The Flimflam defense of Mainstream Economics (with Paul Krugman's Remarks and the Author's Reply)

The teaching of economics has recently been in the news. One reason is the activities of Manchester University undergraduates who have formed the Post-Crash Economics Society to protest the monopoly of mainstream neoclassical economics in university lecture halls. A second reason is criticism of the neoclassical reasoning in Thomas Piketty’s runaway best seller Capital in the Twenty-First Century.

This criticism and calls for including heterodox economic theory in the curriculum have prompted a defense of mainstream economics from Princeton University’s Paul Krugman and Oxford University’s Simon Wren-Lewis. Both hail from the mainstream’s liberal wing, which muddies the issue because it is easy to conflate the liberal wing with the critics. In fact, the two are significantly different and their defense of mainstream economics is pure flimflam.

To avoid misunderstanding, let us be clear there is near-uniform agreement among the critics that Piketty’s book makes a huge constructive contribution to exposing the scale of today’s inequality. However, the books’ mainstream theoretical foundation is subject to legitimate critique. First, it makes a very big difference for politics and policy if extreme inequality is explained as the result of the technical marginal productivity conditions of production versus economic and political power determining ownership patterns and capital’s share of total income. Second, the marginal productivity approach to income distribution is subject to a host of objections that, collectively, show mainstream theory is logically flawed and implausible as a description of reality.

The above critique of Piketty feeds into a much more important and fundamental critique of mainstream economics that has existed for years but has only gained traction following the global economic crisis of 2008. It is that larger critique which is the focus of the Manchester students.

The mainstream’s flimflam defense involves a two-pronged response. The first prong is an assertion that mainstream economics is already a big tent that incorporates Keynesian economics. The second prong is the oversights that led mainstream economists to miss the crisis have been fully corrected. There was no deep conceptual failure, only a myopic failure to observe the real-world rise of shadow banking.

The big tent claim links to the freshwater – saltwater distinction Krugman uses to characterize mainstream economics. Freshwater refers to the Great Lakes and the Chicago School of economics which believes in extreme laissez-faire and new classical macroeconomics. Saltwater refers to Boston Bay and the MIT School of economics which believes in modified laissez-faire and so-called new Keynesian economics.

Krugman’s freshwater – saltwater characterization is profoundly misleading regarding the intellectual state of mainstream economics. Whereas the freshwater metaphor makes sense, the saltwater metaphor does not. The true saltwater school is the now eviscerated Cambridge (UK) School of economics that was home to the likes of Joan Robinson and Nicholas Kaldor. The MIT School is better described as brackish (or even putrid) water.

Why brackish? Because it has retained the nonsense of marginal productivity distribution theory while discarding the foundations of Keynesian economics. The essence of Keynes’ economics was the liquidity preference theory of interest rates and rejection of the claim that price and nominal wage flexibility would ensure full employment. New Keynesians abandon both. They replace liquidity preference theory with loanable funds interest rate theory and they use price and nominal wage rigidity to explain cyclical unemployment.

I have long argued that the new Keynesian nomenclature is a cuckoo tactic because it captures the Keynesian label while having nothing to do with Keynes, in a manner similar to the cuckoo which lays its eggs in other birds’ nests. In my view, it is better labeled new Pigovian economics since it relies on market imperfections and frictions, which were the hallmarks of Pigou’s economic thinking. That makes for bitter irony as Pigou was Keynes’ greatly respected intellectual opponent in the 1930s and his thinking now passes under the Keynesian banner, displacing Keynes’ own ideas.

The “no conceptual failure” claim also stretches the truth. The list of failures includes failure to anticipate the crisis; underestimating the effectiveness of fiscal policy in recessions; failure to incorporate the demand effects of debt and the dangers of debt-deflation; failure to incorporate the demand effects of income distribution; and failure to anticipate secular stagnation. In contrast, heterodox economists did well on all these counts.

Mainstream economists are now working to incorporate these features and they will succeed because of the amoeba like quality of neoclassical economics. But given the mainstream framework is flawed at the core and given its awful track record, at a minimum it surely makes sense to insist on space for heterodox ideas.

Wren-Lewis invokes similar “big tent” and “no conceptual failure” defenses. However, he goes a step further to claim exposure to heterodox ideas would be a disadvantage, potentially confusing students who might be “a future Chancellor, Prime Minister, or adviser to either.” I think nothing could be further from the truth. Exposing a future Prime Minister to Keynesian economics without marginal productivity distribution theory would be a great benefit to country (but maybe not Queen); so too would exposing her to Marx’s economic sociology and philosophy of knowledge.

Finally, Krugman’s opening line that these criticisms are “a sideshow in the larger scheme of things” is wrong and reflects the underlying snobbishness of mainstream economists. Ideas matter. If you do not believe me, think of the influence Keynes had in the thirty years after World War II and the influence Milton Friedman had after that. Including heterodox ideas in the economics curriculum will not solve the immediate economic crisis, but it will make it more likely that we conduct future economic policy in ways that are more conducive to shared prosperity.

It could also diminish the likelihood of future crises. The financial crisis of 2008 has been likened to a black swan event, a surprise shock that no one anticipated. Such events are not acts of nature akin to bolts of lightning. They are sociological events resulting from groupthink and tunnel vision produced by intellectual monopoly. Future black swan events would be much less likely if the highest counsels of the Federal Reserve, the Bank of England, the European Central Bank, the IMF, and elite talk-shops like the Jackson Hole meeting included significant heterodox representation. That is much more likely to happen if the monopoly of mainstream neoclassical economics is broken.

Hangups of the Heterodox (Vaguely Wonkish) [3]

Thomas Palley and Simon Wren-Lewis have been having a back [4] and [5] forth [6] over heterodox economics versus garden-variety saltwater economics, and their role in making sense of the economic crisis. Palley accuses Wren-Lewis and me of “flimflam”; Wren-Lewis wonders what he’s talking about.

Actually, I think I know what’s going on here, but first a point about flimflam. Palley tells us that

The essence of Keynes’ economics was the liquidity preference theory of interest rates and rejection of the claim that price and nominal wage flexibility would ensure full employment. New Keynesians abandon both. They replace liquidity preference theory with loanable funds interest rate theory and they use price and nominal wage rigidity to explain cyclical unemployment.

My reaction was, what? New Keynesians assert — as Keynes did, although I don’t think it matters for this debate what he said — that both liquidity preference and loanable funds are true [7]. There are conditions under which one or the other is the main one to focus on — at full employment, loanable funds are crucial, in a liquidity trap, liquidity preference. But no modern Keynesian, new or paleo [8], forgets about the importance of liquidity preference.

And as for wage and price inflexibility as the cause of unemployment — grrr. I’ve written again and again on this subject, pointing out that in a liquidity trap price flexibility probably makes things worse [9], not better; Gauti Eggertsson and I have analyzed the paradox of flexibility in a New Keynesian model.

It’s hard to escape the impression that Palley here is engaging in his own version of the right-wing myth of the stupid progressive economist [10]; he’s so sure that mainstream Keynesians have unlearned all the important lessons that he hasn’t bothered to read what we actually write.

So what’s this all about then? Palley goes on in both posts about the evils of the marginal productivity theory of distribution; like Wren-Lewis, I don’t see what this has to do with analyzing the crisis, one way or another. But I think I do understand where this is coming from. There’s a long if bizarre tradition among some left-leaning economists that sees the notion that factors of production are paid their marginal products — or even that this is a useful first cut when thinking about the factor distribution of income — as somehow implying an acceptance of the moral right of capitalists to keep their spoils. This doesn’t really make sense, but you do see attacks on marginal productivity theory cropping up in weird places — e.g., in Jamie Galbraith’s oddly off-center attack on Thomas Piketty [11].

And what’s going on here, I think, is a fairly desperate attempt to claim that the Great Recession and its aftermath somehow prove that Joan Robinson and Nicholas Kaldor were right in the Cambridge controversies of the 1960s. It’s a huge non sequitur, even if you think they were indeed right (which you shouldn’t.) But that’s what seems to be happening.

Palley's replay

I enjoy what you write and have great admiration for your work, but this piece is unfair.

(1) Here is an article of mine on what you term the paradox of flexibility, published in 2008 and extending James Tobin’s seminal paper on “Keynesian Models of Recession and Depression”.

“Keynesian Models of Deflation and Depression Revisited,” Journal of Economic Behavior and Organization, 68 (October 2008), 167 - 77.

(2) I do not think I am misportraying you. Your own macroeconomic framework seems unconvincing to me as a description of a capitalist economy, being Keynesian at the zero lower bound and classical the rest of the time. I think of Keynesianism as being a macroeconomic theory that applies at all times. But these are issues that require more space for discussion.