Rational Irrationality: Where Is the New Keynes? : The New YorkerPosted: October 27, 2011
On Monday, I was on Leonard Lopate’s WNYC radio show talking about my recent article on John Maynard Keynes. (The piece is no longer behind a firewall. You can read it here, and listen to the interview here.) At the end of the show, Leonard asked me an interesting question: Has the financial crisis and Great Recession produced any big new economic ideas? My immediate response was that it hasn’t, or, if it has, I wasn’t aware of them. After the show, I thought about the question a bit more.
I still think the answer is no. There is nothing to compare with Keynesianism or Monetarism or even the so-called Washington Consensus of the nineteen-eighties and nineteen-nineties. Certainly, there is no new Keynes. But I do think that some important ideas have been discovered—or, rather, rediscovered. Here are six of them, together with some tips for further reading, one of which is rather self-serving:
1. Finance matters. This lesson might seem obvious to the man in the street, but many economists somehow managed to forget it. Two who didn’t were Hyman Minsky and Wynne Godley, both of who were associated with the Levy Institute for Economics at Bard College. Minksy’s now-famous “Financial Instability Hypothesis” can be found here, and one of Godley’s warnings about excessive household debt can be found here. (It is from 1999!)
2. Credit busts are different from ordinary recessions. On this, the most widely quoted work is Carmen Reinhart and Ken Rogoff’s historical survey, “This Time is Different: Eight Centuries of Financial Folly,” which details how debt overhang in the public and private sectors tends to produce “lost decades.” For an old but still very readable account of how debt overhang can create deep recessions, I would recommend Irving Fisher’s famous essay from 1933. For something more recent, I recommend this essay by Ray Dalio, the head of Bridgewater Associates, the world’s biggest hedge fund.
3. Positive feedback and multiple equilibria have to be taken seriously. With the rise of rational expectations theory, the idea that financial markets and entire economies can spiral into bad outcomes—and for no very good reason—was relegated to a mathematical curiosity: so called “sunspots.” Now, the notion is back, and for good reason. It appears to describe the world pretty well.
The role positive feedback played in amplifying the credit crisis of 2008 has been studied extensively, and this article by Princeton’s Markus Brunnermeier provides a good survey. Turning to what is happening in Europe, Paul De Grauwe, of the Brussels-based Center for European Policy Studies, and <a href=”http://krugman.blogs.nytimes.com/2011/08/08/wonking-out-about-the-euro-crisis-very-wonkish/-23109?pagewanted=all”>Paul Krugman have both written interesting analyses of the Euro system from a multiple equilibrium perspective.
4. Especially in financial markets, self-regarding rational behavior isn’t necessarily socially optimal. I wrote a lot about this in my book, “How Markets Fail: The Logic of Economic Calamities.” For those seeking a more technical analysis, I would recommend “Risk and Liquidity,” by Princeton’s Hyun Song Shin.
5. Monetary policy doesn’t always work very well. This lesson should have been relearned in Japan. One person who did relearn it was Paul Krugman. This essay of his from 1998 explains how economies can get stuck in a “liquidity trap,” and is still worth reading, as his book “The Return of Depression Economics,” an updated version of which was reissued in 2008.
6. Fiscal stimulus programs don’t provide a panacea for deep recessions, but the alternatives—do-nothing policies or austerity—are much worse. If you doubt this, I would suggest you look at what is happening in Greece and the United Kingdom, where austerity programs have been in effect for more than a year. As for the Obama stimulus, most serious studies show it did have a positive impact on G.D.P. growth and job creation—as detailed in this helpful post by Dylan Matthews on the Washington Post’s Wonkblog.
Looking at this list, anyone familiar with Keynes will quickly realize that almost all of the points on it can be found in his writings, at least in embryo form. If economics is about building internally consistent models of toy economies from first principles, he wasn’t a great economist. If it is about providing telling insights into how real economies function and malfunction, he still has few rivals. That is why he never goes away.
Endnote: Others will have different ideas about the lessons learned in the past few years. I’d be interested in seeing them. But please, spare yourself the effort of posting a comment to say that Keynesian stimulus programs don’t work or that a return to the Gold Standard is our only salvation. Those are old canards, not new insights.
Keynes in 1925. Photograph: Bettmann/Corbis.