18 Jan 2012

Paul Krugman’s Been Hanging Around in Bars

Economics, Krugman 16 Comments

…though we have no proof that he puts on women’s clothing.

Some of you may recall that in May 2011, Chicago economist Casey Mulligan wrote a critique of New Keynesian economics. He wrote:

Our labor market has long-term problems that are not addressed by Keynesian economic theory. New Keynesian economics is built on the assumption that employers charge too much for the products that their employees make and are too slow to cut their prices when demand falls. With prices too high, customers are discouraged from buying, especially during recessions, and there is not enough demand to maintain employment.

When the financial crisis hit in 2008, the New Keynesian “sticky price” story had some plausibility because economic conditions were, in fact, deflationary (although I have my doubts about other aspects of their theory). That is, the demand for safe assets surged in 2008, which means that those assets had to become expensive or, equivalently, goods had to get cheaper in order to clear the market.

Mulligan then went through an argument seeking to demonstrate that “[t]he low employment rates we have today are too persistent to be blamed on price adjustment lags,” and hence that New Keynesianism offers little guidance.

Enter Paul Krugman. For the ultimate point he wanted to make, Krugman could have said something like, “I understand why a hard-core market-clearing guy like Mulligan would think New Keynesianism is all about sticky prices, and how that gives rise to the necessity for activist fiscal policy. But, in this particular crisis at least, sticky prices aren’t really the issue, because blah blah blah.”

But no, Krugman didn’t say that. Instead, in a post entitled, “Why Casey Can’t Read,” Krugman claimed that Mulligan

should try reading a bit of Keynesian economics — old or new, it doesn’t matter — before “explaining” what’s wrong with it. For the doctrine he’s attacking bears no resemblance to anything Keynesians are saying.

This is fairly typical of freshwater economists. They know that what the other side is saying is obviously stupid, so there’s no need to read it; they picked up enough about it talking to some guy in a bar, or whatever, to criticize it.

At the time, I was flabbergasted that Krugman would take such a hard line. I explained (can’t find the link right now) that I literally was taught at NYU that a defining feature of New Keynesian economics was its insistence on the empirical reality of sticky prices (and wages), and the relevance of that fact to policy prescriptions. And I was taught this…by New Keynesian economists. I also pointed out that when self-described New Keynesian Greg Mankiw scoffed at my laissez-faire position, he cited sticky wages and prices as the problem.

Then Noah Smith jumped in, politely pointing out to Dr. Krugman that an entire class of New Keynesian models was based on exactly the mechanism Mulligan had in mind. But nope, Krugman rejected poor Noah’s appeal to human decency and sanity, and repeated his line about Mulligan learning about New Keynesianism from a guy at a bar. At that point, I checked Wikipedia for its entry on New Keynesianism, saw that it said sticky wages/prices were a defining element, and wrote a post titled “A Bunch of Drunks Must Have Edited Wikipedia.”

Now at the time, I knew Krugman was full of it, because I could vividly remember Krugman himself writing a post talking about the importance of sticky prices/wages, and how it was hilarious that Chicago types could deny the reality staring them in the face. But I couldn’t dig up that exact post. It was also true that Krugman had been a careful blogger for a while, and had been stressing that even falling wages wouldn’t solve our current mess, since we were in a liquidity trap and had massive debt overhang in the private sector. (It was rhetorically important for him to do this, because if the interventionist position rested on sticky wages, it gave right-wingers a great card to play in smashing unions, cutting the minimum wage, etc.)

But just like the killer in an episode of Columbo, Krugman thought the danger was over, let his guard down, and said something that seemed innocuous at the time, but would ultimately spell his demise. Today in discussing the passing of Mike Mussa, who had studied the movement of exchange rates during and after Bretton Woods, Krugman wrote:

All this amounts to the single most compelling demonstration that prices are indeed sticky, with all that follows from that observation — in particular, the case for activist monetary and fiscal policies to fight slumps.

I guess we can forgive Dr. Krugman for hanging around in bars. After all, within the past month Nick Rowe and now Scott Sumner* have totally blown up his positions with irrefutable numerical illustrations, in two different arguments where Krugman had been treating his opponents as second graders. That would drive anybody to the bottle.

* I hadn’t followed the Savings=Investment argument too closely, and at first I didn’t understand what Sumner was saying. But this post made it clear to me that his limited point was right, and that Krugman et al. had made an invalid argument in responding to John Cochrane’s (own) invalid argument against fiscal stimulus.

16 Responses to “Paul Krugman’s Been Hanging Around in Bars”

    • Anonymous says:

      Is it too much to expect that casey mulligan spend half a day reading about the liquidity trap idea before writing an article claiming that keynesian explanations for the current economic situation must be wrong? I think that deserves a harsh response.

  1. Tel says:

    I could vividly remember Krugman himself writing a post talking about the importance of sticky prices/wages, and how it was hilarious that Chicago types could deny the reality staring them in the face. But I couldn’t dig up that exact post.

    I claim two in favour:

    http://www.pkarchive.org/theory/evolute.html

    Another issue: consider the question of whether and how monetary policy has real effects. In the end this comes down to whether prices are sticky in nominal terms. In my view there is overwhelming evidence that they are. But many economists reject such evidence on principle: a rational price-setter ought not to have money illusion, therefore it is bad economics to assume that they do. If neo-Keynesians like me suggest that a bit of bounded rationality would do the trick, the answer is that bounded rationality is too open-ended a concept, and can be used to rationalize too many different behaviors.

    http://www.pkarchive.org/economy/deflator.html

    While Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” may be the most famous tag line in monetary economics, I have always preferred a dictum I first heard from Rudi Dornbusch: “It takes two nominals to make a real”. A change in a nominal variable, like the money supply, can affect the real economy only if some other nominal variable, like wages, is “sticky” enough to give it some traction.

    • Tel says:

      … and one against!

      http://www.pkarchive.org/economy/GeneralTheoryKeynesIntro.html

      So the crucial innovation in The General Theory isn’t, as a modern macroeconomist tends to think, the idea that nominal wages are sticky. It’s the demolition of Say’s Law and the classical theory of the interest rate in Book IV, “The inducement to invest.” One measure of how hard it was for Keynes to divest himself of Say’s Law is that to this day some people deny what Keynes realized – that the “law” is, at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services.

  2. Daniel Kuehn says:

    I think quoting the rest of that Krugman post should clarify.

    I don’t think Krugman was arguing that wages aren’t sticky. His point is that what sticky wages do for Keynesians is not the same as Mulligan’s solution that wages and prices have to fall.

    So I was taught that sticky wages provide the primary explanation for why the short run aggregate supply curve is not perfectly elastic, introducing the prospect of demand-side recessions and demand management policies like monetary and fiscal policy. Sticky wages tell us why the SRAS curve is shaped the way that it is shaped. They also tell us something about the incidence of a negative shock: on employment rather than wages.

    I don’t think Krugman is intending to deny sticky wages as he is explaining why a wage or price decline doesn’t fix things. That conclusion doesn’t follow from the sticky wages premise when there is a debt overhang or a liquidity trap.

    Bryan Caplan made this mistake too recently. If you want to talk about sticky wages, fine. Everybody should be fine with that (although Old Keynesians will remind you we’d still have problems even if wages were perfectly flexible). What’s not fine is when you indiscriminately make claims that this means wages and prices have to fall.

    • Daniel Kuehn says:

      *not perfectly INelastic

    • Major_Freedom says:

      “I don’t think Krugman is intending to deny sticky wages as he is explaining why a wage or price decline doesn’t fix things. That conclusion doesn’t follow from the sticky wages premise when there is a debt overhang or a liquidity trap.”

      Even in a liquidity trap and large debt overhang, there is still a demand for labor and other factors of production. If, given those demands, prices and wage rates fell, then idle resources and unemployment can be eliminated.

      Krugman is making the mistake of believing that a fall in wage rates and prices is somehow the same thing as a fall in demands, which when taking debt overhang into account, allegedly exacerbates unemployment. But wage rates and prices are different from demands.

      It is almost as though Krugman simply presumes sticky wage rates and prices and then treats a fall in wage rates as a fall in the demand for labor. But those are two different things.

      Isn’t it convenient that Krugman blames slumps on sticky wages and prices, thus justifying monetary and fiscal expansion, but then he also denies that falling wages and prices can cure slumps…thus justifying monetary and fiscal expansion?

      It would be like an Austrian to face one way and blame a slump on discoordination between investors and consumers due to monetary manipulation, but then face the other way and say coordination between investors and consumers in a world without monetary manipulation won’t cure the slump because coordination may bankrupt those who are currently discoordinated and heavily indebted.

      It is not true that falling wage rates and prices, in the face of widespread unemployment and idle resources during a depression, makes corporate debt any harder to pay back. For it ignores the additional employment and resource usage is founded upon the same demands buying more labor and resources at lower prices. If a particular demand X for labor, in the face of a given quantity of corporate debt, leads one to say there is “debt overhang” so the demand for labor can’t fall, then splitting that demand X for labor up into X/2 + X/2, thus hiring twice as many people at half the price, won’t make corporate debt any harder to pay back. Sure, it might bankrupt individual indebted laborers, but bankrupted laborers don’t lose their jobs for defaulting on their debt. Their lenders will of course take a hit, but overextended banks taking a hit is healthy for economic recovery.

    • PrometheeFeu says:

      That’s fine, but you should read Mulligan’s article in whole. My understanding is that sticky wages even if they don’t account for the drop in output do explain why the labor market doesn’t clear in the Keynesian model. So it does seem that if we are now in the long run and wages are no longer sticky, we could still be in a recession, but the labor market would clear no? That’s what Mulligan was saying, not that everything would be fixed. Just that the labor market should be clearing once sticky wages are no longer an issue.

      • Andy Harless says:

        The labor market wouldn’t clear at the level Mulligan derives, because reducing nominal wages would would have a feedback effect that reduces the equilibrium wage (since falling prices and wages redistribute wealth to the cash-rich away from debtors, thus exacerbating debt-service problems and reducing nominal demand). There is some wage and price level low enough to clear markets, but given these feedback effects it might be much, much lower than what is in Mulligan’s chart.

        • PrometheeFeu says:

          Nothing that you say refutes Mulligan’s underlying point. Even if the numbers for the market-clearing wages are a lot lower, it seems pretty clear that the current wage level is not falling towards the market-clearing wage. Why is that? Mulligan sets aside sticky wages as an explanation arguing we are now in the long run where wages are flexible. So what’s left in the Keyenesian model to explain the labor market not clearing?

          I think it’s fair to argue that we are not in the long run and wages did not have time to adjust yet. But that’s not the same thing as saying Mulligan isn’t applying the Keynesian model correctly.

          • Andy Harless says:

            Mulligan’s refutes himself with his own chart. The blue and red series converge by about 20% between Sept 2009 and Feb 2011, even though he denies that they are converging.

            Of course the current wage level is not falling, and neither is the market clearing wage, because the Fed is trying very hard to avoid deflation, but the two are converging. (The market clearing wage is conditional on the wage being equal to the current wage, which it couldn’t be if it were at the market clearing wage, but still, as long as the current wage is rising, the two ought to converge, and they do.)

            • PrometheeFeu says:

              You’re not really engaging my point. If you want to argue that the labor market has not cleared yet because of sticky wages that’s fine. But then you can’t say that Mulligan is making a mistake about Keynesian theory. You’re arguing that he is wrongly in assuming that sticky wages have already had time to adjust. Given how silent Keynesian theory is about how long it will take for wages to adjust and the market to clear, his statements are not misrepresenting Keynesianism.

  3. Anonymouse says:

    Hi Bob,

    I thought you might be interested in the following statistics:

    http://www.stat.ee/29958

    The European countries that had the biggest recessions in 2009 [Estonia, Latvia, Lithuania] appear to be the ones that had the biggest recoveries in 2011. This may be a textbook case of ABCT, and is especially interesting because Estonia has been ranked as one of the freest economies in the world, and the government cut spending during the recession:

    http://ideasmatter.typepad.com/ideas-matter/2012/01/free-to-choose-mart-laars-economic-guidebook-for-estonia.html

    I would humbly suggest you consider blogging on this topic and/or spreading this info to others who might do the same, because this appears to be a very important data set in favor of the Austrian paradigm.

  4. John Hawkins says:

    I know this is slightly unrelated to the post, but I just read this and was wondering if you’d ever gotten around to reading this Bob.

    http://guidohulsmann.com/pdf/Structure_Production_Reconsidered.pdf

    This paragraph in particular sort of blew my mind, especially considering the way policymakers talk about interest rates: “What is the economic role or function of a lengthening of the structure of production
    resulting from an increase of the pure rate of interest? There is at least one function
    that we have already stressed in a different context, although at the time were still holding the
    conventional model to be accurate. In Hülsmann (2009) we have highlighted the fact that a
    higher PRI thins out the upstream stages. Fewer investments are made upstream and these
    investments earn a relatively high return, which means that the firms are relatively safe from
    insolvency. Yet this means nothing else but that the structure of production becomes more
    robust. Unforeseen events have a less dramatic impact on the solvency of the different firms
    and, thus, on the stability of entire network of firms. In short, higher interest rates switch the
    structure of production into “safety mode.” Inversely, a lower PRI enlarges the upstream
    stages. Relatively more investments are now made upstream, and in each stage firms operate
    at lower margins. The economy is therefore more vulnerable to unforeseen events.”

    If you have managed to read this paper, would you have any insights as to what this means in a fractional reserve environment rather than a gold commodity money environment?

    • Bob Murphy says:

      Hi John, I can’t give you any good feedback right now, except to say that Guido presented that paper at a Liberty Fund conference, and I bunch of us thought it was…weird. So he is either a genius or a fool, on that one. I genuinely am not taking a stance, I’m just saying, it’s either really great or dumb. (That goes with the territory when you say everybody on a topic has been wrong for 100 years.)

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