19 Jan 2011

Kalling All Keynesians

Krugman 10 Comments

From my favorite Krugman blog post of all time:

I’ve already pointed out the problems, both logical and empirical, with the claim that workers are unemployed because they have zero marginal product. But there are many more problems with the notion of a recession as a supply shock.

A short sample: If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls? Why is there such a strong correlation between nominal and real GDP? Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow? And on and on.

I think I understand all of his objections, but the two I’ve put in bold above, I’m not 100% sure I get what he is saying. So let me paraphrase what I take to be his argument, and then the Keynesian sympathizers in the crowd can either confirm or deny my interpretation:

Krugman’s Logic
(1) Austrians think the boom and recession are “real” phenomena; it’s not about spending or money.

(2) This is what the RBC people say too; they view recessions as a supply shock.

(3) Therefore the Austrians view recessions as a supply shock.

(4) If recessions were purely “real” phenomena, then we wouldn’t see nominal GDP fall when real GDP does. A recession would correspond to a drop in real GDP, of course, but it would be entirely possible for NGDP to keep rising at the normal rate, and for price inflation to make up the gap. But in reality, NGDP collapses when real GDP does, and then during the recovery, it’s not simply that price inflation falls (so real GDP catches up to NGDP) but rather, both real GDP and NGDP rise together. A purely “real” story has no explanation for this, so it’s more fruitful to think that the changes in NGDP are pulling down, or pulling up, real GDP with them.

(5) As a specific example of this point, central banks should have no ability to influence the “real” economy (and hence real GDP) if recessions were actually all about supply-side shocks. It doesn’t affect how many tractors there are, or the skills of computer programmers, if the Fed decides to slow the growth in the monetary base. But clearly, the research shows that monetary policy has real effects. Unless your model incorporates a transmission mechanism from money to the real economy, you can’t possibly explain the recessions we have lived through in modern times.

Is this about right?

10 Responses to “Kalling All Keynesians”

  1. Yogi says:

    I am not a Keynesian….. but I think the primary point made by Krugman is that there is no evidence that we see a “deterioration” of the capital base of the economy.

    He clarified it in a follow up post today……

    His point is that the boom is not “false” just because demand falls off during the bust. This is a point he has made repeatedly… That the economy’s productive capacity is still high enough to maintain the pre-bust level of GDP.

    • bobmurphy says:

      Right I got that one. I’m asking to make sure I understand his two points in bold in this post.

  2. Yogi says:

    Another related point which I think he is making is that if there are some good reasons for unemployment, they should show up in his models as potential employees with a “zero marginal product”

  3. Maurizio Colucci says:

    I think Krugman considers ABCT a supply-shock theory because capital consumption causes a sudden and unexpected drop in the amount of capital, which is after all a shock in the supply of capital.

    So the “therefore” in point 3 is wrong imho. I mean, the reason why abct is a supply shock theory is not that “ABCT is a real phenomena and RBCT theorist say the same”).

  4. jjrs says:

    >”Why is there overwhelming evidence that when central banks decide to slow the economy, the economy does indeed slow?”

    I don’t quite get it either, but as far as I can make out-

    The lead-in question to that passage is “If inflation is a case of too much money chasing too few goods, why aren’t slumps associated with accelerating rather than decelerating inflation, as the supply of goods falls?”. (so far that makes sense- under Austrian theory, we should be experiencing hyperinflation as the fed expands the monetary base, but we have deflation).

    Then he cites a paper that identifies “six episodes in which the Federal Reserve in effect decided to attempt to create a recession to reduce inflation”, and goes on to show that employment fell as a result.

    The idea seems to be that if inflation is simply a matter of two much currency chasing too few goods, reducing the money supply shouldn’t have caused the economy to slow, just for prices to come back in line, because the underlying demand would be the same.

    At any rate, all his questions seem to be squarely aimed at the argument and analogy contained in your 2008 post, which may be all he’s ever read by you. So I would respond in relation to the post he cited.

  5. Lucas M. Engelhardt says:

    I think you’re right about Krugman’s logic.

    I have a response on my blog, and reach a similar conclusion about Krugman’s basic error. For those who want to know: http://engelhardtlm1.livejournal.com/340903.html

  6. virgil says:

    Forgive me for this joke, but I’d love to see Krugman and Murphy engaged in MORTAL KOMBAT!!

    …Just saying…

  7. Silas Barta says:

    Something that came to mind when I debate this topic before: if people suddenly stop liking most of the current output, and so stop buying as much, does that count as a demand shock, or a supply shock? On the one hand, it’s demand that’s dropped, but on the other hand, the fact that people’s tastes have changed means the output is lower in real terms since the same products (and capital for producing them) are less valuable.

  8. Tom E. Snyder says:

    You can ask him yourself during the debate. 😉

  9. jgo says:

    GDP is a shadow of a fun-house mirror reflection of the economy.

    The Keynesians seem to think it’s the economy itself. Even Williams and Sowell seem to make that mistake on occasion.

    The Keynesian econometricians seem to think that their arbitrary, made-up equations ARE the economy, rather than a very imperfect and misleading model of the economy.