On the stimulus, though, Krugman achieves a knockout punch. The view that extra government spending “crowds out” an equal amount of private spending, so that its net stimulus effect is zero, would be true only if the economy were at full employment. Indeed, the Chicago School tacitly assumes that economies are always at full employment. They are unfazed by the fact that the US economy has shrunk by 4 percent in the last year and that more than 6 million people have been added to the unemployment rolls.
To Chicago economists, an increase in the number of idle workers represents a voluntary choice for leisure. In a concession to commonsense, they concede that people may make mistakes and, to that extent, a stimulus may be beneficial. But they insist that the only stimulus that will work is printing money. This will drive down interest rates and lead to an economic rebound.
Against this view, Keynes pointed out that interest-rate reductions may not do the job, because at zero or near-zero rates investors hoard cash rather than lend it out. Hence, as he put it in 1932, there may be “no escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment” — which is what the Obama administration is rightly doing.
On the question of what caused the crash, the debate is more even. Krugman is hampered by the fact that he attributes the crash to “irrationality,” which, as Cochrane points out, is no theory.
This is because Krugman refuses to take seriously Keynes’ crucial distinction between risk and uncertainty. In my view, Keynes’ major contribution to economic theory was to emphasize the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.”
The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.
This makes for considerable stability in markets as long as the conventions hold. But they are liable to being overturned suddenly in the face of passing bad news, because “there is no firm basis of conviction to hold them steady.”
It’s like what happens in a crowded theater if someone shouts “Fire!” Everyone rushes to get out. This is not “irrational” behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn.
Chicago School economics has never been more vulnerable than it is today — and deservedly so. But the attack on it will never succeed unless policy Keynesians like Krugman are willing to work out the implications of irreducible uncertainty for economic theory.
Robert Skidelsky, a member of the British House of Lords, is professor emeritus of political economy at Warwick University and a board member of the Moscow School of Political Studies.COPYRIGHT: PROJECT SYNDICATE
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