DRI-303 for week of 5-11-14: The Real ‘Stress Test’ is Still to Come

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The Real ‘Stress Test’ is Still to Come

Timothy Geithner, former Treasury Secretary and former head of the New York Federal Reserve, is in the news. Like virtually every former policymaker, he has written a book about his experiences. He is currently flogging that book on the publicity circuit. Unlike many other such books, Geithner’s holds uncommon interest – not because he is a skillful writer or a keen analyst. Just the opposite.

Geithner is a man desperate to rationalize his past actions. Those actions have put us on a path to disaster. When that disaster strikes, we will be too stunned and too busy to think clearly about the past. Now is the time to view history coolly and rationally. We must see Geithner’s statements in their true light.

Power and the Need for Self-Justification

In his Wall Street Journal book review of Geithner’s book, Stress Test, James Freeman states that “Geithner makes a persuasive case that he is the man most responsible for the federal bailouts of 2008.” Mr. Freeman finds this claim surprising, but as we will see, it is integral to what Geithner sees as his legacy.

This issue of policy authorship is important to historians, whose job is getting the details right. But it is trivial to us. We want the policies to be right, regardless of their source. That is why we should be worried by Geithner’s need to secure his place in history.

Geithner and his colleagues, Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson, possessed powers whose exercise would have been unthinkable not that long ago. Nobody seems to have considered how the possession of such vast powers would distort their exercise.

Prior to assumption of the Federal Reserve Chairmanship, Ben Bernanke wrote his dissertation on the causes of the Great Depression. Later, his academic reputation was built on his assessment of mistakes committed by Fed Board members during the 1920s and 30s. When he joined the Board and became Chairman, he vowed not to repeat those mistakes. Thus, we should not have been surprised when he treated a financial crisis on his watch as though it were another Great Depression in the making. Bernanke was the living embodiment of the old saying, “Give a small boy a hammer and he will find that everything he encounters needs pounding.” His academic training had given him a hammer and he proceeded to use it to pound the first crisis he met.

In an interview with “Bloomberg News,” Geithner used the phrase “Great Depression” three times. First, he likened the financial crisis of 2008 to the Great Depression, calling it “classic” and comparing it to the bank runs of the Great Depression. Later, he claimed that we had avoided another Great Depression by following his policies. For Geithner, the Great Depression isn’t so much an actual historical episode or an analytical benchmark as it is an emotional button he presses whenever he needs justification for his actions.

When we give vast power to individuals, we virtually guarantee that they will view events through the lens of their own ego rather than objectively. Bernanke was bound to view his decisions in this light: either apply principles he himself had espoused and built his career upon or run the risk of going down in history as exactly the kind of man he had made his name criticizing – the man who stood by and allowed the Great Depression to happen. Faced with those alternatives, policy activism was the inevitable choice.

Geithner had tremendous power in his advisory capacity as President of the New York Federal Reserve. His choices were: use it or not. Not using it ran the risk of being Hooverized by future generations; that is, being labeled as unwitting, uncaring or worse. Using it at least showed that he cared, even if he failed. The only people who would criticize him would be some far-out, laissez-faire types. Thus, he had everything to gain and little to lose by advising policy activism.

Now, after the fact, the incentive to seek the truth is even weaker than it is in the moment. Now Bernanke, Geithner et al are stuck with their decisions. They cannot change their actions, but they can change anything else – their motivations, those of others, even the truths of history and analysis. If they can achieve by lying or dissembling what they could not achieve with their actions at the time, then dishonesty is a small price to pay. Being honest with yourself can be difficult under the best of circumstances. When somebody is on the borderline between being considered the nation’s savior and its scourge, it is well-nigh impossible.

And a person who begins by lying to himself cannot end up being truthful with the world. No, memoirs like Stress Test are not the place to look for a documentary account of the financial crisis told by an insider. The pressures of power do not shape men like Paulson, Bernanke and Geithner into diamonds, but rather into gargoyles.

We cannot take their words at face value. We must put them under the fluoroscope.

“We Were Three Days Away From Americans Not Being Able to Get Money from ATMs”

Not only are Geithner’s actions under scrutiny, but his timing is also criticized. Many people, perhaps most prominently David Stockman, have insisted that the actual situation faced by the U.S. economy wasn’t nearly dire enough to justify the drastic actions urged by Geithner, et al.

Geithner’s stock reply, found in his book and repeated in numerous interviews, is that the emergency facing the nation left no time for observance of legal niceties or economic precedent. He resuscitates the old quote: “We were three days away from Americans not being able to get money from their ATMs.”

There is an effective reply because its psychological shock value tends to stun the listener into submission. But meek silence is the wrong posture with which to receive a response like this from a self-interested party like Paulson, Bernanke or Geithner. Instead, it demands minute examination.

First, ask ourselves this: Is this a figure of speech or literal truth? That is, what precise significance attaches to the words “three days?”

Recall that Bernanke and Paulson have told us that they realized the magnitude of the emergency facing the country and determined that they must (a) violate protocol by going directly to Congress; and (b) act in secret to prevent public panic. Remember also that Paulson told Congress that if they did not pass bailout legislation by the weekend, Armageddon would ensue. And remember also that, typically, Congress did not act within the deadline specified. It waited  ten days before passing the bailout deal. And the prophesied disaster did not unfold.

In other words, Paulson, Bernanke, et al were exaggerating for effect. How much they were exaggerating can be debated.

That leads to the next logical point. What about the ATM reference itself? Was it specific, meaningful? Or was it just hooey? To paraphrase the line used in courtroom interrogation by litigators (“Are you lying now or were you lying then?”), is Geithner exaggerating now just as Paulson and Bernanke exaggerated then?

Well, Geithner is apparently serious in using this reference. In the same interviews, Geithner calls the financial crisis “a classic financial panic, similar to the bank runs in the Great Depression.” In the 1930s, U.S. banks faced “runs” by depositors who withdrew deposits in cash when they questioned the solvency of banks. Under fractional-reserve banking, banks then (as now) kept only a tiny ratio of deposit liabilities on hand in the form of cash and liquid assets. The runs produced a rash of bank failures, leading to widespread closures and the eventual “bank holiday” proclaimed by newly elected President Franklin Delano Roosevelt. So Geithner’s borrowing of the ATM comment as an index of our distress seems to be clearly intended to suggest an impending crisis of bank liquidity.

There is an obvious problem with this interpretation, the problem being that it is obvious nonsense. Virtually every commentator and reviewer has treated Geithner’s backwards predictions of a “Great Depression” with some throat-clearing version of “well, as we all know, we can’t know what would have happened, we’ll never know, we can’t replay history, history only happens once,” and so forth. But that clearly doesn’t apply to the ATM case. We know – as incontrovertibly as we can know anything in life – what would have happened had bank runs and bank illiquidity a la 1930s so much as threatened in 2008.

Somebody would have stepped to a computer at the Federal Reserve and started creating money. We know this because that’s exactly what did happen in 2010 when the Fed initiated its “Quantitative Easing” program of monetary increase. The overwhelming bulk of the QE money found its way to bank reserve accounts at the Fed where it has been quietly drawing interest ever since. We also know that the usual formalities and intermediaries involving money creation by the Fed could and would have been dispensed with in that sort of emergency. As Fed Chairman, Ben Bernanke was known as “Helicopter Ben” because he was fond of quoting Milton Friedman’s remark that the Fed could get money in public hands by dropping it from helicopters in an emergency, if necessary. Bernanke would not have stood on ceremony in the case of a general bank run; he would have funneled money directly to banks by the speediest means.

In other words, the ATM comment was and is the purest hooey. It has no substantive significance or meaning. It was made, and revived by Geithner, for shock effect only. This is very revealing. It implies a man desperate to achieve his effect, which means his words should be received with utmost caution.

“The Paradox of Financial Crises”

Geithner’s flagship appearance on the promotion circuit was his op-ed in The Wall Street Journal (5/13/2014), “The Paradox of Financial Crises.” The thesis of this op-ed – the “paradox” of the title – is that “the more aggressive the government is in designing a rescue plan, the easier it is to force more restructuring in the financial sector, and the better the chances of leaving the surviving system stronger and less dependent on the taxpayer.” Alas, Geithner complains, “Americans don’t give their presidents much in the way of emergency authority to fight” financial crises. As evidence of the need for this emergency authority, Geithner cites the loss of 16% of U.S. household net worth in 2008, “several times as large as the losses at the start of the Great Depression.”

No doubt eyebrows were raised throughout the U.S. when Geithner bemoaned the lack of emergency authority for a President who has appointed dozens of economic and regulatory “czars,” single-handedly suspended execution of legislation and generally behaved high-handedly. Geithner’s thesis – a generous description of what might reasonably be called a desperate attempt at self-justification – apparently consists of three components: (1) the presumption that financial crises are uniquely powerful and destructive; (2) the claim that, nevertheless, a financial crisis can be counteracted by sufficiently forceful action, taken with sufficient dispatch; and (3) the further claim that he knows what actions to take.

The power of financial crises is a trendy idea given currency by a popular scholarly work by two economists named Rogoff and Reinhart, who surveyed recessions featuring financial panics going back several centuries and ostensibly discovered that their recoveries tended to be slow. How much merit their ideas have is really irrelevant to Geithner’s thesis because Geithner’s interest in financial crises is entirely opportunistic. It began in 2008 with Geithner’s improvisations when faced with the impending failure of Bear Stearns, Lehman Brothers, et al. It perseveres only because Geithner’s legacy is now tied to the success of those machinations – which, unlikely as it might have seemed six years ago, is still in dispute.

Geithner’s theory of financial crises is not the Rogoff/Reinhart theory. It is the Geithner theory, which is: financial crises are uniquely powerful because Geithner needs them to be uniquely powerful in order to justify his unprecedented recommendations for unilateral executive actions. In his book and interviews, Geithner peddles various vague, vacuous generalities about financial crises. In order to these to make sense, they must be based on historical observation and/or statistical regularities. But they cannot jibe with the sentiments expressed above in the Journal. Geithner claims to be enunciating a general theory of financial crisis and rescue. But he is really telling a story of what he did to this particular financial system in the particular financial crisis of 2008.

And no wonder, since the financial system existing in the U.S. in 2008 was and still is like no financial system that existed previously. Instead of “banks” as we previously knew them, the failing financial institutions in 2008 were diversified financial institutions – nominally investment banks, although that activity had by then assumed a minor part of their work – some of whose liabilities would once have been called “near monies.” Meanwhile, the true banks were also diversified into securities and investment banking, and the larger ones controlled the overwhelming bulk of deposit liabilities in the U.S. This historically unprecedented configuration accounted for the determination of Paulson, Bernanke, and Geithner to bail them out at all costs. But they weren’t drawing upon a general theory of crises, because no previous society ever had a financial structure like ours.

Geithner stresses the need to “force more restructuring in the financial sector,” as though every financial crisis was caused by corporate elephantiasis and cured by astute government pruning back of financial firms. This is not only historically wrong but logically deficient, since the past government pruning couldn’t have been very astute if crises kept recurring. Indeed, that is the obvious shortcoming of the second component. There are no precedents – none, zero, nada – for the idea that government policy can either forestall or cure recessions, whether financial or otherwise. This is not for want of trying. If there is one thing governments love to do, it is spend money. If there is another thing governments love to do, it is throw their weight around. Neither has solved the problem of recession so far.

What leads us to believe that Timothy Geithner was and is well qualified to pronounce on the subject of financial crises? Only one thing – his claims that “we did do the essential thing, which was to prevent another Great Depression, with its decade of shantytowns and bread lines. We put out the financial fire…because we wanted to prevent mass unemployment.”

Incredible as it seems now, Timothy Geithner had even fewer economic credentials for his post as Chairman of the New York Federal Reserve than Ben Bernanke had for his as Chairman of the Federal Reserve Board of Governors. Geithner had only one economics course as a Dartmouth undergraduate (he found it “dreary”). His master’s degree at John’s Hopkins was split between international economics and Far Eastern studies. (He speaks Japanese, among other foreign languages.) He put in a three-year stint as a consultant with Henry Kissinger’s consulting firm before graduating to the Treasury, where he spent 13 years before moving to the International Monetary Fund, then becoming Chairman of the New York Fed at age 42. As Freeman observed in his book review, Geithner “never worked in finance or in any type of business” save Kissinger’s consulting firm.

This isn’t exactly a resume of recommendation for a man taking the tiller during a financial typhoon. Maybe it explains what Freeman called Geithner’s “difficulty in understanding the health of large financial firms.”

When asked by interviewers if he had any regrets about his tenure, Geithner regrets not foreseeing the crisis in time to act sooner. This certainly contradicts his theory of crises and his claim of special knowledge – if he was the man with a plan and the man of the moment, why did he fail to foresee the crisis and have to go begging for emergency authorization for Presidential action at the 11th hour? Why should we now eagerly devour the words of a man who claims responsibility for saving the nation while simultaneously admitting that he “didn’t see the crisis coming and didn’t grasp the severity of the problems when it appeared?” He now boasts a special understanding of financial crises, but “didn’t require the banks he was overseeing to raise more capital” at the time of the crisis. In fact, as Freeman discloses, the minutes of the Federal Reserve show that Geithner denies that the banking system in general was undercapitalized even while other Fed governors were proposing that banks meet a capital call.

Geithner offers no particular reason why we should believe anything he says and ample reasons for doubt.

“The Government and the Central Bank Have to Step In and Take Risks”

Geithner’s book and publicity tour are a public-relations exercise designed to change his image. Ironically, this involves a tradeoff. He had image problems with both the right wing and the left wing, so gains on one side rate to lose him support on the other side. The Wall Street Journal piece shows that he wants to burnish his left profile. He closes by lamenting that “we were not able to do all that was important or desirable.  …Long-term unemployment remains alarmingly high. There are very high levels of poverty and appalling inequality, not just in income and wealth, but in the opportunities Americans have for a quality education or economic mobility.” Having spent the bulk of the op-ed apologizing for not allowing undeserving Wall Street bankers to go broke, he now nods frantically to every left-wing preoccupation. None of this has anything to do with a financial crisis or emergency authorizations or stress tests, of course – it is just Geithner stroking his left-wing critics.

The real sign that Geithner’s allegiance is with the left is his renunciation of the concept of “moral hazard.” Oh, he gives lip service to the fact that when the government bails out business and subsidizes failure, this will encourage subsequent businessmen to take excessive risks on a “heads I win, tails the government bails me out” expectation. But he savagely criticizes the moral hazard approach as “Old Testament” thinking. (The fact that “Old Testament” is now a pejorative is significant in itself; one wonders what significance “New Testament” would have.) “What one has to do in a panic is the opposite of what seems fair and just. In a financial crisis, the natural instinct is to let creditors suffer losses, let firms fail, and protect taxpayers from any risk of loss. But in a financial panic, a strategy based on those instincts will lead to depression-level unemployment. Instead, the government and the central bank have to step in and take risks on a scale that the private sector can’t and won’t… reduce the incentive for investors, lenders and depositors to run…raise the confidence of businesses and individuals… breaking a vicious cycle in which the fear of a financial-system collapse and a deep recession feed on each other and become self-fulfilling.”

This is surely the clearest sign that Geithner is engaging in ex post rationalization and improvisation. For centuries, economists have debated the question of whether recessions are real or monetary in origin and substance. Now Geithner emerges with the secret: they are psychological. Keynes, it seems, was the second-most momentous thinker of the 1930s, behind Sigmund Freud. All we have to do is overcome our “natural instinct” and rid ourselves of those awful “Old Testament” morals and bail out the right people – creditors – instead of the wrong people – taxpayers.

Once again, commentators have glossed over the most striking contradictions in this tale. For five years, we have listened ad nauseum to scathing denunciations of bankers, real-estate brokers, developers, investment bankers, house flippers and plain old home buyers who went wild and crazy, taking risks right and left with reckless abandon. But now Geithner is telling us that the problem is that “the private sector can’t and won’t …take risks on a scale” sufficient to save us from depression! So government and the central bank (!) must gird their loins, step in and do the job.

But this is a tale left unfinished.  Geithner says plainly that his actions saved us from a Great Depression. He also says that salvation occurred because government and the Fed assumed risks on a massive scale. What happened to those risks? Did they vanish somewhere in a puff of smoke or cloud of dust? If not, they must still be borne. And if the risks are still active, that means that we have not, after all, been saved from the Great Depression; it has merely been postponed.

It is not too hard to figure out what Geithner is saying between the lines. He wants to justify massive Federal Reserve purchases of toxic bank assets and the greatest splurge of money creation in U.S. history – without having to mention that these put us all on a hook where we remain to this day.

In this sense, Timothy Geithner’s book was well titled. Unfortunately, he omitted to mention that the most stressful test is yet to come.

DRI-277 for week of 11-3-13: Why Are There No Economists Among Leading Opinion-Molders Today?

An Access Advertising EconBrief:

Why Are There No Economists Among Leading Opinion-Molders Today?

Today the discipline of economics occupies a strange position within the general public. The Financial Crisis of 2008 and ensuing Great Recession brought economics to the daily attention of Americans more forcefully than since the Great Depression of the 1930s. The Federal Reserve’s monetary policies, particularly its recent tactic of Quantitative Expansion (QE) of the stock of money, have made monetary policy the object of attention to a greater extent than at any time since the days of stagflation and supply-side economics during the Reagan administration in the early 1980s. One would expect to find economists occupying center stage almost every day.

Not so, surprisingly enough. Contrast the position of economics today with, say, that in the 1960s and 70s, just prior to Ronald Reagan’s election as President. At that point, three economists were familiar on sight and sound to a great many Americans: John Kenneth Galbraith, Paul Samuelson and Milton Friedman. Today, the venues, space and time available to economists far outnumber those existing forty years ago. Yet no economist today even approaches the influence and familiarity of the Big Three in their heyday. A brief recollection of each is in order for the benefit of younger readers.

The Big Three of Yesteryear: Galbraith, Samuelson and Friedman

The Big Three economists of yesteryear bestrode the 20th century like colossi and stood tall into the 21st. They were all born and died within a few years of each other: Galbraith (1908-2006) slightly outlasted Samuelson (1915-2009) and Friedman (1911-2006) in longevity although he died first, in April 2006. They were all self-made and experienced the Depression first hand. Each was a prolific writer but appealed to a different audience.

The best-selling writer of the three was John Kenneth Galbraith, whose literary zenith produced The Affluent Society (1958) and The New Industrial State (1967). Compactly put, Galbraith’s thesis was that Americans were satiated with consumer goods but starved for so-called “public goods;” i.e., the goods government was uniquely situated to provide. The economy thrived not on competition but on monopoly exercised by giant corporations, who artificially created the demand for their products via advertising rather than merely responding to the inchoate demands expressed by consumers. Since consumer wants depended on the same process that satisfied them, that process of want-satisfaction could not be justified or defended as simply “giving the people what they want.” Therefore, government was not merely allowed but morally required to tax and regulate business to restrain their behavior and acquire the resources necessary to redress the imbalance between public and private spending. Galbraith’s views resonated with the general public much more than with the economics profession itself, where only the New Left, radicals, institutionalist admirers of Thorstein Veblen and quasi-Marxists found them attractive. Needless to say, Galbraith’s ideas seem quaint today in light of the decline and fall of the supposedly invulnerable giant corporations he worshipped.

In addition to his economic works, which also included American Capitalism (1952) and A Theory of Price Control (1952), Galbraith wrote novels and memoirs of his travels and tenure as Ambassador to India. His iconoclastic views – he minted the phrase “the conventional wisdom” – and ironic style endeared him to the general public, whose distrust of authority he shared. This seems odd of a man whose World War II service as deputy head of the Office of Price Administration made him one of America’s chief bureaucrats, but Galbraith’s early life was spent on a farm in Canada. Another of his books was a novel satirizing America’s foreign-policy establishment (“Foggy Bottom”). Perhaps the chief object of his scorn over the years was the corporate hierarchy, whose morals and mores he never tired of mocking despite his exaggerated opinion of their power over markets.

Paul Samuelson was the leading theoretician among American economists and the first American awarded the economics version of the Nobel Prize in 1970. His scholarly articles numbered in the hundreds, but he is remembered today chiefly for two books: Foundations of Economic Analysis, based on his doctoral dissertation, which signaled a turning point in economics to mathematics as the formal mode of analysis; and Economics, his all-time best-selling college text that combined principles textbooks in microeconomics and macroeconomics in order to integrate the two analytically into the so-called “Neoclassical synthesis. Samuelson combined the elements of classical price theory as developed by Alfred Marshall and refined by subsequent generations with Keynesian macroeconomics as modified from Keynes by the neo-Keynesian generation that included Samuelson himself, Franco Modigliani and James Tobin, among others. This book (really, a double book) taught generations of economists through over twenty editions from the 1940s until the 21st century.

Samuelson’s central conceit was that individual free markets worked beautifully, but markets in the aggregate were prone to unemployment or inflation. This aggregate shortcoming could only be corrected by government spending directed by… well, by men like Samuelson himself; although he always refused to take a policy post in the Democrat administrations he supported and advised.

As with Galbraith, it is difficult for non-economists today to credit the veneration Samuelson inspired in certain quarters. In the late 1950s, Samuelson began predicting that the Soviet Union would soon overtake the U.S. in per-capita GDP (then GNP). He retained this prediction in successive editions of his textbook – until the final overthrow of the Soviet Union in 1991. Galbraith and Samuelson made an odd couple of Keynesians – the former supporting massive government spending in spite of his distrust of the bureaucracy and the latter embracing deficit spending by government because he had faith in the ability of government to fine-tune aggregate economic activity. Samuelson shared a forum in Newsweek Magazine in an alternating column with the third member of our Big Three, Milton Friedman.

Friedman became well-known among fellow economists long before he attracted public notice. He won the John Bates Clark medal awarded to the leading economist under the age of 40 and published a notable collection entitled Essays in Positive Economics that contains some of the best expository writing ever done in his subject. 1957 saw what he considered his best piece of work, A Theory of the Consumption Function, which successfully reconciled cross-section data on aggregate consumption among different groups over the same time period with time-series data on consumption among all groups over time.

In the early 1960s, Friedman published two books within a year of each other that catapulted him to public attention and professional eminence. Capitalism and Freedom made both the political and economic case for free markets, an analytical position that had almost deteriorated through neglect. A Monetary History of the United States, which he co-authored with Anna Schwartz of the National Bureau of Economic Research, made an empirical case for the money stock as perhaps the chief economic variable of interest both historically and for policy purposes. Milton Friedman became the world’s chief exponent of the Quantity Theory of Money, which had been around ever since David Hume in the 18th century but had never before been put to such comprehensive use in economic theory. Ironically, Friedman’s single-minded focus on the money stock proved to be his Achilles heel. Although still greatly respected for his manifold contributions to economic theory and his prodigious talents as a defender of freedom and popularizer of economic thought, Friedman’s monetary theory is little regarded among professionals of all ideological stripes.

As the 60s and 1970s wore on, Friedman headed up the disloyal opposition to Keynesian economics within the economics profession. Keynes had been posthumously crowned king in the 1950s and early 60s as Western economies began to adopt the policy of spending their way to prosperity. But the advent of simultaneous high inflation and high unemployment, or “stagflation,” in the 1970s put paid to the Keynesian tenure atop the profession. Friedman and Edmund Phelps independently and more or less simultaneously developed the hypothesis of a “natural rate of unemployment” that defied Keynesian efforts to reduce it via deficit spending. Only through continually increasing injections of money into the economy – producing ever-increasing rates of inflation and resulting unrest – could unemployment be reduced and held below this “natural rate.” Friedman’s Nobel Prize, received in 1976, was by this time a foregone conclusion.

In 1980, Friedman reached his zenith of public popularity with the best-selling book and accompanying PBS television series Free to Choose. This was a popularized version of Capitalism and Freedom, updated for the 80s. For the first time, an economist had scaled the heights of public popularity, professional acclaim and policy prominence. Like Samuelson, Friedman preferred to exercise his influence outside of government. Unlike Samuelson, though, Friedman had actually worked for government in World War II. It was Milton Friedman, of all people, who devised the concept of government tax withholding to streamline the process of revenue collection.

Vacuum at the Top

Today, economics is omnipresent in our lives. Yet there is nobody in the public square whose position rivals that of the Big Three of yesteryear. The closest would be Paul Krugman, who has written several popular books, whose Nobel Prize is spelled exactly like the one received by Samuelson and who believes that the stock of money can play an important role in economic policy. In other words, he is a pale shadow of Galbraith, Samuelson and Friedman.

Noted economist Sam Peltzman probed this seeming paradox in an article published in the May, 2013 issue of Econ Journal Watch, 10(2) pp. 205-209, entitled “Why Is There No Milton Friedman Today?” Peltzman’s analytical qualifications are impeccable. He has carved out a distinguished career as a critic of government regulation. His crown jewel is a famous 1975 study on automobile safety that introduced the pioneering concept of “risk compensation” to the social sciences.

Risk compensation refers to the behavioral effects created by safety improvements and regulations. When people take more risk in response to safety improvements and/or regulation, this change in behavior has been christened the “Peltzman Effect.” Thus, Sam Peltzman has been given the greatest scientific honor of all – a scientific principle has been named for him.

Peltzman notes the absence of successors to the Big Three. He especially abhors the vacuum created by the loss of Milton Friedman. Peltzman’s explains it by citing Friedman’s unique talents. The first of these was his knack for communicating economic insights to the masses. The same expository skill Friedman brought to his professional work equipped him to educate the general public.

Peltzman illustrates Friedman’s style with a revealing anecdote from his own (Peltzman’s) academic career. Peltzman’s first graduate-school class was Friedman’s legendary class in Price Theory at the University of Chicago. The students “eagerly awaited our introduction to the technical mysteries of our chosen profession. Instead, we got an extended paraphrase of an article entitled ‘I, Pencil,’ in which a humble pencil tells us of the herculean coordination problem required to get itself produced and distributed and of the virtues of markets in solving that problem.” Peltzman correctly attributes the essay to Leonard Read, founder of the Foundation for Economic Education and its journal, The Freeman, in which the essay originally appeared. Peltzman’s points are that Friedman’s pedagogy was time-tested and simple and he employed it before professional audiences as well as public ones.

Friedman’s second unique virtue was his zest for combat. Libertarian economists were scarce in Friedman’s day and he knew his arguments would be received with scorn and incredulity. Nevertheless, his rejoinders were cheerful and clever; he relished the opportunity to buck the tide of collectivist conformism. And his devotion to his principles was unyielding. “All against one makes for a good show,” observes Peltzman, “and Friedman liked the odds.” This brings to mind the answer made by John Wayne’s character J.B. Books, the dying gunfighter in the movie The Shootist, when asked to account for his luck in surviving so many gunfights over the years: “I was willing.”

It is clear that even Galbraith and Samuelson couldn’t measure up to Milton Friedman by Peltzman’s criteria. Galbraith had the communication skills and debating talent but little worthwhile to communicate; his theory badly needed shoring up. Samuelson had the theory but communicated largely by writing letters to his fellow economists in the language of differential equations. His text worked well enough for a captive academic audience but nobody ever characterized his persona as “dynamic.” Both these men were, to some greater or lesser extent, arguing for the status quo, while one of Friedman’s books was titled The Tyranny of the Status Quo.

So far, so good. Peltzman makes a concise, compelling case for Milton Friedman as sui generis. Now, though, Peltzman tries to explain why today’s economists do not measure up to the standard set by Friedman. Although his observations of the economics profession seem descriptively accurate, his attitude toward their change in behavior is disturbingly complacent.

The Contemporary Economist as Engineer

In assessing the state of the profession today, Peltzman at first sounds optimistic. It’s true that there is no Milton Friedman leading the charge for freedom and free markets. But that isn’t due to a lack of free-market economists. “There are…numbers of them within our gates, perhaps more than in Friedman’s time…But they lack something that Friedman had in…his time.” Actually, they lack several somethings.

First, they lack the kind of dedicated, first-rate opponents Friedman had in abundance. “…The range of belief within economics has narrowed, partly because of Friedman’s efforts…the modal economist is less [interventionist]… than the modal economist of Friedman’s era…Market solutions…are given a respectable hearing or are part of the consensus today (think flexible exchange rates or unregulated railroad rates). There is less room today for a good fight among economists.” Apparently, Peltzman does not read Paul Krugman’s column in the New York Times.

If this sounds dubious, just listen to Peltzman’s next assertion. “Consider…what has happened in the aftermath of the financial crisis of 2008. The chattering class pronounced with excited joy that Capitalism is now Dead, but the political center hardly moved, and in some countries even moved right – to fiscal rectitude, labor market reform, etc. Hardly any left party that moved away from socialism in Friedman’s heyday has moved back since. What is a committed free-market economist spoiling for a good fight to do when the other side is not so far away?”

This narrative hardly sounds like a description of the multi-trillion dollar stimulus, multiple bailouts of big banks and financial firms, government seizure and handover to autoworkers of two of the Big Three auto companies, impending nationalization of health care, regulatory reign of terror and Federal-Reserve money-creation and asset-purchase binges that have characterized the U.S. since 2008. Contrary to Peltzman, events since 2008 have conformed more to Newsweek‘s famous cover headline: “We Are All Socialists Now.” And what has today’s “modal economist” done in response to this overwhelming frontal assault on free markets?

If Peltzman’s judgment that the economics profession has gravitated toward freer markets were correct, we would expect to read protests from our modal economist. Instead, he has, according to Peltzman, turned into “a much cooler customer. This one tends to be less committed to any politico-economic system.” Wait a minute – what happened to all those “numbers of …free-market economists…within our gates” just a minute ago? We could sure use them, because it now turns out that among the cooler customers, “the animating spirit is more the engineer solving specific problems than the philosopher seeking a unified world view. The questions asked tend to be smaller than, say, the connection between capitalism and freedom.”

Strangely, Peltzman doesn’t seem perturbed about this loss of ideological fervor, because “the skill with which the question is answered tends to be greater than in times past.” What about their professional duty to educate the public in the great truths of economics? “At some point,” Peltzman declares airily, “today’s leading economists may want to communicate their results to a wider audience. But this is an afterthought, in the sense that what is valued within the profession – the skill in obtaining the result – is not what the outside audience is interested in.”

Peltzman is surely wrong about the outside audience, who is intensely interested in “the skill in obtaining the result” because (at least in principle) it should affect the veracity of the result. Presumably what Peltzman meant to say is that the audience doesn’t care what method economists use to get the answer as long as they get the right one. And in this connection, it is hard to see what economics profession Peltzman is referring to – surely not the one that actually exists. For over two decades, Deirdre McCloskey and Steven Ziliak have proclaimed that econometric practice within the social sciences – in economics and elsewhere – is scandalously incompetent. Most empirical articles in the leading professional journals over-rely upon and misuse the principle of “statistical significance.” Thus the foundation of empirical economics has rotted away – and with it has gone Peltzman’s claim of greater skill.

Peltzman is not merely blind to the failings of his profession today; he is complacent about its future prospects. “It is hard for me to see a reversal of the kind of trends I have described…in…fields where the engineer has replaced the philosopher. Perhaps an economic calamity will shake things up in economics. But we had one in 2008, and very little changed within the profession. There was a period of befuddlement [after which] economists went back to their tinkering and were largely irrelevant to the political response to the crisis.”

Peltzman’s complacency even extends back to Friedman’s work. He attributes the fact that “there is no serious socialist faction left within economics” to “Friedman’s success,” which “makes it harder for someone to follow in his footsteps.” Peltzman declares flatly that “there is no serious political/economic alternative to some form of capitalist organization in any major economy.” Peltzman cannot have forgotten – can he? – that this was exactly the point made by Ludwig von Mises and reinforced by Mises and his student F.A. Hayek in the Socialist Calculation debates of the 1930s. This was a central contention of Hayek in his great polemic The Road to Serfdom in 1944. It was Hayek, the guiding spirit behind the Mont Pelerin Society of worldwide free-market economists who sparked Friedman’s interest in political activism in the late 1950s. Friedman admitted all this in his Introduction to the 1994 edition of The Road to Serfdom and in interviews with Hayek’s biographer, Alan Ebenstein.

Peltzman’s most outrageous error is his claim that “the Fed chairman learned from Friedman not to permit a credit freeze to turn into a monetary implosion.” Milton Friedman would have slit both wrists and reclined in a warm bath before endorsing the policies followed by Ben Bernanke before, during or after the Financial Crisis of 2008. Friedman’s criticism of Federal Reserve policy during the Great Depression did not pertain to a “credit freeze” but rather to the wholesale failure of banks throughout the U.S. and resulting nosedive taken by the money stock when deposits were destroyed. A credit freeze – whatever else it might entail – implies no such rapid decline in the money supply and therefore does not demand a “helicopter drop” of money, a la Milton Friedman, in order to cure it. Peltzman’s jaw-dropping attempt to imply a posthumous endorsement of Bernanke by Friedman is as inexcusable as it is inexplicable.

Peltzman has chosen the wrong model for his model economist – Friedman rather than Hayek. He has also chosen the wrong model for his modal economist – the engineer rather than the philosopher. In The Counter-Revolution of Science (recently republished under its original planned title, Studies on the Abuse and Decline of Reason), Hayek outlines the disastrous effects of subjecting society to control by the “mind of the engineer.”

The engineer strives to bring all aspects of a problem under his conscious control in order to achieve a technical optimum. He chafes at external constraints such as prices, incomes and interest rates; they are not “objective attributes of things but reflections of a particular human situation at a given time and place.” He sees them as meaningless, irrational interferences with his optimization techniques. When an engineer confronts a machine, for instance, he typically strives to gain the maximum power or energy output from given inputs of resources. In fact, as Hayek points out, the engineer’s technical optimum is usually just the solution that would obtain if the supply of working capital or resources was unlimited or the interest rate was zero. In adopting the perspective of the engineer, the economist is losing his own unique perspective. A good real-world example of the engineering perspective gone wrong in economic practice would be the misguided activist economic policies of former-engineer Herbert Hoover in trying to combat the Great Depression.

Peltzman correctly recalls that Milton Friedman advanced the view that the profession should pursue “positive economics” by formulating hypotheses and testing them empirically. But Peltzman neglects to inform his readers that today this viewpoint is as dead as the dodo – deader, actually, since today we can clone dodos back to life but we are not about to resurrect the canard that econometrics can be used to test predictive hypotheses in the social sciences in the same way that laboratory experiments test natural scientific hypotheses. In academic economics today, nobody believes that anymore. The massive, sausage-producing enterprise of submitting articles to refereed professional journals for acceptance continues, but purely as a ritual for granting tenure. Nobody now pretends that this process has any value above the purely ceremonial. It is now axiomatic in economics that econometrics does not prove anything, test any hypotheses or rule out (or in) any part of economic theory.

The format mathematical models economists swear by give the appearance of scientific rigor, but this is spurious. In order to reduce actual human activity to systems of solvable equations and stable equilibria, economists have to remove so much realistic detail that their models are unrecognizable to the layman. They are virtually useless for making quantitative predictions. We know this because, as the former Donald McCloskey put it, economists cannot answer “the American question: If you’re so smart, why aren’t you rich?”

Today, economic policy is taking measured that economists have warned against for centuries. The attempt to create wealth and induce prosperity by massive money creation is traditionally a tactic of desperation, one that inevitably ends in crisis and chaos. Yet economists sit silent instead of rising in indignant protest. And Peltzman appears to approve both the desperation tactics and the compliance of his profession.

Actually, Peltzman does betray deep-seated doubts about the current path of economics profession in his last sentence. It reads: “But one wonders still: is this only the calm before the storm?” And one wonders if Peltzman will have cause to regret his failure to speak out.

Whither Economics?

Sam Peltzman has courageously taken on one of the great contemporary mysteries. It is a missing-persons case. Where did the economist go in our public discourse? Peltzman succeeds in finding his quarry, all right. But having found him, he is distressingly indifferent to the runout. His confidence in the methods and motives of today’s economists seems utterly misplaced. Without realizing it, Peltzman himself is providing part of the explanation for the absence of economists from public discourse. He is sanctioning the abandonment of what they do best – teaching the philosophy behind economics – in favor of what they do worst – pretending to employ the methods and techniques of engineering in the foreign realm of economics.