What’s Natural? Peter Temin in Conversation with The Straddler

On February 21, 2011, The Straddler met with Peter Temin at his office at MIT to seek his perspective on recent events and, more generally, the field of economics.
Temin is perhaps best known for his work on the Great Depression, but his work as an economic historian spans many eras and areas of inquiry. His recent books and papers have examined aspects of the ancient Roman economy; the decline of the bargaining power of American workers; the American health care system; and the problematic (as he sees it) rise to prominence of the general equilibrium theory of economics (a theory that, in layperson’s terms, amounts to an abiding commitment to the belief that, when left alone, the price is just about always right).
Temin, February 21, 2011
In my opinion, macroeconomics has lost its way. The kind of models that many people use—general equilibrium models—start from assumptions of perfect competition, omniscient consumers, and various like things which give rise to an efficient economy. As far as I know, there has never been an economy that actually looked like that—it’s an intellectual construct. But many people claim that the outcomes of that economy are natural outcomes. When you say “natural,” you already have an emotionally laden term. Deviations from the “natural”—say, like, minimum wage laws, or unions, or governments that give food stamps, or earned income tax credits—are interferences with the natural order and are therefore “unnatural.”

A parallel notion within the field is that our goal as economists is to maximize efficiency; we should leave all the other things to other people. Now, when you take the theory of efficiency, it turns out that there are an infinite number of efficient equilibria, each corresponding to a different distribution of income. Equity and efficiency are different kinds of things.

In work Frank Levy and I did,[1] we talked about a period we called the Treaty of Detroit (1945—1970s),[2] where you had a lot of government intervention, and then this later period which we nicknamed The Washington Consensus (1970s—present), where there was minimal government intervention. At first, our tendency was to say that the later period was natural competition and the earlier period was unnatural government intervention. But then we had to say, no, the government is involved in all of these things, it’s just that government policy is different in one period than in another period. It’s not that one is natural and one is unnatural. It’s that one does something, and the other does something else. Since we’re both economists, we had to cleanse our language because it was such a natural a thing for us to be talking about the habitual and unnatural.

The general equilibirum view tends to lend support to those who want to make the economy more efficient in the sense of having fewer “distortions”—you know, all of these neutral economic words—from taxes, from labor unions, from minimum wages, and so on. Now, what has happened in the last thirty years—and this is what Hacker and Pearson note in their book [Winner-Take-All Politics]—is we have gotten ourselves into a feedback situation. As people have gotten richer, conservative people have funded organizations which generate economic research promoting their political views.

I recently reviewed a book [published by the Federal Reserve Bank of Minneapolis and] edited by Timothy Kehoe and Edward Prescott—a Nobel Prize winner in Economics—which had a very distinguished group of people writing about macroeconomics and depressions using the currently fashionable general equilibrium analysis. In my review, I argued that the answers that they got were terrible, that the model—however useful it is for other things—is not useful to analyze the conditions like the conditions today. And I even suggested [here Temin read from the review]:

Lurking behind these presumed inefficiencies appears to be a campaign for minimal government. Minimal government would not require many taxes as it would not have large expenditures; it would not interfere in labor markets, letting individual workers deal with large business firms as ordinary people deal with the grocery store. This is not an attractive place to live for some people, and this book appears to be supporting such an arrangement by stealth, rather than by direct argument. If this is an intended subtext, it would be appropriate for the authors and the Federal Reserve Bank of Minneapolis to bring it out into the open.[3]

The authors of the book deny that that’s what they were doing, but I think it is implicit that current economics has a political stance, or at least political implications.[4] But these guys working at the Minneapolis Fed can say, well, you know, we’re not partial, we’re neutral scientists.

One of the things that Barry Eichengreen and I argued in “Fetters of Gold and Paper”[5] is not that people are necessarily wrong, it’s that they have an alternate construction of what’s going on. So they have this alternate reality, but it’s very sanctioned. In 1931, for example, when the Fed raised its interest rate to maintain the gold standard, it was cheered by people. They didn’t think they were wrong, they thought they were right.

People who make these arguments make them because they believe in them. Look at the current troubles in Wisconsin, where the state is having fiscal problems, not because of anything they did, but because all states have problems. States cannot run deficits the way the federal government can, and it’s clear that the federal government should be bailing them out. Obama has been trying to do that. He did it in the original stimulus bill, and he’s been trying to do more as things have progressed, and now he’s been stymied. All states are in this bad position. So that’s a function of our government. And it shows a little bit that our 18th century form of government isn’t adequate to 21st century problems. I don’t know how one would solve that problem, but it’s a big issue.

In any case, in Wisconsin, the governor wants state employees to take a hit along with other people. Okay, you can debate that. But he then says, I also want to destroy the unions. Now, these would seem to be two entirely different things, but they are very much linked in people’s minds by a notion of unfair advantage. There are other ways that you could argue this. State employees generally are not paid very well, and they get what economists call deferred compensation—they get good pensions. And there is a lot of literature in labor economics to say that. But that’s not the economics that is around and being used by the governor of Wisconsin. He’s got a whole normalized language and mindset that says unions are distortionary. So there’s a very direct route where you can see this ideology going into policy.[6]

Unions do have their problems—but everything does. And one of the things about this model of general equilibrium is that all of the problems of running organizations, and running them over time, doesn’t appear in it. And so you miss the fact that yes, unions have all those kinds of problems, yes, governments have all those kinds of problems, but business also has those kinds of problems. So it’s not that the criticism of labor unions is wrong, it’s that it’s taken out of context. And economists have helped to do that.

Look at another concept: structural unemployment. There can be structural unemployment. It’s a well-defined concept. But the argument that what we’re seeing now is structural unemployment is a way to support the efficiency, general-equilibrium, conservative view of economics because it’s a statement that policy can’t do anything. That’s what the Fed said in the 30s: “It’s not my job to do this.” Structural unemployment is something that happens; people have tried to deal with it by retraining, and so on. But, mainly what you need is this old Keynesian notion of aggregate demand. In the Second World War, all of a sudden all of this structural unemployment disappeared. Everyone went to work.

So, there is something like structural unemployment, which is why education is important. People need to know what they’re doing. You can have mismatches. But you have to distinguish between people who are trying to solve the problems of how you fit the existing labor force to the existing demands, and the people who are using structural unemployment as a way to further these conservative, do-nothing policies.

Where do these policies come from? What made them possible? In the 70s, as a result of Keynesian theory and the policies that came from it, we found ourselves in a lot of trouble. Now, it’s true that we tried to fight a war, but it’s also true that Keynesian theory was deficient—it didn’t cover everything. There were two reactions to this. One was to patch up the theory and extend it. The other came from people who said that Keynesian theory is terrible—it got us into this mess, we have to do something different. And that fed into this desire to use mathematics to set up elaborate models and to have everything be efficient. That’s within economics.

Now, in the general culture, the reason behind the change is a really complicated story. In the piece that Frank and I did, we wanted to document that this had happened, that there was a change in policy, but we didn’t go into the cultural reasons that made the change possible. Hacker and Pearson’s book goes into it, but even they don’t have a real explanation. They have a lot of villains, but they don’t have a sense of why these changes came at this time.[7] The mechanism which led to this change is just obscure.

And the difference between the parties is not the thing. Just look at what is happening today. When Obama got elected, I was very happy. I thought he would have more new ideas than he did. If McCain had been elected, he might have had the same advisors. I think he would have done worse in foreign policy, but we just don’t know. A lot of people say, “If McCain had been elected, it would have been a disaster!” Well, it probably wouldn’t have been a disaster. And given that Obama has turned out not to be radical, maybe it wouldn’t have been all that different. I don’t know.

Obama selected people who seemed knowledgeable, and who were bright, and who he got along with. He was charmed by all of these hedge fund people. Now let’s take the parallel with the Great Depression. Roosevelt came in, and he brought a bunch of loonies in with him to Washington, and they suggested all kinds of things and he did all kinds of things. The net effect of the New Deal was not as great as it seemed, but on balance he did a splendid job. Obama just didn’t do that. I mean, if he had come in and taken Jeff Sachs, Joe Stieglitz, and even Paul Krugman—maybe none of these guys has the personality to do the things that needed to be done, but Obama could have reached a little further about. The worst appointment was Geithner, who was very much involved with the banking community of New York. That was a bad decision.

In the end, they tinkered around the edges. I think it’s perfectly clear. The original rescue was done under the Bush Administration by Paulson, to save his friends. And they did save his friends, and in so doing they promoted the consolidation of investment banks and made the problem worse. The risks are higher now. Paulson didn’t recognize—these were his friends, he wanted to help them—he didn’t recognize these banks as a problem. The problem somehow came from other things, and so Paulson helped them. Now, it’s hard to find an economist who would have said, “do nothing; let them all go to hell.” We know that happened in the 30s and it took a long time to put it back together again. But Obama didn’t try to do something at the time that we were in crisis. And Simon Johnson is on to a good point: “too big to fail” is dangerous.[8]

There are a couple of policies that could address this danger. One would be to reduce the leverage that financial institutions could have. Another would be to reduce the size banks could attain. So there are options, and you can discuss which ones are better or worse, but none of them were done. Dodd-Frank is an amalgam of all kinds of little stuff growling around the edges, but it doesn’t affect the main problem.

A real problem is that a lot of people don’t know enough economic history. I’m an economic historian, which is a kind of endangered species. When I think about macroeconomics, I think about the Great Depression a lot because I worked on it and taught about it and so on. But, look, a lot of people in the 90s didn’t have personal experience of the Depression. They didn’t think it was terribly relevant.

Peter Temin is the Elisha Gray II Professor of Economics, Emeritus at MIT, and former head of the MIT economics department. He has been a Guggenheim fellow and President of the Economic History Association. His books include The Jacksonian Economy (1969), Did Monetary Forces Cause the Great Depression? (1976), The Fall of The Bell System: A Study in Prices and Politics (1987), Lessons from the Great Depression (1989), The European Economy Between the Wars (1997), and Reasonable Rx: How to Lower Drug Prices (2008).