Thursday, September 10, 2009

Friedman, Krugman and iceberg economics

The late Milton Friedman, as the Huffington Post reports, said this about the U.S. Federal Reserve in 1993:

"Having something like 500 economists is extremely unhealthy. As you say, it is not conducive to independent, objective research. You and I know there has been censorship of the material published. Equally important, the location of the economists in the Federal Reserve has had a significant influence on the kind of research they do, biasing that research toward noncontroversial technical papers on method as opposed to substantive papers on policy and results."

This is the Federal Reserve that brought you the Greenspan bubble and the "Bernanke Put" (and Bernanke has just been re-appointed) and the online newspaper's extensive investigations into the matter have revealed that

"The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession."

The full article is well worth reading: it notes, for example, that the Fed has budgeted an astonishing $433m for "analysis, research, data gathering, and studies on market structure;" much of this is doled out to consulting assignments, papers, presentations and so on and it "keeps many of the influential editors of prominent academic journals on its payroll."

"Try to publish an article critical of the Fed with an editor who works for the Fed," says (economist James) Galbraith. And the journals, in turn, determine which economists get tenure and what ideas are considered respectable.

As TJN officials have found for years, leading journals have tended to shun the "let a thousand flowers bloom" approach, in favour of a "our way or the highway" one.

The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

This is alarming enough. Then, link this to what the bomb-throwing Willem Buiter called the "‘cognitive regulatory capture’ of the Federal Reserve by Wall Street.

So you have two things happening here: first, Wall Street captures the Fed; then the Fed captures the economics profession. Houston, we have a problem.

And don't get us started on the Bank of England. As it happens, David Blanchflower, former member of the Bank's Monetary Policy Committee, has been speaking out about it in the New Statesman, noting that:

"Why did the committee get it so wrong? From my perspective, it was hobbled by "group think" - or the "tyranny of the consensus". Governor Mervyn King, the old iron fist of the Bank of England, with his hawkish views on rates, dominated the MPC. Short shrift was given to alternative, dovish views such as mine."

And he adds that:

"The Bank of England may more suitably be called "the Bank of Economic Theory". Unfortunately, the economic theories failed just when we needed them most.
. . .
There were too few regulators on the staff. Instead, the Bank was stocked full of mathematical modellers who had never seen the inside of a commercial bank or a hedge fund - and the models they used failed to pick up on the greatest financial crisis in a century."

And what has been the result? Well, I think we all have some kind of idea. If you want a thoughtful and intelligent, fresh perspective on this, try Paul Krugman's latest long article on the subject, who asks

"What happened to the economics profession? And where does it go from here?"

The answer seems to be - we need to tear up, or at least rewrite, most of our textbooks. Krugman's article is a very good read, if a bit long, and it explores the hubris of economists such as Robert Lucas of the University of Chicago, who declared in 2003 that the

“central problem of depression-prevention has been solved.”

You might call it iceberg economics. Everyone was focusing on this stuff that was going on the surface, while ignoring the darker, deeper and bigger "don't look under the water" realities - offshore and the overlapping shadow banking system, for example -- underneath.

And let's not forget another important ingredient: the deafening social silence.


Blogger Demetrius said...

Years ago I was suggesting that it would all end in tears. The Fed have never paid me a dime. Is this just a coincidence?

7:41 am  
Blogger Physiocrat said...

All of us are guilty of not looking beneath the surface of things. The financial jiggery-pokery, tax fiddling and the rest that is going on an overlay on one of the underlying issues, which is what happens to the economic rent of land.

A second issue which none of us have been paying proper attention to concerns usury. This is partly because of the highly abstract nature of the subject and partly because some of us do nicely with things as they are.

There appears to be a link between usury and land tenure, in that there is a division between owners who are rich and hold non-owners to ransom, and non-owners who are poor and need to get into debt. There is a further link in that land is used as collateral for loans, often given or taken imprudently for inappropriate purchases such as consumer spending, which is best paid for out of savings.

Tax Research is doing some good work but the underlying economic assumptions are Keynesian which is problematic. His theory of demand stimulation is open to abuse by politicians. It is one thing to go into debt to pay for infrastructure but another to just boost aggregate demand by pushing money into the system. One adds to wealth creating capacity, the other does not. During recession, all it does is pay for people to stay unwillingly at home living on a pittance from the state.

There is more. First, there is a link back to usury again. Tax Research, presumably following Keynes, is claiming that inflation is necessary to prevent the economy from grinding to a halt. One of the effects of inflation is that it reduces real interest rates to almost nothing. Could it be that inflation is needed to counteract the effect of interest?

Keynes famously claims that Say's Law is wrong. But there is a chicken-and-egg issue here. If there is a blockage in supply then Say's Law still holds in conditions of apparent over-supply. And there is such a potential blockage: the land market does not operate efficiently. In times of recession, land rents and land prices do not fall to market-clearing levels but stand empty. Sites are often vacant so long that shrubs and saplings grow to a sturdy size. Bearing in mind that the two primary factors of production are land and labour, shortage of land supply is precisely the blockage that could account for the apparent failure of Say's Law. One of the factors is literally locked out of use.

A further difficulty with Keynes concerns the concept of aggregate demand itself. Demand is not aggregate but particular. The market is supposed to respond to particularities. This is where easy consumer credit can distort the market. Aggregate demand is of course pumped up unrealistically but it is the particular that counts. Suppose, for instance, that entrepreneurs have identified a demand for luxury muscle cars. They raise credit and build a factory to produce the things. In order to recover the cost of their physical capital, they might have to sell a million units. When the demand turns out to have been based on lending on the strength of a land price bubble, then the apparent demand is shown to have been illusory. The luxury muscle car factory is then worth its value in scrap metal and the credit cannot be repaid. Suppliers of credit then get the jitters and the economy grinds into slump.

One effect of inflation is that it reduces the real price of land and land rents to a point that production can take place on them. This would explain why inflation appears to work but it is a "solution" that avoids dealing with the underlying problem.

It seems to me that many of the more influential economics of the twentieth century have given us insights that are a mixture of profundity and nonsense.

2:08 am  
Blogger Penn said...

Ben Bernanke and Milton Friedman:

12:48 am  

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