As you may have read in my previous post, my economics capstone focuses on macroeconomics. My professor is a great fan of Keynes and his followers and therefore Keynesian views dominate our reading list. For our second week we are scheduled to read Paul Krugman’s Return of Depression Economics and the Crisis of 2008. Krugman is a devoted Keynesian and even more devoted leftist. He writes a semiweekly column published in the New York Times, which is heavily political. In a 2009 New York Times Magazine he published a long acerbic description of the roots of the economic slump, in which he dismissed most of modern economics and basically declared most of the living economists to be incapable failures. One of those failures, John Cochran, wrote back and called Krugman the Rush Limbaugh of the left.
Because of his personality and aggressiveness, I’m not a big fan of Krugman. Generally I don’t disagree with him on economic terms; perhaps I’ve been affected by the largely left-leaning (edit: macroeconomics) faculty of Gettysburg and I identify myself as largely Keynesian (with a twist). But in practically every article and book I’ve read it seems as though he’s looking at events of yesteryear (or older) and saying “how could you be so stupid you didn’t this or that coming.” After a battle, everyone is a general.
In Depression Economics he looks at recent economic crises around the globe, including the tequila crisis in Mexico in 1995, Asian crisis in 1997 and continues with the dot com bubble and the housing bubble. Few other events — rise of hedge funds, Russian default– and personalities — Soros, Greenspan– are described here and there. The books is a very easy read. Its font size and line heights are big and easy for the eyes; I appreciate that. The content is largely non-technical and practically no knowledge of economics is required. It seems as though Krugman wrote a popular science book than an economics books. If he didn’t so strongly imply everyone involved in the crises (and particularly their resolutions) was an absolute idiot, the book would have been a good companion for a rainy Sunday afternoon (it’s been raining here for the past two days and the forecast for the rest of the week is no less gloomy).
In between chapters on crises Krugman revisits some of the key Keynesian concepts. Personally I find those chapters most interesting and useful; lacking ad hominem attacks, they offer a cursory look at ideas that have been tremendously influential in modern economic history (until they were periodically replaced by new inventions). One of the concepts described were animal spirits.
The classical economics of the late 19th and early 20th century was based on the assumption that people are perfectly rational. According to macro theories of the time, people’s decision would be a direct result of utility-maximization functions that take into account all available information. Under those circumstances many of the macro events we’re familiar with, like unemployment, do not exist. In the view of a classical (and neoclassical) economist an unemployed person has made a decision to become and remain unemployed. Such interpretation seems silly.
Keynes argued that people make decisions based on their animal spirits. In other words, rationality gives a way to moodiness and gut feeling, to human psychology. In General Theory he wrote that “[o]ur knowledge of for estimating the yield ten years hence of a railway, a copper mine, a textile factory [...] amounts to to little and sometimes to nothing. [...] Decisions can only be taken as a result of animal spirits.” George Akerlof and Robert Shiller in Animal Spirits identify five psychological forces that govern our economic decisions. As I picked up the book only today, and as I had to take care of my regular coursework too, I’ve only reached the end of the first part, which describes the spirits. The second part uses that analysis to answer like “why are financial prices so volatile?” or “why do economies fall into depression?”
Animal Spirits are much more insightful than Depression Economics. Not only does the book not waste space by calling names, it also goes much deeper into analysis of economic — and psychological — events. First part’s main contention is that confidence, fairness, corrupt and anti-social behavior, money illusions, and stories (damn you, Oxford comma) are the key animals spirits.
They open with the discussion of Keynesian fiscal multiplier and augment it with confidence. Confidence in the economic sense (ie, belief in bright future) behaves like marginal propensity to consume. A unit of confidence, however arbitrarily measured, will trickle down from person to person. This increased confidence will be visible through less desire to spend and invest money even if it’s not fully aligned with rational fundamentals. On the other hand, a negative shock to confidence will have the opposite effect and result into slump in aggregate demand, run on banks etc. The massive runs on banks during the Great Depression may be viewed as results of confidence multiplier, of self-fulfilling prophecy. As the book first went to print in 2008, the authors suggest the government and Fed must not only stimulate the economy fiscally and monetarily, but also confidence stimulus.
Fairness is described in more psychological and sociological terms. Authors argue that people make irrational decisions because they seem fair, and that many macro concepts can be more easily interpreted if we include fairness. Supposedly involuntary unemployment or relation between inflation and aggregate output are among those concepts (I’ll read about them in later chapters).
Emergence and prominence of corruption and bad faith tends to correlate with business cycle. Akerlof and Shiller describe three recent major recessions — following S&L crisis and dot com and housing bubbles — and point at excesses and moral hazard that have surfaced with the crisis. They argue that as time goes on, the penalties for bad and corrupt behavior are forgotten. The profits of a corrupt trailblazer inspire others and soon we find the economy based on lies.
Lastly, stories allow people to remember general scenarios even when individual facts have been forgotten. The stories of success breed further success, much akin to the first animal spirit, the confidence multiplier. Imperfect, selective memory may however give rise to a behavior far away from a utility-maximizing rational optimum.
As I’ve mentioned the book is very insightful and my summaries of the key points so far are truly just summaries. I’d highly recommend it.
