The Era of Instability: Where We Went Wrong

Monday, 27 December 2010 15:22 By Paul Krugman, Krugman & Co. | Op-Ed | name.

The Era of Instability: Where We Went Wrong
(Image: HAJO / studiohajo.nl / CartoonArts International)

It seems that in the United States, our perception of history has changed in the wake of the Great Recession. J. Bradford DeLong, a professor of economics at the University of California at Berkeley, makes this point in an online syndicated column about how our generation used to pity our grandfathers, who lacked the knowledge and compassion to fight the Great Depression effectively, and how we are repeating the same mistakes today.

I share his sentiments.

Witnessing the failure of economic policy over the past three years has led me to suspect that the kind of moderate economic policy regime that Mr. DeLong and I support - one that largely takes a hands-off approach to the markets, but where the government is always standing by to rein in excesses and fight slumps - is inherently unstable.

It can last for a generation or two, but not much longer. And I am not only referring to financial instability - intellectual and political instability are equally crucial.

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Intellectual Instability

The most reasonable approach was largely established by Paul Samuelson in 1948, in his classic textbook "Economics": he combined the grand tradition of microeconomics, with its emphasis on the markets’ tendency to self-regulate (which leads to generally desirable outcomes), with Keynesian macroeconomics, which takes into account the ways that the economy can get into trouble, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only then do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach - but it’s also intellectually unstable, because it requires some strategic inconsistency in how you think about the economy. On the micro scale, you must assume that individuals are rational and markets will rapidly clear (that markets will adjust so that supply is equal to demand); on the macro scale, you must assume that there will be market frictions and individuals will sometimes behave irrationally.

Economists were bound to push at the dividing line between micro and macro -which in practice has meant trying to make macro more like micro, basing more and more of the theory on optimization and market-clearing. And it was probably inevitable that a substantial number of economists would simply ignore the realities of the business cycle that didn’t fit their models.

Now, the result is what I’ve called the Dark Age of Macroeconomics, during which large numbers of economists have been ignorant of the hard-won insights of the 1930s and 1940s _ and, of course, go into spasms of rage when their ignorance is pointed out.

Political Instability

In practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of the socialist wedge.

I’ve always considered monetarism (the belief that controlling the rate of increase of the money supply is the key factor in stable economic growth) to be, in effect, an attempt to assuage conservative political prejudices without denying macroeconomic realities. But when monetarism failed, especially in the 1970s and early ‘80s - these are fighting words, but it really did fail - it was replaced by the cult of the independent central bank. A bunch of bankerly men were put in charge of the monetary base, insulated from political pressure, and left to deal with the business cycle; meanwhile, everything else was conducted on free-market principles.

This worked for a while - roughly speaking, from 1985 to 2007 - in part because the political insulation of the central banks gave them intellectual insulation, too.

If we’re living in the Dark Age of Macroeconomics, the central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world.

But this system, too, was unstable. Sooner or later, there was bound to be a shock that would be too big for the central bankers to handle without help from broader fiscal policy. Sooner or later, the barbarians were going to go after the monasteries too. As the current furor over quantitative easing in the United States shows, the invading hordes have finally arrived.

Financial Instability

The very success of central-bank-led stabilization combined with financial deregulation set the stage for a crisis too big for central bankers to handle.

So, when the really big shock arrived, it pushed the economy straight into a liquidity trap.

The descent into the intellectual Dark Age combined with the rejection of fiscal policy changes on political grounds left us unable to agree on a response. The era of the Samuelsonian synthesis was, I fear, always doomed to come to a nasty end.

The result is the wreckage we see all around us. 

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including "The Return of Depression Economics" (2008) and "The Conscience of a Liberal" (2007).

Copyright 2010 The New York Times.

Last modified on Tuesday, 28 December 2010 13:05