19th Systemic Breakdown

The basic IS-LM model, with its possibility of a liquidity trap, has been a very good guide in these troubled times. And there’s a reason for that: as I wrote long ago, in a piece from the 1990s, IS-LM is basic economics applied to a world in which in addition to production of goods there is both money and a bond market. Aside from the assumption of sticky prices — which is overwhelmingly obvious and supported by strong evidence — it’s your basic, minimal, compelling model. It should come as no surprise that it gets at a lot of what’s going on.

Yet people don’t know this model — which is to say, they don’t have any simple framework for thinking about how money, interest rates, and the real economy interact.

Which people am I talking about? Money managers, obviously; they may know a lot about individual markets and companies, they may have lots of experience, but now that we’re talking about macro issues of a kind not seen since the 1930s, those talents are a lot less relevant than usual. Pimco used to have Paul McCulley, who was very good on the macro, but with him gone, they seem to be making up theories on the fly. And whatever model Paulson is using, it’s not IS-LM.

But economists also don’t know this stuff. We’re living in a dark age of macroeconomics, in which much of the profession has turned its back on past knowledge. There’s also a contingent of economists who have read Hicks, or at least claim to have read him, but seem to have come out of the experience with nothing more than misleading catchphrases and the strange conviction that they have transcended something they actually don’t understand. (Brad DeLong takes on some of this stuff).

Reinhold Niebuhr suggested two answers:

1. Humans have "limited self-transcendance," which means we basically have the ability to learn from our mistakes--but not the power to see all the mistakes we make. That leads to overconfidence in our own ability, which must be a particular temptation when you're used to being the smartest guy in the room.

2. We like to think of ourselves as rational beings, but our opinions and insights are more determined thank we'd like to admit by our commitments to the needs of our social group. That goes beyond "groupthink" to moral obligation: the more people we represent, the more obliged we are to represent their interests. So if Bond Traders in general think T-Bills are a bad bet, it's terribly difficult and may even feel *wrong* to think outside that conclusion. This is exactly why the Founding Fathers were dubious about establishing a permanent capital: they were afraid of exactly what has come to pass, which is that national leaders feel more beholden to the Village than to their true constituencies, which are far away and not yammering in their ears all day.

It's also while appeals to fear work. When people think their community is threatened, they're liable to go along with ideas they wouldn't otherwise because they perceive them as necessary to protect the community. Hello, invasion of Iraq.

Niebuhr, who was after all a theologian, believed that Christ provided the only true transcendance to these situations. YMMV, but I think his insights are helpful whether or not you buy his ultimate conclusions, or at least I hope they are. I am, after all, a representative of the Christian community. ;-)