You’ve all heard the story of the Manhattan socialite who expressed shock at Nixon’s landslide 1972 victory because “nobody I know voted for him.” (Attributed variously to Pauline Kael, Katharine Graham, Susan Sontag, and others, and probably apocryphal, but who cares; it’s a great quote.) I was reminded of this by a line in Larry Summers’s confidential 2008 economic policy memo now making the rounds, courtesy of the New Yorker: “Greg Mankiw is the only economist we have consulted with [about the optimal stimulus package] who refused to name a number and was generally skeptical about stimulus.” How can a huge stimulus package be wrong — everybody I know favors it!

(For the record, the economists consulted — supposedly representing the full spectrum of legitimate opinion — were Robert Reich (recommended stimulus: $1.2 trillion over 2 years), Joe Siglitz ($1 trillion over two years), Paul Krugman ($600 billion in one year), Jamie Galbraith ($900 billion in one year), Dean Baker and colleagues ($900 billion), Marty Feldstein ($400 billion in one year), Larry Lindsey ($800 billion to $1 trillion), Ken Rogoff ($1 trillion over two years), Mark Zandi ($600 billion in one year), an unnamed group of Fed officials (over $600 billion), Adam Posen ($500-700 billion in one year), and an unnamed group at Goldman Sachs(!) ($600 billion). So, we’ve got left-wing Keynesians, right-wing Keynesians, moderate Keynesians, Robert Reich who wouldn’t know a Keynesian from a Kenyan, and Goldman Sachs. How’s that for diversity of opinion?)

Update: Mankiw agrees: “Of course, the fact that I was ‘the only economist’ expressing skepticism reflects the range of economists that Team Obama chose to consult.”

I am not sure if this book has already been review on this blog space — I haven’t seen it. Similarly, I haven’t seen any other reviews, so these are my fresh impressions. The book is Keynes Hayek: The Clash that Defined Modern Economics by Nicholas Wapshott (W. W. Norton: 2011).

With the growing interest in Hayek as the antidote to the resuscitated Keynes, this book is timely providing for the reader lively insight into the life and times of these two key individuals. In terms of the details of the lives of Keynes and Hayek the book appears to be well researched. I learned a few things from it — interesting details about events and personalities. On Keynes particularly one gains a sense of the power of the man and how a whole generation of economists at the LSE and Cambridge were won over by his revolutionary vision. Though Wapshott provides a lot of material on Hayek, I could not fight the impression that it was Keynes who captured his interest (and admiration?) most. Hayek is presented in all of his aspects, including the not so wholesome ones. The picture of Keynes seems less forthcoming, or differently spun to cast a more favorable light. But maybe that is just me and my biases.

When it comes to the economics, however, the case is much clearer. Wapshott is very weak on this part of the story, especially when it comes to Austrian economics. He is able to do a fairly good job of Keynesianism, again positively spun — including the story of multiplier. It adds to the plausibility of Keynes’s appeal. But when it comes to explaining the essence of Hayek’s opposition, his treatment is very inadequate at best and complete wrong at worst. Like Keynes himself, Wapshott does not understand capital theory and the time structure of production. So he gets the story of the business cycle wrong. He simply parrots in a formulaic way the ingredients of Hayek’s case. His treatment of Mises is almost a caricature. He does not understand the nature of the Austrian turn from classical economics and has some misleading things to say about the concept of “value.” Likewise he does not understand the differences and similarities between the economics of the Austrians  and the Monetarists and invents bogus differences. I found this part of the book frustrating.

So, the question in my mind is: do I recommend this book to my macro/money students? I think I probably will, with suitable warnings, just because it is such a vital and interesting story.

Keynes’s idea that investors are motivated by “animal spirits” has come back into vogue with the recent Keynesian revival, but the term is often misunderstood. Keynes referred not to psychological factors that make investors reluctant to invest, but those that make them invest at all — in the face of deep uncertainty, he thought, only a manic, driven, strong-willed person would put capital at risk. When animal spirits are strong, investment is sufficient to maintain aggregate demand; when they lag, aggregate demand falls, and the economy lapses into depression. (Lord Skidelsky approvingly calls this the “mood swings theory” of business cycles — an idea just crazy enough to spawn a recent NBER paper.)

The new issue of Capitalism and Society features a piece on What Keynes Really Meant on this issue, and it’s a good read:

Animal Spirits Revisited

Alexander Dow, Glasgow Caledonian University
Sheila C. Dow, University of Stirling

The term ‘animal spirits’ has returned to academic and public discourse in a way which departs significantly from the original use of the term by Keynes. The new behavioural economics literature uses the term to refer to a range of behaviour which falls outside what is normally understood as rational. This treatment follows from the mainstream dichotomisation between rationality and irrationality. However, Keynes explained that, given fundamental uncertainty, rationality alone was insufficient to justify action. Animal spirits was the name he gave to the (psychological) urge to action which explained decisions being taken in spite of uncertainty; animal spirits for him were neither rational nor irrational. Nor are they beyond analysis. We explore how the nature and role of animal spirits can vary according to context (as between different sectors, types of firm and within firms). This analysis indicates ways in which policy can promote structural change to strengthen animal spirits in the long term as well as offset short-term weakening in animal spirits.

The idea that mainstream macroeconomic thinking focuses at too high a level of aggregation is a frequent complaint on this blog (e.g., here, here, here, and here). Our recent Strategic Organization paper hammers home this point. The level of aggregation is of course a fundamental difference between Keynesian and Austrian theorizing about economic fluctuations. But Keynesian economists don’t seem to recognize this.

The other day I posted a snarky blog entry at The Beacon, responding to a Krugman smear of Hayek (yawn). Today Mario Rizzo pens a more thoughtful response, emphasizing exactly this level-of-analysis issue:

I think the real issue is this. Hayek’s approach attacks, root-and-branch, the macroeconomic way of thinking. It is not simply a challenge to a particular theory of the determinants of mass unemployment, inflation, business cycles and the like. Hayek is not accepting the rules of the game or the parameters of the sub-discipline of modern macroeconomics. Hayek does not want to argue that the government expenditure multiplier is 0.5 instead of 2.0, for example. He does not want to discuss just how much fiscal stimulus should be undertaken and what form it should assume.

In short, he does not want to focus on aggregate spending and aggregate consequences. Hayek’s approach says: Let us pierce the veil of aggregates and look at the distortive effects on relative prices and relative output produced by boom-time credit expansions. Let us look at the distortive effects that booms leave us as we work our way through a recession. Let us concentrate on sustainable lines of expenditure both during the boom and during the road out from the bust.

A nice post from former guest blogger Craig Pirrong on regime uncertainty and its role in hampering economic recovery. As Craig points out, it’s not the level of government intervention per se that delays investment, but uncertainty about anticipated changes in government intervention. Options theory provides a useful way to see this.

Bob Higgs approves. And here are Craig’s old O&M posts.

We have often blogged on the work of Axel Leijonhufvud on O&M (here). Here is a 2008 talk which was given in Denmark (and which, unfortunately, somehow missed my attention at that time) on “Keynes and the Crisis.” The talk contains many characteristic Leijonhufvudian themes (smashing of Ricardian equivalence, representative agent modeling, and the foundations of financial theory), little on Keynes (luckily!), and much critique of monetarism, in particular the choice of the CPI as the unique target of central bank policies and the notion of the independence of central banks from the political system. Here is Leijonhufvud’s overall diagnosis of the root causes of the current crisis:

The process leading up to today’s American financial crisis had the dollar exchange rate supported by foreign central banks exporting capital to the United States. This capital inflow was not even to be discouraged by a Federal Reserve policy of extremely low interest rates. The price elasticity of exports from the countries that prevented the appreciation of their own currencies in this way kept US consumer goods prices from rising. Operating an interest-targeting regime keying on the CPI, the Fed was lured into keeping rates far too low far too long. The result was inflation of asset prices combined with a general deterioration of credit quality (Leijonhufvud 2007a). This, of course, does not make a Keynesian story. It is rather a variation on the Austrian overinvestment theme.

Several people have called to my attention this extraordinary interview in which Paul Krugman states his belief that a military buildup to fight a mythical alien invasion would pull the economy out of recession. I guess it would be more entertaining than paying people to dig holes in the ground and paying other people to dig them up. Were Krugman’s remarks tongue-in-cheek? Unlikely, as he seems to believe in a sort of old-school, 1950s-era, hydraulic Keynesianism, and hasn’t otherwise demonstrated a sense of humor.

Of course, as Bob Higgs has tirelessly demonstrated, World War II didn’t end the Great Depression, but that doesn’t stop this canard being trotted out every time someone wants to justify deficit spending. Notes Mary Theroux: “the Great Depression ended in 1946, when 10 million individuals were returned to the ranks of the unemployed, and federal spending plunged 40% in the aftermath of FDR’s death and the abandonment of the New Deal.” But the more fundamental point is that spending for spending’s sake does not increase economic well-being. To see why, we must challenge the core Keynesian concept of “idle resources,” the idea that, when the economy is away from “full employment,” the usual laws of microeconomics — resources are scarce, decision-makers face tradeoffs at the margin, costs are opportunity costs — don’t apply. As Brad Delong recently put it in one of his characteristically classy missives: during a recession, “[t]he full-employment world of Bastiat is very very far away.” Of course, Bastiat’s brilliant demonstration of hidden costs and the fallacy of spending one’s way into prosperity has nothing to do with “full employment,” a concept that isn’t even coherent, given that efficiency in resource employment makes sense only with regard to the subjective production plan of the entrepreneur (cf. Penrose, 1959; Kirzner, 1966).

W. H. Hutt’s powerful and underappreciated critique of Keynes, The Theory of Idle Resources (1939) — available for free download at Mises.org — attacks this core Keynesian concept. As Hutt explains, all resources have alternative uses, and even “idleness” is a use, in the sense that the resource owner prefers to hold the resource for a future, as-yet-unavailable or unimagined use — a real option, if you like. Dragooning such resources into some random use, outside the price mechanism, serves no productive purpose. Even outside the mythical world of “full employment,” there are no free lunches.

So put those ray-guns back into storage, boys. We may need them later.

An important point from Ken Rogoff:

Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a “Great Recession.” But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.

For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms.

I don’t agree with all of the discussion, for example Rogoff’s call for price inflation to mitigate the burden on debtors, but this is a big advance over the vulgar Keynesianism that passes for analysis at the New York Times. (See also Peter L.’s post on Rumelt.) The main point is that a recession like the present one is structural, and has nothing do with shibboleths like “insufficient aggregate demand.” I wish Rogoff (here or in his important book with Carmen Reinhart) talked about credit expansion as the source of structural, sectoral imbalances that generate macroeconomic crises.

The University of Missouri’s sprawling new student center recently opened Mort’s, a reproduction of an old campus hangout called The Shack, made famous by Beetle Bailey creator and Mizzou alumnus Mort Walker. I snapped the photos below from the entrance to Mort’s, which is full of old Walker cartoons. I spied a 1950 cartoon featuring an economics test. Click to enlarge the strip.

Funny, but what was Professor Brown smoking when he wrote that question? (Maybe he was just a Keynesian, bless his heart.)

Wikipedia on market fundamentalism: “a pejorative term applied to an exaggerated religious-like faith in the ability of unfettered laissez-faire or free market economic views or policies to solve economic and social problems.”

Alvin Plantinga (from Tom Gilson via T-bone) on religious fundamentalism:

I fully realize that the dreaded f-word will be trotted out to stigmatize [my model of Christian epistemology]. Before responding, however, we must first look into the use of this term “fundamentalist.” On the most common contemporary academic use of the term, it is a term of abuse or disapprobation, rather like “son of a bitch,” more exactly “sonovabitch,” or perhaps still more exactly (at least according to those authorities who look to the Old West as normative on matters of pronunciation) “sumbitch.” When the term is used in this way, no definition of it is ordinarily given. (If you called someone a sumbitch, would you feel obliged first to define the term?) Still, there is a bit more to the meaning of “fundamentalist” (in this widely current use): it isn’t simply a term of abuse. In addition to its emotive force, it does have some cognitive content, and ordinarily denotes relatively conservative theological views. That makes it more like “stupid sumbitch” (or maybe “fascist sumbitch”?) than “sumbitch” simpliciter. . . . The full meaning of the term, therefore (in this use), can be given by something like “stupid sumbitch whose theological opinions are considerably to the right of mine.”

Maybe I should be more careful calling people “Keynesians.”