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Keynes versus the Classics: Round Two.

LONDON: The economist John Maynard Keynes Noun 1. John Maynard Keynes - English economist who advocated the use of government monetary and fiscal policy to maintain full employment without inflation (1883-1946)
 wrote The General Theory of Employment, Interest, and Money (1936) to "bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory." Seventy years later, heavyweight economists are still at each other's throats, in terms almost unchanged from the 1930s.

The latest slugfest features New Keynesian champion Paul Krugman Paul Robin Krugman (born February 28, 1953) is an American economist. Krugman, a liberal, is currently a professor of economics and international affairs at Princeton University.  of Princeton University Princeton University, at Princeton, N.J.; coeducational; chartered 1746, opened 1747, rechartered 1748, called the College of New Jersey until 1896. Schools and Research Facilities
 and New Classical champion John Cochrane For the North Dakota Supreme Court justice, see .
John Cochrane (1798 – 1878), was a Scottish chess master and lawyer. An amateur player, he was the epitome of the early romantic phase of chess history.
 of the University of Chicago. Krugman recently published a newspaper article entitled "How Did Economists Get It So Wrong?" There was nothing in mainstream economics, Krugman wrote, "suggesting the possibility of the kind of collapse that happened last year."

The reason was that "economists, as a group, mistook beauty, clad in impressive-looking math, for truth." They purveyed an "idealized i·de·al·ize  
v. i·de·al·ized, i·de·al·iz·ing, i·de·al·iz·es
1. To regard as ideal.

2. To make or envision as ideal.

 vision of an economy in which rational individuals interact in perfect markets." Unfortunately "this sanitized san·i·tize  
tr.v. san·i·tized, san·i·tiz·ing, san·i·tiz·es
1. To make sanitary, as by cleaning or disinfecting.

 vision of the economy led most economists to ignore all the things that could go wrong." So now economists will have to accept "the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic id·i·o·syn·cra·sy  
n. pl. id·i·o·syn·cra·sies
1. A structural or behavioral characteristic peculiar to an individual or group.

2. A physiological or temperamental peculiarity.

 imperfections of markets and accept that an elegant economic 'theory of everything' is a long way off."

Krugman's heavy pounding of Chicago School Chicago School

Group of architects and engineers who in the 1890s exploited the twin developments of structural steel framing and the electrified elevator, paving the way for the ubiquitous modern-day skyscraper.
 economics goaded goad  
1. A long stick with a pointed end used for prodding animals.

2. An agent or means of prodding or urging; a stimulus.

 Cochrane, a professor of finance, into some bad-tempered counter-punching on the university's Web site, much of which consisted of a personal attack on Krugman's scientific integrity. When he gets around to economics, Cochrane aims his blows at two points: Krugman's attack on the "efficient market theory" and his advocacy of "fiscal stimulus" for depressed economies.

Cochrane accuses Krugman of misleading his readers about the efficient market theory, which asserts that, given the available information, financial markets always get asset prices right. Rather than defend that theory, Cochrane admits that "asset prices move more than reasonable expectations of future cash flows." Unfortunately, "no theory is particularly good at that right now."

But it's theoretical nihilism nihilism (nī`əlĭzəm), theory of revolution popular among Russian extremists until the fall of the czarist government (1917); the theory was given its name by Ivan Turgenev in his novel Fathers and Sons (1861). , Cochrane argues, to ascribe these excessive fluctuations to "irrationality" as Krugman does. What Krugman is really after ("though he can't quite come out and say this") is for the government to "take charge of the allocation of capital." And the one thing we do know is that however badly asset markets behave, government control "has always been much worse."

Cochrane's heaviest punching is reserved for Krugman's support for President Barack Obama's fiscal stimulus. He invokes the hoary hoar·y  
adj. hoar·i·er, hoar·i·est
1. Gray or white with or as if with age.

2. Covered with grayish hair or pubescence: hoary leaves.

 old "Ricardian equivalence Ricardian equivalence, (also known as Barro-Ricardo equivalence proposition or Ricardian rent), is an economic theory which suggests that government budget deficits do not affect the total level of demand in an economy.  theorem," revived by the Harvard economist Robert Barro Robert Joseph Barro (born 1944) is an influential classical liberal macroeconomist and the Paul M. Warburg Professor of Economics at Harvard University.

Barro graduated with a B.S. in physics from the California Institute of Technology in 1965 and earned a Ph.D.
, according to whom "debt-financed spending can't have any effect, because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered."

In short, Krugman "has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward" -- except that the government should now spend money like a drunken sailor. Far from having too much math, economists need more, in order to "keep the logic straight."

On the stimulus, though, Krugman achieves a knock-out punch. The view that extra government spending "crowds out" an equal amount of private spending, so that its net stimulus effect is zero, would be true only if the economy were at full employment. Indeed, the Chicago School tacitly assumes that economies are always at full employment. They are unfazed un·fazed  
Not fazed or disturbed.
 by the fact that America's economy has shrunk by 4 percent in the last year and that over 6 million people have been added to the unemployment rolls.

To Chicago economists, an increase in the number of idle workers represents a voluntary choice for leisure. In a concession to commonsense, they concede that people may make mistakes and, to that extent, a stimulus may be beneficial. But they insist that the only stimulus that will work is printing money. This will drive down interest rates and lead to an economic rebound.

Against this view, Keynes pointed out that interest-rate reductions may not do the job, because at zero or near-zero rates investors hoard cash rather than lend it out. Hence, as he put it in 1932, there may be "no escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment" -- which is what the Obama administration is rightly doing.

On the question of what caused the crash, the debate is more even. Krugman is hampered by the fact that he attributes the crash to "irrationality," which, as Cochrane points out, is no theory.

This is because Krugman refuses to take seriously Keynes's crucial distinction between risk and uncertainty. In my view, Keynes's major contribution to economic theory was to emphasize the "extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.

This makes for considerable stability in markets as long as the conventions hold. But they are liable to being overturned suddenly in the face of passing bad news, because "there is no firm basis of conviction to hold them steady." It's like what happens in a crowded theater if someone shouts "Fire!" Everyone rushes to get out. This is not "irrational" behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn.

Chicago School economics has never been more vulnerable than it is today -- and deservedly so. But the attack on it will never succeed unless policy Keynesians like Krugman are willing to work out the implications of irreducible irreducible /ir·re·duc·i·ble/ (ir?i-doo´si-b'l) not susceptible to reduction, as a fracture, hernia, or chemical substance.

 uncertainty for economic theory.

Robert Skidelsky , a member of the British House of Lords Noun 1. British House of Lords - the upper house of the British parliament
House of Lords

house - an official assembly having legislative powers; "a bicameral legislature has two houses"

British Parliament - the British legislative body
, is Professor emeritus of political economy at Warwick University, author of a prize-winning biography of the economist John Maynard Keynes, and a board member of the Moscow School of Political Studies. This commentary is published by Daily News Egypt in collaboration with Project Syndicate, ( ).

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Publication:Daily News Egypt (Egypt)
Date:Oct 21, 2009
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