CEPR - Center for Economic and Policy Research


En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press Paul Krugman and the Economics Fringe

Paul Krugman and the Economics Fringe

Saturday, 26 April 2014 07:34

Paul Krugman has devoted two recent blogposts to address complaints from heterodox economists over Thomas Piketty’s new book. I have written several pieces on the book and made my own view quite clear. I think it is a great book and I am happy to see it bring so much attention to the growth in inequality over the last few decades, even if Piketty gives short shrift to policies that could reverse this rise in inequality.

Rather than dealing directly with the dispute over Piketty, I will take some issue with Krugman’s account of the mainstream and the crisis. Krugman writes:

“It is true that economists failed to predict the 2008 crisis (and so did almost everyone). But this wasn’t because economics lacked the tools to understand such things — we’ve long had a pretty good understanding of the logic of banking crises. What happened instead was a failure of real-world observation — failure to notice the rising importance of shadow banking. Economists looked at conventional banks, saw that they were protected by deposit insurance, and failed to realize that more than half the de facto banking system didn’t look like that anymore. This was a case of myopia — but it wasn’t a deep conceptual failure. And as soon as people did recognize the importance of shadow banking, the whole thing instantly fell into place: we were looking at a classic financial crisis.”

To my mind this seriously mischaracterizes the nature of the downturn we have experienced since 2008, with important real world consequences. I have long argued that the crisis is really the story of the housing bubble and its collapse. However entertaining it might have been, the financial crisis was secondary.

There are two reasons this is important. First, if we see the financial crisis as being primary then it both gives economists greater excuse for their ignorance (hey, who knew AIG had issued $600 billion in credit default swaps on mortgage backed securities?) and creates the basis for the story of Bernanke-Geithner heroism in saving us from the second Great Depression (SGD).

If we see the housing bubble as the story, then some very serious financial stress was virtually an inevitable outcome. If you have an asset (housing) that is highly leveraged even in normal times, which then became incredibly highly leveraged in the bubble years, it is virtually certain that the plunge in house prices associated with the collapse of the bubble was going to lead to some serious financial disruptions. I raised the prospect that Freddie and Fannie could fail as early as my 2002 paper on the bubble, to the great annoyance of Fannie and Freddie's economists at the time. Uncovering the specific course of the cascade of collapse would require some investigative footwork, but the loss of $8 trillion in housing wealth should have been sufficient information to know that the financial system would be teetering.

The saving us from (SGD) myth is especially pernicious because it implies that we should somehow be thankful for an economy that continues to inflict massive amounts of needless pain. The problem with the SGD story is that a full-fledged financial collapse in 2008 would not have condemned us to a SGD any more than the collapses in 1929 and 1933 forced us to incur a decade of double digit unemployment.

We know how to boost an economy out of a downturn. It’s called spending money. We ultimately did this in 1941 to fight World War II. Had we instead spent a huge amount of money on some peaceful purpose in 1931, we would not have experienced a decade of double-digit unemployment.

The same logic applies to the current downturn. If we had a worst case scenario and the major banks were allowed to collapse, we know how to reboot the economy to return it to normal levels of output. To have a SGD (defined as a decade of double-digit unemployment) it would have been necessary to see both a financial collapse and a failure to have an effective fiscal response for a full decade.

Given the current political environment the latter is perhaps a possibility, but people should be clear: their fears of a SGD were not based solely on the prospect of a financial collapse. It was based on their assessment of a political system that is so incredibly dysfunctional that we would rather have tens of millions of people needlessly sit unemployed than spend the money to put them to work.  

The other reason why it is important to see the housing bubble as central is it brings home how serious and longstanding the problem of secular stagnation is. When we recognize that the housing bubble was driving the economy after the 2001 recession, we see that the Fed’s ability to boost the economy back to full employment through conventional monetary policy was already seriously limited even before the housing crash.

The labor market’s recovery from the 2001 recession was extremely slow. The economy continued to lose jobs all through 2002 and most of 2003. We didn’t regain the jobs lost in the downturn until January of 2005. At the time this was the longest period the country had gone without job growth since the Great Depression.

The Fed had the federal funds rate at 1.0 percent from the summer of 2002 to the summer of 2004. This is not quite zero, but no one thinks that the difference between a one percent federal funds rate and a zero percent federal funds rate would provide much additional boost to the economy. The demand generated by the housing bubble did eventually lead to healthy job growth and brought the unemployment rate down to 4.5 percent by 2007, but it should have been clear at the time that the economy was suffering from a deficiency of demand – a problem that was largely assumed away in the orthodoxy of the profession.

Krugman is right that this story could have been told using the standard tools of the trade. It would be easy to draw this picture using the IS-LM framework from any of the editions of Samuelson’s textbook. However, the orthodoxy’s dismissal of both the idea that asset bubbles could lead to serious economic distortions and the possibility that the economy’s self-correcting mechanisms towards full employment might be very weak, prevented almost the entire profession from seeing what should have been pretty damn obvious.

I personally am not interested in a fight over the tools, but this failure of the profession was humongous and that needs to be acknowledged. There was no excuse for a competent economist not to recognize the housing bubble and the danger it posed to the economy.

Also, while there is no reason for score-settling, score-keeping is still worthwhile. It’s great to see Larry Summers talking often and forcefully about the problem of secular stagnation. However, there are few people that bear more responsibility for this problem than Summers. His management of the bailout from the East Asian financial crisis sent the value of the dollar soaring against other currencies. This led the trade deficit to explode, creating a huge gap in demand that we all now know cannot be easily filled. Throw in his vigorous support for financial deregulation and it is understandable that some folks feel uncomfortable with Summers as an ally.

In short, there are some grounds for us fringe types to be unhappy about the current course of mainstream economics, but to my view it’s better to look for allies than enemies. For this reason, I remain happy that Piketty has renewed public focus on inequality, and I will pass over the technical grounds on which he has rightly been criticized by my fellow fringists.

Comments (25)Add Comment
Why are you considered a fringiest?
written by Dave, April 26, 2014 8:32
I suspect money has something to do with it. The prominent voices in economics, even those who do rock the boat, tend to be those who don't rock it too much. Perhaps Dean relates to fringiest, but I think public opinion will catch up to make this position much more main stream. The advantage this position has over the others is that it not only explains the causes of the problems, it also appeals to common sense, which is something mainstream economists often get annoyed with.

I just hope we can entertain policy ideas long enough to use them as brainstorming material rather than jumping to political judgements about feasibility first, which puts a hard stop on potentially new ideas.

written by JSeydl, April 26, 2014 8:37
Well written, Dean.
Speaking of fringists...
written by LSTB, April 26, 2014 8:39
...I think they have more than technical grounds to criticize Piketty.

If I'm not mistaken, the marginal product theory Piketty uses was pioneered by John Bates Clark in the 1890s. His goal, though, was to eliminate land as a production factor to silence Henry George and his land-taxing followers. Clark also used it to justify low wages and wealth concentration ala "just deserts" and Social Darwinism.

I would love a correction or explanation for how Piketty can use the same theory to argue for the exact opposite ends.
written by Kat, April 26, 2014 8:58
If you concern yourself with real life consequences on ordinary Americans, I guess this makes you fringe.
What a silly debate for Krugman to be having. Sure, mainstream economics had the tools to see the bubble and not discount it. But they didn't. That's what matters.
Piketty is good for the attention it brings to inequality, and especially for the death blows it delivers to the idea that it doesn't matter how the pie is divided as long as it is growing. I think (from what I've read here) that discounting of wealth concentrating effects of imperfect competition from monopolies seems like a glaring omission. Maybe someone could cover this in The Wealth of Nations in the Twenty-First Century? That might really make the wingnuts heads' spin.
written by skeptonomist, April 26, 2014 9:34
Housing itself was not really itself the main problem, the housing price bubble was the symptom that should have alerted economists and policy-makers. There have always been local housing bubbles as land becomes scarce in booming areas. This is probably why Bernanke thought the bubble was only "froth". The main problem was overextension of leverage, as Dean points out. Over-leverage is always the fundamental problem with financial bubbles. Economists should have known about the dangers of leverage by this time, but they refuse to learn. One reason for allowing leverage to increase is that economists thought they had figured out how make corrections in case of trouble, using monetary manipulations. This is quite obvious in the rhetoric of many authoritative non-fringe persons with diverse economic ideologies, including the likes of Greenspan, Bernanke, Summers, DeLong and Krugman (although Krugman began to have some doubts as Greenspan became ever more detached from reality). Financiers are always looking for ways to increase leverage - it's how you make big money fast - and when economists agree that it's not a danger and set policy accordingly there is usually trouble.
written by Steve Lightner, April 26, 2014 9:49
I think you all miss Krugman's point. His argument is that we don't need new economics, we just don't need to ignore basic Econ 101 that would have informed us of this coming crisis. He is trying to keep us from throwing the baby out with the bath water. As for Dean's assertion that the root cause was the housing bubble, not the financial crisis, again I think it is a chicken and egg thing. Without the creative financing, we could not have had the housing bubble, and which came first is kind of irrelevant. One was part and parcel of the other to spurr continued massive profit taking.
written by PeonInChief, April 26, 2014 10:40
Concentrating analysis on the financial collapse isn't that surprising--it means that you don't have to look at the real problems of the vast majority of the population, just as ignoring the housing bubble meant that you didn't have to look at the problems of the vast majority of the population. I get the feeling that most economists would rather spend their time talking to Jamie Dimon, rather than some poor soul whose mortgage servicing was sold by BofA to Greentree.
Nope - Finance caused the SGD, not The Housing Bubble.
written by ibilln, April 26, 2014 1:06
See, "Finance" is a thing. The Housing Bubble looks silly in all caps as if it were a thing

"If you have an asset (housing) that is highly leveraged even in normal times, which then became incredibly highly leveraged in the bubble years, it is virtually certain that the plunge in house prices associated with the collapse of the bubble was going to lead to some serious financial disruptions."

NO ONE KNEW about the incredible high leverage - no one being most economists plus most people. Dean Baker prob. knew - indeed, the quoted sentence gives him up - it was the -leverage- which is , um Finance. The event that lots of random people "owned" housed that they previously couldn't afford is not, qua event, either necessary or sufficient to cause an SGD.

Ie, no one knew about the shadow banking system. The "incredible leverage" with all it's moving parts - criminal ratings agencies, mortgage brokers, investment banks, the incompetent brain-dead MERS thing, Summers et al fighting hard to keep the few criers in the wilderness, eg Brookley Born, pounded down, out of sight - was one thing: That there were massive securitizations which had really no chance of fulfilling their bond-like destiny because they were impossible to construct such that the necessary condition for a securitization to hang together was not met: That a securitization's parts must be able to be described as independent variables.

The very first CDO at JPM, composed of JPM's real estate related CDS (!) could in no way then or now be honestly described as a collection of random variables. It was almost guaranteed to not perform as desired and in fact started to unravel in it's first months.

There are a few people who knew about the danger of these things, but they were not heroes - maybe they knew how Summers destroyed Born. So the fable continued - as long as everyone was dancing, no one wanted to stop. "They" are/were the shadow banking executive staffs. This is what Greenspan was "surprised" about - that these guys knew they were going to blow up and continued to dance.

But look - one can securitize any income stream. People could and do securitize insurance policies. etc. But Dean is, EOD, probably right (ish) - real estate has enough moving parts that it's easy to not be fully aware of what's happening at any point. Probably the SGD could not have been caused by life insurance run amok.

But to say that "the housing bubble" was the culprit is IMVHO completely is untrue, almost in it's semantics let alone it's substance.
Other than that, I really liked the post!
How would you answer Brad DeLong?
written by Another Scott, April 26, 2014 2:24
Hi Dean,

Perhaps its just a difference of emphasis, but DeLong (as I understand the argument) strongly disagrees with that picture - http://delong.typepad.com/sdj/...risis.html

As I have said repeatedly: I simply do not buy this. From the fourth quarter of 2005 through the fourth quarter of 2007 lending standards tightened enormously, and investment is residential construction collapsed. By the end of 2007 residential investment had fallen 2.5%-points from its peak-of-the-boom level. But the heightening of lending standards and the unwillingness of people to make further NINJA (no income, no job or assets) loans had not sent the economy into any sort of a recession. It was the spiking of risk premia in 2008 that sent us to Wicksellian natural-rate-of-interest-below-the-ZLB territory. And there is no reason to think that we would have been in such a situation but for the financial crisis--and every reason to think that the whole mishegas would have been avoided had congress simply put the too-big-to-fail banks into conservatorship in January 2008...

It seems to me that housing was the money machine that was underpinning everything, but the Masters of the Universe were leveraging paper backed by housing a million other ways. Once that people saw that the pile of paper wasn't worth what they thought it was, that's when everything started to freeze-up quickly. Yes, there would have been a nasty recession due to the housing bubble, but the AIG and Lehman and all the other stuff broke people's faith in the whole banking system and made it much worse.

I'd be interested in hearing your counterpoint to DeLong.


And thanks for this great blog.

@Another Scott
written by medgeek, April 26, 2014 2:38
Thanks for the DeLong quote. I was just sitting down to write a comment exactly along the lines you indicated. Yes, there was a housing bubble, but an enormous amount of mortgage obligation money was repackaged by Wall Street into securities like CMOs, CDOs and whatever. People suddenly realized that those instruments weren't as valuable as advertised, and then things unraveled in a hurry.
Brad is being sloppy
written by Dean, April 26, 2014 2:45
My argument is that housing prices and construction were falling and would have continued to fall. Once the deflation starts, it is hard to stop. The process accelerated because of the financial crisis, but we would have gotten there anyhow. Also, the reduction in consumption, which is another big part of the picture, would predictable follow with a bit more of a lag.

I think Spain provides a good story of a more pure housing bubble effect. The country did not have a financial crisis in 2008. I went to several conferences in 2009 where people were touting its well-regulated financial system as a contrast to the U.S.

Nonetheless, Spain had a huge housing bubble that fueled an enormous construction and consumption boom. These gradually came to an end as house prices went into reverse. And, Spain has had a very serious downturn.

For Brad's story to make sense you have to be able to say what component of demand would be higher today if we had not had the financial crisis. I can't imagine what his answer would be.
Not That It Matters But We Have Still Learned Nothing
written by Jesse, April 26, 2014 9:32

I am not so much worried about the last bubble and the financial crisis that greatly exacerbated its effects.

I am concerned that almost no one is talking about the next one, which should be arriving sometime in the next 24-36 months, or less.

written by Peter K., April 27, 2014 7:32
I find the debate confusing. I see what Baker is arguing but perhaps what DeLong and Krugman aren't explaining very well is how the epic panic (where people pulled their money) made things worse than they would have been otherwise. Baker points to Spain but Spain had the sadomonetarist European Central Bank doing its monetary policy.

Would the Fed have behaved the same way if things got worse and worse and worse? With the financial crisis, the Fed can drag its feat (even as it seems to be doing a lot, driving the rightwing shrill) as it says "look, things are slowly getting better." Yeah at an glacial pace.

There are those like Scott Sumner who argue the Fed allowed NGDP levels to drop (in its misplaced focus on nonexistent inflation) as the bubble deflated. They could have hit the gas and turned into the skid.
@Peter K. Indeed it is confusing.
written by Another Scott, April 27, 2014 8:20
It's important that we (the public, and the economists) learn the right lessons from what caused the Great Recession (GR) and how to fight such things when they happen again. It would be nice if there were more of a consensus on "our side" (the reality-based community) as to what that was.

Given the reality of the split in our politics these days, it's not clear that anything better could have been done (or will be done in the future), but having the various theses argued for and against, in detail, is important to learn the right lessons. Blogs and OpEds are a great resource, but they're not sufficient.

Krugman and DeLong and Baker are all very bright and very persuasive (to me at least). There's obviously room for disagreement. But it's a little disconcerting that they seemingly aren't on the same page on what "caused" the GR.

(I do think that PK wasn't including Dean (and Bill McBride of CalculatedRisk) on the list of economists that didn't predict the housing, etc., crash. I think that was just short-hand on PK's part. The major part of the disagreement seems to be the strength of the belief about the counter-factual (would the GR have happened anyway without Lehman's bankruptcy ($600B in assets) and the rest).)

My $0.02.

written by he who pays the piper, April 27, 2014 8:27
when the entire system wants a bubble, any one who exposes it will not be a popular person.

when you are paid to not understand something, it can be difficult to understand it.

THe FIRE sector runs the show, and the FIRE sector loves bubbles - they get to have the cake and eat it too because of the bailouts that are guaranteed now because of the paper money system.
written by gordon, April 27, 2014 8:51
For what it’s worth, my interpretation has been that the housing bubble’s collapse acted like a demolition charge going off under the foundations of the shadow banking sector when all those mortgage-based CDOs supporting the shadow banking sector suddenly became valueless as the bubble burst. It was like watching those demolition videos; first you see the little explosions around the base of the building, then after a (very) short pause the whole building gracefully collapses into a cloud of dust. So to my way of thinking the collapse of the housing bubble was a fundamental part of the story – though not the whole story, by any means.

I definitely agree with Dean Baker’s remark that “…the Fed’s ability to boost the economy back to full employment through conventional monetary policy was already seriously limited even before the housing crash”. The way the US political system put the responsibility largely on the Federal Reserve to reboot the US economy after the crash really represents a massive avoidance of responsibility. The politicians quailed before the massive fiscal action required, and did their best to pass the hot potato to the “experts” at the Fed. That was bad, but almost equally bad was the way the Fed tried to do the impossible. Instead of passing the potato back again on the grounds that they weren’t really able to do the Federal Government’s work for it and shouldn’t be expected to do so, Bernanke seemed to swell to twice his normal size as the spotlight fell on him, and started behaving like an actress at the Oscars. I suppose the sudden fame and breathless attention went to his head, but he should have known what Dean Baker pointed out, and refused to let the Congress and Executive off the hook.
written by Jay, April 27, 2014 9:26
I think Krugman probably got lulled by the press. The real estate industry has done a great job by changing the conversation from housing affordability and inflated prices.
written by Glen, April 27, 2014 10:49
While you alluded to it at the end, I don't believe you have fully addressed it. IMO, the real cause of this mess is the trade deficit. The housing bubble hide this from us, but as you mentioned regarding De Longs post, this is the only issue that would address today's lack of demand.
written by Chris, April 27, 2014 11:36
The idea that the housing crisis was some force of nature that couldn't possibly be predicted is similar to the talking points re Iraq and every other crisis.

People in power in DC and Wall Street thought housing prices were the golden goose and they were wrong. They bet everything on the belief that they were right and when they lost they used lies and obfusciation to rebuild themselves so they could presumably do it all over again at some point.

The elites hosed the people and could care less that they did. They see it as their proper role and use massive leverage, money printing, laws etc to ensure there's no way to protect ourselves from them and their decisions.

Michael Hudson called all this way before it happened
written by Chris O'Rourke, April 27, 2014 2:28
UM Economist Michael Hudson called all this way before it happened. No one would listen. All of his predictions have come true: the reduction in real wages, the Latvian experiment, etc. Anyone who thinks any of this was unexpected has their head in the sand. Yay Capitalism!
.A reluctant dissent.
written by Oregoncharles, April 27, 2014 3:33
"while there is no reason for score-settling" - I disagree, strongly. Mr. Baker is very reluctant to draw the obvious conclusion: a lot of economists are worse than useless and should be fired. Since the collapse, he's made it his business to make it clear that essentially the whole profession - at least the macro side - is profoundly corrupt and should be replaced, along with the academic departments that ALL the Wall St. thieves came from. It would give him, and the few others who "saw the bubble," a chance to remake the field. A huge job, I realize, so I can understand his reluctance.
But a necessary one.
Model Assumptions
written by Peter Bayley, April 27, 2014 4:36
While economic models assume a) people can't be manipulated by media and so continue to act rationally and b) the financial and political systems have not both been dangerously compromised by a burgeoning criminality, the Models will continue to deliver nothing but rubbish predictions
written by John Kissinger, April 27, 2014 9:13
Great article. IMO the mantra should be 'remember WWII', and this should be said over and over... it is widely believed that WWII got us out of the depression, so focusing on this point, that the main worry is not deficits but unemployment, and that deficits melt away as a percentage of GDP when the economy returns to full employment, is the best pushback against austerities.

Steve Keen's chart showing the rise of private sector debt, already higher as a percentage of GDP by 2000 than it has been in 1929, is the best explanation of why the Fed's only real tool, i.e. short-term interest rates, took longer than normal to function; people were maxed out on what they could pay, and so had little incentive to borrow more. Subsequently private sector debt continued to surge along with the housing bubble, to the point that in 2008, when the Fed dropped interest rates to zero in its attempt to boost the economy, there was no response at all to the interest rate reduction. IMO we will have to see private sector debt decline to less than where it was in 2000 before the Fed can once again moderate the business cycle. Lately, however, students have been borrowing to go to college in the hope that more eduction will make them employable, and debt has begun to rise, not fall... these students are of course not good prospects for buying a new house, as they might have been at their age in previous cycles.
Of course, the Fed had to drop rates whether the economy responded or not, the wall street banks were insolvent and it was once again critically necessary to transfer wealth from the household sector to the banking sector. So in this respect, the decline in interest rates to banks was successful and has allowed them, perhaps, to approach solvency, though of course fat salaries, share buybacks, and dividends drains much of the profits from the interest rate decline. As an aside, I presume at least some banks remain insolvent, else why would FASB not require, as they really would like, banks to mark assets to market?
written by bananaguard, April 28, 2014 3:26
OK, couple of things. Arguing for a single factor to have precedence while recognizing a multitude of factors at work can veer pretty close to dancing on the head of a pin. Your argument is that housing prices were based on leverage, and that both were too high. Krugman says shadow banking was a problem. Somehow, I remember that shadow banking folk were found to have lobbied mortgage desks to create more crappy paper so there was more paper to short. That suggests the distance between your conventional leverage argument and Krugman's unconventional leverage argument is pretty small. I doubt that the CDX market was the only instance of a linkage between the two.

Another problem is with your presentation. You start with the urge to blame economists and avoid crediting Bernanke and Geithner. That gives this a whiff of doing the analysis to fit the view. IF we don't see this as a conventional finance problem, THEN I can't blame economists and policy makers the way they need to be blamed. If that isn't what you meant, then maybe you shouldn't gone with the "who gets blamed" part of your story so high in the text.
Questions of substance, Minsky & mainstream economic tools
written by Peter L., April 29, 2014 2:56
At the moment I'm trying to learn a little bit about Hyman Minsky's ideas. Minksy and others who study banking and money would seem to fall under Krugman's criticism.

There are two things about Dean's post that I find a little difficult to accept:

(1) The housing bubble: my crude reading of Minksy is that the housing bubble entered a stage of what he called Ponzi finance, i.e. income on assets bought with debt was not enough to pay the debt service, and only by going further into debt could people put off bankruptcy.

Minsky tried to develop a theory that put finance at the heart of the matter.

(My understanding, for example, is that if a housing bubble (like maybe in London, now) was fueled by people buying without debt, maybe rich people buying for all cash, the result of the collapse would not be predicted to cause financial problems. This speaks to the importance of the banking sector in driving the housing bubble and creating the debt-based conditions for the devastating effects of its collapse.)

(2) The fight over tools: while I definitely don't think this is necessarily productive, when it comes to Krugman, it seems like this might be an important topic.

In Krugman's discussion with Steve Keen (please use search engine to read if one has not yet done so), Krugman denied that banks have anything to do with leverage and debt. Krugman seemed to take pride in the fact that he didn't consider or seem to understand facts about how the banking system works (legal and institutional details about how banks make loans, appear irrelevant to Krugman). Krugman called Steve Keen a "banking mystic." But Keen didn't say anything controversial. To me, it was shocking that Krugman was so dismissive of banking and money.

This looks like a serious deficiency in whatever model he is using.

Isn't there a good argument that if the "tools" are deficient the outcome will be as well?

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.


Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.