For those not familiar with the Krug, he is an op-ed writer for the New York Times, recipient of the 2008 Nobel Prize in economics and widely considered to be the top Keynesian economist in America today.
He is also quite frequently wrong.
The inspiration for this post came while reading a 2009 article about the state of macroeconomic thought. Here Krugman and I have some common ground, we both would characterize the past few decades as a “Dark Age of macroeconomics”, pointing the blame for the housing crisis on the intellectual door step of Milton Friedman’s monetarism.
Where we differ, of course, is where we define the Golden Age.
Krugman makes his case that 2008 came due to an unhealthy faith in free markets:
“Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.
It is this view of economic history that is vital to progressive economic thought: the Great Depression was the consequence of the lassiez-faire policies of Silent Cal, Herbert Hoover and the capitalistic gluttony of the “Roaring Twenties”.
And then out from the darkness of worldwide depression rode a mustachioed British knight who arrived to save capitalism from itself. The man, the myth, the legend: John Maynard Keynes.
As Krugman writes:
“[Keynes challenged] the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.”
To put it another way, Keynes believed that markets were generally effective but needed the occasional government tending due to the ability of men to act irrationally and make poor choices. Slowness in the economy stems from a lack of demand for products, which leads to unemployment, which further lowers the demand for goods as people have less money to spend. When you see Obama sign a bill authorizing 550 billion dollars in government spending and an extra $150 billion in tax cuts under the title of “stimulus”, this is Keynesianism in action.
So what caused the economic crisis, according to Keynesianism? A superabundant faith in markets led by Federal Reserve’s Maestro Alan Greenspan (a disciple of Ayn Rand after all!) Banks made risky bets on mortgages in search of profits and when they failed brought down the economy with them. Bastards.
But does this mesh with reality?
Fed Chairman Bernanke once wrote, “To Understand the Great Depression is the Holy Grail of macroeconomics.” As such, let’s begin with the Keynesian view of the Great Depression. Keynes believed that the Great Depression was the cause of overinvestment and under consumption. He placed a heavy emphasis on consumer confidence; that under consumption could be caused by economic pessimism. For this, Keynes coined the term “animal spirits” (which is why prosperous markets are described as Bull markets, falling markets as Bear). This was why government spending was vital. If producers knew that there would be a guaranteed consumer for goods and services (the government), they would increase production and increase employment. More jobs meant more income, more income meant more consumer spending – this acted like a defibrillator to the general economy. Economists and government officials came to really dig this economic theory because it increased the influence of both groups.
Friedman’s monetarists, on the other hand, viewed bad monetary policy as the cause of the Depression. Along with his partner Anna Schwartz, in his classic study, A Monetary History of the United States, Friedman pointed to* the uncertainty thrust into the financial market due to the death of Benjamin Strong, the governor of the Federal Reserve Bank of New York causing a panic through the financial system, resulting in a 31% decrease in the money supply*. In 1931 the Federal Reserve actively worked to further decrease the money supply by raising interest rates as a reaction to fears of a devalued currency, sparked by Britain’s move off the gold standard. Friedman calls this time the “Great Contraction”. As Friedman puts it:
“It happens that a liquidity crisis in a unit fractional reserve banking system is precisely the kind of event that trigger- and often has triggered- a chain reaction. And economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse”
The solution, says Friedman, would have been to for the Federal Reserve to increase the money supply to avoid the contraction. As Ben Bernanke, a proud Friedmanite, wrote in his paper The Macroeconomics of the Great Depression: A Comparative Approach, “In particular, the evidence for monetary contraction as an important cause of the Depression, and for monetary reflation as a leading component of recovery, has been greatly strengthened.” (pg 26-27)
A careful eye would already identify an early conflict. Keynesians view the lack of government intervention caused the Depression, Monetarists blame government policy for the Depression. Both solutions, however, rely upon government intervention to fuel an increase in demand for goods.
Which, if either, is right?
Going back to Krugman’s assertion that the Great Depression was the result of reckless lassiez-faire policy, a frequent progressive talking point – let’s look at record. As pointed out earlier, the Roaring 20’s were fueled by an aggressive policy of inflation pushed by the Federal Reserve – a government interventionist act. It is true that Calvin Coolege was a devoted individualist and an advocate of lassiez-faire capitalism, but he was not in charge of the money supply. The Federal Reserve was established in 1919 and monetary policy has since resided with the central bank.
The “Herbert Hoover as an advocate of lassiez-faire” card gets a bit daffier. It is often forgotten that while Herbert Hoover later became an opponent of government intervention, he was initially a Progressive politician. In fact Progressive Democrats sought a Hoover/FDR ticket for the 1920 election until Hoover joined the Progressive Republicans.
President Hoover, far from being a hand’s off President, reacted to the growing economic crisis with a plan consisting of the following:
-Establish a Reconstruction Finance Corporation, which would use Treasury funds to lend to banks, industries, agricultural credit agencies, and local governments;
-Broaden the eligibility requirement for discounting at the Fed
-Create a Home Loan Bank discount system to revive construction and employment measures which had been warmly endorsed by a National Housing Conference recently convened by Hoover for that purpose
-Expand government aid to Federal Land Banks
-Set up a Public Works Administration to coordinate and expand Federal public works
-Legalize Hoover’s order restricting immigration
-Do something to weaken “destructive competition” (i.e., competition) in natural resource use
-Grant direct loans of $300 million to States for relief
-Reform the bankruptcy laws
-Fund and protect railroads from unregulated competition
He then raised income taxes and enacted the protectionist Smoot Hawley Tariff. The massive unemployment that often characterizes the Great Depression today stemmed from Hoover’s lobbying of private companies not to decrease wages. As Hoover’s Secretary of Labor proclaimed,
There never has been a crisis such as we have had as the stock market crash that threw … millions out of employment that there wasn’t a wholesale reduction in wages. … If Hoover accomplishes nothing more in all of his service to the government, that one outstanding thing of his administration — no reduction in wages — will be a credit that will be forever remembered not by the working classes alone but by business men as well, because without money in the pay envelope business is the first to suffer.
The lack of reduction in wages created the phenomenon of “sticky wages” which kept unemployment levels high.
So the Krugman-Keynes theory of the great depression, that a lack of government intervention into the markets created the depression, seems to have a few leaks. But what about Milton Friedman’s?
As Krugman mentions in his post, Friedman’s Chicago School became the dominant trend in macroeconomics as the 20th century continued. Alan Greenspan relied upon monetarist theory in response to the bursting of the dot-com and telecom bubble, along with the economic fallout from 9/11, by lowering the interest rate (which serves to increase the money supply). It should be noted that this was also advocated by Krugman.
According the Austrian School, whose economists identified the housing bubble years before Greenspan, Bernanke and Krugman, the answer to the Great Depression does not lie in 1929-33, but during the Roaring 20’s itself. From the period of 1921-1929 the money supply enjoyed an annual increase of 7.7%, a surplus of 28 billion dollars (pg 60-61). An important and often overlooked factor of inflation is that this new money is not distributed evenly overnight. The money is created by the Federal Reserve and then pumped into the banks; the banks then lend this new cash out. This increases the amount of long-term investments in the economy (residential and commercial housing, capital production, etc.) since loans are typically made for project development, not immediate consumption. Just as the period before 2008 witnessed rapid growth in housing construction (and thus rapid growth in all economic players that go into construction), so did the 20’s.
While this new money is going out, it gives the impression of increased wealth. Unfortunately it’s fool’s gold. Money itself has no value; it is production and effort that makes currency valuable. As the money makes its way through the economy, prices adjust to change in the money supply and adjust accordingly.
Unfortunately during this process, the false market indicators of the inflated currency have short and long term consequences. The consumption of resources (commodities, labor, capital, buildings) is skewed. This is what causes unemployment during a recession. More people were employed in the housing industry, for example, than there was real market demand to sustain. More houses and condos were built in areas like Panama City Beach and Phoenix than were really needed.
The solution to such a crisis, says Austrian economist Murray Rothbard, is:
In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers’ goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.
Unfortunately instead of following the advice of Rothbard, we have continued the path of Hoover, with the added joy of radical inflation to the money supply.
Those that follow the news would be prone to believe that while the economy is not recovering rapidly, we have avoided catastrophe. Don’t fault me for not being as optimistic.