Listen to the Pauls (Krugman and Samuelson); We don't live in a world of perfect, or near perfect, information and calculation

In response to RueTheDay's comment entered May 17^th at 8:14 am in Steve Waldman's Blog:

You write, "because once you acknowledge real balance effects, you have to either keep the hoarding part and explain why the price mechanism doesn't work (sticky wages/prices) or discard the hoarding".

But the whole point is that wages and prices are sticky. Information doesn't disseminate and become ubiquitous and acted upon instantly. This is the big strength of Keynesian or New Keynesian economics; the assumptions that it depends on are far more realistic than the assumptions that real balance arguments and rational expectations arguments, and the like depend on.

It's far more realistic to assume, as Keynesian type theories do, that everyone in the world does not have every bit of information everywhere in the economy and cannot analyze all of it perfectly, with perfect expertise, instantly, when it comes to price and wage setting, and many other things.

It's much more realistic to assume that people severely lack information, and they acquire it relatively slowly, and don't analyze it perfectly with Ph.D. techniques, and that it takes time (which is money), and effort to analyze information, and there are costs and risks to changing prices and wages, and therefore prices and wages adjust relatively slowly and imperfectly.

These are much more realistic assumption to make about the economy, and that's why the empirical evidence is immensely stronger for Keynesian type theories, and for the effectiveness of Keynesian type prescriptions.

Real balances arguments, rational expectations arguments, and the like, only really work and are the whole story if it's true, or close to true, that that everyone in the economy has perfect information about everything, perfect expertise and education about everything, perfect rationality, and the ability to analyze and update all information constantly and instantly in their brains (although some of these make an exception for one or a few things like job search time). Obviously, we don't fit this bill with a majority almost picking W. in 2000, and actually picking him in 2004!

Here is Princeton Economist and John Bates Clarke Medal Winner Paul Krugman on this (from his book "Peddling Prosperity", page 47):

When Keynes published his theory of the business cycle, some conservative economists argued that there was no need for government policy to combat recessions because recessions would be self correcting. Their argument went as follows: In the face of high unemployment, wages and prices will tend to fall. This fall in wages and prices will increase the real money supply – that is the given stock of money in circulation will have steadily rising purchasing power. And this expansion in the real supply of money will in turn lead to an economic expansion.

Keynes did not deny the logic of this so-called classical argument; he was willing to concede that in the long run economic slumps would be self-correcting. But he regarded this self-correcting process as very slow, and as he pointed out in a widely quoted but rarely understood remark, "In the long run we are all dead." What he meant was: Recessions may eventually cure themselves. But that's no more a reason to ignore policies that can end them quickly than the fact of eventual mortality is a reason to give up on living.

On page 214, Krugman more specifically discusses what happens once you realistically take into account that it's far from the truth that all people are instantly calculating machines with perfect and constantly updated knowledge about every single bit of information in the economy:

Suppose now that in this imperfect world we once again play the Keynesian experiment of posting an increase in the desire of people to hold cash. Recall that in Chapter 1 we saw how an attempt by everyone at once to increase cash holdings leads to a general fall in employment and incomes. The same will be true here.

At this point, the monetarist says that wages and prices will fall, increasing the real value of the cash in circulation and curing the recession. But will wages and prices really adjust?

What if firms are reluctant to cut their prices, either because there are measurable costs to putting on new price tags (menu costs in the jargon of the new Keynesians) or because they just don't want to be bothered with rethinking their pricing schemes? (The difference between real costs of changing stickers and subjective costs of thinking is actually quite blurry – that's why near rationality may in a way be regarded as a higher form of true rationality.) If markets were perfect, a firm that charges too high a price would lose all its business. In a world of highly imperfect markets, a firm that charges a price a little too high gains almost as much from that higher price as it loses in sales; a firm that fails to cut wages has a gain in higher leverage over its workers that almost compensates for its higher cost; and so on. In other words, the costs to an individual firm of being a little less than totally rational and not cutting wages and prices may be quite small, small enough that reasonable people just don't do it.

And yet the individually reasonable decision not to cut prices in the face of a recession can have collectively disastrous results. If prices don't fall when people decide to hold more cash, then the slump in output and employment is not self-correcting. In an imperfect world, senseless things can happen to groups of people who behave sensibly as individuals.

The case for active monetary policy is now obvious. Suppose that we have slid into a recession, just as described. There is an easy way out: put more money into circulation, and spending, incomes, and employment will rise...

In addition to menu costs, information gathering and analysis costs and time, efficiency wages, and other non-behavioral (non-psychological) imperfections, there are also strong behavioral causes of sticky or relatively slow price adjustment. For example, many businesses are reluctant to cut prices until they can really be sure that they will be able to keep the price at that lower level for a while, because (especially for certain products) customers don't like price increases or jumpy prices. That kind of thing can hurt customer goodwill and loyalty. It is also well documented that managers facing substantial competition often put off raising prices because they don't want to be the first to do so.

One very interesting, important, and widespread behavioral phenomenon is that workers are much less resistant to taking a real paycut if it doesn't involve a nominal paycut. In other words, the empirical evidence shows overwhelmingly that most workers are far more resistant to a 3% paycut when inflation is 0, than they are to a pay freeze when inflation is 3%, even though they are basically the same thing.

Krugman notes this in his 1996 Economist article, "Fast Growth and Stable Prices: Just Say No":

Messrs Akerlof [Nobel Prize winner], Dickens, and Perry have produced compelling evidence that workers are indeed very reluctant to accept nominal wage cuts: the distribution of nominal wage changes shows very few declines but a large concentration at zero a clear indication that there are many workers whose real wages 'should' be falling more rapidly than the inflation rate but cannot because to do so would require unacceptable nominal wage cuts.

This nominal wage rigidity means that trying to get the inflation rate very low impairs real wage flexibility and therefore increases the unemployment rate even in the long run. Consider the case of Canada a nation whose central bank is intensely committed to the goal of price stability (the current inflation rate is less than 1%). In the 1960s Canada used to have about the same unemployment rate as the United States. When it started to run persistently higher rates in the 1970s and 1980s many economists attributed the differential to a more generous unemployment insurance system. But even as that system has become less generous the unemployment gap has continued to widen: Canada's current rate is 10%. Why? A Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47% of his country's collective-bargaining agreements involved wage freezes. Most economists would agree that high-unemployment economies like Canada suffer from wage inflexibility; Mr. Fortin's evidence suggests however that the cause of that inflexibility lies not only in structural microeconomic problems but also in the Bank of Canada's anti-inflationary zeal.

It can also take a while for a person looking for work to understand and/or admit that the equilibrium wage in his field has dropped, and he has to accept less. It's not just bad luck that he's getting lower offers than were common last year, and instead the market has, in fact, changed. It can take a while for an individual to discover this, with all of the complication and random factors in the labor market. This is known as the Misperceptions theory.

What is the empirical evidence that there is a substantial amount of stickiness in prices, and especially wages? It's pretty obvious if you're willing to look at it objectively. Have you ever heard of anyone signing a contract for their job for a year or more? Have you ever noticed that unions only negotiate new contracts every few years? Have you ever thought about how difficult it would be to attract workers if instead of offering them a wage that's relatively steady and guaranteed, you started jumping it up and down constantly in perfect tune to aggregate demand in the economy (even assuming that all managers had the expertise to do that and the cost of the huge amount of time they would spend doing this was zero). The empirical evidence for nominal (and real) wage rigidity is vast. A good start is Fehr and Goette's 2005 paper in the Journal of Monetary Economics (volume 52, pages 779-804), "Robustness and Real Consequences of Nominal Wage Rigidity".

To sum it up from Krugman's text "Macroeconomics", with Robin Wells (2006), "Wages do not fall quickly in the face of labor surpluses or rise quickly in the face of shortages. Almost all macroeconomists agree that wages adjust slowly to surpluses or shortages of labor." (page 381). And from the other Paul, Samuelson, you know the legendary Nobel prize winner, "Keynesian economists point to much evidence suggesting that prices and particularly wages move slowly in response to shocks, and few economists believe that labor markets are in constant supply-demand equilibrium. When the assumption of perfectly flexible wages and prices is abandoned, policy will regain its power to affect the real economy in the short run." (From Samuelson's text, "Macroeconomics", 18^th edition, 2005, with William Nordhaus of Yale, page 364.)

The bottom line is that you can't take simple Austrian or classical models literally; that is you can't assume the actual economy is identical to the simple model. These models, and similarly simple ones, are just useful as a first step. An actual economic situation may have 10 major factors and many smaller, but still important, noisy ones. It's usually harder to understand such a situation if you just look at it as a whole. It can be useful instead to first look at a few of the factors in isolation, to understand better how those few factors work. But that's only the first step. You don't say from there, "Oh, that's how the economy with the many more factors works too". No, instead you next look at what happens when you add a few more factors. How much, and how, does this change things? Next you add more factors, and keep re-evaluating until you have considered all of the significant factors. You may find that some factors don't make a qualitative difference when you add them, or you may find that they do, or are likely to.

The next step, to help screen out mistakes you may have made in your analysis, is to look at the real world data, with lots of empirical studies, to see how well it fits your analysis.

A process like this is a lot more complicated than just acting like simple models are identical to reality, but this kind of in-depth and logical thinking has lead to great advances in our quality and quantity of life.

With regards to Keynes's views on wage decreases: Keynes' writings can be hard to interpret. The style of English is old, formal, artsy, and complicated, but there's no dispute among experts on Keynes that he thought in the long run prices and wages would adjust to an equilibrium (until the next disequilibriating shocks) where normal unemployment was restored, but as Keynes said, "In the long run, we're all dead" (so why wait, suffer, and lose wealth unnecessarily for a long time).

In the short run (without smart action by a central bank) funny things could happen like "The Widows Curse" or "The Paradox of Thrift", but these are not long run equilibriums, and some of them are very unlikely even in the short run. Most of all, they can all easily be stopped by smart action by a central bank (and/or fiscal action). For more on this, I recommend reading Krugman's 1997 Slate article, "Vulgar Keynesians".

The more superficially we chose candidates, the more W.s we get

With regard to Paul Krugman's May 26^th New York Times column, "Divided They Stand":

There are at least two key things to realize here:

1) When people work massive hours on sleep deprivation, as the 60 year old Hillary has, they're likely to make some slips and gaffs. In fact, this is a big reason why candidates should think carefully about whether it's worth working that extra hour or two per day at the expense of less sleep. The same goes for people in many other important thinking professions. If you look at Hillary's lifetime of real giving, caring, and sacrificing for others, and the policies she advocates to help those less fortunate, even though she's been a member of the wealthy and powerful – real things not the superficial – then you realize that obviously things like Hillary's pointing out Robert Kennedy's assination in June were not because she's a bad person.

2) The more we judge candidates based on the superficial – instead of what they really advocate for the people, their policies (like Obama's Health care policy versus Hillary's), the caring they've shown in their actions and sacrifices – the more we will get good ol' boy act George W. Bushes, or just far worse politicians who do more bad and/or less good for ourselves and our families.

Conversation with Steve Waldman; Act 4: Enter the Krugman

From my running conversation on Steve Waldman's blog:

Steve,

You write, "By the way, it is true that banking panics were a regular feature of the American economy up through the Great Depression and New Deal reforms. But is there any evidence that harmed real economic growth? Financial losses, insolvencies, etc. are wrenching, but they are part of the feedback mechanism that ought to guide capital allocation.".

But with banking panics we're not talking about mistakes and inefficiencies made by logical, sophisticated managers with high levels of information, and then the system just purges and penalizes those mistakes. We're talking about illogical and unnecessary panics that occur largely as a result of a massive asymmetric information and externality problem and then they become a self fulfilling prophesy. They often happen even when there's little or no fundamental reason for them, due to the huge lack of information and expertise on these things by regular people, which is pretty much everyone except the tiny sliver of the population who have studied and trained in depth in these areas of the economy.

So many of the mistakes made by people regarding economics (including lots of trained economists) come from acting as though their models are exactly reality. When a model assumes, as most of the basic ones do, that everyone in the economy has perfect information about everything, perfect expertise and education about everything, and perfect rationality, this is fine, as a way of isolating some of the important factors in an economic situation, to see better how they work by looking at what they do in isolation from other factors.

But then after you have isolated all of the important factors and studied them in various models, you have to ask what happens in reality where they are all combined together. What will be the aggregate of all of the forces pushing in their different directions with different amounts of strength. How will the results be altered by the inclusion of the real phenomena that all people don't have Ph.D.s in every subject, and don't have 100% of every single sliver of information in the economy stored and constantly updated in their brains.

And now a big tangent into academia (but I think it's worth the diversion):

The above questions are obviously what a good economist should ask and really think about, but a lot of economists don't. Moreover, sadly, there's a penalty to most economists for spending much time thinking about these kind of things, because most are evaluated almost completely on publication production, and they will usually produce a lot more if they just save time and act as though the models are given, then micro-specialize in an area, and just do lots of little probes based on taking the models as givens.

For most economists it's dangerous to their career advancement to spend much time thinking about the intuition, and how the models apply to the real economy, and how relaxing the assumptions changes the results, and how things outside of their micro-specialized area relate and interact. This kind of overall intuitive thinking and analysis, reading intuition books like "Peddling Prosperity", reading outside your micro-specialization, etc., can take a lot of time away from what is for most economists their fast bread and butter – assuming the models are reality, taking them as givens, and doing some little probes or empirical tests. There's a lot of pressure not to take too much time away from that, at least for the 99% of economists not at top universities, because it's publish or perish (It's mostly publish or perish at top universities too, but there they put more than just a little weight on intuition, insight, and long term promise).

I myself spend huge time on intuition, the bigger picture, and interrelations, as well as important subjects that the largely insular gatekeepers of the top academic journals turn their noses up at, like much of behavioral and especially personal finance, and normative and practitioner corporate finance. Society would really benefit if academics would bring their advanced statistical and theoretical skills to the effort to advance these areas, but because those who pay for most academic work – politicians and voters – can understand very little of the jargon and math in the papers, they can't distinguish between research which is highly socially beneficial and research which is much less socially beneficial, so they can't bring much pressure for efficient changes like this, at least not directly. I'd like to see something like government appointed boards of academic experts with fiduciary responsibility and powers to oversee and pressure academia's chiefs to publish and reward research based on its social benefit.

So, the big asymmetric information problem in academia fosters a lot of inefficiency. It allows journal editors and department heads to get away with a great deal of insularity. As for myself, luckily, our business and investment activities have done very well, and we have enough money saved that we don't really need university income, so this obviously makes it a lot easier for me to just go off and work on what I want to work on.

Economists at the top universities, as I alluded to, do in fact have more leeway to think about intuition, and how the many aspects of the economy as a whole interrelate, rather than just focusing on a micro-specialization. And tenure certainly decreases the penalties for not cranking out a lot of publications, but there's still a lot of pressure to publish even at the top universities and among those with tenure; there's still strong pressure to crank out pubs and not spend too much time thinking about intuition and what happens in the real and broad economy where the neat assumptions don't hold.

I am being very critical of economics and finance academia, but as I said in my second May 11th post: "Academia may have serious flaws and waste, but it's essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it's immensely worth having to pay for the waste that's hard to fight in academia's insular world of massively asymmetric information.", and let me add, we also cannot say just let the free market provide this research because due to externalities, inability to patent, and many other market problems, the free market would underprovide and underdiseminate this kind of research in a grossly inefficient way.

End of tangent, now back to banking panics, recessions and depressions:

These just aren't efficient market feedbacks, like companies overinvest in high speed Internet cable, and so capacity gets too big for consumer demand and they start losing money and go out of business, sending the message to not move more money into Internet cable. And even in that case, externalities could make the market message an inefficient one, where a strong government role can increase efficiency and welfare.

With panics the market messages become extremely inefficient and detached from fundamentals. You get self fulfilling prophesies that don't just lead to purging of inefficiency, they lead to severe demand crunches that result in enormous amounts of unnecessarily idle human and material capital for long periods of time, and this certainly lowers wealth creation. Without Keynesian measures, in the long run prices would come down, and that would relieve the demand crunch, but as we saw with the great depression, the long run can be very long, and great human suffering and trillions of dollars in lost production can be the cost of waiting when you didn't have to. This is why Keynes said, "In the long run we're all dead."

Moreover, any market message regarding bad capital allocation is still there whether the central bank increases the money supply or not. If there is overbuilding of fiber optic cable, prices and profits for fiber optic cable relative to prices and profits for other activities don't change when the money supply is increased. It's not like the money supply is increased only for a favored fiber optic cable industry. Smart businessmen still won't put their new money into relatively low profit, overbuilt fiber optics. They will put it into more promising industries.

A quote from Krugman to sum it up: From "The Return of Depression Economics", page xv:

Most economists, to the extent that they think about the subject at all, regard the Great Depression of the 1930s as a gratuitous, unnecessary tragedy. If only Herbert Hoover hadn't tried to balance the budget in the face of an economic slump; if only the Federal Reserve hadn't defended the gold standard at the expense of the domestic economy; if only officials had rushed cash to threatened banks, and thus calmed the banking panic that developed in 1930-31; then the stock market crash of 1929 would have lead only to a garden-variety recession, soon forgotten. And since economists and policy makers learned their lesson – no modern treasury secretary would echo Andrew Mellon's famous advice to "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate...purge the rottenness out of the system" – nothing like the Great Depression can ever happen again.

Then Krugman goes on to say that many have not learned these lessons, and we are not doing enough.

I also strongly recommend you read Krugman's 1998 Slate article, "The Hangover Theory". This really gets to the heart of things and teaches a lot in just a couple of pages. A quote to whet your appetite, "A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire.".

One more quote, because I'd really like to motivate you and the other readers to read this article:

Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

Finally, I'd like to give an analogy to help show the inefficiency of banking panics. At a football game if others start standing up for a better view, then it's best that you stand up too, and eventually everyone may stand up. But almost all would be better off if everyone had stayed seated. As Cornell economist Robert Frank would say, standing up is "smart for one, dumb for all", and this is the title of chapter 10 of a book of his I highly recommend, "Luxury Fever". An important quote from that book: Despite the mythology actively propagated by Republicans, Adam Smith, "although he is widely remembered for his account of why the individual pursuit of self-interest often promotes social ends, he was under no illusions that this was always the case." (page 171).

Conversation with Steve Waldman; Act 3: Keyensian Logic and Bank Runs

From my running conversation on Steve Waldman's blog:

Steve,

Generally what I would say about that graph is that yes volatility in the U.S. economy plummeted just about right at the time of the adoption of (at least largely) Keynesian policies by strong central banks, and it stayed that way for over 50 years, right up to today, but was it causal or coincidental?

I would say it was almost surely highly causal, primarily due to information not in the graph – the very strong logic chains of Keynesian demand-crunch economics. And these are logic chains that rely only on extremely realistic and plausible assumptions. That's the strongest evidence. You saw a nice chunk of it in the Krugman baby-sitting co-op article, and to see a lot more and with great intuition I recommend again Krugman's books, "The Return of Depression Economics" and "Peddling Prosperity".

But other evidence for strong causation in the graph comes from timing, magnitude, and associated logic. The U.S. economy did become more large and diversified after the adoption of Keynesian policies in from about 1935 on, but it had been doing that to a large extent for the period from 1835-1935, and we saw no drop in volatility. The drop only came suddenly just about right at the time of strong use of Keynesian techniques by central banks. As far as political stability, stable periods like 1880-1910 had far greater volatility than during the Keynesian years.

One big thing, though, which did occur just about simultaneously with strong Keynesian central banking, was simply strong bank regulation, FDIC insurance, etc. This, you could argue, deserves the credit for the decreased volatility. A quote from the text, "Money, Banking, and Financial Markets", 3rd Edition, by Miller and VanHoose: "In the United States between the 1830s and 1930s, national banking panics seemed to occur in regular cycles of fifteen to twenty years." (pages 35-36). But nonetheless, again, the strongest evidence is the very strong logic chains of Keynesian demand-crunch economics.

I do think, like in any part of government, transparency is crucial (with, of course, a few exceptions, like some ongoing military operations), as are checks and balances. This can greatly increase performance. On that subject, another book I recommend is University of Texas Economist and Public Affairs Professor Robert Auerbach's new book, "Deception and Abuse at the Fed". I just got it and have only perused it, but it looks good. I think you'll really like it.

Catastrophes are far more likely with a weak central bank than a strong one.

My reply to Steve Waldman's May 13th post, "Capabilities, constraints, and confidence":

Steve, you write, "I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged.", and this is a very big theme in your blog. But it's important to realize that catastrophe is much more likely to happen with a very weak central bank, or essentially no central bank, as with a gold standard, or some simplistic algorithm used to manage money supply (and even a long complicated formula or computer program is simple compared to the ultra-multidimensional, flexible, high level intelligence of strong and logical human minds, using formulas and programs only as an aide. With highly complex situations, even long formulas and programs may be far too simple, relative to the analysis of smart and logical human brains, and may perform on average far worse).

Please see graph 3, on page 7 of this paper by Carreras and Tafunell. It shows U.S. GDP from 1831-2000. Look at the massive swings in GDP before the introduction of a strong basically Keynesian modern central bank towards the end of the depression. Talk about catastrophe, after catastrophe, after catastrophe. You don't need to be an econometrician to see that volatility in the economy has been vastly lower in the 50+ year era of strong (essentially Keynesian) central banks.

This not only prevents or diminishes the great human suffering of depressions and recessions, it also raises total long run GDP, because these demand crunches result in a great deal of idle human and material capital that could have been producing if a powerful central bank had countered the demand crunch, essentially by increasing money supply and circulation. As I've recommended before, I recommend again as strongly as possible that you read the great Princeton Economist Paul Krugman's book, "The Return of Depression Economics" (and "Peddling Prosperity"). It explains this with great intuition. If you can't find the time to read this book now, please at least read his 1998 article in Slate, "Baby-Sitting the Economy". In a few pages it gives great intuition on the importance of a strong fed in fighting recessions and ending them quickly.

Mark Thoma aludes to the enormous importance of recession and depression fighting in item 6 of his rejoinder to your post. You're very critical of the fed's performance and very concerned with it having a lot of power, but really; take a look at the historic GDP graph; recessions have been far less severe since we have had powerful, modern, central banks.

Another of my analogies: Costly mistakes and abuses can happen from having a powerful police force, and there should be checks and balances, but, overall, far worse things would happen if we had a weak police force.

One final note: Fiscal measures are also very important. It's much better to fight a recession by employing people in building infrastructure, clean energy research and projects, education, etc., than in making yachts, mansions, and luxury hotels, or restaurant meals and new cars. Fiscal policy has the drawback, though, of taking longer to take effect than monetary policy (increasing the money supply, lowering interest rates, etc.).

As with government in general, central banks can be flawed, but not having one at all would be far worse

In response to Steve Waldman's April 6^th post, "Central banks are dangerous":

I know you're concerned that the fed chairman could be incompetent, and so if you give him a lot of power he could cause serious problems. Further, you state, "Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete."

What I say to that is this: it's like saying our long term plan should be to have no U.S. government. U.S. Governments may sometimes be horribly incompetent and corrupt, relative to what we normally have, like the Bush administration and the Republican congresses of the conservative era. But having no government at all would be far worse. That would lead to far lower quality of life and wealth creation. It would mean no police, no courts, no military, no public education, and on and on.

I know you recently started a finance Ph.D. program. As you learn more and more about economics you will find out more and more the crucial importance of government in addressing pure free market problems like externalities, asymmetric information, inability to patent, large economies of scale and monopoly power, and much more.

As with government in general, likewise for the Fed. Because Greenspan, despite the mythology, was a horrible Chairman, doesn’t mean we should have no Fed, or that we should not give it strong powers. The cost of a rare terrible chairmen, like Greenspan who acted largely based on Libertarian ideology rather than what's best for the economy, is better than the immensely greater costs from having no Fed at all or a very weak one.

Keep in mind that if a fed chairman is grossly incompetent for a long period of time the economic community will speak out en masse, and congress and the president can pass a special law to remove him. There are checks and balances.

Why is the Fed so important and indispensible. You will learn this as you progress in your education, but to learn a great deal about this quickly and with great intuition, I strongly suggest you read two books by Princeton Economist and John Bates Clarke Medal winner Paul Krugman: "Peddling Prosperity" and "The Return of Depression Economics". You will really enjoy and learn from these books. Also, here's a good article on Greenspan from Barrons.

A final analogy is with modern scientific medicine. You can find terrible doctors, but that doesn't mean it's best to never use modern medicine and instead to go back to primitive herbs and folk remedies for everything. With all of the flaws in modern medicine, it's more than doubled the human lifespan compared to the days of only non-scientific medicine, given us a Polio vaccine, etc., etc.

And really, I'd say the same thing for academic economics and finance. It has a lot of flaws and inefficiencies, but it's essentially the only game in town that is largely trying to be, and succeeding in being, scientific, and that thinks long and deep about issues, well beyond simpleminded sound bite "analyses" like those used by today's conservatives (which is virtually all of today's Republican politicians and those who control the party and its machine).

Academia may have serious flaws and waste, but it's essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it's immensely worth having to pay for the waste that's hard to fight in academia's insular world of massively asymmetric information.

No place for glib false modesty, "Why Do Some Countries Remain Poor While Others Grow Rich?" The answer: We know a great deal.

In Harvard Political Economy Professor Dani Rodrick's May 8^th post, he writes, "The title of my talk: Why Do Some Countries Remain Poor While Others Grow Rich? The answer: I wish I knew."

I have been following Dani's blog, and I can see that he is a good and caring man, who's very intelligent and competent in economics, but I don't like the false and misleading modesty in this quote. I know, people like it when you sound modest, even if you're saying something that's not true in order to sound that way, and that can be fine, if it's not going to mislead in an important way. But here it is too likely to mislead in an important way. The truth is we do know a tremendous amount about what makes some countries remain poor while others grow rich, even though there's still a lot we don't know.

The research presents very strong or overwhelming evidence on some key things. For example, we know that good governance is crucial. This includes things like low corruption and high transparency, a professional and unbiased judiciary, "the rule of law", and strong government investment in infrastructure, public health, and education. The latter requires substantial taxes, but these things are very high return investments that the unfettered free market will underprovide due to substantial market imperfections which are ubiquitous.

It's very important to note here (and in general, and often) that despite the myth, even in 1776 Adam Smith understood that there were circumstances that would cause the invisible hand to work poorly (see, for example, Cornell Economist Robert Frank's book, "Luxury Fever", pages 171-2.) And, in the last 200 years economics has advanced greatly and overwhelmingly shown that a substantial and smart government role will tremendously increase efficiency and wealth creation over the 100% free market for everything – I'm talking about academic scientific economics, not screaming talk show host, sound bite "economics".

Things like externalities, potential monopoly power, asymmetric information, information costs, large economies of scale, inability to patent, and many more free market problems make it so that a government role can immensely increase wealth, efficiency, and public welfare. These can be found in any college intermediate microeconomics text.

Other things that explain why some countries remain poor while others grow rich: Peace is clearly huge, both internally and externally. Iran and Iraq are very poor despite enormous oil reserves largely because of horrible fighting against other countries and of groups within their own countries. Free trade is almost always a big plus or an enormous plus. But with free trade although the gainers gains outweigh the losers losses, it's important to distribute the gains broadly through high return public investment in things like education, infrastructure, and public health.

So the truth is we know an enormous amount about why some countries remain poor while others grow rich, so there's an enormous amount of good we can do by aiding and encouraging the things we know are highly effective. This is the message we want to get out, that making an effort to help can work, can do great good. When we falsely say glib things like, "The title of my talk: Why Do Some Countries Remain Poor While Others Grow Rich? The answer: I wish I knew.", it encourages people and nations to not try to help because it falsely implies that we don't know enough to have a significant chance to make a difference. So let's be careful. Dani's clearly a very good man, but this is a bad way to display glib false modesty.

The first of many Krugmans

Below you will see my reply to Princeton Economist Paul Krugman's May 7th post, Phase Two. I'll be commenting a lot on Paul's work; blog posts, New York Times columns (He's a regular columnist every Monday and Friday), popular books, academic books, papers, and other works. I'm a huge admirer of his. I really think he is a great man. He's absolutely brilliant and he's a great person with a big heart and great character. He won the John Bates Clarke Medal, which is Economics second most prestigious prize, and he is likely to eventually win the first, the Nobel. But at the height of his academic career, he diverted what I would guess is much more than half of his time to helping others by writing for the general public about economics and politics in order to educate and encourage people to support policies that make our country and the world a much better place, thus his many popular books, regular New York Times column, and blog, as well as his public and press appearances.

All of this takes huge time away from his academic work, and the vast majority of top academics do little but work huge hours on their academic work. Thus, he has seriously risked his chance of winning a Nobel prize, and of being recognized as one of the great economists in history. This huge amount of time could also have been spent on his personal life, which, with all he does, I doubt he has much time for. So he's truly a caring man who has sacrificed much to help others.

O.k., a moment to dry our eyes...Now to my comments on Paul's recent post:

Some key things to keep in mind:

1) The graph has average (real - I checked the book) income growth of those employed. It doesn't factor in the unemployment rate, and this could and should be factored in. That's why even in recession years like 1992 we see about 2% growth in incomes - it's growth in incomes of those who have an income.

2) It doesn't factor in how skewed the average income growth is, which can be very important this year, where a huge percentage had their incomes decrease or stagnate, and a small minority had giant gains. This also can, and should be factored in.

A quick idea (very technical) - try catagorizing the data. For example:

Define the parameters a1 through a7 as follows;

-a1 = Unemployed person

-a2 = Decrease in earnings greater than 10%

-a3 = Decrease in earnings between 5% and 10%

-a4 = Decrease in earnings between 1% and 5%

a5 = Increase in earnings between 1% and 5%

a6 = Increase in earnings between 5% and 10%

a7 = Increase in earnings greater than 10%

Then, come up with numbers for the parameters a1 through a7 by calibrating to the historic data before 2008 (finding the values for the a1 through a7 that will make this model best fit the historic data).

So, you might find a1 = 5, a2 = 3.7, a3 = 1.4, etc.

Then, plug in 2008's numbers and see what comes out for the probability of the incumbent party losing.

The idea behind catagorizing is that it stops false linearity. What do I mean by that? The way the model is now, if a person's income increases by 50%, it's saying it's 10 times more likely that he will vote for the incumbent party than if his income increased by only 5% (this is approximately true, technically due to a non-zero intercept -- sorry to the laypeople). This is probably very unrealistic. In reality it's probably something like there's typically a 60% chance of a person voting for the incumbent party if he has a 5% increase in income and an 80% chance if he has a 50% increase in income. So the probability increase from 60% to 80%, a 33% increase, not a 10 fold, or 1,000%, increase.

What really matters is how much net good they would do

Economist Mark Thoma in his May 4^th post understandably doesn't like Hillary's recent support of a gas tax holiday and her related comments, and he muses about whether he will vote for Hillary or Obama. Here is my reply:

With regard to your choice for President, I agree with Paul Krugman. The biggest issue is universal health insurance. It is huge in its own right, but because it would be so successful, it would give a clear and massive demonstration to the public that the simpleton Republican ideology that government is always bad, and the unregulated free market is always better, is deeply wrong.

This would generate enormous political capital for the Democrats, and it could easily mean control of the senate with a filibuster proof majority. Remember that after the New Deal the Democrats had such high political capital for their ideals, they were able to usher in a golden age of high and equitable economic growth and social advancement. And, the Republican party was forced to move far to the left (a great description of this is in Krugman's new book, "The Conscience of a Liberal").

The Democrats could use the great political capital that would come from universal health insurance to do great good, for example to have a tremendous increase in action against oil dependence (which would devastate the funding and ability of terrorists) and global warming. In fact, I think the best thing that could happen in combating global warming is to pass universal health care. This would provide enormous political capital to really do big things.

Based on the fact that Obama's program doesn't mandate insurance – which is crucial for evolving towards universal health care, and based on the things Obama has said, I think we are much more likely to get it with Hillary. I also think Hillary is about as electable, maybe more.

Both her and Bill are extremely intelligent and care very much what economists say. This is clearly shown by overall what they say and support. Hillary only said what she said because she thought it would help her get elected. Both her and Bill have clearly shown that they are very willing to say and do smaller bad things in order to get done far larger good things, and I think on net, Hillary would do far more good than Obama.

Obama has been trying to cultivate this image as a great new age compromiser, so on the issues overall he proposes much less improvement than Hillary, and much less improvement than we could actually get through today. The public has been so hurt by simpleminded and plutocratic Republican policies at this point that they will back big and positive change, so the greater positive changes Hillary proposes can overall really be put through. We don't have to settle for the relatively timid new age compromising, not too different from the extreme Republican, positions of Obama.

Especially with so much today that can so greatly help or hurt people, I think the vote should be based on who will do the most net good, not who says the most pleasant things, and I think clearly, from what I've seen so far, that's Hillary.

Welcome to my blog

As this is the first post, I'd like to tell you a little bit about what the blog will be like. My catch phrase above really gets to the heart of it. I believe I have accumulated a great deal of intuition and knowledge regarding economics, finance, and other subjects (please see the "About Me" blurb to the left), and that I am good at teaching what I know in a way that's clear and easy to understand, but also accurate.

I am far less willing than average to say something that is simple but substantially false and misleading in order to make it easier to understand. What you end up easily understanding is something that's substantially false, and often in important ways. I believe I am good at teaching difficult things clearly and in an easy to understand way without saying things about it that are simple, but very untrue. What makes me think this? As you can see from the "About Me" blurb, I have a lot of experience teaching and have gotten some great feedback.

This leads me to the next point. First, I really want to be truthful and accurate, and part of that is not lying about myself, so I don't want to say I don't think I'm an excellent teacher because that would be untrue. Furthermore, I don't want to just say nothing about it, because I think it's valuable for you to know this, and that I do get outstanding teaching reviews. It is an important benefit of reading my blog. In any case, though, if I sound egotistical, I apologize.

You may have also noticed that my writing often deviates from what is considered today to be "good style". For example, it's not "tight enough", "concise enough"; it has grammar errors, non-misleadingness is not a word, etc., etc. I am far less willing than average to sacrifice clarity, accuracy, ease of understanding, and important nuance, details, caveats, etc., to get what is considered "good writing style".

For important material, it's usually much better that it be less "tight" so that people really understand it. You do no one a favor if you make it have 50% less words, but they end up having to slowly read it twice, actually spending more time, and they still don't understand many important things. You do them no favor if you leave out a lot of important nuance, detail, and caveats, so it's smooth flowing and concise, saving them maybe 10 minutes, but costing them far more from mistakes they make from not knowing this important nuance, detail, etc.

So you will see that my writing often deviates substantially from what's considered today to be "good style", but I hope you will also find that it's very clear, fast and easy to understand, and that you gain a great deal of valuable understanding, that in many cases you weren't finding elsewhere.

Sometimes you may think I could have explained something just as well with "good writing style", and you may be right, but if I don't have time to think of a way to explain it well that's smooth, I may just choose to just state it clearly and accurately, even if it's clunky, rather than not stating it at all. As you can see from my "About Me", like most people, I have a lot going on in my life and limited time, and I believe in having a personal life and plenty of sleep for good health. So often I won't have much time for the blog. But I think one of the great things about blogs is they're a way to get writing out quickly; they're a forum where you don't have to spend a lot of time to get it really polished, and this is very valuable, because without such forums a lot of great information and ideas would really never get out, or would get out much later. It would just keep getting put off until the person had time to polish it and get it into a finished state. That might be years later (if ever), and the ideas and information might have done a lot of good if they were released earlier, especially if they were very topical. So blogs serve an important function in that regard, and I'm quite sure I'll be posting a lot of very unpolished writing.

Thank you for reading, and without further ado, let's get started...