Paul Krugman has devoted two recent blogposts to address complaints from heterodox economists over Thomas Piketty’s new book. I have written several pieces on the book and made my own view quite clear. I think it is a great book and I am happy to see it bring so much attention to the growth in inequality over the last few decades, even if Piketty gives short shrift to policies that could reverse this rise in inequality.

Rather than dealing directly with the dispute over Piketty, I will take some issue with Krugman’s account of the mainstream and the crisis. Krugman writes:

“It is true that economists failed to predict the 2008 crisis (and so did almost everyone). But this wasn’t because economics lacked the tools to understand such things — we’ve long had a pretty good understanding of the logic of banking crises. What happened instead was a failure of real-world observation — failure to notice the rising importance of shadow banking. Economists looked at conventional banks, saw that they were protected by deposit insurance, and failed to realize that more than half the de facto banking system didn’t look like that anymore. This was a case of myopia — but it wasn’t a deep conceptual failure. And as soon as people did recognize the importance of shadow banking, the whole thing instantly fell into place: we were looking at a classic financial crisis.”

To my mind this seriously mischaracterizes the nature of the downturn we have experienced since 2008, with important real world consequences. I have long argued that the crisis is really the story of the housing bubble and its collapse. However entertaining it might have been, the financial crisis was secondary.

There are two reasons this is important. First, if we see the financial crisis as being primary then it both gives economists greater excuse for their ignorance (hey, who knew AIG had issued $600 billion in credit default swaps on mortgage backed securities?) and creates the basis for the story of Bernanke-Geithner heroism in saving us from the second Great Depression (SGD).

If we see the housing bubble as the story, then some very serious financial stress was virtually an inevitable outcome. If you have an asset (housing) that is highly leveraged even in normal times, which then became incredibly highly leveraged in the bubble years, it is virtually certain that the plunge in house prices associated with the collapse of the bubble was going to lead to some serious financial disruptions. I raised the prospect that Freddie and Fannie could fail as early as my 2002 paper on the bubble, to the great annoyance of Fannie and Freddie's economists at the time. Uncovering the specific course of the cascade of collapse would require some investigative footwork, but the loss of $8 trillion in housing wealth should have been sufficient information to know that the financial system would be teetering.

The saving us from (SGD) myth is especially pernicious because it implies that we should somehow be thankful for an economy that continues to inflict massive amounts of needless pain. The problem with the SGD story is that a full-fledged financial collapse in 2008 would not have condemned us to a SGD any more than the collapses in 1929 and 1933 forced us to incur a decade of double digit unemployment.

We know how to boost an economy out of a downturn. It’s called spending money. We ultimately did this in 1941 to fight World War II. Had we instead spent a huge amount of money on some peaceful purpose in 1931, we would not have experienced a decade of double-digit unemployment.

The same logic applies to the current downturn. If we had a worst case scenario and the major banks were allowed to collapse, we know how to reboot the economy to return it to normal levels of output. To have a SGD (defined as a decade of double-digit unemployment) it would have been necessary to see both a financial collapse and a failure to have an effective fiscal response for a full decade.

Given the current political environment the latter is perhaps a possibility, but people should be clear: their fears of a SGD were not based solely on the prospect of a financial collapse. It was based on their assessment of a political system that is so incredibly dysfunctional that we would rather have tens of millions of people needlessly sit unemployed than spend the money to put them to work.  

The other reason why it is important to see the housing bubble as central is it brings home how serious and longstanding the problem of secular stagnation is. When we recognize that the housing bubble was driving the economy after the 2001 recession, we see that the Fed’s ability to boost the economy back to full employment through conventional monetary policy was already seriously limited even before the housing crash.

The labor market’s recovery from the 2001 recession was extremely slow. The economy continued to lose jobs all through 2002 and most of 2003. We didn’t regain the jobs lost in the downturn until January of 2005. At the time this was the longest period the country had gone without job growth since the Great Depression.

The Fed had the federal funds rate at 1.0 percent from the summer of 2002 to the summer of 2004. This is not quite zero, but no one thinks that the difference between a one percent federal funds rate and a zero percent federal funds rate would provide much additional boost to the economy. The demand generated by the housing bubble did eventually lead to healthy job growth and brought the unemployment rate down to 4.5 percent by 2007, but it should have been clear at the time that the economy was suffering from a deficiency of demand – a problem that was largely assumed away in the orthodoxy of the profession.

Krugman is right that this story could have been told using the standard tools of the trade. It would be easy to draw this picture using the IS-LM framework from any of the editions of Samuelson’s textbook. However, the orthodoxy’s dismissal of both the idea that asset bubbles could lead to serious economic distortions and the possibility that the economy’s self-correcting mechanisms towards full employment might be very weak, prevented almost the entire profession from seeing what should have been pretty damn obvious.

I personally am not interested in a fight over the tools, but this failure of the profession was humongous and that needs to be acknowledged. There was no excuse for a competent economist not to recognize the housing bubble and the danger it posed to the economy.

Also, while there is no reason for score-settling, score-keeping is still worthwhile. It’s great to see Larry Summers talking often and forcefully about the problem of secular stagnation. However, there are few people that bear more responsibility for this problem than Summers. His management of the bailout from the East Asian financial crisis sent the value of the dollar soaring against other currencies. This led the trade deficit to explode, creating a huge gap in demand that we all now know cannot be easily filled. Throw in his vigorous support for financial deregulation and it is understandable that some folks feel uncomfortable with Summers as an ally.

In short, there are some grounds for us fringe types to be unhappy about the current course of mainstream economics, but to my view it’s better to look for allies than enemies. For this reason, I remain happy that Piketty has renewed public focus on inequality, and I will pass over the technical grounds on which he has rightly been criticized by my fellow fringists.

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