Uneasy Money

Mervyn King, former Governor of the Bank of England, and professor of economics at LSE, recently published a book, The End of Alchemy, containing his reflections on the current state of economic theory and policy from the special vantage point of someone who has been a practitioner of both callings at the highest levels. Paul Krugman has a review of King’s book in the current edition of the New York Review of Books. Krugman points out that King’s tenure at the Bank of England coincided with that of Ben Bernanke, also an academic economist of some renown before embarking on a second career as a central banker, and who has also published a book about his experience as a central banker. A quick check of the Wikipedia article about King reveals a fact left unmentioned by Krugman: that while a Kennedy Scholar at MIT in the late 1970s, King actually shared an office with the young Ben Bernanke who was then working on his Ph. D. at MIT.

In his review, Krugman observes that, unlike Bernanke’s recent memoir, King’s book is less an account of his tenure as a central banker during the 2008 financial crisis and its aftermath than it is a “meditation on monetary theory and the methodology of economics.” Here’s how Krugman describes King’s book.

Now King, like Bernanke, has written a book inspired by his experiences. But it’s not at all the book one might have expected. It’s not a play-by-play of the crisis, or a tell-all, or a personal memoir. In fact, King not-so-subtly mocks the authors of such books, which “share the same invisible subtitle: ‘how I saved the world.’”

King’s book is, instead, devoted to “economic ideas.” It is rich in wide-ranging historical detail, with many stories I didn’t know—the desperate shortage of banknotes at the outbreak of World War I, the remarkable emergence of the “Swiss dinar” (old Iraqi notes printed from Swiss plates) in Kurdistan. But it is mainly an extended meditation on monetary theory and the methodology of economics.

And a fascinating meditation it is. As I’ll explain shortly, King takes sides in a long-running dispute between mainstream economic analysis and a more or less radical fringe that rejects the mainstream’s methods—and comes down on the side of the radical fringe. The policy implications of his methodological radicalism aren’t as clear or, I’d argue, as persuasive as one might like, but he definitely challenges policy as well as research orthodoxy.

You don’t have to agree with everything King says—and I don’t—to be impressed by his willingness to let his freak flag fly. His assertion that we haven’t done nearly enough to head off the next financial crisis will, I think, receive wide assent; I don’t know anyone who thinks, for example, that the US financial reforms enacted in 2010 were sufficient. But his assertion that the whole intellectual frame we’ve been using is more or less irreparably flawed is a brave position that should produce a lot of soul-searching among both economists and policy officials.

I don’t want to discuss Krugman’s review in detail, but I was struck by a passage toward the end of the review in which Krugman takes issue with King’s rather pessimistic assessment of the possibility that central bankers or economic policy makers can do much to improve an economy that is underperforming.

In any case, King’s policy proposals don’t stop with banking reform. He also weighs in on macroeconomic policy, on how to fight the economic weakness that has persisted long after the acute phase of the financial crisis ended. He dismisses talk of demographic and other “headwinds”—such as an aging population—that may be holding the economy back. What has happened, he declares, is a change in the narrative that consumers are telling themselves to a story far more pessimistic about what the future might hold, leading them to spend less year after year. And then a funny thing happens: his radical views on economics lead him to what would ordinarily be considered conservative, even boringly orthodox policy recommendations.

The conventional Keynesian view . . . is that what we need in the face of persistent weakness is policies to boost demand. Keep interest rates low, and maybe raise inflation targets to further encourage people to spend rather than hoard. Have government take advantage of incredibly low interest rates by borrowing and spending on much-needed infrastructure. Offer relief to individuals and nations crippled by debt. And so on.

King is, however, having none of it. Under his leadership, the Bank of England was aggressively engaged in monetary easing by keeping interest rates low—the bank was as aggressive in this respect or even more so than the Bernanke Fed. Now, however, King seems to condemn his old policies:

Monetary stimulus via low interest rates works largely by giving incentives to bring forward spending from the future to the present. But this is a short-term effect. After a time, tomorrow becomes today. Then we have to repeat the exercise and bring forward spending from the new tomorrow to the new today. As time passes, we will be digging larger and larger holes in future demand. The result is a self-reinforcing path of weak growth in the economy.

Is this argument right, analytically? I’d like to see King lay out a specific model for his claims, because I suspect that this is exactly the kind of situation in which words alone can create an illusion of logical coherence that dissipates when you try to do the math. Also, it’s unclear what this has to do with radical uncertainty. But this is a topic that really should be hashed out in technical working papers.

I must admit to being a surprised – and disappointed – that Krugman gave such a mild response to King’s argument, which seems to me obviously problematic rather than, as Krugman implies, plausible, but potentially disprovable if subjected to sufficiently rigorous mathematical scrutiny. The problem is not whether you can produce a mathematical model that generates the result King has asserted. It’s really not that hard for a smart theorist to work out a mathematical model that will generate whatever result he or she wants to generate. The problem is whether the result corresponds to any plausible state of the world, so that one could specify the conditions under which the result of the model would be relevant for policy.

But the argument for stimulus to which King is objecting is that the economy is operating at a lower time path of output and employment than the path at which it is capable of operating; actual output over time is less than potential output over time. Thus, if you stimulate the economy and increase output now, the economy will move to a path that is closer to its potential than the current path. King’s argument, at least as reproduced by Krugman, is simply irrelevant to the question whether a stimulus can move an economy from a lower time path of output to a higher time path of output. The trade-off that supposedly exists in King’s argument is not a real trade-off.

So the issue is, not the model, but the underlying assumption about what the initial conditions are. Is the economy operating at its potential or is operating at less than its potential. If King is right about the initial conditions – if the economy is already operating as well as it could – then he is right that stimulus is futile and increasing output now may decrease output in the future (presumably by reducing investment that would generate increased future output). But if he is wrong about the initial conditions – if the economy is not operating as well as it could – then the increase in output resulting from a stimulus does not imply any reduction in future output; it merely prevents a loss of current output that would otherwise be – avoidably – wasted. King’s argument is actually not an argument – at least insofar as Krugman has accurately characterized it – it is just question begging.