Paul Krugman
Opinion Columnist
Today’s newsletter isn’t about Modern Monetary Theory (MMT), which has been the subject of a lot of back-and-forth in the economics world over the past couple of days. Suffice it to say that I consider MMT the cryptocurrency of macroeconomics: It sounds edgy and forward-looking, but when you press its devotees on what exactly is its point, what it can do that you can’t do better using more conventional approaches, the response is a lot of bombast but no clear answer.
My topic today is, instead, more meta (not to be confused with Mark Zuckerberg’s Meta). Here’s the question: When do events tell us that we need a fundamental rethink of economic concepts?
You might think that the need for new theory is obvious whenever consensus economic forecasts are wildly off. But it’s a big, complicated world out there, and conceptually sound models may end up being way off because of inadequate data or outside events.
Here’s an example from “real” science: Britain’s Great Storm of 1987, whose severity came as a complete surprise. Nobody suggested that there was something wrong with the fundamental principles of meteorology. Instead, while forecasters came in for a lot of criticism, the main conclusion was that the Met Office’s data collection for the ocean south and west of Britain was inadequate and needed to be reinforced.
What’s an economic example? This may surprise you: Essentially nobody saw the 2008 financial meltdown coming (other than people who predicted many other crises that didn’t happen), but when it did come, there wasn’t much existential angst among economists I talked to. We’ve long had a theory of banking crises; we just thought that regulations and deposit insurance made an old-fashioned wave of bank runs impossible — which they did, for traditional banks.
What few had realized, however, was that much of the modern financial system now involved “shadow banks” that did bank-type business but, because they weren’t marble buildings with rows of tellers, lacked both the regulations and the government guarantees that protected traditional banking. As soon as that became clear, the crisis, although unanticipated, was easily slotted into the standard framework; in the weeks after Lehman Brothers fell, you could find economists roaming the halls muttering “Diamond-Dybvig, Diamond-Dybvig” under their breath.
So which economic crises clearly demonstrated the need for a fundamental rethink? The Great Depression, of course: Such a thing was undreamed of under the era’s prevailing economic philosophy, and the fact that it happened converted many to the economic vision of John Maynard Keynes.
The stagflation of the 1970s also forced a major rethink. Persistent inflation despite high unemployment seemed to provide a spectacular vindication for the argument of Milton Friedman and Edmund Phelps that sustained inflation would get built into wage- and price-setting — not an entirely new idea but one that became part of the canon.
Conversely, the Volcker recession of the 1980s refuted some of the popular economic models of the 1970s. According to these “equilibrium macro” models, tight money would cause a recession only if people didn’t see it coming. The huge, sustained slump associated with disinflation showed that these models were wrong — although this time, sadly, a large part of the profession refused to accept the evidence and went into decades of denial.
Finally, Japan’s sustained economic weakness beginning in the 1990s had a profound effect on the thinking of a number of economists — including yours truly and a guy named Ben Bernanke (what ever happened to him?). Back in 1998, I argued that the rules would change in an economy in which the amount people wanted to save exceeded the amount businesses wanted to invest. Even huge increases in the money supply would just sit there, rather than causing inflation. Nor would budget deficits raise interest rates, unless they were big enough to absorb all the excess saving.
What about subsequent events? Believe it or not, there has been nothing comparably earthshaking, at least in intellectual terms. After 2008, the whole world started to look like Japan a decade earlier; well, we already had the intellectual framework for that.
It’s true that many financial types and policymakers, together with a few economists, kept predicting that interest rates and the rate of inflation would soar any day now. But these predictions weren’t based on any coherent model. Instead, they reflected some combination of gut feelings and, it must be said, wishful thinking. For example, Alan Greenspan, who kept predicting terrible things from money-printing and deficit spending, declared the failure of inflation and interest rates to soar “regrettable.”
Those of us who stayed with the models thought this was silly. Way back in 2010, I made fun of “invisible bond vigilantes” (and also of people who believed in the confidence fairy).
Getting this story right is important because I keep seeing writers declaring that the persistence of low interest rates, despite large deficits and government debt, is somehow a shocking development that refutes conventional economic thinking, so we should turn to novel doctrines like MMT. Well, I do not think that word “conventional” means what they think it means. You can find famous people who kept predicting a big rise in rates, but nothing that happened between the global financial crisis and the Covid-19 pandemic contradicted standard Keynesian theory.
What about the recent surge in inflation? I don’t want to minimize the fact that I called that one wrong, and it’s a big deal. But the odd thing about this debate is that Team Inflation and Team Transitory started out with more or less the same intellectual framework, just different interpretations of the numbers.
And, for now, the failure of many economists to get inflation right looks like the 2008 failure to appreciate the fragility of the financial system, or, for that matter, the Met Office’s bad weather forecast in 1987, rather than an existential intellectual problem. Nobody saw supply-chain woes or worker shortages driven by the Great Resignation coming, but as I said, it’s a big, complicated world out there, and sometimes stuff happens.
The moral of this discussion isn’t that the mainstream is always right, or that you should listen only to people with the right formal credentials. It is, instead, that new ideas should be judged as ideas, not by whether those proposing those ideas talk a good game. We all love tales of brave innovators challenging a stodgy establishment, but that very love opens the doors for hucksters — who may be fooling themselves, as well as others — who actually have nothing to offer but a good story line.
Quick Hits
Why are interest rates on the rise?
A center-right history of macroeconomics.
The 1970s are a very bad analogy for today.
The Bank of England against higher wages.
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