Krugman fails to take up the challenge

from Peter Radford

Sifting amongst the debris left after the recent collapse of economic orthodoxy is not easy. The big guns of the academy are clinging on for all they are worth to the idea that a few fixes and we are all back on track. They have the most to lose in reputation and standing, so I suppose this stubborn refusal to admit the extent of the defeat is understandable. But it is not acceptable. Things have to change in a more dramatic way for economics to rehabilitate itself as a credible body of thought upon which policies can be based. It is simply not enough to continue the old “freshwater” versus “saltwater” debate – that please recall is the argument between various grades of orthodoxy, the former ensconced in Chicago and other universities far from the coasts, and the latter based primarily on those two coasts.

Paul Krugman is a great example of the problem.

He presents a strong argument and  defense of a Keynesian approach to macroeconomics. This is the part of economics that deals with the big issues that occupy policy makers, especially in times of recession. In this he finds himself ranged against the more orthodox ideas of the Chicago style thinking that has invaded and taken over most of the high ground in the discipline. So he thinks of himself as an insurgent of “heterodox” thinker, and likes to do combat as a rebel.

This is curious since the rebellion is simply an attempt to reinstate the Keynesian theoretical constructs that were so successful in the immediate post war years until they were dethroned by monetarist and then hyper rationalist versions of what is called neoclassical economics. That neoclassical set of ideas was largely initiated by Paul Samuelson in 1948, when he published his enormously successful textbook and sought to incorporate Keynes within the pre-existing classical tradition.

The problem this melding produced as its legacy is that there is an inherent and implacable break between Keynesian and classical economics. Keynes spoke to aggregate issues: before him there was no notion of “aggregate demand” as a concept to be studied, managed, or fitted into policy. He argued that uncertainty was axiomatic and that the classical notions of perfect competition and so on were thus invalid. Unfortunately Keynes did not follow through and give us a full replacement for the old classical system. He was a practical and conservative person dealing only with the larger issues: indeed he invented what we now called “macroeconomics” so he could propose solutions to those larger issues, especially the devastation wrought by the Great Depression.

To put it bluntly: economics became a mess.

At the big picture level the emergence of Keynesian thinking split the subject apart. The saltwater versus freshwater fight is the result of this division.

But at the lower level much of the classical tradition survived untouched. The magic of markets; the workings of rational agents making perfectly rational decisions; the possibility of a “Pareto Optimum” – that mystical point at which an economy reaches its most efficient allocation of resources; and the other paraphernalia of classical “microeconomics” remained supreme.

So economics was cleft in two. The Keynesian constructs at policy level were based upon a worldview at odds with the micro analysis economists still relied on to understand the workings of the marketplace.

One response within economics was to replace Keynesian macro with a cobbled together version based upon classical micro. The mantra became “macro built upon a micro foundation”. This new classical tradition is the basis for freshwater thinking.

The other response was simply to ignore the contradictions between Keynesian macro and classical micro. This was the basis for saltwater macro.

Krugman falls into the second group. He voices little concern about the contradictions. Indeed he accepts them.

The obvious parallel is with physics, where the physics of very small things, known as generally as quantum mechanics, is incompatible with the physics of very large things, which is the relativity of Einstein. If physics can exist with a great divide, Krugman argues – I am putting words in his mouth – so too can economics.

This, frankly is rubbish.

Why?

For two reasons:

One, is that physics at each level is supported by empirical testing to an extraordinarily high degree of accuracy.

Two, is that physicists the world over are striving to connect to the two traditions. they do not find it acceptable to have deep contradictions within their thought, and so have set out to look for the necessary theoretical breakthroughs needed to reconcile them.

Not so in economics,according to Krugman. We, apparently will have to make do with the odd supposition that aggregate constructs are subject to inherent, and axiomatic, uncertainty. While our understanding of the deeper workings of the markets, firms, and consumer behavior from which those aggregates are composed are subject to no such thing. On the contrary those lower order objects behave supremely rationally in a world admitting of no uncertainty at all.

Talk about a muddle.

That this muddle persists is indefensible. It is time to eliminate the error left in the aftermath of the Samuelson synthesis. If Krugman won’t take up the challenge, then others will. Building a new micro based on the acceptance of uncertainty as its central axiom is the work we now need to undertake. Much has been done, much is yet to be done. One thing is clear: the challenge must be met.