The Argument on the Left: Does the Great Recession Justify a Paradigm Shift? (Part 2)

-- Posted by Neil H. Buchanan

In yesterday's post, I discussed an ongoing debate between some top-flight left-leaning economists, who are disagreeing about whether the failures of economic policy that led to (and then failed to deal adequately with) the Great Recession are a reason to radically rethink modern economics.  As I noted, the main combatants are Paul Krugman on the near-left (who defends the orthodox approach), and Tom Palley on the further-left (who advances heterodox approaches).

Most of my post yesterday was devoted to setting up the stakes of the debate, largely to show that the left-leaning economists in positions of relative power and prestige have nothing to fear from a serious challenge to the orthodoxy.  These are smart people, some of whom are already at least familiar with "heterodox" thinking and could adapt to a broader conversation.  They face no existential personal threat, because they have tenure (and, in some cases, great fame) and already have the ears of the political elite.

The substantive question, then, can be addressed without fear of un-feathering anyone's nest.  Do we really need to open up economics beyond the very narrow methodological orthodoxy that has increasingly dominated the profession over the past several decades?  Krugman's answer is, in essence, that there is nothing wrong with mainstream economic theory, because its failure to predict the crisis prior to 2008 is forgivable (because it was really a failure to notice changes in the banking sector, not a failure of the theory itself), and its track record since then has been quite good.

To be clear about that second point, Krugman is saying that orthodox Keynesianism has a great track record post-2008.  People who worked from the standard Keynesian approach got pretty much everything right, from the non-threat of inflation due to massive monetary easing to the stagnating effects of fiscal austerity.  Yes, there are people who got it all wrong, representing roughly half of the "respectable" economics profession, but they got it wrong because went rogue, abandoning textbook theory in the pursuit of political agendas.  If politicians had known nothing other than undergraduate-level macro as propounded in the mainstream textbooks -- and, importantly, if they had actually followed what the textbooks said -- we would have come out of the crisis much sooner and with more momentum.  There would have been less human suffering, and the future would look brighter.

So what could people like Palley be arguing about?  To a large degree, the debate is not about whether standard Keynesian theory would have been a better guide than its chief conservative alternative (the latter of which amounts to a revivalist faith in the miracles of free markets, complete with confidence fairies and all that).  Certainly the heterodox left agrees that the anti-Keynesian policies of our era have been an enormous mistake.  The debate, in the end, is about whether such mistakes could be avoided in the future if we open up mainstream economics to a broader set of theoretical approaches.

Here, Krugman starts to go off the rails, essentially saying, "Well, my friends and I weren't poisoned by the supposedly dangerous consequences of a non-heterodox world, so orthodoxy must not be all that dangerous."  But that merely says that the orthodox approach is not 100% infectious.  Perhaps, however, the 50% infection rate could have been reduced if the economics profession had attracted and trained more people in a more open intellectual environment.

As Palley points out, the orthodox approach is based on the idea that the economy is inherently self-regulating, unless one builds special assumptions into the models.  That, in turn, gives laissez-faire approaches the presumption of truth, because one can only win the debate if one posits and then successfully defends the insertion of one or more assumptions that change the baseline predictions.  This leads to lots of discussions about "myopia" and "bounded rationality," for example, which are then endlessly debated as if it makes sense to assume as a default that people have perfect foresight and unbiased logic.

Krugman, again, says essentially that he can win those debates, so there is no problem.  He then defends his use of "New Keynesian" models, which is a hybrid approach that tries to reach Keynesian results from models based on hyper-rational atomistic individuals.  His defense amounts to the ultimate modernist justification: Hey, it's just a model, folks.  Everyone knows that what ultimately matters is how well the models predict the real world.  No one really thinks that the assumptions have to be true.  Models are just tools, to be used or abandoned as needed.

I do not want to revisit the modernist-postmodernist debate here.  I will say that modernism requires a great deal of confidence in one's ability to know what the truth is in the first place.  Despite my skepticism, however, I definitely see why Krugman is frustrated.  What is the big deal?  If my approach gets it right, it gets it right.  Everything else is just academic noise.

I should also say that I understand Krugman's frustration with many on the heterodox left (although not Palley).  Before I transitioned out of economics and into the legal academy, I spent a fair amount of time learning heterodox theory, which meant that I listened to a lot of people who were angry about being frozen out of modern economics.  Their anger was justified, but it was also toxic.  Most (but not all) of the people I met were engaged in self-undermining exercises, attacking people with sympathetic views for even the slightest lapse, and engaging in the kind of destructive personal nastiness that later came to typify online comment boards across the internet.

Krugman has been attacked by those guys on more than one occasion, to his great annoyance.  But that does not justify his general dismissal of heterodoxy.  Again, Palley is not being nasty, and he is offering a serious argument about the dangers of maintaining the academic status quo.  His position deserves a serious response, but Krugman and his side have thus far mostly said, "Why are you saying that we got it wrong, when we got it right?"  (To be fair, Palley did miss the fact that Krugman has been rather loudly saying, for some time now, that allowing wages to fall would not improve matters.  I understand Palley's larger point, but that was a needless oversight.)

As I discussed in my post last Friday, a key part of the argument between the orthodox left and the heterodox left hinges on the the theoretical validity of "production functions," which simplify the world by saying that we can measure "capital" as one number and "labor" as one number, put them into a mathematical equation, and see how much output the economy will produce.  Thomas Piketty's new book relies in large part on models that are built upon such functions.  But not just any production functions.  He relies on production functions that are built so that both labor and capital are paid according to their relative contributions to the output of the economy, with nothing left over.

In response to heterodox objections to this approach, Krugman again argues that it does not matter whether production functions are "true," and that the implicit assumptions about distributive justice (capital and labor supposedly being paid what they should be paid, based on their relative productivity) can be overcome by noting that the people who own capital do not necessarily deserve to own it or to reap its rewards.

As I argued last Friday, that is strategically dangerous, but at least it is coherent.  Yet Krugman never responded to what I view as Palley's most important point, from his very first blog post that kicked off this debate.  Palley wrote: "The conventional character of Piketty’s theoretical thinking rears its head in his policy prescriptions. His neoclassical growth framework leads him to focus on taxation as the remedy. There is little attention to issues of economic institutions and structures of economic power because these are not part of the neoclassical framework."

And this is where the importance of Palley's case for heterodoxy comes into focus.  He is correct that orthodox (aka neoclassical) economics has nothing to say about economic institutions and power, because all of that is part of what people like Krugman assume away in their "simple little models that help us understand the world, but shouldn't be viewed as the absolute truth."  Famously, Paul Samuelson (in some ways the father of all orthodox Keynesians, or at least their chief public spokesman) once said that it does not matter whether workers hire capital, or capital hires labor.  His point was that the models would work the same, no matter how capital and labor happen to get together.

Why does this matter?  What Palley is saying is that we constrain our choices by assuming away certain institutional realities.  If we do not allow for the possibility that capital and labor are not monolithic concepts, and if we ignore the legal rules that determine how much capital "earns" in the first place, then we are left with a very narrow set of policy responses.

And if the remaining policy instrument -- tax increases -- is politically nonviable, then we have nothing left in our arsenal, because we have assumed it all away.  Maybe those harmless, simple little models are not so harmless after all.