Sunday, October 26, 2008

Mankiw's Contradiction

Today's New York Times column by Greg Mankiw again shows the limits of orthodox economists' thinking. See my comments below.

October 26, 2008 / Economic View / New York Times

But Have We Learned Enough?

Like most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.'s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was "nearly nil." He added, "We've learned a few things in 80years."

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. [a big ellipsis here, where Mankiw scetches a conventional story about the onset of the Depression]

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system's normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households' debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy's ability to channel financial resources toward their best use was seriously impaired....

Less successful were various market interventions. According to a study by the economists Harold L. Cole and Lee E. Ohanian, both of the University of California, Los Angeles, and the Federal Reserve Bank of Minneapolis, President Roosevelt made things worse when he encouraged the formation of cartels through the National Industrial Recovery Act of 1933. Similarly, they argue, the National Labor Relations Act of 1935 strengthened organized labor but weakened the recovery by impeding market forces....<

Here we see a big contradiction! Above, Mankiw first blames deflation (steadily falling prices) for being a major force pushing the US economy into Depression. Then, he blames FDR for fighting deflation! Note that at the time, many policy-oriented economists were explicitly in favor of preventing deflation (and instead in favor of "reflation"). Though they were often often unorthodox, their reasons were very similar to those of Irving Fisher, a famous and very orthodox economist of the time: to quote Mankiw, "deflation pushe[s] up the real burden of households' debts."

Now, it may be that if we looked deeper into this question, there's no contradiction here, but he doesn't address the issue at all. He instead seems to be assuming the standard economics BS about falling prices being a good thing at the macro level. This should be called "knee-jerk economics."

He continues:
... three researchers show that the leading economists at the time, at competing forecasting services run by Harvard and Yale, were caught completely by surprise by the severity and length of the Great Depression. What's worse, despite many advances in the tools of economic analysis, modern economists armed with the data from the time would not have forecast much better. In other words, even if another Depression were around the corner, you shouldn't expect much advance warning from the economics profession.

Let me be clear: Like Mr. Blanchard at the I.M.F., I am not predicting another Great Depression. We have indeed learned a lot over the last 80 years. But you should take that economic forecast, like all others, with more than a single grain of salt.

It's about time! This Harvard elite economist is actually expressing modesty, something he's never been good at. So the financial melt-down has had at least positive effect.

Jim Devine


Econoclast said...

as usual, I'm posting a comment so that responses will be e-mailed to me.

Myrtle Blackwood said...

..President Roosevelt made things worse when he encouraged the formation of cartels through the National Industrial Recovery Act of 1933...

Dominant financial and industrial cartels already existed in the US before the Great Depression. But it's interesting to observe how economic crisis in the past and present go hand-in-hand with ever worse concentration of economic power.

Look at the US $700 billion bailout moneys being used by a dysfunction bank to buy up others not so well graced with taxpayer funds.

Econoclast said...

I forgot to mention that cartels and the like usually do not have the ability to stop (domestic) deflation unless they are general, i.e., organized by the government. If aggregate demand is falling so much that it creates falling prices, the cartels lead to falling prices in other sectors, which then gain a competitive advantage compared to the cartels.

The problem is that Mankiw (a) recognizes that severe falls in prices can be bad and then (b) doesn't follow through to realize that this tells us that market competition (once again) can be a bad thing.
Jim Devine

Shag from Brookline said...

Mankiw looks at the Great Depression with the benefit of a long period of economic commentary (which he carefully selects from) in his hindsight examination. He accepts the difficulties economists have with foresight. But i think he has a problem with his hindsight. I am awaiting his take on Alan Greenspan's recent mea culpa. Perhaps he is reviewing what he has publicly stated in the past about Greenspan before we hear from him. And does Greenspan's mea culpa also bring in Milt Friedman for examination?

Ken Houghton said...

"It's about time! This Harvard elite economist is actually expressing modesty, something he's never been good at. So the financial melt-down has had at least positive effect."

Nah; it's a false modesty that will either allow him to equivocate in a few months or sadly report that he Told You So even as he decides not to work for the next four years.