The Great Disruption in Economic Thought

|Peter Boettke|

Roughly speaking classical political economy, or economic orthodoxy, taught the following: private property, freedom of contract and trade, sound money, and fiscal responsibility.  For our purposes we refer to this set of policies as the lassize-faire principle.  Of course throughout the history of economic ideas there were always subtle differences of opinion within orthodoxy, and fine points of disagreement in method and methodology.  But these paled in comparison with the broad consensus on matters concerning the nature and signficance of economics and political economy.  Yes, John Stuart Mill had exceptions to the laissez-faire principle that one could drive an intellectual truck through, but re-read how he sents up that discussion and the importance he places on the laissez-faire presumption.  

Orthodoxy from Adam Smith onward was suspicious of the claims of those who argued that deviations from the laissize-faire principle were required, and especially so if the claim was made that they should have the power to act in violation of that principle.  Think of the laissze-faire claim as basically saying: individuals should be free to choose within the bounds of a system of property, contract and consent, and that within that rule regime markets are self-regulating to such an extent that errors are detected and corrected, and inefficiencies will be weeded out, and the gains from trade and the gains from innovation will constantly guide the processes of exchange and production toward the efficient solution.  Economic forces are forever working in the selective process of the market economy to improve the material well-being of the consumer as they judge that for themselves.

Throughout the history of the discipline many voices rose in opposition to this message, but while many were heard, none changed the core teachings of economic orthodoxy.  Not Malthus, not Marx, not Veblen.  But Keynes proved successful where the others did not, and his efforts resulted in a great intellectual shift in the way the teachings of the classical political economists were thought of, and the way that modern economics was taught, practiced and applied.  What was once held with suspicion, was now the norm, and what was once the norm, was now viewed with suspicion.

Keynes was not, I should stress, arguing that we should abolish the private property market economy as say Marx did.  He simply said that markets are prone to financial instability, that there is no reliable self-regulating mechanism in those situations, and that governmental intervention into the system can fix the problem.  Whereas the classical political economists were optimistic about the market's self-regulating capacity, and pessimistic about government's ability to intervene effectively (for a combination of incentive issues and informational issues), Keynes and the Keynesians argued the opposite --- they were optimistic about government's ability to intervene to manage aggregate demand, and they were pessimistic about the market to self-regulate in the face of a liquidity crisis to maintain full employment levels of output.

The relative optimism/pessimism issue is in many ways the critical issue involved in these debates.  And we should keep that in mind always when discussing The Clash of Economic Ideas [btw, best book you can read on the modern history of thought and its relevance to the disputes our day].  I am a classical political economist in my balance of optimism about the market, and pessimism about politics.  If someone was to label me a classical political economist, then I could hardly complain though of course this would be inaccurate on subtle points of doctrine.  It would not be an insult to me, but in some broad brush sense painting me accurately.  So I don't consider it a cheap shot or insulting when I label folks "Keynesians".  If the shoe fits, then wear it.  If you believe that markets are prone to macroeconomic instability that will not be self-corrected, and you believe that positive actions by the government can in fact fix the situation, then broadly speaking you are adopting the Keynesian stance.

It is in this spirit that I wrote my op-ed last week about Janet Yellen and her ascendency to the head of the Fed.  There is no doubt that Yellen is an economists of great accomplishments within scientific and public policy economics.  All of us who are ambitious and enter into the competitive game of professional economics would dream of a such a successful career in these different realms.  But she is a Keynesian economist and she will do in her position of power what a Keynesian economist would do.  She believes markets are prone to failure, and that government can engage in pro-active measures to fix the failure.  She is pessimistic about markets, but optimistic about politics.

How do we adjudicate between the different balancing of optimism/pessimism?  Especially if we take seriously the problems with assuming unambiguous statisical testing of theories in the sciences, what are we to do to make progress?  Well, the first test is theoretical coherence, the second is correspondence.  It is about weighing theory and history, and trying to think through what argument or evidence would persuade you to the opposite so that you don't just suffer from confirmation bias.  It isn't as easy as everyone outside of the science believes it to be, but that is true for natural scientists as well as social scientists.  Science and scholarship are endeavors of ongoing discovery and quests for truth tracking.  I sincerely believe that my balance of optimism/pessimism is justified by theory and history, and I am pretty sure that Prof. Yellen would say that as well.  Fortunately for me, my intellectual mistakes result only in my downgraded professional reputation.  But for Prof. Yellen, her intellectual mistakes can downgrade an entire economy.  So as she weighs her optimism/pessimism I'd like to suggest she contemplates 2 quotes from the main representatives of the classical political economy perspective in the second half of the 20th century -- F. A. Hayek and Milton Friedman.

"[T]he main point about which there can be little doubt is that Smith's chief concern was not so much with what man might occasionally achieve when he was at his best but that he should have as little opportuity as possible to do harm when he was at his worst.  It would scarcely be too much to claim that the main merit of the individualism which he and his contemporaries advocated is that it is a system under which bad men can do least harm.  It is a social system which does not depend for its functioning on our finding good men for running it, or on all men becoming better than they are now, but which makes use of men in all their given variety and complexity, sometimes good and sometimes bad, sometimes intelligent and more often stupid.  Their aim was a system under which it should be possible to grant freedom to all, instead of restricting it, as their French contemporaries wished, to 'the good and the wise'."  F. A. Hayek, Individualism and Economic Order, 1948, pp. 11-12.

"Any system which gives so much power and so much discretion to a few men that mistakes -- excusable or not -- can have such far reaching effects is a bad system.  It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic -- this is the key political argument against an 'independent' central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an 'independent' central bank. To paraphrase Clemenceua, money is too important a matter to be left to Central Bankers." Milton Friedman, Capitalism and Freedom, 1962, pp. 50-51.

I don't expect these quotes to shake Prof. Yellen's faith in Keynesian solutions, but I can hope it might make her trace back the modern political economists concern with rules versus discretion back to the classical political economists concerns with the "man of system" and especially the danger implicit in the situation when those who assume that position of power actually  "have the folly and presumption enough to fancy himself fit to exercise it." 

Comments

[Ed Rector]

So who/what is "fit enough" to exercise monetary policy if not an independent central bank? The Congress?

[Daniel Kuehn]

I think you are cherry-picking some of the points here. As one example, on optimism or pessimism about the market, Malthus, Keynes and Keynesians are leaps and bounds more optimistic about the market than Ricardo was in the long run. They are of course more pessimistic than Ricardo on short run stability.

It's hard for me to not make the same assessment.

Does that make me pessimistic about the market? I don't think of myself that way at all. I'm incredibly optimistic about the market, more so even than some classical political economists like Ricardo or Mill.

And I support fiscal responsibility, suspicion of the state, and sound money too... UNLESS those turn into euphemisms for libertarianism. And if it's a political view we're disagreeing about, let's say that. Let's not pretend that it's the orientation of classical liberalism we disagree on. We don't. We have different political views of the details.

Obviously there was a big change with Keynes, but I don't think it's quite the change you've tried to establish here.

[Peter Boettke]

Daniel,

As you know the Cambridge economists like Pigou said many of the same things about politics and bureaucracy that were later stressed by public choice thinkers. But they didn't emphasize them. They were more optimistic about state action than those qualifying remarks might indicate, and also while they also could be quoted saying good things about the market, they were less optimistic about that institutional arrangement. So pessimism about the market v optimism about the state. BTW, fast forward 50 years and you can find similar quotes about market failure in Buchanan and Tullock to what you have read elsewhere, but they are more pessimistic about state corrective measures. Markets fail, but governments fail as well.

I actually don't think I am cherry-picking, I actually think I am trying to be fair-minded to someone and a position which I am in radical opposition to, and I am trying to find a reasonable way to voice that criticism.

It isn't political ideology, it is a judgement call about the weight of the theory of economics and the evidence of economic history says about the alternative institutional arrangements we are examining.

Pete

[Daniel Kuehn]

But Pete, you're conflating more optimistic than Pete Boettke with abandonment of the classical tradition of skepticism of government.

That, I think, is a mistake.

I'm fully willing to agree that I'm willing to do more with government than you are. I'm not going to concede that you're holding up a Smithian legacy I've abandoned.

re: "Markets fail, but governments fail as well."

Of course.

[Peter Boettke]

Do you agree with the quotes I provided from Hayek and Friedman, and then also from Smith from TMS and WoN in the post? If you do, then you and I are in basic agreement with perhaps subtle differences. But can you imagine Janet Yellen agreeing with those quotes in deep substantive ways? I cannot.

Paul Krugman? Larry Summers? Greg Mankiw?

In fact, in Mankiw's JEP paper, he is pretty explicit about his belief that economics is a tool of social control to be wielded wisely no doubt, but nevertheless wielded by trained experts.

Read those quotes again, so you sincerely believe that if we had a system where bad men can do least harm we would have the Fed?! Do you believe that if we had a system where arrogance and opportunism were held constantly in check, that we would have a CEA?

The metaphor outside of the Federal Trade Commission is there for a reason -- man controlling/taming the beast of commerce.

Foreground and background in arguments do not mean abandonment, they mean emphasis. As good coaches know, what you emphasize becomes what you are. You can have all the caveats in the world, but in the end -- what you emphasize is what you are. If you are willing to do more with government, it means by definition in those instances where you are willing to do more you are pessimistic about the market solving the problem on its own, and optimistic about the state providing a solution.

Again saying that is not derogatory toward that position, it is merely clarifying the position being held.

[Daniel Kuehn]

I agree completely with the Hayek quote. I sympathize with the Friedman quote but don't entirely agree with the application. Obviously I have the same concerns about the Fed's action in specific circumstances (notably the Depression and to a certain extent even now), but the question is not whether it's perfect - of course it's not - it's whether the alternative would be better. I want rules-based Fed policy but I don't know that central banking itself is the principal problem.

I agree with the Smith quotes you've posted here. Smith is a little naive about public finance and we've learned a lot since his time. Malthus even began addressing a lot of that in his Principles. But I think it's a mistake to copy and paste an 18th century quote to the 21st century in a progressive science for precisely that reason. In other words, I'm not convinced that given the ensuing 300 odd years of economics since Smith, that he would be on your side of things Pete.

On the broader points of classical political economy - fiscal responsibility, sound money, skepticism of government - I'm very much in agreement with him. On the specific points I'd have differences.

re: "Do you believe that if we had a system where arrogance and opportunism were held constantly in check, that we would have a CEA?"

I think we have a CEA precisely to hold arrogance and opportunism in check. It's good we have economists talking to politicians making economic policy.

[Barkley Rosser]

Pete,

It is one thing to say that there should not be a body run by a small number of people that has great power over the economy, and that therefore we would be better off with free banking, perhaps tied to a gold standard as Larry White now supports I gather, rather than our current Fed or some variation on it.

It is quite another to then criticize the current candidate to run that ongoing outfit, which probably will continue to exist for some time in the future by applying a label to her and then saying "She believes this that and the other" because you identify that label with those beliefs as you have done with your labeling of my friend Janet Yellen as a "Keynesian" and your subsequent discussions of her views and possible future policy actions.

Certainly she has published and expressed views that can be given that label, but the Fed is a very complicated place where labels have become all but meaningless. One of the biggest "hawks" in the place is Jeffrey Lacker, President of the Richmond Fed, whose major prof is a very prominent Tobin-student Keynesian, Don Hester of Wisconsin (Yellen also being a student of Tobin's as well as of Hester, then still at Yale). One of the leading current "doves" is Narayana Kotcherlakota of the Minneapolis Fed who came out of a hard monetarist RBD background, and similar discombobulations with others there. Labeling these people is just a joke unworthy of you, frankly, Pete.

As it is with Janet, she has taken many differnt positions in the past, including a hawkish one in the 90s at one point that Greenspan rejected. The most salient point for the moment is that she has the best forecasting record of anybody at the Fed or nearby (referring to Summers or his sidekick Shleifer). If the place is going to exist and have all this power, you should prefer to have somebody who is more capable and knows what is going on more than others.

The bottom line is that you should keep your general criticism of the Fed separate from an inappropriate personal attack on the highly capable Janet Yellen, please. Not one of your better moments, Pete.

[Roger McKinney]

Barkley, I think you missed the part of Pete's post in which he wrote that calling someone a Keynesian was not a personal attack but merely identifying her economics. Do you think she is not philosophically Keynesian? At least New Keynesian? If not, are you saying she is she eclectic? What would you call her economics. BTW, even Keynes opposed some inflationary policies. Recall that when Hayek challenged Keynes on the policies of some of his students, Keynes told Hayek he would straighten them out. Then he died.

[Roger McKinney]

Daniel, you seem to be trying to draw out a Venn diagram of the overlapping of positive and negative attitudes toward the market. Some of Yellen's decisions may run contrary to her philosophy, but it's the preponderance of evidence that should decide on which side of the Venn diagram she falls.

Besides, opposing inflation occasionally doesn't make one an Austrian. Even Keynes opposed it at times.

Do you think Yellen is predominantly Keynesian, or are you saying she has no predominant philosophy and follows a cafeteria style of economics?

[Barkley Rosser]

Roger,

What I am saying that once one gets beyond the basic issue of whether or not one accepts there to be a Fed functioning at least somewhat like it does now or not, then this matter of attempting label economists who work at its highest reaches is a waste of time. Tell me, Roger, just what does it imply in terms of what their policy approach will be if we determine that a particular individual is a "Keynesian" or "new Keynesian" anyway?

Part of my answer pointed out that the answer is not much, indeed, near zero. It is a joke, irrelevant. The problem is that since the crash Fed policy has simply gone very far from how it operated in the past. We are not in Kansas anymore, and the old labels mean next to nothing.,

For example, once upon a time there was classical monetarism a la Milton Friedman. Have some measure of M grow at the rate of real growth. That has been defunct since the mid-80s, with even Uncle Miltie admitting near the end of his life that it had failed, and he came out for inflation targeting.

And indeed there is a perception that inflation targeting is more "hawkish" than alternatives. Pretty much around the world the central banks that so inflation target aim for a 2% inflation rate. It turns out that it was Janet Yellen who convinced Greenspan that this was what the Fed should do and from there it spread elsewhere even though the Fed at that time did not adopt it as its official target, and this was based on some research by her husband, George Akerlof. Oh, so is the "new Keynesianism"?

Here is a joke. Given that in both US and Europe, it looks like targeting 2% inflation now looks more like "dovishness" because the inflation rates are lower than that, so this suggests "monetary stimulus." If they all woke up tomorrow and decided on a 1% rate target, the Fed would tighten while the ECB would supposedly get more stimulative, although it has not been all that stimulative up to now.

Just to note how much more messy this is, let me note that what is being done now indeed does not look what we are used to seeing. So, the QEs look like stimulus, adding securities to the bank balance sheet. But this has not resulted in remotely comparable increases in any measures of the money supply, and certainly has not resulted in outbursts of inflation, much less the hyperinflation forecast by many, including by many claiming to be Austrians. This is a farcical situation.

This is part of the reason why we see people who are supposedly hawkish coming from supposedly "Keynesian" background, such as Lacker (although he just announced that he was wrong about forecasting that inflation would result from the policies of the last 5 years), while someone supposedly "hawkish" ends up appearing "dovish," as with Kotcherlakota, with such twistings showing up with other top Fed folk.

Yellen has said that we should worry about employnment as well as inflation, so that can be argued that she is "a Keynesian" and not some sort of classical monetarist." But nobody at the Fed is a classical monetarist anymore, nobody, and she is the mother of the famous 2% inflation target, along with having clearly in fact urged tighter policies at times when Greenspan was in power.

I think it is less important to figure out whether she is knowledgeable, open-minded, smart, and with good sense, all of which she appears to have in large measure (along with deep knowledge of the Fed itself, which does not hurt), certainly in comparison with pretty much any rival, with a few odd exceptions (no, Stanley Fischer was not ever going to be a candidate). This is what matters, not which silly box one thinks one has succeeded in sticking her into.

[Barkley Rosser]

Clearly at end I meant to say that is it "more important" not "less important" to figure out whether she knowledgeable, etc. :-).

[Roger McKinney]

Barkley,
Seems like what you say is that since everyone has moved so far to the left of Keynes, what's the point of labels? And that's a good point. There doesn't seem to be anyone who would even consider something like following a rule.

Labels are a way of putting the policies of current economists in historical perspective. Are there any members of the committee you would consider Hayekian or Friedmanlike (rules following)? Probably not. And since you can't put those labels on them it says a lot about their policies.

No one thinks Janet Yellen is not smart, knowledgeable, etc. The fact that she has a PhD and is on the committee allows us to take those for granted.

But to paraphrase Hayek, intelligence is overrated, especially by intelligent people. They think because they're intelligent they can control things they have no control over. And the rest of us suffer for it.

[Barkley Rosser]

Now now, Roger. I certainly did not say that all of these folks went "to the left" of Keynes. I have not heard of any of them calling for "the socialization of investment" for example.

I also think this has nothing to do with rules. After all, I pointed out that the widely used 2% inflation target rule that even Milton Friedman approved at the end of his life was basically invented by Janet Yellen back in the mid-90s, although drawing on work of her husband, George Akerlof. Now, if you want to delve into that work I suppose one could say it was behavioral new Keynesian in the sense that the foundation of the whole argument is the stylized fact that nominal wages tend to be very sticky downwards. I am not going to draw the rest of the argument out here, but focusing on stylized facts that seem to have no optimizing foundation is behavioral, and it is often alleged that NK models focus on sticky prices and wages, although those tend to rely on rational expectations arguments, where this does not. If anything, this is behavioral macro, which George gave a presidential lecture on at the AEA some years ago. That is not one of your standard schools of macro, such as Austrian, old classical monetarist, new classical mistake, new classical RBC, supply-side, new Keynesian, old Keynesian, post Keynesian, Marxian, or whatever.

I think when Hayek stated intelligence is overrated, he was criticizing such intelligence that becomes disconnected from reality. As I noted, one of the things that suggests that Yellen may be about as good as we can get for this thankless job is her track record of being a better forecaster than anybody else at the Fed. Maybe her forecasting ability will fail in the future, but I was the first person to publicly call for to be appointed (all the way back in 2009), and I shall stick with that.

Also, I do not think it is useful to call her approach "cafeteria style." I would prefer eclectic, or better yet, pragmatic. In a world where there are so many competing schools, and so many of them have failed, I certainly understand policymakers being very alert to find pretty much anything that will work, even if in the end that search will be frustrated.