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-186 for week of 1-5-14: The Secular Stagnation of Macroeconomic Thought

An Access Advertising EconBrief:

The Secular Stagnation of Macroeconomic Thought

The topic du jour in economic-policy circles is “secular stagnation,” thanks to two recent speeches on that topic by high-powered macroeconomist Lawrence Summers. The term originated just after World War II when Keynesian economists, particularly Alvin Hansen, used it to justify their forecast of the high unemployment and low growth that ostensibly awaited the U.S. after the war.

Now, nearly 70 years later, it is back. In a recent Wall Street Journal op-ed, monetary economist John Taylor likened its re-emergence to a vampire arising from his crypt. There is indeed something ghoulish about the propensity of Keynesian economists to ransack outdated textbooks in search of conceptual support for their latest brainstorm.

The backstory behind secular stagnation is only half the story, though. The other half is the insight it offers into the mindset of its patrons.

The Birth of the Secular Stagnation Hypothesis

As World War II drew to a close, economists gradually turned their attention to a problem that had intermittently occupied them since the late 1930s. The Great Depression had soured the profession on the workings of free markets. The publication of John Maynard Keynes’ General Theory of Employment Interest and Money had suggested a new framework for economic analysis that placed emphasis on unemployment and its elimination. While war mobilization had made this issue moot, the return of servicemen and readjustment to a peacetime economy brought it back to prominence.

Many Keynesians foresaw a return to mass unemployment and Depression. The leading American exponent, Alvin Hansen, developed a specific hypothesis along those lines. Keynes had posited a simple theory of aggregate consumption: consumption was a stable, linear function of income. These properties implied that, over time, it might become progressively more difficult to maintain full employment.

A numerical example using the simple Keynesian macroeconomic model will clarify this point. Y = real income or output, which is the sum of C (Consumption), I (Investment) and G (net Government spending). Further, C is a linear function of Y; that is, C = a + bY, where the “a” term reflects the influence on Consumption of factors other than real income and “b” (the slope of the Consumption function depicted diagrammatically) is the marginal propensity to consume from additional income acquired. Assume, purely for expository purposes, that a = 50, b = .75, I = 100 and G = 100. If Y = 1000, then C = 50 + .75 (1000) = 800. The influence of technology, which improves from year to year, will cause productivity to increase and output to increase over time, all other things equal. Assume, again purely for illustrative purposes, that this increase is 5%. In that case, the full employment level of income will increase from 1000 to 1050. But C does not increase by 5% to 840; it increases only to 837.50. In order to preserve full employment (according to Keynesian logic), the sum of I and G will have to increase by 212.50, an increase of 6.25% over its previous value of 200 – which is more than 5%. Over time, this putative annual shortfall in Consumption would get larger and larger, requiring successively larger doses of I and G to keep us at full employment.

Already we can see the germ of logic behind Hansen’s secular stagnation hypothesis, which is that Consumption over time will fall farther and farther behind the level necessary to preserve full employment. (The word “secular” does not reflect its customary meaning of “non-religious or worldly” but rather its technical economic meaning of “a long time series of indefinite duration.”) Underconsumption is a theme dear to the hearts of Keynesian economists. In this case, it depends as a first approximation on the algebraic structure of the simple Keynesian model, in which Consumption is a simple linear function of income (Y).

There was much more to the analysis than this. In principle, Consumption might increase for reasons unrelated to income. But Hansen predicted just the opposite. He believed the primary source of autonomous increases in Consumption was population growth, and he foresaw a sharp in U.S. population growth after the war. He was equally pessimistic about increases in autonomous Investment because he thought the highest-returning investments had already been tapped. Thus, by default, government deficit spending was the only possible remedy for progressively worsening unemployment and stagnating economic growth – hence the term “secular stagnation.”

The Gruesome Death of the Secular Stagnation Hypothesis

Alvin Hansen was known as the “American Keynes.” Presumably this was because of the apostolic fervor with which he preached Keynesian gospel. In this case, he shared something else with Keynes: the thoroughness with which history repudiated his ideas.

Hansen predicted population decline. Instead, the U.S. experienced the biggest baby boom in history. Among other effects, this produced an explosion of household investment in consumer durables such as homes, automobiles and appliances. The shortages and government-imposed rationing of World War II had generated a pent-up demand that burst its boundaries in the postwar climate.

Rather than unemployment and depression, the U.S. enjoyed one of its biggest expansions ever in 1946. This eventually created problems when, during the Korean War, the Truman administration preferred to fund the war via money creation rather than employing the borrowing that had financed most defense expenditures during World War II. The result was inflation, which the Administration countered with wage and price controls.

The U.S. had borrowed to the max in its conquest over the Axis powers, with debt climbing to its highest level as a percentage of national output. In his recent book, David Stockman pointed out the important role played by the Eisenhower Administration in paying down this debt and returning a semblance of sanity to federal-government spending.

This combination of private-sector buoyancy and government fiscal retrenchment left no need or room for the Keynesian remedy proposed by Hansen. As the 1950s unfolded, economic theoreticians on all sides of the spectrum delivered the coup de grace to the secular stagnation hypothesis.

In 1957, Milton Friedman presented his “permanent income” hypothesis of consumption spending, which fleshed out the individual utility-maximizing theory of consumer behavior with the picture of a consumer whose spending is governed by an estimation of lifetime or “permanent” income. He or she will tend to dissave by borrowing when young and by drawing down accumulated assets when old, meanwhile accumulating assets via saving in prime earning years. It is not actual or realized income so much as this individualized conception of expected normal income that influences consumption spending.

Keynesian Franco Modigliani developed his own theory of “life cycle” consumption, rather broadly similar to Friedman’s, within the same time frame. Left-wing economist James Duesenberry developed a “relative income” hypothesis stating that consumption was influenced by the consumer’s income relative to that of others. While there were important theoretical and practical differences between the three theories, they all rejected the simple Keynesian linear dependence of consumption on income. And this drove a stake through the heart of the secularly widening gap between consumption and income. The slats had been kicked out from under the secular-stagnation platform.

The secular stagnation hypothesis had already been proved to be a resounding flop in practice. Now it was shown to be wrong in theory as well. Before Keynesian economics had even been adopted on a wholesale basis, it had suffered its first crushing defeat.

The Rise of the Undead: Secular Stagnation Rises from the Crypt

Broadway impresarios sometimes revive past productions, but they invariably choose to revive hit plays rather than flops. Based on its first run, secular stagnation would not seem to be a prime candidate for revival. Nevertheless, Lawrence Summers mounted a new version of the concept and took it out of town for a tryout in two recent speeches, supplemented by comments on subsequent blog posts.

In his first speech, made to the International Monetary Fund Research Council, Summers grappled with the theoretical issues involved in resurrecting Hansen’s ancient bogeyman. Paraphrasing Clemenceau on war and generals, Summers mused that “finance is too important to be left to financiers.” The U.S. quickly recovered from the financial panic of 2008-09, but the ensuing four years brought astonishingly little progress when measured in standard macroeconomic metrics like employment and output growth. Although the term “secular stagnation” has long been neglected by his profession, Summers now finds it “not…without relevance” in understanding our current situation.

If the U.S. suffered a mass power blackout, output would fall precipitously. It would be idiotic for economists to object that electricity constitutes “only 4%” of total output – obviously, its importance is not indicated by its fraction of total output. Similarly, finance should be viewed in the same light – as the intermediating, lubricating force that enables the bulk of our goods and services. If a power blackout did occur, we would naturally expect restoration of service to be followed by a catch-up period of increased output, rather than the sort of prolonged stagnation we have actually experienced after the financial crisis. So why hasn’t it happened?

Summers’ explanation to the IMF audience was technical – that the “natural rate of interest” is negative; e.g., below zero. “We may need to think about we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.” Summers means that the practical inability to charge negative rates of interest – e.g., subsidize loans rather than charge money for them – is what is chaining the U.S. economy down.

In his second speech and follow-up blog  comments, Summers elaborated on the policy implications of his musings. “Our economy is constrained by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services.” Of course, this is the old-time Keynesian religion of underconsumption, set to the background music of Cole Porter’s “Everything Old is New Again.” Secular stagnation has been brought down from the attic, fumigated with a dusting of demographics (the declining U.S. birth rate) to remove the stench of disgrace left by Hansen.

We need to “end the disastrous trends toward less and less government spending and employment each year.” In other words, the problem is not that we overspent and created too much sovereign debt in 2008-09; the problem is that we spent too little – and then cut spending after that. We should replace coal-first power plants – that will necessitate a huge program of capital spending to keep the power on. Following Keynes, Summers stresses the importance of supporting domestic demand by improving the trade balance.

Just as this program begins to sound suspiciously like a hair of the dog that bit us – or maybe the entire hair coat – Summers removes all doubt. It is “a chimera to rely on regulation” to pop asset bubbles in the face of the monetary excess necessary to underpin his program.

At the close of his first speech, Summers provided the only saving grace with the caveat: “This may all be madness and I may not have this right at all.”

Krugman’s Endorsement of Summers: For This We Need Economists?

Summers’ revival of the secular stagnation hypothesis was the talk of policymaking circles. Half of the talk was probably devoted to wondering what Summers was saying; the other half to wondering why he was saying it. Perhaps trying to be helpful, Summers’ partner in Keynesian crime Paul Krugman weighed in with his own interpretation of Summers’ remarks.

Inevitably, Krugman’s own views crept in to his discussion. The result was a blog post that could scarcely be believed even when read. (Readers with broad minds and strong stomachs are referred to “Secular Stagnation, Coalmines, Bubbles, and Larry Summers,” 11/16/2013, on the Krugman archive.)

Krugman begins with an uncharacteristic (and unrepeated) touch of humility. Noting the similarity between his own previous published diagnosis of our economic ills and Summers’ current one, he admits that Summers’ is “much clearer…more forceful, and altogether better.”

According to Krugman, he and Summers both view the U.S. economy as stuck in a “liquidity trap.” This is another Keynesian illustration of market pathology. As Keynes originally described the concept, a liquidity trap existed during an economic depression so intense that monetary policy was rendered impotent. Governments use banks as their tool for creating money; securities sold to the public are snapped up by banks, which in turn use them as the basis for making loans to businesses. But banks cannot force businesses to take out loans. If businesses decide that conditions are so bad that investing is too risky no matter how low the borrowing rate of interest, then monetary policymakers are helpless. In contrast, fiscal policy labors under no such constraint, since the government can always spend money for stimulative purposes. In a liquidity trap, though, monetary policy is likened to “pushing on a string” – a fruitless effort.

Krugman carries this notion further by identifying it with Summers’ evocation of a negative equilibrium interest rate. Investment demand is so weak and the desire to save so strong that the two are equilibrated only when “the” interest rate is below zero. In this climate, Krugman maintains, “the normal rules of economic policy don’t apply…virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment thanks to the paradox of thrift.” Krugman hereby drags in Keynesian anachronism #3. The so-called “paradox of thrift” states that the attempt to save more results in less saving because ex ante increases in saving will reduce income and employment, thus preventing the saving that consumers are trying to do, while reducing consumption as well. The only problem with this is that we have actually realized increases in saving and income at the same time, which is diametrically opposite to the effects predicted by the concept.

But these are trifles compared to the powerhouse contentions Krugman has coming up. Summers outlined a general program of public spending to increase demand and frankly admitted the futility of suppressing bubbles caused by the money creation necessary to finance the spending. Is Krugman troubled by this? Not merely “no,” but “Hell, no.”

“While productive spending is best, unproductive spending is still better than nothing…this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future.” And how could that possibly happen? (See “Europe, Sovereign Debt of; Europe, Financial Crises of; Europe, Bailouts Multiply Across; Europe, Political Protests Blanket.”)

Krugman continues with an example of wasteful spending by U.S. corporations that produced virtually no payoff after three years. “Nevertheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would have otherwise been idle.[emphasis added] F.A. Hayek characterized Keynesian economics as the negation of the market, a description well befitting this rationalization. In Krugman’s world, the labor market and relative prices might as well not exist, for all the effect they have. Microeconomics either does not exist or operates on a different plane of existence than the macroeconomic plane on which the statistical construct of aggregate demand wields its decisive influence. For this we need economists?

Krugman now arrives at “the radical part of Larry’s presentation” – as if the foregoing weren’t radical enough! He straightforwardly, even proudly admits what Summers guardedly suggests – that asset bubbles are a good thing. In fact, according to Krugman, U.S. prosperity has been built on bubbles for quite a while. “We now know that the economy of 2003-2007 was built on a bubble.” Krugman is being coy here since he made a celebrated statement in 2002 calling for the Federal Reserve to create a bubble in the housing market. Oddly enough, this attracted almost no attention at the time and has brought him no adverse reaction since then. “You can say the same about the latter part of the 90s expansion; and… about the later years…of the Reagan expansion, which was driven …by runaway thrift institutions and a large bubble in commercial real estate.”

Krugman’s recall of history is curiously defective, especially considering that he was employed in the Reagan Administration at the time, albeit in a minor position. The 1986 tax reform law was, and still is, pinpointed for tax-law changes that helped pop a real-estate bubble largely built on tax-deductibility. The political Left is fond of criticizing Reagan for claiming to have lowered taxes in the early 80s while actually raising them later on. The Left is even fonder of excoriating Reagan and Paul Volcker for ending inflation on the backs of the poor by killing off inflation by stopping monetary expansion too abruptly. Now Krugman is criticizing Reagan for doing just the opposite!

Krugman’s piece de resistance is his riposte to future critics who will object to the runaway inflation that the Summers/Krugman project will promote. Krugman unblinkingly admits that inflation “expropriates the gains of savers,” but replies that “in a liquidity trap, saving may be a personal virtue but it’s a social vice.” And in an economy facing secular stagnation, the liquidity trap is “the norm. Assuring people they can get a positive rate of interest on safe assets means promising them something the market doesn’t want to deliver.”

Krugman implicitly and explicitly assumes that markets are as dysfunctional as life-support patients with no respirator. But when he needs a justification for deep-sixing the life savings of hundreds of millions of people, he suddenly pulls out “the market” and gives its ostensible verdict a personal blessing of moral authority. Yet in this very same blog post, he cavalierly dismisses his critics as “a lot of people [opponents of Krugman] want economics to be a morality play and they don’t care how many people suffer in the process” [!!] For the benefit of readers unfamiliar with the long-running debate between Krugman and his critics, those critics are free-market economists who want bubbles to end with unsustainable businesses being liquidated rather than bailed out, and the business cycle to be cut short rather than prolonged indefinitely with each iteration worse than the previous one.

Intellectual Stagnation, Not Economic

At this point, it is all too clear that secular stagnation has taken place. But the stagnation is intellectual, not economic. Keynesian economists are framing policy arguments using terms like “secular stagnation,” “liquidity trap” and “paradox of thrift.” These recondite terms went out of fashion over thirty years ago, along with the paleo-Keynesian economic theory that spawned them. They survive in the 20th-century textbooks and graduate-school memories of economists now approaching retirement.

The shocking character of the Summers/Krugman hypothesis doesn’t derive from its vintage, though. Its anti-economic character – relative prices are irrelevant, waste is a good thing, markets are worthless except when economic managers need a pretext for arbitrary action – is professionally repellent. Even more frightening is the hubris on display. Summers is a disgusting sight, standing up in front of an audience at the International Monetary Fund, pontificating with grandiose gravity about “managing an economy” – as if he were the CEO of a U.S. economy of some 315 million people and tens of thousands of businesses.

There are quite a few people who consider a large public corporation too unwieldy to manage effectively. The difficulty of one economist managing an entire economy must increase not merely linearly but exponentially, considering the interaction and feedback effects involved. At least Summers had the minimal presence of mind to recognize that he might be mistaken. Krugman, in contrast, displays the same mindset as his intellectual antecedent, John Maynard Keynes. Several biographers and friends – including F.A. Hayek, with whom his relations were cordial despite their opposing views – remarked that Keynes was obsessed with his own preeminence as a public intellectual rather than with mastery of economic theory as such. Hayek remarked that Keynes may have been the most brilliant man he ever encountered but was a bad economist. Summers and Krugman show no signs of possessing the intellectual diversity and flexibility of Keynes – only his arrogance and deep-seated need for personal attention.

There is another shocking aspect to this latest policy flap. Summers/Krugman are in the anomalous position of criticizing the results of their own policies. That is, even they cannot credibly maintain that we have lived under a regime of laissez-faire or tight fiscal or monetary discipline for the last five years. They can only insist that not enough was done. Of course, this is the standard big-government lament; when big-government fails, try bigger government. But in this case, they are telling us that the results they formerly called bad were really good and we should expect no more from them in the future. The friendliest left-winger would have to acknowledge that Summers/Krugman are confessing failure and telling us that this is the best we can do. Notice, for example, that neither man stressed the very short-term nature of their policy prescription or promised that once their strategy of fiscal inebriation reached its apogee, we could let the market take over. No, theirs was a counsel of despair reminiscent of late 1970s malaise.

You can’t get any more stagnant than that.