Paul Krugman is out again defending mainstream economics against students and others who rightly suspect that it has taken a wayward path. I won’t go too much here into Krugman’s own history as a gatekeeper for orthodox economics, having dug up some of the rather embarrassing historical record on this blog before.
Let me just note two rather large ironies with what Krugman is saying here. First of all there is the obvious one. On the one hand Krugman claims that all is right with the state of macro. Yet on the other hand he himself is publishing papers that try to absorb certain heterodox theories into the profession.
Thus he is talking out of two sides of his mouth. He is at once saying “ignore those heterodox guys” and at the same time saying “read my papers that integrates their important theoretical insights”. I don’t think it would require too much psychological subtlety on the part of the reader to understand what Krugman is doing here, whether consciously or unconsciously.
The second irony is rather more technical but also highlights something important about mainstreamers like Krugman: namely, that they don’t properly understand the implications or theoretical foundations of their own theories. In his recent post Krugman says,
Efficient markets theory arguably deserves more blame for the failure of too many economists to recognize the housing bubble, but textbook economics always presented EMT as a baseline, not a revealed truth.
That sounds nice, right? Well, not really. It’s become something of a cliche for mainstreamers to attack the EMH. This feeds into the whole ‘saltwater’ versus ‘freshwater’ pantomime that the mainstream has been playing at for over 30 years.
Beyond that many of Krugman’s own formulations require an implicit EMH. Krugman himself doesn’t understand this, of course, but again I contend that mainstreamers don’t understand a very good deal about their own theories because they lack detached theoretical and historical perspective on such matters.
So, which formulations require an implicit EMH? Well, the natural rate of interest theory for one. As I wrote here (apologies in advance for the long quotation but I see no point in repeating the argument here):
Note carefully that [mainstreamers like Krugman when they refer to a natural rate of interest] refer to this interest rate in the singular, not in the plural. This is because, as we have already seen, they assume that the rate that needs to be set in line with the natural rate is the central bank overnight interest rates – what used to be called the “money rate of interest”. However, the central bank overnight interest rate is but one of many interest rates in the economy. There are, in fact, distinct interest rates on every financial asset in the economy. There are separate interest rates, for example, on triple-A rated company debt and on low-rate junk bonds; there are separate interest rates on personal mortgages and on credit-card debt – and so on and so on.
The reason that the Bastard Keynesians ignore this fact is that they assume – quite correctly – that when the central bank raises or lowers the overnight interest rate, all these other interest rates respond accordingly. The central bank rate of interest can properly be seen as the “risk-free” rate of interest while all the other interest rates integrate whatever risks the borrower is seen to represent. To understand this better let us imagine that the central bank risk-free rate is set at, say, 4%. Investors and savers know that by parking their money in government bonds they can get this 4% without incurring any risk. So, if they are to put their money into, say, a risky junk bond that has a high risk of default they will demand maybe 15%.
Now, say that the central bank lowers the risk-free rate to 0%. Well, now the investors and savers are going to be willing to accept a much lower return from the risky junk bond. Their choice is no longer between a risk-free rate of 4% and a risky rate of 15% but is instead between a 0% rate of return that incurs no risk and a risky asset with a high default risk. Thus they might be willing to buy the junk bond if it has, maybe, an 11% rate of interest or so.
This is all well and good if we assume that savers and investors are perfectly rational and price in risk perfectly. After all, if investors and savers are not subject to irrational swings and do not misprice risk because they essentially know the future then this whole process should work like clockwork – or, more poignantly, like an enormous series of neoclassical supply and demand curves that exist all across the money markets. However, if investors and savers are not perfectly rational and cannot price in risk perfectly because they do not know the future, then the interest rates on everything except the risk-free rate set by the central bank is completely and utterly indeterminate and is subject to the whims of investors…
The idea of a natural rate of interest then implicitly rests on the idea that investors and savers in the economy are perfectly rational and have perfect information about the future. Indeed, it actually implicitly relies on the Efficient Market Hypothesis in its strongest form.
The natural rate of interest is, of course, central to Krugman’s basic understanding of macro. It is also central to many of the policy recommendations that he makes; such as the idea that in ‘normal times’ monetary policy alone can be used to steer macroeconomic activity.
This is the problem with people like Krugman. In their zealous defence of a status quo that has been failing them for years (again, see this post) they are completely blind to what their theories actually imply. Meanwhile they pick the bones of the heterodox economics that they actively try to suppress in order to form models with which to explain the crisis to one another. Something is rotten here indeed.