Discretion Aside...

The Big Piece

Krugman's "big state-of-economics piece" is the focus of much attention, this fifteen minutes. Here is his conclusion:

"So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit... that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics...."

Here it is in shortform:
1. Economists have ignored the imperfection of markets.
2. Keynesian economics provides the best understanding.
3. Economics must incorporate the realities of finance.

Going thru the wormhole and coming out on my side, we get the following:

1. The Madness of Crowds

Krugman is obsessed with the vagaries of human nature. He is not alone in this, and "obsessed" may be too strong a word. But one of the impressions I got from his "big piece" is that he thinks economists have forgotten the role of animal spirits. This brings to mind what Wikipedia says of the Austrian School: "Austrians hold that the complexity of human behavior makes mathematical modeling of the evolving market extremely difficult (or undecidable) ...."

On the other side of that coin is Marx. His famous "From each according to his ability, to each according to his need" requires a total reconstruction of human nature. Which is the reason Marxism cannot work.

From the Marxist failure we learn that human nature cannot be changed. From the Austrians we learn that human behavior is complex. From Krugman we learn that economists have neglected human complexity. For Krugman, this is the real cause of the failure of economics. He writes:

"Actually, let me put it this way: the economy is a complex system of interacting individuals — and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both.... [And] the temptation is always to keep on applying these extreme simplifications, even where the evidence clearly shows that they’re wrong. What economists have to do is learn to resist that temptation."

And again, in the conclusion of his piece:

"When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly...."

I think not. I think that's totally the wrong way to go. I think economists have no business at all with human nature. Not to change it, like Marx. Not to use it as a reason to abandon mathematics, like the Austrians. And not to use it as an excuse for failure, like Krugman. (For more on human nature, see my September 1 post.)

2. The Framework

When the economy goes bad, people want to blame somebody. Alan Greenspan for example. Couple years back, he was loved by all. Now, held in contempt by most. Sad.

Our politicians in general, for example. We hold them in contempt, too. We think we know how to fix the economy and they just won't do it. But I don't think so. Because I think I know how to fix the economy, and I can't even find anybody who understands what I say.

Politicians are between a rock and a hard place. They think they know how to fix the economy, but their plans don't work. Or they cannot do the things they want to do, like balancing the budget. I'm not making excuses for politicians. I'm saying the generally accepted analysis of the economic problem is wrong, and so is the generally accepted solution. Which is why the problem remains.

And then there is Keynes. One of the smartest men who ever lived. You can tell, if you read his stuff. My opinion, he is dissed most by those least familiar with his work. Yes: Keynes provides the best framework. Keynes, plus my 12 pages.

3. The Realities of Finance

The simple reality is that we rely too much on finance.

There is a phrase, financial innovation. It means people keep inventing new forms of debt, like junk and derivatives and subprime. I don't care. The problem is not what we call it. The problem is, there's just too much of it. Too much debt. I know: People have been saying this since Perot. Since Reagan.

And now, now that we see the effects of excessive debt accumulation, people express concern about government debt. I don't get it. What about business and personal debt? The pot calling the kettle black. It was not the government that had to be bailed out last fall. It was Wall Street. And the banks. And the auto manufacturers. It was big business that had to be bailed out, and it was government that came to the rescue. And we dis the government for trying to prevent economic collapse. People are angry. They're not thinking clearly.

Krugman has a lot of lame argument saying that Obama's stimulus debt won't hurt the economy, and that even more of it won't hurt the economy. His argument is weak. But it has a juicy center. Actually, I think even Krugman misses the luscious core: Look at the size of government debt compared to all the rest of the debt. If the government's gets relatively bigger, and the rest gets relatively smaller, that is not a bad thing. Of course, less debt all around would be good. But if government debt going up makes ours go down, that is not bad.

(There is this notion I have from somewhere, that government debt tends to become money. If that's true, then government debt going up leads to the quantity of money going up. And if the quantity of money goes up more than total debt goes up, financial stress is relieved. Most people say debt must be reduced. I say debt must be reduced relative to the quantity of money in circulation.

Other factors, like inflation, are not to be ignored. But we are well aware of those factors. The thing that has been ignored is the quantity of debt relative to the quantity of money in circulation, this thing I call monetary balance. In our present circumstances, of course, it is a monetary imbalance.)

If there is too much debt, then obviously we rely too much on finance.

This graph (from my 12 pages) shows the state of monetary balance. After 1990, debt climbs so high that it makes the "correction" of the FDR years look insignificant.