Re: NYTimes.com Article: Devotion to Free-Market Makes for Ineffe

[Clifford Poirot <cpoirot@xxxxxxxxxxx>]

All right, since it is a slow Friday afternoon and summer quarter is over, I
will bite, in the hopes of provoking some discussion.

See my comments below-interspersed throughout the original article:

-----Original Message-----
From: pdavidson@xxxxxxx [mailto:pdavidson@xxxxxxx]
Sent: Friday, September 06, 2002 10:51 AM
To: pkt@xxxxxxxxxxxxxxxx
Subject: 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.

My response:
My understanding is that margin sales are a small part of total stock market
volume and this is what Greenspan bases this assertion on. However, margin
sales help to feed speculation, and by raising margin requirements he could
have sent a strong message. But just as prediction is impossible, so
sometimes is retrodiction.


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.

My response:
As I have suggested before, such rules of thumb as historical P/E ratios are
useful as general rules of thumb, with no guarantees of proving true. That
said, unless there is reason to believe to believe that long run
expectations of fundamentals had fundamentally changed, there was every
reason to believe stock prices were being fed by irrational expectations.

Paul argues that stock market prices are not fed by fundamentals or future
expectations of earnings. I argue (in contrast) that over the long haul,
there is a subjective/objective connection between earnings, real underlying
assets and stock market prices. However, in my view, Paul's theory applies
in specific cases in that when markets stray into speculative and Ponzi
territory, then Paul is correct. The market disconnects fundamentals and
financial asset prices. Thus the level of financial asset prices can only be
sustained by further fueling irrational expectations. It seems reasonable to
me that steps designed to prick at these expectations (say be increasing
margin requirements) may have some merit in deflating the bubble before it
gets too big.


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

My response: Yup.

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.

My response: That of course is the rub in the EMH. Prices must reflect all
available information, and markets always process that information
correctly, then any price is by definition, efficient, and only
unanticipated information can move the market. Thus a value of 5000 for the
NASDAQ was not too high, and a value of the NASDAQ of 1200 is not too low.
But these people canot explain what unanticipated news caused this dramatic
movement in the NASDAQ in a relatively short time span-or even why indexes
move as much as 10-20% over the space of one to two months-with no real
change in the outlook.

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.

My response:
It seems we have beaten discussions about asymmetric information to death,
so let me point to what I think is an interesting aspect of behavioral
economics for Post-Keynesians. Behavioral economics takes into account
interdependencies in decision making. So you can get outcomes such as Keynes
pointed to (and that Paul, as I understand it, bases much of his argument
on)in which stock markets resemble beuaty contests where participants vote
on what they think other people's votes will be. As I said above, I believe
this leads to situations where the market is dominated by this type of
thinking, rather than by fundamentals-though this does not preclude the long
run role of fundamentals.

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.

My response:
Interestingly, I think this interpretation leads the New Keynesians down the
primrose path to Minsky-though not all the way to Davidson. I would be
interested in hearing from Paul whether or not he thinks fundamentals play
any role at all in determining asset prices, what role the FED should
(should not) play in providing liquidity to a potential bubble situation.

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.

My response:
I do agree that this can in fact occur. I disagree that elimination of job
rationing would lead to full employment. At least Stiglitz (I am not sure
about Akerlof) seems to argue that the Keynes effect of falling wages and
prices (though he does not call it this) can swamp the Pigou effect of
falling wages and prices (though again he does not put it quite this way),
thus creating either a) additional unemployment and further falls in income
or b) a very, very, very long time before the pigou effect finally takes
over.

This is an important point because Paul keeps asking (and it is a good
question) why, if sticky wages and prices cause unemployment, why not
advocate flexible wages and prices as the solution to unemployment.

This gives us two good reasons: a) in an economy of coordination failures,
income adjusts faster than wages and prices, so that even downwardly
flexible wages and prices do not create full employment or correct for the
deficiency in aggregate demand. This certainly creates a good argument for
corrective policy. b) even if the pigou effect will eventually work, the
resultant instability and dislocation will simply be too costly for society.
Why go through that painful and lengthy adjustment process that can even be
politically unsettling (leading to riots in the streets, workers voting for
communist led governments, the rise of extremist, racist groups preying on
the instability)when fiscal and monetary policy can shortcircuit the
problem.

This does raise the prospect that market economies will have a built in
inflationary bias and leads to a conscious political choice of accepting a
built in inflationary bias as the price of full employment and political
stability.

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.

My response:
i believe it was Goodwin? who put some of these arguments into a
prey-predator cyclical model where full employment led to rising wage
inflation and falling profits, thus leading to business cycles and falling
wages, only to start all over.

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."

My response:
I am pleased to see that at least some of the New Keynesians are returning
to the aggregate analysis of Keynes, while trying to build, logical,
consistent explanations that take agency into account.

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.

My response:
I think this same author was responsible for the earlier piece a couple of
weeks ago citing Minsky, and among some other people currently working on
these issues, Charles Whalen. So it is gratifying to see someone in the NYT
acknowledging that there are "other" people working on these issues. There
is clearly a strong disagreement on this list about the significance and
direction and meaning of what one might term "New Institutionalist/ Post
Walrasian" analysis, that I dealt with in my recent JEI article: "Whither
the NIE" JEI, June 2003. Of course, a lot of people have written far more
and in a lot more depth on this.

I thought Bill Dugger had an interesting comment about North a few years ago
in one of his articles. he suggested that Douglas North should be encouraged
to sin more. I would echo that sentiment. The New Institutionalists are
straying into heresy, and as a practicing heretic, I would gladly welcome
them to the fold.

Nonetheless, it is galling to see how respectable mainstream economists can
present institutional analyses and say with a straight face that there had
been no institutional economics before now! All the while, they build on
concepts such as bounded rationality, interdependent decision making, follow
the leader concepts of consumption-many of which go back to (among a lot of
other writings) Veblen's "Theory of the Leisure Class". On a panel several
years ago, I heard Douglas North admit that Marx and Veblen had influenced
him. Though I oppose slavish adherence to any dead-or living author-it does
seem that one should acknowledge intellectual debts-even if it is only to
distinguish new directions from old directions.



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.

My response:
There does seem to be a cautious revival of "respectability" for some
Keynesian type ideas. Though on the other hand, here is a sobering note. I
recently sent one fairly intelligent student on to a Master's program in
economics. Though she was strongly inclined to be a fan of Friedman's, I had
persuaded her to at least understand the Keynesian view-even if only better
to disagree and argue with it. Being an open minded person, she was quite
willing to do this, which was all I asked. Imagine her shock when during her
first quarter of graduate school keynes was characterized as "a socialist,
who just did not want people to have money" and the professor stated he
would not present the Keynesian view, because it was just "wrong".

It is indeed sobering to consider just how deeply this profoundly
anti-intellectual stance is embedded among academic economists. Ideas, for
good or ill, are not considered by weighing merits and demerits, they are
merely labeled "wrong".

There is a long, long way to go before the battle for ideas, or even a very
partial victory, is "won".

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



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