Krugman Illustrates Caplan’s Point

In January 2019, co-blogger Bryan Caplan wrote:

The theory of market failure is a reproach to the free-market economy.  Unless you have perfect competition, perfect information, perfect rationality, and no externalities, you can’t show that individual self-interest leads to social efficiency.*  And this anti-market interpretation is largely apt.  You can’t legitimately infer that markets are socially optimal merely because every market exchange is voluntary.

Contrary to popular belief, however, market failure theory is alsoa reproach to every existing government.  How so?  Because market failure theory recommends specific government policies – and actually-existing governments rarely adopt anything like them.

What we also often see and, depressingly, even usually see, is that economists who are pro-government intervention to fix market failures have a much lower standard for the government than they have for the market. So the odds are that avoiding the specific government policy being proposed would get us closer to the optimum than implementing the government policy.

A case in point is Paul Krugman and his views on the recent $1.9 trillion spending bill. In Benjamin Wallace-Wells, “Larry Summers versus the Stimulus,” March 18, 2021, Wallace-Wells makes that point, although I’m not sure that that’s his intention.

Wallace-Wells, describing a recent debate between Krugman and Larry Summers about the Biden spending plan, writes:

Krugman asked, rhetorically, which elements of the package Summers would cut. Not the public goods, like vaccination and funds for school reopening, and surely not the needed income support. What was left was the part that members of Congress had most vociferously demanded: the aid to state and local governments (which Krugman agreed probably exceeded the fiscal need) and the checks to people who had not much suffered. Krugman said, “The checks, which are the least-justifiable piece in terms of standard economics, are also by far the most popular, and I don’t think we can entirely disregard that.”

Put aside the fact that the funds for school reopening are almost certainly not justified because the risks to students and teachers are so low. Notice what even Krugman admits. First, that the aid to state and local governments is too much, even by his standards. Second, the checks to people who hadn’t suffered much, which are a huge part of the package, are the “least-justifiable piece in terms of standard economics.” And what’s Krugman’s justification for those payments? That they are “by far the most popular” and, for that reason, we can’t “entirely disregard that.”

In short, in order to get hundreds of billions in spending that Krugman thinks are justified, he is willing to have the government spend other hundreds of billions for things that are not justified. Such is the nature of many, perhaps most, economists’ advocacy of government policy.

Note: The picture above is of a Rube Goldberg machine, which is what I think a lot of government policy is like. There is one difference. The Rube Goldberg machine always worked.


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If it ain’t broke . . .

Paul Krugman has a new Substack, and his first post revisits the famous cycle of rising inflation and disinflation during the 1970s and 1980s, which led to a revolution in macroeconomic theory.  The subtitle is:

Did we get the whole macro story wrong?

I’m going to argue that the answer is “no”.

The model that won out in the 1970s and 1980s was mostly developed by monetarists like Milton Friedman, who argued that the Phillips Curve was an unreliable policy tool and that expansionary demand-side policies would have only a temporary effect on unemployment.  Once expectations of inflation caught up to reality, unemployment would return to its natural rate.

Krugman suggests that he initially accepted much of this thesis, but now has some doubts. In my view he’s focusing too much on the Keynesian interpretation of Friedman’s argument, which makes the data look more puzzling than it actually is.

In Friedman’s Natural Rate model, unexpectedly high inflation causes low unemployment, and vice versa. The Keynesian version of the same model reversed the causation. Now it’s low unemployment (i.e. “economic overheating”) that causes high inflation.

To give a sense of how this distinction matters, consider this comment by Krugman:

The truth is that I’ve always been a bit uneasy about the standard story of inflation in the 1970s, even though it seemed to fit the prediction of clockwise spirals. My uneasiness came from the sense that the economy never seemed to run hot enough to explain such a big rise in inflation. I actually remember the 70s! And while there were years of good job markets, they never felt as good as the 60s, the late 90s, or 2019.

But that’s not at all a problem for monetarist theory, as the monetarists always insisted that inflation was not caused by a hot economy, it was caused by rapid money supply growth. And monetarists also suggested that the effect would be quite transitory, with unemployment returning to its natural rate after a few years.  And finally, the natural rate was itself volatile, and could not be used as a guide to stabilization policy.  (To be fair, the preferred monetarist indicator, money supply growth, also eventually turned out to be faulty.)

Rapid growth money pushed unemployment down below 4% in the late 1960s, as inflation soared.  This fits the monetarist model.  Then it rose back to its natural rate during the 1970s, rising above that rate during occasional periods of disinflation or adverse supply shocks.  This also fits the monetarist model.

So Krugman’s right that the 1970s don’t fit the Keynesian interpretation of Friedman’s Natural Rate model (low unemployment cause high inflation), but the data does fit Friedman’s actual Natural Rate Hypothesis, if you assume rapid money growth and sprinkle in a few supply shocks.  The Keynesian model says high inflation should have delivered a booming 1970s, the monetarist version does not.  To the monetarists, the employment gains from stimulus were mostly exhausted by 1969.

Much of the discussion is framed in terms of the slope of the “Phillips Curve”, which I view as an unhelpful construct.  People debate whether the Phillips Curve is flat or steep, which is like debating whether the price and quantity combination in the apple market is flat or steep.  It entirely depends on the nature of the shocks hitting the economy.

If inflation fluctuates wildly between 0% and 12%, as it did from 1945 to 1982, and unemployment also fluctuates, then the Phillips curve will likely not be flat.  If a central bank successfully targets NGDP growth at a stable rate, then the Phillips Curve will likely slope the wrong way.  And if the central bank keeps inflation close to 2% (as they’ve mostly done since 1990), and unemployment moves around for reasons unrelated to inflation, then the Phillips Curve will be fairly flat. But the slope of the Phillips Curve is not a deep parameter of the economy; it’s an outcome that is contingent of the sorts of real and nominal (or supply and demand) shocks hitting the economy.

Perhaps the most interesting aspect of Krugman’s post is his discussion of some research by Jonathon Hazell, Juan Herreño, Emi Nakamura & Jón Steinsson (HHNS), which re-examines the Volcker disinflation:

Now, the Friedman/Phelps story behind clockwise spirals did involve changing expectations: high unemployment was supposed to lead to lower actual inflation, which would over time be reflected in lower inflation expectations, which would feed through to further inflation declines. But the 80s decline is too fast to be explained that way, and seems to have started a bit before actual inflation came down.

They [HHNS] suggest that there was a regime shift: When people realized that Volcker was really willing to put the economy through the wringer, they marked down their expectations of future inflation in a way that went beyond the mechanical link via unemployment.

I think HHNS are correct, but not because Friedman was wrong.  As noted above, Krugman seems to assume that Friedman advocated the Keynesian interpretation of the Phillips Curve—unemployment causes low inflation.  Instead, Friedman argued that high unemployment is caused by lower than expected inflation. And both are ultimately caused by tight money.

Nonetheless, the HHNS research does present one problem for Friedman’s monetarism—why did inflation expectations fall quickly with a decline in the actual rate of inflation?  Friedman used an adaptive expectations model, where a decline in actual inflation should lead to a decline in expected inflation with a substantial lag.

Krugman then discusses other examples of where “regime changes” quickly broke the back of inflation, such as Spain after joining the euro.

Fortunately, there is another model that can explain the HHNS findings—rational expectations.  When the public saw that Volcker was serious about reducing inflation, the expected rate of inflation fell faster than what one would predict using an adaptive expectation model. And this also explains why inflation fell faster than predicted by Keynesian models that focus on causation going from unemployment to disinflation.  Unfortunately, Krugman has already dismissed the usefulness of rational expectations models:

Second, since the Friedman/Phelps prediction was based on trying to assess what rational price-setters would do, their apparent success gave a big boost to the notion that all economics should be based on maximizing behavior. Friedman always had too strong a reality sense to personally go down the rational-expectations rabbit hole that swallowed much of macroeconomics, but given the law of diminishing disciples it was bound to happen.

Not surprisingly, Krugman fails to draw the conclusion that HHNS’s interpretation of the Volcker disinflation is a big win for rational expectations models.

In fairness, the most extreme forms of Ratex models don’t fit the Volcker disinflation.  Some economists argued that inflation could be brought down costlessly if the policy of disinflation were fully credible.  I always doubted that view, due to sticky nominal wages.  Furthermore, in practice any disinflation will almost never be fully credible.  After all, Volcker first tried to bring inflation down in early 1980.  Then, after unemployment soared in the spring, Volcker reversed course and cut rates sharply (before the November election), and then made a renewed attempt to bring down inflation in the spring of 1981.   This time he persisted, but can you blame the public for being somewhat skeptical?

Krugman is right that macro took a wrong turn in the 1980s, and is also correct that the conservative wing of the profession was especially prone to going down “rabbit holes”.  But the actual problem was not too much reliance on the rational expectations; it was too much reliance on “classical” models where labor and goods markets are assumed to be in equilibrium.  (Actual classical economists believed in sticky wage models.)

To summarize, unemployment rose sharply during the Volcker disinflation, but if one uses a Keynesian model then the rise was not large enough to fully explain the Volcker disinflation.  Friedman’s adaptive expectations model of inflation also fell short.  Instead, the best model seems to be rational expectations combined with an assumption that the Volcker disinflation was partly anticipated and partly unanticipated—as if the public thought he had perhaps a 50% chance of successfully bringing inflation down before political pressures forced him to relent.

To me, that seems like a triumph of Chicago school economics (before it went off course), not an unexplained phenomenon that cries out for a new explanation.

PS.  I don’t like either the (old) monetarist or the Keynesian view of causation (P –> U or U –> P).  Instead, monetary policy causes NGDP growth, which causes trend inflation.  Variations in inflation are caused by either supply shocks (when NGDP growth is stable) or demand shocks (variations in NGDP growth.)  Unemployment fluctuations are mostly caused by unanticipated moves in NGDP growth, i.e. “monetary policy”, properly defined.

HT: Tyler Cowen



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Eric Hoffer on “Property Rights” in Jobs

I’ve written before about how “The Box,” that is, containerization, slashed the cost of international trade, thus leading to more of it. My guess is that that reduction in cost was the equivalent of dropping tariffs by at least 5 percentage points.

I quoted the famous statement by Paul Krugman that put it nicely:

The ability to ship things long distances fairly cheaply has been there since the steamship and the railroad. What was the big bottleneck was getting things on and off the ships. A large part of the cost of international trade was taking the cargo off the ship, sorting it out, and dealing with the pilferage that always took place along the way. So, the first big thing that changed was the introduction of the container. When we think about technology that changed the world, we think about glamorous things like the internet. But if you try to figure out what happened to world trade, there is really a strong case that it was the container, which could be hauled off a ship and put into a truck or a train and moved on.

The quote is from here.

Like Krugman, I’m a big fan of Marc Levinson’s The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger, Princeton University Press, 2006.

I happened to page through Levinson’s book the other day looking for something on the famous Harry Bridges, leader of the International Longshoremen’s and Warehouseman’s Union (ILWU). He was very important in the West Coast economy in the 1950s and 1960s, and especially the San Francisco Bay Area economy. Not that I was looking for this, but, as one wag put it when Bridges’s power was near its height, “In San Francisco, there are three bridges: the Golden Gate Bridge, the Oakland Bay Bridge, and Harry Bridges.”

In the process I found an interesting tidbit on Eric Hoffer, the author of The True Believer. (That’s a picture of him above.)

In 1960, employers on the West Coast were trying to clear the decks (pun intended) for mechanization and so they had a bright idea: compensate port workers with the amount of compensation scaled according to how long they had worked.

Levinson writes that in return for “near-total flexibility, the employers agreed to pay $5 million per year.” That was a lot of money in 1960 dollars. Longshoremen with 25 or more years of service would get $7,920, which was about 70 weeks’ base pay, upon retirement at age 65. They would also get the $100 per month ILWU pension. Workers aged 62 to 65 “would be paid $220 a month until age 65 if they retired early.” Others were guaranteed wages on 35 hours of work weekly even if their services weren’t needed. Levinson adds, “Anyone hired as a longshoreman after the agreement was signed would never be eligible for the guarantee because, as a union spokesman explained, ‘they will not have given un anything.’”

I think that most economists who looked at this agreement would approve of it as a way of compensating losers in a relatively efficient way. Eric Hoffer didn’t like it.

Levinson writes:

More than one-third of the ILWU’s members voted no. Some opponents, such as San Francisco’s famed longshoreman-philosopher Eric Hoffer, were outraged on ideological grounds. “This generation has no right to give away, or sell for money, conditions that were handed on to us by a previous generation,” Hoffer stormed.

In short, Hoffer saw the right to a job as an inalienable right.


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Krugman on the effect of increased money growth

Tim Peach directed me to a graph in Paul Krugman’s International Economics textbook (coauthored with Maurice Obstfeld and Marc J. Melitz.) It’s a very elegant display of the long run effect of an acceleration in the money supply growth rate (and roughly describes the US economy from 1963-73):

Here’s how to read these graphs.  Graph A shows the money growth rate increasing, say from 5%/year to 8%/year (a steeper slope to the line).  Graph C shows that the growth rate of the price level also increases due to the quantity theory of money.  Prices take a sudden jump at time=0, which we’ll consider later.

In Graph B you see the nominal interest rate jump up at time=0 due to the Fisher effect—higher inflation leads to higher nominal interest rates.  Because the nominal interest rate is the opportunity cost of holding money, this causes money demand to fall at time=0, or if you prefer it causes velocity to rise.  Going back to graph C, this drop in money demand explains the sudden jump in the price level at time=0.  The bottom line is that when money growth accelerates, prices rise even faster than the money supply, as there’s less demand to hold zero interest money.  Both the growing money supply and falling money demand push prices higher.

And in Graph D we see the exchange rate follow the price level, due to purchasing power parity.  BTW, an increase in the price of euros means the dollar is actually depreciating.

This is roughly what happened during 1963-73, and the analysis is right out of Milton Friedman’s monetarism.  Money growth accelerated, inflation accelerated, nominal interest rates rose, and the dollar depreciated.  The process was less smooth than you see here, because in the real world prices are sticky and hence the price level does not jump discontinuously when money growth accelerates.

This exercise helps us to understand the difference between New Keynesians like Krugman and MMTers.  Both groups tend to agree on policy at zero interest rates, favoring fiscal stimulus and not worrying about crowding out.  Both are skeptical of the efficacy of monetary policy at zero rates (although MMTers are even a bit more skeptical than New Keynesians.)

It is when nominal interest rates are positive that the two schools of thought sharply diverge.  When I try to explain the views of MMTers I get shot down.  But that’s never stopped me before, and so I’ll try again here.  I believe that MMTers would start by claiming that the Fed can’t increase the money supply growth rate, as money is “endogenous”.  If you insisted that they consider what would happen if the Fed persevered in trying to force more reserves into the economy, they’d argue that this would drive rates to zero.  Krugman is arguing that faster money growth raises interest rates in the long run.  This difference helps to explain why Krugman differs from MMTers on the existence of a “money multiplier”.

MMTers would claim that driving interest rates to zero would cause banks to hoard most of the new money, and thus it would not have a multiplier effect.  They’d also suggest that it would have relatively little impact on the price level, as aggregate demand is determined by spending, not the stock of bank reserves.

Both New Keynesians and monetarists argue that the Fisher effect is very important when thinking about the long run effect of a change in the money growth rate.  In contrast, MMTers seem to pretty much ignore the Fisher and income effects, and view interest rates as being set by the central bank via the liquidity effect.  An exogenous increase in the money supply growth rate would lead to lower interest rates, in their view.  Because central banks target interest rates, MMTers assume money is endogenous.  They basically ignore the vast empirical literature on the “superneutrality of money” when the money growth rate changes.

To be a good macroeconomist, you need to hold two models in your head simultaneously.  One is the long run flexible price classical model, such as Krugman illustrates in the graph above.  The other is the short run sticky price model, which has special characteristics at zero interest rates.   Krugman’s a brilliant macroeconomist, and thus is not attracted to MMT models that have no tools for evaluating the long run impact of changing money supply growth rates.



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Casey Mulligan’s Excellent Adventure

A sharply dressed bearded man stood up near the door of the White House meeting room and bellowed, “HHS, you need to hear the OMB loud and clear: your AKS RIA is DOA!” and exited the meeting. As several others filed out of the room behind him, I leaned toward CEA’s General Counsel Joel Zinberg and whispered, “That must be a world record for number of acronyms in one sentence. What the hell does it mean?” Joel chuckled and said, “I have no idea, except that we’re going to enjoy working with that guy.”

“That guy” was Joel Grogan, a high-level Trump appointee in the Office of Management and Budget (OMB). The quote is from You’re Hired: Untold Successes and Failures of a Populist President, by University of Chicago economist Casey B. Mulligan. It’s about his time as the chief economist at President Trump’s Council of Economic Advisers (CEA) for the 2018–19 academic year. Oh, and Mulligan did enjoy working with Grogan. I’ll tell why later.

I’ve respected Mulligan’s work for about a decade. He’s a first-rate economist who, by relentlessly applying economic thinking to policy issues, reaches important conclusions.

But I was not a fan of his too-academic writing style. In a 2013 review, I wrote that his 2012 book, The Redistribution Recession: How Labor Market Distortions Contracted the Economy, “could have been one of the most important books of 2012.” Even I, a PhD economist, found it hard slogging. I don’t know what writing pill Mulligan took, but his latest book is profound, important, entertaining, economically solid, and easy to read. It will be one of the most important books of 2020.


The above is from David R. Henderson, “Economic Savvy in the White House,” Defining Ideas, October 8, 2020.

Another excerpt:

Mulligan himself realized that he needed to “think like a Democratic Congress” to help Trump deal with hostile Democrats in Congress. Here’s how Mulligan characterizes the mindset of the twenty-first-century Democratic Congress: “that big government is likely to achieve big progress, that incentives are of second-order importance, that the title of a bill need not reflect its contents, and that profits are glorified theft by private business from workers and consumers.” Mulligan also regularly read economist Paul Krugman’s tweets. Why? They “proved helpful for predicting mistakes that would be made by the president’s opponents.”

Read the whole thing.

HT to John Cochrane.


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