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January 2, 2001
recessionary tendencies can usually be effectively treated with cheap, over-the-counter medication: cut interest rates a couple of percentage points, provide plenty of liquidity, and call me in the morning.
-- Paul Krugman, We're not Japan, N.Y. Times, Dec. 27, 2000
I'll be right back. I promise.
-- Chuck Nolan (the character played by Tom Hanks in the movie "Cast Away").
Dr. Krugman opposes the Bush tax cut as a prescription for a recession, and I would not disagree exactly. Keeping the medical metaphor, you could interpret my previous essay as saying that treating an economic slump with the Bush tax cut would be like treating impotence with Alka-Seltzer.
But what Krugman is saying is that he would not even recommend Viagra. Monetary policy is so remarkable that small adjustments can cure anything. Even erectile dysfunction.
I believe that Krugman fails to appreciate what I call Halberstam's Law, which I shall explain shortly. If Murphy's Law made a liar out of Chuck Nolan, then Halberstam's Law may make a liar out of Krugman's generation of economists.
First, let me clarify the issue concerning tax cuts by separating it into two questions.
Krugman, whose ambitions to play a role in economic policy were set back by the November/December election/Supreme Court decision, would say "no" to both questions.
John Taylor, another distinguished economist, whose ambitions to play a role in economic policy require him to say "yes" to the second question, has been quoted in the press as saying "no" to the first question.
In my previous essay, I said "yes" to the first question and "no" to the second question. Whatever ambitions I have to play a role in economic policy, I suffer from too much ambivalence to be able to back Gore as strongly as Krugman or to back Bush as strongly as Taylor.
One of the books that influenced me the most when I was an undergraduate was written by David Halberstam. It was not assigned in any course, but I read it after hearing it praised by Tom Marcus and Gingy Scharff, two friends that I admired in high school.
Halberstam chose his title, "The Best and the Brightest," with some irony, because one of his main points is that the most rational, intelligent experts managed to lead us into the madness of Viet Nam. Halberstam's thesis is that our failure reflected the fact that both in Viet Nam and in the U.S., people did not act according to the models of rationality that were posited by the experts.
Halberstam tells an anecdote in which David Riesman warned some typical Kennedy Administration intellectuals in 1961.
'You all think you can manage limited wars and that you're dealing with an elite society that is just waiting for your leadership. It's not that way at all,' he said. 'It's not an Eastern elite society run for Harvard and the Council on Foreign Relations.'
To make a long story short, we can formulate
Halberstam's Law: Making the assumption that everyone else shares your model of reality can lead to tragic mistakes.
By the time I got to graduate school, the most exciting phenomenon in economics was the doctrine of "rational expectations." To make a long story short, this doctrine can be formulated as:
Rational Expectations: Making the assumption that everyone else shares your model of reality is a methodological necessity.
Until recently, it never occurred to me to try to juxtapose what I read while an undergraduate with what I was taught in graduate school. In any event, I drifted away from academic economics. The ratio of my research output to Krugman's was about .001, for reasons that had nothing to do with doctrine.
Now, however, I believe that one must choose, and my opinion is that it is a mistake to buy into Rational Expectations. Halberstam's Law has much more significance.
Krugman titled his op-ed piece "We are not Japan." He indicates that he is quite pleased to see Japan's economic engine apparently failing to re-start. If you know the history of Krugman and Japan, you appreciate where his schaudenfreude comes from. For one thing, Krugman was one of the few skeptics of the "Japan is triumphant" doctrine that was popular around 1990, and he continues to revel in any news that provides vindication.
More importantly, Japan has never tried Krugman's idea of announcing an inflation target for monetary policy of, say, 3 percent. It is Krugman's conceit that announcing and implementing such a policy is necessary and sufficient to pull Japan out of its slump. As long as they refuse to adopt his novel approach, he could not be happier than to see their economy continue to falter.
The idea that announcing an inflation target can pull an economy out of a slump is a hypothesis that only could have been developed in the context of the "rational expectations" paradigm. Within that framework, individual business and consumer decisions are based on people's forecasts for economic policy. Therefore, policymakers can influence behavior by announcing a path for policy. The catch, in this view, is that policy paths are not credible unless they are based on the assumption that consumers share the model of the world of the policymakers.
When I look around, I see all sorts of people whose economic beliefs are derived from models that are not rational by my reckoning: day traders, momentum investors, protectionists, Naderites, punk supply-siders (a term coined by the late Herbert Stein), not to mention ordinary civilians who never even open the business page. Yet the Rational Expectations paradigm invoked by Krugman, Taylor, and other leading economists of our generation assumes that everyone uses the same sophisticated model to make decisions.
Instead, Halberstam's Law would tell you not to assume that everyone shares the same rational model. Halberstam's Law strikes me as more consistent with the views that I ascribe to Keynes. For Keynes, the economy is subject to the fads, rules of thumb, and irrational impulses of entrepreneurs, investors, and consumers. The volatility of their moods makes economic forecasting difficult and stabilization policy challenging.
Krugman and his cohorts believe that it will be easy for the United States to avoid a severe economic slump. They are telling us not to worry about flying into turbulence, because Captain Greenspan is in the cockpit and in control. I just hope that Bush's economic team does not wind up like Chuck Nolan, drenched and sputtering, clinging to a raft for dear life.