The Wisdom and Folly of Paul Krugman

Could there be a more perfect description of the EU’s woes? In this analysis, Krugman here aligns himself with the neoclassical wisdom of the economists who predicted the demise of the euro before it was born: “the long list of economists [who were mocked for this warning] has…become a sort of honor roll, a who’s who of those who got it more or less right.”

Yet Krugman then does an about-face and asserts: “So could the euro be saved? Yes, probably. Should it be saved? Yes…for failure of the euro would be a giant blow to the wider European project, which has brought peace and democracy to a continent with a tragic history.”

In other words, when you discover a scientific fact that is inconsistent with your religion, don’t change the religion – bring out a team of scholastics who will argue that the fact is, indeed, consistent with the religion.

Why health insurance is so wildly expensive²

Krugman is also half-right about Obamacare. It isn’t very good, and he doesn’t like it very much. But he doesn’t mention its biggest failing, which is the huge deductible that applies to most policies. In other words, it’s bad insurance, which is what Obamacare was intended to eliminate. His solution is (surprise!) a single-payer system.

He gets the basic economics of health insurance right (something that is often overlooked):

Modern health care…needs to be paid for mainly by some kind of health insurance. Why? Because costs strike unevenly, but are huge when they happen. Routine doctor visits and over-the-counter drugs don’t cost much; the big money is in dialysis, open-heart surgery, and so on. In any given year, most people don’t face those major expenses; as a result, at any given time, a small fraction of the population accounts for the great bulk of health costs. But you don’t know whether you’ll be one of those unlucky people…

In other words, health insurance smooths the cost experience over time and across people, just like car insurance or any other insurance worth having. We don’t buy (and no one tries to sell us) food insurance, because everyone needs roughly the same number of calories. The need for food is thus not a risk that can be pooled, where those who need very little food can subsidize those who need a lot. (Pooling risk is what insurance is for.) Instead, we buy our own food, provided in the private market – and we have food aid, as we should, for those who cannot afford it.

Having established the need for health insurance of some kind (a competitive market or a single payer), what is the rationale for a single-payer system?

Efficiency is the usual argument: eliminating insurers’ high labor costs, which go primarily to gatekeeping rather than caregiving; eliminating profits; and reducing what Krugman calls the “crazy quilt [policies, providers, and so forth] with…big holes in it.” Another argument is universal coverage, although that could be accomplished through largely private means as it is in Germany. In the U.S., a voucher system could enable the poor to buy the same kinds of insurance policies that the non-poor pay for. Health insurance aid.

What’s Krugman’s bottom line? Having criticized Obamacare pretty roundly, he finds it irreplaceable and accuses those wanting to repeal and replace it as “the cruelty caucus.” This is not an unusual posture for Krugman – reasonably thoughtful skepticism before a policy is enacted, rigid absolutism afterward. For thinkers like Krugman, no increase in the size or reach of government can ever be rescinded, only expanded further to repair the flaws that are discovered in the original policy. If you think I’m exaggerating or talking a partisan line, read Krugman’s book and discover the rigidity for yourself.

Krugman versus Cochrane: Understanding the global financial crisis

We have all struggled to understand the global financial crisis of 2007-2009. Unlike the current novel coronavirus crisis, it was endogenous to the financial system, seemingly revealing flaws in the system itself rather than taking place as a reaction to an external shock. In a memorable exchange of poison-pen letters, Krugman and the free market-oriented University of Chicago economist John Cochrane (now at Stanford) asked how economists could have failed to see the global financial crisis coming.

In his lengthy and widely circulated article, “How Did Economists Get It So Wrong,” reproduced in Arguing with Zombies (it is not a newspaper column),³ Krugman asserts that macroeconomists were way too confident in believing, as the University of Chicago’s Robert Lucas said, that “the central problem of depression prevention has been solved.”⁴ Krugman was right to lampoon this Pollyanna view, shared among many economists, including former Fed chairman Ben Bernanke, who apologized for the Great Depression (which he blamed on his predecessors at the Fed) and promised not to do it again.⁵

Of course, most economists aren’t macroeconomic forecasters. The large majority are microeconomists and work in universities or industry, having little to do with public policy and rarely offering an opinion on GDP growth, unemployment, or inflation. They are more likely to help airlines buy the right number of airplanes, or determine the likely peak load demand for an electric company. But, a few cautious and contrarian souls aside, macroeconomics as a discipline does need to account for its wild, pre-2008 overconfidence.

Krugman asserts – as have many, including me (and he put it particularly well) – that “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.” The mathematization of economics is the legacy of Paul Samuelson, another (even more respected) Nobel Prize winner. Before Samuelson – and I overgeneralize – economists tried to understand as much as they could about the economy. They wrote in descriptive terms, accessible to almost everyone. Afterward, in Krugman’s words, they instead embraced “the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess,” forsaking practical knowledge about the economy in favor of efforts that would better be domiciled in a math department.

As a result, complex math prevents me from reading any formal economics paper written after about 1960, except in my own specialty (investment finance).

It is, unfortunately, within my specialty that Krugman aims his sharpest arrows:

[T]he study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds… The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information.

Market efficiency, in Krugman’s fertile imagination, is not a hypothesis deserving of testing, or a benchmark by which active managers should be evaluated, but the root of all evil. To briefly summarize his view: the idea that asset prices are correct means that financial markets and institutions should be allowed to do anything they want, including taking on practically infinite leverage, issue and trade in derivatives worth trillions with almost no oversight, and allow or encourage price bubbles to form in the housing and mortgage markets. Hence the crash of 2008 and all that followed.

John Cochrane, hero of and spokesman for the neoclassical crowd, was furious. Krugman quotes him: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.”

Cochrane was stretching a point: Keynesian ideas were indeed taught after the 1960s, just not at the University of Chicago which both Cochrane and I attended. But Krugman was stretching a point even farther: “Keynesian” economics had departed so far from the relatively sober economics of Keynes that it was barely recognizable and not worth much for policymaking. Keynes thought that governments should engage in deficit spending during emergencies, and accumulate a surplus (to pay for the emergency spending) in ordinary good times; “Keynesians” thought it was always an emergency.

In a response, sharply titled, “How Did Paul Krugman Get It So Wrong?”, the usually wry and good-natured Cochrane fired back:⁶

Here’s all [Krugman] has to say: “Irrationality” caused markets to go up and then down. “Spending” then declined, for unclear reasons, possibly “irrational” as well. The sum total of his policy recommendations is for the Federal Government to spend like a drunken sailor after the fact.

Paul, there was a financial crisis, a classic near-run on banks. The centerpiece of our crash was not the relatively free stock or real estate markets, it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up [Douglas] Diamond, {Raghuram] Rajan, [Gary] Gorton, [Anil] Kashyap, [Jeremy] Stein… They’ve thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, and how they give incentives for excessive risk taking.

Cochrane, with a PhD, a top-university professorship, and a Nobel mention (for the future) every time the prize is given, rebuts Krugman with more skill than I have, so I’ll let him continue:⁷

Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis. Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research… Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so… If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.

Debt doesn’t matter?

Paul Krugman’s view of government debt is this: “[I]f you can raise funds cheaply and apply them to high-return projects, you should borrow.”

That is a lesson from the first class in the corporate finance course everybody takes in business school. It is correct insofar as it goes. The second lesson is that the first lesson is wrong if the debt exposes the company to the risks and costs of potential bankruptcy. Franco Modigliani and Merton Miller won Nobel Prizes (1985 and 1990) for saying something like this.

Admittedly, Krugman backpedals a little and makes reasonable arguments for one particular form of debt hawkishness, which is to raise taxes (or not cut them) on “the rich” to pay for “a progressive agenda.” (There is more than one progressive agenda, ranging from the absurdly expensive and destructive Green New Deal to the very sensible desire to cover everyone with some minimal level of medical insurance.) But, overall, Krugman doesn’t think much of debt and deficit hawks, calling their guru Paul Ryan a scold, a flimflam man, a dope, a charlatan, and a fraud. Krugman sounds like a sixth-grade playground bully with a thesaurus.

Krugman also implies that because Donald Trump, who appeals to some conservatives, has increased the national debt massively, everyone to the right of center (or to the right of Krugman) has suddenly become converted to the drunken-sailor philosophy of government. This isn’t logic; it’s polemics, and it isn’t true. There are plenty of people who remain concerned about debt, now more than ever because we are in a national emergency that requires massive additional borrowing.

Given that we are in that circumstance, isn’t it just possible that we should have borrowed less, or maybe even paid back debt, during the last 10 years of relatively good times?

Krugman’s philosophy of research

I feel obligated to say something kind about Krugman, given that his contribution to economic theory, before his conversion from theorist to polemicist, was substantial enough to earn him a Nobel Prize and has real merit. Of particular note are his “four basic rules for research””

• Listen to the Gentiles
• Question the question
• Dare to be silly
• Simplify, simplify

I agree with all of these, and because they’re a little obscure, let’s spend a moment on each.

Listen to the Gentiles

In New Testament times, a Gentile did not mean a Christian; it simply meant a non-Jew. When Paul took the message of Jesus to the Gentiles, let’s recall who was who: Paul and Jesus were Jews. The Gentiles were everyone else. (There were no Christians other than Jesus’ immediate circle.) Listening to the Gentiles means listening to those with whom you have no direct affinity or sympathy; listen to foreigners, to your opponent or rival.

Krugman made his reputation in trade theory and economic geography. Without getting into the weeds, the conventional economic theories of trade had already been questioned by many outside the subspecialty of trade economics, without much impact on those inside the subspecialty. By listening to the Gentiles, those who were on the outside looking in, Krugman obtained insights that could not be obtained by talking only to people in the trade-theory bubble. The same happened in geography, where actual geographers (not economists) had accumulated evidence that traditional economic geography was on the wrong track. Krugman’s integration of these heterodox views into economic geography made the field smarter.

Question the question

“If people in a field have bogged down on questions that seem very hard, it is a good idea to ask whether they are really working on the right question,” writes Krugman. Enough said.

Dare to be silly

Anyone who knows me is aware that I follow this maxim, often to extremes. But Krugman is talking about silly assumptions in economic models, not the kind of silliness I engage in.

Silly assumptions are the stuff of which economic models are made. Assume Max U (an imaginary character who maximizes utility). Assume an efficient market. Assume everyone has an equal endowment of intelligence, or money, or entrepreneurial ability. These ridiculous simplifications are necessary for economists to craft intelligible theories, because realistic assumptions would make any given problem insoluble. It is like physicists assuming a vacuum and ignoring air resistance when calculating the acceleration of a falling body. They know the assumption is wrong, but it is the right point of departure for figuring out what is right, for example by factoring in air resistance as well as gravity to calculate the landing path of a spacecraft.

Krugman is right to defend unrealistic (“silly”) assumptions in economics. Economic models are a metaphor for reality, an intentional oversimplification. That is why they are called models, and they are not supposed to mimic reality precisely, any more than a model airplane is supposed to transport people across the Atlantic.

Simplify, simplify

Krugman applies Occam’s Razor to economic theorizing: “Always try to express your ideas in the simplest possible model.” This is sensible philosophy and good science. While Krugman is not a finance scholar, we can apply this principle to investment analysis. The “factor zoo” in equity analysis has gotten so large as to rival the number of animal species in the San Diego Zoo, until recently the country’s largest. Professors Campbell Harvey and Yan Liu write, “The rate of factor production in the academic research is out of control. We document over 400 factors published in top journals. Surely, many of them are false.”⁸

Yes, all but about five or six are false – and I’d venture a guess that those five or six are really proxies for two or three. Which two or three is a topic for another day.

Conclusions

A reviewer should reveal his biases. My idea of a great collection of newspaper columns is any of George Will’s books: his classically liberal centrism is very close to my own position.⁹ But Will is admired by many people who disagree with his politics, because he is, quite literally, a gentleman and a scholar. Krugman is just a scholar. There is serious economics in Krugman’s articles, although their seriousness is tempered by his proclivity for ad hominem attacks, starting with the trope of calling his opponents zombies in the book title.

The biggest weakness of Arguing with Zombies is a moral failing, not an analytical one. Krugman attributes evil intent to those who disagree with him. He often alleges that they say what they do because they are being paid to.¹⁰ This is a particularly crass form of character assassination, and he should not get away with it. Unfortunately it has become common to impute, to people with whom you disagree, wicked motives such as dishonesty, greed, or even a desire to destroy the world (or the less fortunate) to enrich oneself.

Krugman is not the only writer playing this game, but he is the best known. Stop already. By the way, I’m not a zombie.

Laurence B. Siegel is the Gary P. Brinson Director of Research at the CFA Institute Research Foundation and an independent consultant. He is the author of Fewer, Richer, Greener, published by Wiley in 2019, as well as author or editor of many articles, CFA Institute Research Monographs, and other works. Siegel serves on the editorial boards of several prominent journals and on the board of directors of the Q Group and the American Business History Center. Until 2009, Siegel was director of research in the Investment Division of the Ford Foundation. Before that, he served as a managing director at Ibbotson Associates (now Morningstar). His website is www.larrysiegel.org. Siegel received a BA in urban geography and an MBA in finance from the University of Chicago.

¹ It’s Nokia; Ericsson is a Swedish company that once tried to take over Nokia and failed, but picky, picky.

² In the service of rational discourse, I’m calling health insurance “health insurance,” instead of health care. Health care is what doctors, nurses, pharmacists and pharmaceutical companies, biotech workers, medical equipment manufacturers, and other people in similar occupations provide. Health insurers pay for them. Important difference, often muddied by those who find it easier to sell whatever they’re promoting by dressing it in the gentle language of “care” instead of the colder phrasing of “insurance.”

³ The article was published as a long-form feature in the New York Times Magazine, September 2, 2009.

⁴ Lucas, winner of the 1995 Nobel Prize in economics, said this in his American Economic Association presidential address in 2003.

⁵ Bernanke, Ben S. 2002. Speech on the occasion of Milton Friedman’s 90th birthday, University of Chicago (November 8), https://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/

⁶ https://www2.bc.edu/thomas-chemmanur/phdfincorp/Cochrane%20Response%20to%20Krugman.pdf

⁷ I mean that he is mentioned by his colleagues as a likely candidate, not by the Nobel committee.

⁸ Harvey, Campbell R., and Yan Liu. 2019. “A Census of the Factor Zoo.” Working paper (March 25), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3341728

⁹ See, for example, Will, George P. 1983. The Pursuit of Virtue, and Other Tory Notions; 1984. Statecraft as Soulcraft: What Government Does. He has continued to publish books but the oldest are the best. Will calls himself a Tory (and even named his daughter Tory, Victoria in full); I’m a Whig (and have trademarked Whiggish Books as one of my imprints). Yet we agree on almost everything. This shows you how far American political discourse has strayed from the classic divisions.

¹⁰ What is wrong with being paid to say something, as long as you already believe it? If you’re a persuasive exponent of a particular point of view, you will attract the attention of a like-minded research institute, foundation, television channel, web site, or university, and that institution (if they have any sense) will hire you. I’m in this position myself. I am paid to write – in those cases when I’m in fact paid – because (some people say) I can convey my point of view effectively. I make no pretense of objectivity. Neither does Krugman, who is also paid (by the Times, CUNY, and on one occasion the Nobel Foundation, to name only the income sources I know of) and I would never accuse him of insincerity or whorishness. He believes what he believes, he expresses it uncommonly well, and he deserves his paychecks. I wish he would give the rest of us scribblers similar credit.

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