Krugtron the Invincible, Part 2

Why, you may ask, did Krugman feel the need to be so bold (and so wrong) in predicting the euro's collapse over and over again, in his column, on his blog and to every media outlet that would give him an interview?
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As I pointed out yesterday, Paul Krugman's right to consign others to the "Always-Wrong Club" , and routinely to insult anyone who dares to disagree with him, is fatally vitiated by his own embarrassingly bad record of commentary on the European phase of the financial crisis. His repeated and erroneous predictions of the European Monetary Union's imminent collapse constitute a perfect example of what he and his cronies childishly call "derping": to "take a position and refuse to alter that position no matter how strongly the evidence refutes it, who continue to insist that they have The Truth despite being wrong again and again".

Regrettably, Krugman - also known to himself and his cronies as "the Invincible Krugtron" - has not found time in his busy schedule of blogging to make the apologies that I believe are due, not only for his incivility and hypocrisy, but also for his own personal contribution to the crisis of confidence that afflicted Europe in 2011 and 2012. Seldom in the history of the economics profession can one man in a crowded theater have shouted fire more often and more loudly, apparently indifferent to the real economic consequences of his actions.

Why, you may ask, did Krugman feel the need to be so bold (and so wrong) in predicting the euro's collapse over and over again, in his column, on his blog and to every media outlet that would give him an interview? The answer is because he and his beloved economic models had so completely failed to predict the U.S. financial crisis and he did not want to repeat his mistake.

In 2006, the year before the financial crisis began, Krugman had a twice-weekly New York Times column. What a perfect opportunity, one might have thought, for the infallible Nobel laureate and author of Depression Economics to warn his readers about the gathering storm. Retrospectively, Krugman pats himself on the back. "How did I do?" And the answer is, not too badly. ... I've had a pretty good stretch." In fact, only eight of Krugman's more than a hundred columns in 2006 referred to the bubble in the U.S. housing market and the danger posed by its bursting. The key word "subprime" did not appear in his column until March 2007. Nearly everything else was a partisan rant of one sort or another against the policies of the administration of George W. Bush.

As an economist honored by the Swedish central bank for his work on trade theory, and as someone who had also cut his teeth as a commentator on the 1997-8 Asian Crisis, Krugman made the mistake of thinking the trade deficit and therefore the dollar were crucial. Here is a revealing passage from a column he wrote in February 2006:

Sooner or later the trade deficit will have to come down ... and both American consumers and the U.S. government will have to start living within their means. So how bad will it be? ... A "soft landing" looks unlikely, because too many economic players have unrealistic expectations. This is true of international investors, who are still snapping up U.S. bonds at low interest rates, seemingly oblivious both to the budget deficit and to the consensus view among trade experts that the dollar will eventually have to fall 30 percent or more to eliminate the trade deficit.

Many other economists had been making predictions like that for years. Yet this was the one thing that didn't happen in the financial crisis. On the contrary, when the crisis struck, investors' appetites for U.S. bonds and dollars surged.

Interestingly, in those days Krugman dismissed an argument of which he is now inordinately fond - that low bond yields signal a capacity for additional government borrowing: "Of course," he wrote in April 2006, "optimists have a comeback: if things are really that bad, why are so many foreign investors still buying U.S. bonds? And they point out that those predicting problems from the trade deficit have been wrong so far. But I have two words for those who place their faith in the judgment of investors, and believe that a few good years are enough to prove the skeptics wrong: Nasdaq 5,000." These days, it is Krugman who repeatedly assures his readers that low bond yields are proof that "deficit scolds" are wrong - in fact, they are an invitation to the Treasury to run a bigger deficit. I have one word for him: hypocrite.

To be sure, Krugman identified the house price bubble as a potential problem. But he failed to understand the nature of the problem. With typical "Econ 101" thinking, he predicted that house prices would fall, and that "spending will suddenly drop off as both the bond market and the housing market experience rude awakenings". He consistently failed to understand that the subprime crisis was financial in nature. Its macroeconomic effects would be huge not because of a reverse wealth effect as falling house prices depressed consumption, but because rising defaults on subprime mortgages would drastically affect all the structured financial products that used them directly or indirectly as collateral, and that the highly leveraged holders of such products - banks, in particular - would find themselves first illiquid and then insolvent.

Back on the eve of the crisis, Krugman also blew hot and cold on inflation, which I suppose is one way of being "right about everything". In April 2005, for example, he detected "A Whiff of Stagflation", but by June the following year he had changed his tune. Now, inflation was a "phantom menace" and - perversely given his concerns about the housing bubble - he worried that the Fed was wrong to tighten monetary policy. A general rule of Krugman's journalism is that monetary policy is never too loose and central bankers are always tightening too early. Another rule is that if someone erroneously anticipates higher inflation, that person is a member of the Always-Wrong Club. Who knew that he himself founded that club in 2005?

By August 2006, Krugman's diagnosis of the risk of a coming recession was correct in only one respect: that he thought there was a risk. In every other respect he was wrong:

The forces that caused a recession five years ago never went away. Business spending hasn't really recovered from the slump it went into after the technology bubble burst: nonresidential investment as a share of GDP, though up a bit from its low point, is still far below its levels in the late 1990's. Also, the trade deficit has doubled since 2000, diverting a lot of demand away from goods produced in the United States. ... [But] now, for the first time, problems in the housing market are starting to seriously reduce economic growth: the latest GDP data show real residential investment falling at an accelerating pace. ... based on what we know now, there's an economic slowdown coming. This slowdown might not be sharp enough to be formally declared a recession.

Once again, he was looking at the wrong dials on the dashboard, completely missing the financial implications of falling house prices.

Later that same month, an increasingly nervous Krugman gave an unexpected but qualified endorsement to Nouriel Roubini of NYU, "the only well-known economist flatly predicting a housing-led recession in the coming year. ... While I don't share Mr. Roubini's certainty, I see his point." Krugman's first reference to the role of "irresponsible bank lending" - and the Fed's failure to "crack down" on the banks - came on October 30, 2006. Note, however, that as late as December 1, 2006, he was still giving "roughly even odds that we're about to experience a formal recession". And when Krugman tried to imagine how the crisis would play out, with a piece published in March 2007 under the dateline "Feb. 27, 2008", his predictions were laughable. According to the man who would come to be known as the Invincible Krugtron:

1. The crisis would begin with a stock market crash ... in China.

2. Then it would spread to the junk bond market.

3. Then would come the defaults on subprime mortgages.

4. But the crisis would only be really big if "large market players, hedge funds in particular, [had] taken on so much leverage - borrowing to buy risky assets - that the falling prices of those assets would set off a chain reaction of defaults and bankruptcies".

Still capable of caution in those days, Krugman concluded the column by wimping out. "I'm not saying that things will actually play out this way," he wrote. "But if we're going to have a crisis, here's how." As we all know, the crisis still hasn't come to China (though the Shanghai stock market fell, the macro consequences were minimal), junk bonds were not crucial, and it was the losses of banks, not hedge funds, that did the most serious damage.

As late as January 2008 - again looking myopically at trade data - he was arguing that the U.S. economy had "dodged a bullet ... which is why I haven't been as sure about a looming recession as, say, Larry Summers or Marty Feldstein, let alone Nouriel Roubini ... I'm actually uncertain about where things go this year." Nor was he "nearly as pessimistic" as Carmen Reinhart and Kenneth Rogoff, whose seminal paper on the likely huge macroeconomic impact of the subprime crisis appeared that February. It was only in March that Krugman finally grasped the financial nature of the crisis. "A lot of people", he wrote, "saw that there was a huge housing bubble":

What's going on now, however, is beyond that: the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse of the whole system, was not, I think, so widely foreseen. I don't think many people saw how much the system itself would break down.

No, not many economists did see the complex interrelationships between the subprime mortgage market, collateralized debt obligations, highly leveraged banks and international derivatives markets that were the key to the scale of the crisis and its macroeconomic impact. But at least one historian did here and here and here and here and here. And here. I don't claim to be always right. But always wrong?

One might have expected a little more humility from an economist who so clearly failed to understand the nature of the biggest financial crisis of his lifetime until after it had happened. Or at least a little less egomania: "Yes," he wrote in January, "I've heard about the notion that I should be Treasury Secretary. I'm flattered, but it really is a bad idea." Gee, Professor Krugman, why do you say that?

It would mean taking me out of a quasi-official job that I believe I'm good at and putting me into one I'd be bad at. ... An op-ed columnist at the [New York] Times ... [can] have a lot more influence on national debate than, say, most senators. Does anyone doubt that the White House pays attention to what I write? ... By my reckoning ... an administration job, no matter how senior, would actually reduce my influence.

Not to mention smugness:

Obviously I'm plenty combative, and in a way still ambitious too; I do track my Twitter followers, wonder how each column will do on the most-emailed list, and all that. But there are no promotions I'm seeking, no honors I desperately desire that I don't already have. ... I'm wonderfully relaxed: no more steps to climb, no more boxes to check. I just do what I feel I should, and try to have some fun along the way. I'm a very lucky guy.

I confess I am at a loss to understand the basis for this self-satisfaction. If Krugman was wrong about the origins of the crisis, and wrong about the fate of the euro - wrong, in short about the two biggest crises of our time - what exactly was he right about? What, besides the doubtless large number of his Twitter followers, entitles him to be so pleased with himself?

That is a question I shall answer tomorrow, in the third and final part of this series.

Niall Ferguson's latest book is The Great Degeneration (Penguin Press).

© Niall Ferguson 2013

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