NYTimes.com Article: Devotion to Free-Market Makes for Ineffectual Policy

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Devotion to Free-Market Makes for Ineffectual Policy

September 5, 2002
By JEFF MADRICK






N a widely cited speech in Jackson Hole, Wyo., last week,
Alan Greenspan tried to defend his failure to tame the
1990's stock market bubble. The Federal Reserve chairman
said raising interest rates would have caused too much
damage to the economy. He said raising margin requirements
would not have mattered, although senior Wall Street hands
like the economist and consultant Henry Kaufman had long
urged him to do so.

But most telling, Mr. Greenspan said Fed officials could
not know when stocks were too high. Maybe the market, even
when violating all sorts of historical precedents, was just
right.

Such thinking is all too representative of the undue faith
in the magic of markets that characterizes today's policy
making.

Mr. Greenspan was quick to help the market when it was too
low. During the Asian financial crisis in 1997, the fear
that the financial system might collapse weighed heavily in
his decision to cut rates sharply.

But when stocks were in a bubble and the political pressure
was to keep the good times rolling, he consistently
retreated to his deepest belief that the markets were
basically efficient and should not be interfered with. A
few economists have even asserted that stock bubbles are
entirely rational.

A highly respected mainstream economist has issued one of
the strongest criticisms yet of such thinking. George
Akerlof, a professor at the University of California at
Berkeley, won the 2001 Nobel in economic science, with
Joseph Stiglitz and Michael Spence.

In his Nobel acceptance speech, reprinted in the June issue
of The American Economic Review, Mr. Akerlof uses
behavioral economics to criticize oversimplified
laissez-faire theories.

Such theories depend greatly on one assumption: that buyers
and sellers are rational and seek to maximize their own
incomes and profits. These economists, perhaps best
represented by the work of the so-called new classical
economists, whose home base is the University of Chicago,
conclude that stocks are almost always sensibly priced.
They also conclude that unemployment cannot be reduced
without creating inflation, people save enough on their
own, regulations that limit the international flow of
capital are anathema, and even monetary policy has little
or no consequence.

Mr. Akerlof argues, however, that market bubbles can exist
and should be kept under control; that unemployment can
often be pushed lower by government without generating
inflation; that people will not save enough on their own;
and that liberalized global capital flows have been
damaging. He argues that monetary and fiscal policies do
matter in creating jobs and raising incomes.

The starting point for Mr. Akerlof and his colleagues is to
make the central assumption of economics realistic. People
are often not rational, maybe even most of the time.
Consider investors in stocks. Keynes implied long ago in
his "General Theory of Employment, Interest and Money," Mr.
Akerlof notes, that investors are subject to fads and
fashions.

Behavioral economists have developed a lot of evidence to
support this idea. For example, Robert Shiller of Yale has
carefully shown that stock prices are much more volatile
than corporate profits and dividends.

An important conclusion is that when stock prices are
historically far out of line with profits, there is a good
chance that it is a bubble, not a "new economy" of
ever-higher profits, as Mr. Greenspan often suggested in
the 1990's.

Similarly, new classical economists argue that markets are
so efficient that unemployment is largely voluntary. For
the most part, they say, people who are out of work can
find jobs if they are willing to work for less. Government
cannot really help them.

Mr. Akerlof argues that in real life, businesses often pay
more than the market wage to retain good workers, bolster
morale or create incentives to work harder. Thus, jobs are
actually rationed, and many job seekers are shut out.

Mr. Akerlof argues that behavioral economics also casts
doubt on the related assertion that there is a unique
natural rate of unemployment. If policy makers push the
jobless rate lower, the argument is that inflation will
inevitably accelerate. Mr. Akerlof believes that when one
considers the way people really act, this is just plain
wrong. As Keynes asserted, monetary and fiscal stimulus can
produce more jobs and higher incomes that will not be
undermined by higher inflation.

As for savings, much economic theory argues that people
save rationally over their lifetimes for retirement. But
behavioral economists show that people systematically
procrastinate - they spend today and plan to save tomorrow.


This may seem obvious. But consider how far Social Security
privatization has gotten, based largely on the new
classical view of rational human behavior. Proponents argue
that if people are deprived of Social Security as a safety
net, almost all of them will save adequately for
retirement, no matter their level of income. There is no
basis in human observation or economic history for this
conclusion. For many people, especially with lower incomes,
saving is very difficult.

The strength of behavioral economics is that it is based
largely on actual observation of human behavior, not pure
theory. "In the spirit of Keynes," Mr. Akerlof writes,
"behavioral macroeconomists are rebuilding the
microfoundations that were sacked by the new classical
economists."

To be fair, economists from other schools of thought,
including post-Keynesians, structural economists and gender
economists, have tried to explain the same observations
with other interesting theories, and they deserve more of a
hearing.

But Mr. Akerlof and his colleagues have attacked today's
conventional wisdom, which dominates the halls of power, on
the basis of its own assumptions and values. Mr. Akerlof's
side, I believe, is winning this battle of ideas. The
battle for power may be another matter.

http://www.nytimes.com/2002/09/05/business/05SCEN.html?ex=1032323863&ei=1&en=6e582ba00fcbaf96



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