Krugman: Irish Monk or Norse Raider?

Paul Krugman is fond of describing the current state of macroeconomics as a dark age — starting around 1980, the past 50 years’ progress in economics was forgotten. True that. If we want to tell a coherent story about the operation of modern capitalist economies, we could do a lot worse than start with the mainstream macro of 1978.

Thing is, as Steve Keen among others has pointed out, liberal New Keynesians like Krugman are every bit as responsible for that Dark Age as their rivals at Chicago and Minnesota. Case in point: His widely-cited 1989 paper on Income Elasticities and Real Exchange Rates. The starting point of the paper is that floating exchange rates have not, in general, adjusted to balance trade flows. Instead, relative growth rates have roughly matched the growth in relative demand for exports, so that trade flows have remained roughly balanced without systematic currency appreciation in surplus countries or depreciation in deficit countries. Krugman:

The empirical regularity is that the apparent income elasticities of demand for a country’s imports and exports are systematically related to the country’s long-term rate of growth. Fast-growing countries seem to face a high income elasticity of demand for their exports, while having a low income elasticity of demand for imports. The converse is true of slow-growing countries. This difference in income elasticities is, it turns out, just about sufficient to make trend changes in real exchange rates unnecessary.

The obvious explanation of this regularity, going back at least to 1933 and Roy Harrod’s International Economics, is that many countries face balance-of-payments constraints, so their growth is limited by their export earnings. Faster growth draws in more imports, forcing the authorities to increase interest rates or take other steps that reduce growth back under the constraint. There are plenty of clear historical examples of this dynamic, for both poor and industrialized countries. The British economy between the 1940s and the 1980s, for instance, repeatedly experienced episodes of start-stop growth as Keynesian stimulus ran up against balance of payments constraints. Krugman, though, is having none of it:

 I am simply going to dismiss a priori the argument that income elasticities determine economic growth… It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth… Furthermore, we all know that differences in growth rates among countries are primarily determined in the rate of growth of total factor productivity, not differences in the rate of growth of employment; it is hard to see what channel links balance of payments due to unfavorable income elasticities to total factor productivity growth. Thus we are driven to a supply-side explanation…

Lucas or Sargent couldn’t have said it better!

Of course there is a vast literature on balance of payments constraints within structuralist and Post Keynesian economics, exploring when external constraints do and do not bind  (see for instance here and here), and what channels might link demand conditions to productivity growth. [1] Indeed, Keynes himself thought that avoiding balance-of-payments constraints on growth was the most important goal in the design of a postwar international financial order. But Krugman doesn’t cite any of this literature. [2] Instead, he comes up with a highly artificial model of product differentiation in which every country consumes an identical basket of goods, which always includes goods from different countries in proportion to their productive capacities. In this model, measured income elasticities actually reflect changes in supply. But the model has no relation to actual trade patterns, as Krugman more or less admits. Widespread balance of payments constraints, the explanation he rejects “a priori,” is far more parsimonious and realistic.

But I’m not writing this post just to mock one bad article that Krugman wrote 20 years ago. (Well, maybe a little.) Rather, I want to make two points.

First, this piece exhibits all the pathologies that Krugman attributes to freshwater macroeconomists — the privileging of theoretical priors over historical evidence; the exclusive use of deductive reasoning; the insistence on supply-side explanations, however implausible, over demand-side ones; and the scrupulous ignorance of alternative approaches. Someone who at the pinnacle of his career was writing like this needs to take some responsibility for the current state of macroeconomics. As far as I know, Krugman never has.

Second, there’s a real cost to this sort of thing. I constantly have these debates with friends closer to the economics mainstream, about why one should define oneself as “heterodox”. Wouldn’t it be better to do like Krugman, clamber as far up the professional ladder as you can, and then use that perch to sound the alarm? But the work you do doesn’t just affect your own career. Every time you write an article, like this one, embracing the conventional general-equilibrium vision and dismissing the Keynesian (or other) alternatives, you’re sending a signal to your colleagues and students about what kind of economics you think is worth doing. You’re inserting yourself into some conversations and cutting yourself off from others. Sure, if you’re Clark medal-winning Nobelist NYT columnist Paul Krugman, you can turn around and reintroduce Keynesian dynamics in some ad hoc way whenever you want.  But if you’ve spent the past two decade denigrating and dismissing more  systematic attempts to develop such models, you shouldn’t complain when  you find you have no one to talk to. Or as a friend says, “If you kick out Joan Robinson  and let Casey Mulligan in the room, don’t be surprised if you spend all  your time trying to explain why the unemployed aren’t on vacation.”

[1] “In practice there are many channels linking slow growth imposed by a balance of payments constraint to low productivity, and the opposite, where the possibility of fast output growth unhindered by balance-of-payments problems leads to fast productivity growth. There is a rich literature on export-led growth models (including the Hicks supermultiplier), incorporating the notion of circular and cumulative causation (Myrdal 1957) working through induced investment, embodied technical progress, learning by doing, scale economies, etc. (Dixon and Thirlwall, 1975) that will produce fast productivity growth in countries where exports and output are growing fast. The evidence testing Verdoorn’s Law shows a strong feedback from output growth to productivity growth.”

[2] Who was it who talked about “the phenomenon of well-known economists ‘rediscovering’ [various supply-side stories], not because  they’ve transcended the Keynesian refutation of these views, but because  they were unaware that there had ever been such a debate”?

Bond Market Vigilantes: Invisible or Inconceivable?

Brad DeLong is annoyed with people who are scared of invisible bond-market vigilantes. And he’s right to be annoyed! It’s extraordinarily silly — or dishonest — to claim that the confidence of bondholders constrains fiscal policy in the United States. As he puts it, “Any loss of confidence in the long-term fiscal stability of the United States of America” is an “economic thing that does not exist.”

So he’s right. But does he have the right to be right?

I’m going to say No. Because the error he is pointing to, is one that the economics he teaches gives no help in avoiding.

The graduate macroeconomics course at Berkeley uses David Romer’s Advanced Macroeconomics, 3rd Edition. (The same text I used at UMass.) Here’s what it says about government budget constraints:

What this means is that the present value of government spending across all future time must be less than or equal to the present value of taxation across all future time, minus the current value of government debt. This is pretty much the starting point for all mainstream discussions of government budgets. In Blanchard and Fischer, another widely-used graduate macro textbook, the entire discussion of government budgets is just the working-out of that same equation. (Except they make it an equality rather than an inequality.) If you’ve studied economics at a graduate level, this is what government budget constraint means to you.

But here’s the thing: That kind of constraint has nothing to do with the kind of constraint DeLong’s post is talking about.

The textbook constraint is based on the idea that government is setting tax and spending levels for all periods once and for all. There’s no difference between past and future — the equation is unchanged if you reverse the sign of the t terms (i.e. flip the past and future) and simultaneously reverse the sign of the interest rate. (In the special case where the interest rate is zero, you can put the periods in any order you like.) This approach isn’t specific to government budget constraints, it’s the way everything is approached in contemporary macroeconomics. The starting point of the Blanchard and Fischer book, like many macro textbooks, is the Ramsey  model of a household (central planner) allocating known production and consumption possibilities across an infinite time horizon. (The Romer book starts with the Solow growth model and derives it from the Ramsey model in chapter two.) Economic growth simply means that the parameters are such that the household, or planner, chooses a path of output with higher values in later periods than in earlier ones. Financial markets and aggregate demand aren’t completely ignored, of course, but they’re treated as details to be saved for the final chapters, not part of the main structure.

You may think that’s a silly way to think about the economy (I may agree), but one important feature of these models is that the interest rate is not the cost of credit or finance; rather, it’s the fixed marginal rate of substitution of spending or taxing between different periods. By contrast, that interest is the cost of money, not the cost of substitution between the future and the present, was maybe the most important single point in Keynes’ General Theory. But it’s completely missing from contemporary textbooks, even though it’s only under this sense of interest that there’s even the possibility of bond market vigilantism. When we are talking about the state of confidence in the bond market, we are talking about a finance constraint — the cost of money — not a budget constraint. But the whole logic of contemporary macroeconomics (intertemporal allocation of real goods as the fundamental structure, with finance coming in only as an afterthought) excludes the possibility of government financing constraints. At no point in either Romer or Blanchard and Fischer are they ever discussed.

You can’t expect people to have a clear sense of when government financing constraints do and don’t bind, if you teach them a theory in which they don’t exist.

EDIT: Let me spell the argument out a little more. In conventional economics, time is just another dimension on which goods vary. Jam today, jam tomorrow, jam next week are treated just like strawberry jam, elderberry jam, ginger-zucchini jam, etc. Either way, you’re choosing the highest-utility basket that lies within your budget constraint. An alternative point of view – Post Keynesian if you like – is that we can’t make choices today about future periods. (Fundamental uncertainty is one way of motivating this, but not the only way.) The tradeoff facing us is not between jam today and jam tomorrow, but between jam today and money today. Money today presumably translates into jam tomorrow, but not on sufficiently definite terms that we can put it into the equations. (It’s in this sense that a monetary theory and a theory of intertemporal optimization are strict alternatives.) Once you take this point of view, it’s perfectly logical to think of the government budget constraint as a financing constraint, i.e. as the terms on which expenditure today trades off with net financial claims today. Which is to say, you’re now in the discursive universe where things like bond markets exist. Again, yes, modern macro textbooks do eventually introduce bond markets — but only after hundreds of pages of intertemporal optimization. If I wrote the textbooks, the first model wouldn’t be of goods today vs. goods tomorrow, but goods today vs. money today. DeLong presumably disagrees. But in that world, macroeconomic policy discussions might annoy him less.