The harm a Nobel Prize can do: The case of Edmund Phelps

Both Karl Smith at Modeled Behavior and Russ Roberts at Cafe Hayek today took on remarks by Edmund Phelps made last November on the Keynes-Hayek debate. Both single out the ending:

What now do we do? With some luck, the economy will “recover” through a return of investment activity to sustainable levels once some capital stocks, like houses, have been worked down. But it will not recover to a strong level of business activity unless something happens to boost innovation. The great question is how best to get innovators humming again through the breadth of the land. Hayek himself said little on innovation. But at least he had an applicable theory of how a healthy economy works.

The Keynesians, sad to say, show no understanding of how the economy works. They think they can lever employment up or down by pushing buttons – as if the economy were hydraulic. They show no grasp of the concepts that would be necessary to restore us to prosperity and flourishing. In an old image that applies well to the posturing of today’s self-styled Keynesians, “the Emperor has no clothes.”

Seems Phelps has become a “supply only matters” guy. But he gets it really wrong at the very start:

Keynes was a close observer of the British and American economies in an era in which their depressions were wholly or largely monetary in origin – Britain’s slump in the late 1920s after the price of the British currency was raised in terms of gold, and America’s Great Depression of the 1930s, when the world was not getting growth in the stock of gold to keep pace with productivity growth. In both cases, there was a huge fall of price level. Major deflation is a telltale symptom of a monetary problem.

Ever since, the followers of Keynes – the Keynesians, as they are called – see every slump as monetary. They suppose that behind the slump is a shortfall of liquidity and a resulting deficiency of ‘effective demand’ – an insufficient flow of money circulating through the affected economy to support the normal level of employment. So they always call for anti-deflation measures – for a “stimulus” to “demand.”

Sounds to me (David Glasner, what do you think?) he´s talking about Cassel and Hawtrey, not the Keynes of the GT.

As Nick Rowe has pointed: “Recessions (or depressions) are always and everywhere a monetary phenomenon”, just like inflation.

But all that is just to allow him to say:

It’s true that such a deficiency of liquidity occurred twice in recent US experience – hence an actual or incipient deficiency of aggregate demand. With the fall of Lehman in 2008, there was a rush to get into liquid assets. So the Keynesians (and everyone else) were right to urge the US central bank – the Fed – to create a massive increase of the money supply. Then, by spring 2010, another deficiency had developed – one of the Fed’s own making.

There was clear evidence of that in the fall of the inflation rate from the customary rate of 2% per annum to 0.9% in half a year’s time. The Fed had to engage in QE2 to get the inflation rate back up to 2% per annum.

These measures served to remedy a deficiency of liquidity and thus to forestall or remove a deficiency of effective demand.

The evidence: Inflation is running at about 2% again. The expected rate of inflation at 1.5% or so. Consequently, we do not have a “deficiency of demand” now!

And then he comes peddling his 1994 book “Structural Slumps”:

So what do we have? We have a structural slump! We are slowly coming out of a structural slump – thanks to structural forces, such as wealth decumulation and a build-up of untried ideas for innovation.

If the present slump is wholly or largely structural, Keynes’s theory of employment, since it’s monetary, does not apply to the slump.

He gets it wrong. The Fed provided liquidity to banks, but did not increase the money supply in order to match the increased money demand. Therefore, the monetary-induced, not structural, slump.

Back in 1985, long before receiving his Nobel, Phelps wrote a great Introductory Text called “Political Economy”. The preface reads:

This book is an introduction to economics for the university student and general reader. The focus, in common with other such texts, is on political economy. Economics arose in response to questions of political interest about the national economy; and though economics has since found other applications as well, it´s vitality and development continue to stem from this central concern. The causes and effects of the way society organizes and regulates its economy – and the resulting debates over instability, inequality, joblessness, inflation, organizational incentives, and the rest – are the main stuff of economics from here to China.

6 thoughts on “The harm a Nobel Prize can do: The case of Edmund Phelps

  1. “Recessions (or depressions) are always and everywhere a monetary phenomenon”,

    Including supply side recessions? (I’m not suggesting that’s what we had here).

  2. Saturos,

    IIRC, Nick’s point was that it’s only monetary recessions + depressions which require a macroeconomic explanation. There’s nothing about, say, an oil-crisis driven recession or a price-control/political collapse depression (like the Soviet depression under Gorbachev) which requires going beyond microeconomics 101: demand exceeds supply and so we see a fall in output combined with a propotionate rise in prices.

    What makes macroeconomics so difficult is the existence of demand-side recessions, which are always and everywhere caused by the money supply growth rate falling below the level necessary to sustain the previous path of nominal expenditure.

  3. Marcus, You know, when I watched the debate on Youtube, I couldn’t believe how ill-prepared Phelps was. He just seemed to be groping for something to say and out came this. I remember thinking, “oh that’s interesting, he has a gold theory of the Great Depression, why doesn’t he mention Hawtrey and Cassel for heaven’s sake,” or words to that effect. But most of what he was saying seemed so unintelligible that I just forgot about it, and I am surprised that Karl Smith and Russ Roberts even bothered dredging it up. I would just chalk it up to Phelps having been sleep deprivation or something like that. I am sure that if Phelps thought anyone would bother reading what he was saying, he would have been more careful. Nevertheless, since everyone is piling on him, maybe I will write up a post on my blog on the fact that even though Phelps understands that the Great Depression was caused by an increase in the value of gold, he obviously doesn’t understand, or forgot to mention, the roles of the insane Bank of France and the incompetent Federal Reserve (after the untimely departure of Benjamin Strong).

  4. Pingback: Edmund Phelps Should Read Hawtrey and Cassel « Uneasy Money

  5. Pingback: Aggregate Demand and Structural Problems | Economic Thought

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