I have just finished reading Paul Krugman’s book The Return Of Depression Economics and the Crisis of 2008.

It is a very informative book written in an easy to understand style.  Even for me who follows economics somewhat closely, he presented new ways, at least to me, of looking at some of the past history of economic crises and their resolution.  He talked about various currency crises and showed that almost all paths of action had some serious downsides.

I could hardly wait to get the the final chapters where he would tell us how to get out of this mess.  The book has a copyright of 2009, so it had to be written before Obama had a chance to do much.  The book could therefore not be informed by the results of any actions taken by Obama.  Still, I had my hopes set high. (If you want to preserve your good opinion of the book, don’t read the paragraph starting at the end of page 182. I’ll explain below. Spoiler alert!)

On page 182 of this 191 page book, Paul Krugman blew my hopes right out of the water.  It is as if he had decided to take a vacation from writing this book and had one of his freshmen students write a few sentences.

He had the following in a section titled What Is Depression Economics:

Briefly, the source of the theoretical disputes was this: in principle, shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment.

Say what?!?!  If you are typical of many people at the time and you were hugely leveraged with debt, falling wages and falling prices would make your life a living hell with debts that did not fall with the wages and prices.  How could you expect consumers to go out and buy more when they were deeply underwater with debt?

If you had bought a $250,000 house with a $200,000 mortgage and then refinanced it with a $300,000 mortgage as its value rose to $310,000, and then the value of the house dropped to $200,000, you would be in a world of hurt.  If you lost your job and had the opportunity to take another in a town a thousand miles way, what were you going to do with your house on which you owed $300,000 but was only worth $200,000?  You became an unemployed prisoner of your own house.  You could search and search for nearby work to avoid foreclosure.  Unless you found a source of income relatively quickly, you would find yourself with no job, no house, and not enough savings to move to a place where you could get a job (if such a place existed.)

I cannot believe that Krugman’s editors let the following sentence remain in the book.

In reality prices don’t fall quickly in the face of the recession, but economists have been unable to agree about exactly why.

I don’t suppose that the falling value of the dollar and consequent rising price of oil could account for keeping prices up.  Could it be that the need for homeowners to sell their houses at above market value to be able to pay off their mortgages kept them from lowering the prices right away in the forlorn hope that they could come out of the deal financially whole?

Throughout the book, Krugman used an example of a large baby-sitting coop formed in Washington DC, where members would collect coupons for future babysitting service by performing baby-sitting themselves.  He demonstrated failures of demand when everyone attempted to increase their saving of coupons at the same time.  There were a number of other lessons in economics that he could demonstrate with this example.

So when he wrote on page 182,

In the story baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall, so that the purchasing power of the existing supply of coupons would have risen, and the co-op would have returned to “full employment” without any action by management.

I was aghast.  In the baby-sitting co-op example, he did not have the members mortgaged up to the hilt and leveraged to the max to own their supply of coupons. In the example, the members of the co-op had a positive net worth in terms of saved coupons. In the real world, many people had a negative net worth.

In the introduction to the book, Krugman explained his rationale for using stories to make his points.

…  Suppose on the other hand, that I illustrate Japan’s problems with the entertaining tale of the ups and downs of a baby-sitting co-op (which will, in fact, make several appearances in the book).  Maybe it sounds silly, maybe the levity will even offend your sensitivities, but the whimsicality has a purpose: it jolts the mind into a different channel, suggesting in this case that there may indeed be  a surprisingly easy way out of at least part of Japan’s problems.

Knowing that you are using a simplified small example to illustrate the principles of a real world sized situation, when the behavior of the small example does not match the behavior of the real-world situation, a natural question should come to the mind of any intelligent person.  That question is, “What is there in my small example that is missing or different from the situation in the real world that would explain the discrepancy?”

Surely as a Nobel Prize winning economist, Paul Krugman has asked himself this question many times during his career of economic research. How he could make a stumble like this in his book written this late in his career, is a complete mystery to me.

RichardH’s reaction to my diatribe above was that I ought to reread the last chapter.

I did do so. And yes, Krugman did propose many steps to solve the problems.  Not only that, but he wrote other paragraphs that showed he already knew what nonsense it was to write the paragraph of my ire.

So why did I get so upset with a single paragraph in an otherwise useful book?

Go to my previous post Keynes v Hayek and click on the link to the actual “debate”.  There you will find that the anti-Keynes debaters focused quite a bit of their caricature of Keynes around an intemperate or facetious remark attributed to Keynes.  He said that for a fiscal stimulus even if you spent money to dig holes and fill them back in, that would be better than nothing.  I think Keynes’ point was that you needed to put people back to work so that they would have spending money to create consumer demand.  Even if the work wasn’t overly productive, it was better to have  them earning money than not.

The caricaturists then took Keynes’ remark, divorced the idea of government spending from the creation of jobs, and then laughed at the idea that spending money wastefully could be good for the economy.

One should never discount the opportunity you can create for taking your words out of context and then beating you over the head with them.

The paragraph in question was sloppily written.  As I read the words, I could imagine how those words would come back to haunt Krugman and all of us who believed the theories Krugman was promoting.

August 16, 2011

So maybe I am suffering from confirmation bias, but Brad DeLong seems to agree with some of my criticsm of Krugman. See my post Department of “Huh?!”: Labor Market Demand and Supply for the Elderly Edition.