rogoff in his 2001 Mundell-Fleming Lecture:

At the time Rudi [Dorbusch] was working on his [overshooting] paper, the concept of sticky prices was under severe attack. In his elegant formalization of the Phelps island model, Lucas (1973) suggested one could understand the real effects of monetary policy without any appeal to Keynesian nominal rigidities, and by 1975 Lucas had many influential followers in Sargent, Barro, and others. The Chicago-Minnesota school maintained that sticky prices were nonsense, and continued to advance this view for at least another 15 years.

It was the dominant view and academic macroeconomics. Certainly there was a long period in which the assumption of sticky prices was a recipe for instant rejection that many leading journals. Despite the religious conviction among macroeconomic theorists the prices cannot be sticky, the Dornbusch model remained compelling to most practical international macroeconomists. This convergence of use led to a long rift between macroeconomics and much of mainstream international finance. Of course, today the pendulum has swung back entirely, and there is a broad consensus across schools of thought that some form of price rigidity is absolutely necessary to explain real-world data... Rotemberg and Woodford (1997), Woodford (2002).... Phelps-Lucas islands paradigm for monetary , for now, a footnote (albeit a very clever one) in the history of monetary theory.

There are more than a few of us in my generation of international economist who still bear the scars of not being able to publish the key price papers during the years of new classical repression. I still remember a mid-1980s breakfast with a talented young macroeconomic theorist from Barcelona who was of the Chicago-Minnesota school. He was a firm believer in the flexible-price Lucas islands model and spent much of the meal ranting and raving about the inadequacy of the Dornbusch model:

What garbage! Who still writes down models with sticky prices and wages! There are no microfoundation. Why do international economists think that such a model could have any practical relevance? It's just ridiculous!

Eventually the conversation turns and I ask:

So, how are you doing at recruiting? Your university has made a lot of changes.

The theorist answers without hesitation:

Oh, it is very hard for Spanish universities to recruit from the rest of the world right now. With the recent depreciation of the exchange rate, our salaries [that remained fixed in nominal terms] have become totally uncompetitive.

Such was life.

As I see it, Lucas's initial bet was that informational imperfections and the consequent confusion between nominal and real price changes where the drivers of the short-run accelerationist Phillips curve, and that credible monetary policies that eliminated any such confusion would stabilize output and employment. Milton Friedman warned at the time that this was silly--or, perhaps, that this was silly if one did not understand that the inflation "expectations" relevant to next year's price level were a long distributed lag of inflation expectations extending at least a generation into the past. And as model after model failed Lucas, Prescott, and their epigones doubled down, calling for better microfoundations and thinking up new statistical reasons why the correlations in the data that suggested that their research program was degenerating could be explained away.

Where Rogoff--and Krugman, and Blanchard--were wrong, of course, was in assuming that by the end of the 1990s the fever-bubble had spent itself. A little attention to graduate reading lists might have kept them from this misconception--as Matthew Shapiro would tend to say at least every other lunch: "You know, we assign their stuff in our courses, but they do not assign our stuff in their courses." But I am getting an increasing sense that the non-macroeconomists even in the most Chicago-oriented of departments are increasingly unhappy with and unwilling to hire more macroeconomists who cannot teach anything relevant to the world of the past decade.

My hope (and my expectation when I am optimistic) is that slots that have been earmarked for Chicago-Minnesota macroeconomists will be used, instead, to hire international macroeconomists and institutional growth economists.

However, the big problem, of course, is not that there are a bunch of people from Chicago-Minnesota claiming to be macroeconomists and talking nonsense--the big problem is not the Michele Boldrins and the John Cochranes and the Eugene Famas and the Niall Fergusons and the David Levines and the Robert Lucases and the Edward Prescotts and the Stephen Willliamsons and the Luigi Zingaleses and the others who either never learned or have forgotten how to mark their beliefs to market, and whose response to getting a prediction wrong is to try to add another epicycle to save the appearances.

The big problem, of course, is the freezing-up of economic policy. That is due to the dominance at so many levels in so many communities of two currents of thought. The first is, as Barack Obama put it at the very start of 2010:

Families across the country are tightening their belts and making tough decisions. The federal government should do the same. So tonight, I’m proposing specific steps to pay for the trillion dollars that it took to rescue the economy last year. Starting in 2011, we are prepared to freeze government spending for three years.... Like any cash-strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t. And if I have to enforce this discipline by veto, I will...

The second is the belief that even if the Wicksellian nominal natural interest rate that balances total spending with real potential output times the current level is zero, it is nevertheless for some vaguely-described financial-stability reason undesirable to keep interest rates that low unless necessary to avoid another recession. As Ben Bernanke put it:

The first risk is that rates will remain low, and the second is that they will not.... In an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe 'reach for yield'.... Alternatively... a risk that... rates will rise sharply... imposing capital losses.... The two risks may very well be mutually reinforcing.... [Bu] premature rate increases would carry a high risk of short-circuiting the recovery... and the economies of the major industrial countries are still in the recovery phase...

Now neither of these beliefs comes out of Chicago-Minnesota macroeconomics at all. Chicago-Minnesota macroeconomics does not see financial-stability risk at all. And Chicago-Minnesota macroeconomics has nothing to say about the level of the national debt other than that tax rates should be smoothed and the government right-sized.

Paul Krugman and others sometimes lament that if only the Lucases and the Prescotts had stayed out of the way, sensible macroeconomists would have been able to successfully lobby the political system for better policies. I think that is somewhat naïve. But writing down why I think that is somewhat naïve will have to wait for some other day...