(A note to regular readers of the Strong Towns Blog who may have stopped by Wednesday for the normal posting.....hey, I blew it. It is now Wednesday evening and I have already logged over 700 miles on my car this week going from small town to small town for various meetings. I realized during the middle of one of my trips today that I had not posted. I apologize - we're trying hard to build and sustain a readership interested in small towns, so please keep coming back and telling others about what is going on here. Our routine Monday, Wednesday and Friday postings are something we are committed to.)

Last week in the Friday News Digest I posted the following: 

  • While I don't pretend to be as smart as Fed Chairman Ben Bernanke, it has been somewhat amusing to me (or troubling) that people seem to be soothed by his assertion that the recession is likely over. If you want to join me in the land of cautious cynics, read this fantastic article about how economists got things so wrong. Group-think is dangerously blinding.

The second link there was an article in the New Your Times by Paul Krugman titled, "How Did Economists Get It So Wrong." The entire article printed out was 13 pages and, the first third of which talked about the collective group-think of economists who had really believed they understood all there really was to understand to keep the economy in perpetual prosperity. This was powerful commentary and, when I recommended the article, it was really this section that I was referring to (it was the only part of the article I had fully read).

I printed the entire article out and took it camping with me last weekend. Between futile attempts of trying to get kids to sleep in the tent, I managed to read it in full. While still fascinating, I found myself in disagreement with a couple of key assertions and wanted to get back here this week to provide some context for those who read the article in full based on my recommendation.

Krugman does an excellent job summarizing the views of John Maynard Keynes and Milton Friedman, and also the two camps of economic thought in the United States, the saltwater (Keynes) and freshwater (Friedman) economists, so named for their rough geographic locations (coasts versus heartland). If you have not read the article and are not familiar with those concepts, read it simply for that bit of understanding.

I'm going to admit here now that I have not thoroughly read Keynes. I am also not an economist, amateur or otherwise. I have read enough Milton Friedman and Adam Smith to want to draw a couple of distinctions between what Krugman asserted in the last third of the article and what I view as reality (albeit a reality not informed by a full reading of Keynes, which I intend to do in the near future). This is a little defensive on my behalf because I really just did not want to endorse these two concepts, which I actually believe are specifically damaging to Small Town America.

In discussing the Friedman-economists view of recession, Krugman writes the following:

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly.

Prescott is involved in the Real Business Cycle theory, a rough understanding of which can be found here and a refutation of which can be found here. The idea that this theory, Friedman and the freshwater economists would call the "Great Depression" the "Great Vacation" is provocative, but wrong.

Consider someone I know who was working as a planner making $50,000 per year. Now unemployed, there is an entire range of jobs open to this person, but that person is "choosing" to be unemployed rather than take one of those positions. Now granted, those positions may not pay anywhere near $50,000 and may not be in the profession this planner wants to work in. What allows that individual to continue to remain unemployed is the fact that they are receiving unemployment benefits from the government, a Keynesian approach to stabilize the workforce and the demand side of the economic equation.

Consider a seasonal construction worker here in Minnesota. Most of them that I know take the winter off and, while doing so, receive unemployment compensation. These are people that work extraordinary hours in the spring, summer and fall and choose to take the winter off for leisure. I don't begrudge them that choice, but from a macro-economic perspective, we have created an incentive system that allows them not to work for a few months each year.

I'm not against unemployment insurance and I feel very sympathetic to those real people that have lost their jobs, but as the RBC approach demonstrates, we really don't know the cost or value of labor. This creates price volatility and, in the case of recession, prolongs the length of time it takes for the economy to reach a natural equilibrium so we can move on with new growth. While people don't choose to be unemployed, they frequently choose to remain unemployed. It is hard to get your mojo back as an economy when doing so requires getting back jobs that no longer exist instead of creating new ones, at a new equilibrium. 

At the end of the article, Krugman offers his advice:

So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

I may be one of those who giggle and whispered over Keynes because I do not agree that Keynesian economics remains the best framework for making sense of recessions and depressions. The Keynes approach would argue that the fact that we are saving more now is a bad thing for getting us out of the recession. If people spent more, there would be increased demand and that would drive growth. This simple approach gives us things like stimulus bills and stimulus checks.

It also gives us things like overconsumption and lack of savings and investment. Also, other such concepts as massive debt and overspending on inefficient development. It is a path that leads to financial decadence and bankruptcy.

For small towns in recession, it is doubly damaging to have unfilled jobs while we have unemployed people. It is also damaging to have demand-side economics continue to prop up this false edifice of financial stability. When we create an incentive for people not to take certain jobs, overspend on things like their homes and grow parts of the economy (government, construction) that are financially not sustainable, while at the same time we create a disincentive for savings and investment, we threaten the continued existence of many small towns.

It is hard to start climbing out when you don't really know where the bottom is.