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Output (measured for example by Gross Domestic Product) is a flow concept, not a stock concept. The nation's housing stock, and its other assets, including stocks and bonds, are not part of GDP. What I said, in criticism of economists who deny that a stimulus program can have any beneficial effects, is that while it is true that if a dollar invested by government, say in hiring a road contractor to build a new highway, reduces private investment by a dollar, the government expenditure is unlikely to increase net output, but that I doubted that that would be the effect of the stimulus. If private investment and consumption are down because people and firms are hoarding cash for fear of what the future holds for them, government can in effect put those inert savings to work by deficit spending on public works.

This same economist, Mark Thoma, who like DeLong is notably abusive, resorts to the academic trick of reading a passage literally in order to make the author seem an ignoramus. I had said that one of the events in the second quarter that might have helped reduce the rate of decline in output and employment was increased foreign demand for U.S. goods, relative to the first quarter. Thoma says: "he [Posner] talks about foreign demand for US goods, but doesn't include NX in his definition of output." "NX" means net exports. That is to say that increased foreign demand for U.S. goods is a good thing, since exports increase national income, unless U.S. demand for imported goods grows more. That's true, and if that happened in the second quarter (it didn't) I would not have pointed to the increase in foreign demand as a factor favorable to U.S. output, hence a possible confounding causal factor with the modest stimulus disbursements in the second quarter.

My critics are leftwing economists, and I think they simply can't believe that I really support the stimulus program, that I am a Keynesian, and that I am a critic of conservative macroeonomists and finance theorists, though I do not accuse John Cochrane, a distinguished finance theoriest, as Thomas does, of not knowing freshman economics. 

Well, on to substance.

Romer's speech argues that the disbursements of stimulus funds through the end of the second quarter of this year (that is, through June 30) have had a big effect on economic output and employment. I said this was unlikely as a matter of theory, and that she had no persuasive evidence to back up her claim. And I raised the question of the ethical responsibilities of an academic who takes a government job and then makes a speech that although it deals with a subject that she had studied and written about as an academic is not a responsible academic analysis. My concern is enhanced by the statement of one of my critics that the Council of Economic Advisers, of which Romer is the chairman, has a sterling reputation for political neutrality and analytical rigor. Romer's speech does not bode well for the preservation of that reputation. Another critic argues that since it was just a speech, intended therefore to be heard rather than read, Romer should be permitted to have rounded off her numbers, and thus to have rounded off $89 billion (this critic's estimate of how much stimulus money had been disbursed by the end of the second quarter) to "more than $100 billion" (her language). This overlooks the fact that the speech was posted on the CEA's website, and is replete with footnotes, which I doubt she read aloud.

In fact, while I am on the subject of the amount of stimulus money disbursed so far, $89 billion seems too high. The government's official figure is $60 billion, and a recent estimate by msnbc.com is $58 billion. One of my fiercest critics estimates the figure at "about $60 billion," without however remarking the discrepancy between "about 60 billion" and Romer's "more than $100 billion.

Far more important than the amount of money disbursed is the amount spent. The distinction is essential. When an individual or for that matter a state treasurer (for the entire stimulus disbursements through the end of the second quarter consisted of transfer payments) receives a check, he has a choice between saving it or spending it, or doing some of both; and if he decides to save it, he has to decide whether to hold it in cash, deposit it in a bank account or a money-market account, buy stock, etc. The more of it he decides to save in a safe form, the less the stimulus he received will do to stimulate economic activity. Most economists believe that "transitory" (one-shot) income is mostly saved rather than spent; and the belief is confirmed by most studies of the effect of the $150 billion in tax relief implemented in the spring of 2008 to fight the then-nascent recession.

Romer's speech does not indicate what percentage of the "more than $100 billion" (or is it $58 billion?) had actually been spent rather than squirreled away during the second quarter. Moreover, given the inevitable lag between the disbursement and the expenditure of disbursed funds by the recipient of the disbursement, disbursements made toward the end of the second quarter could not have affected output and employment in that quarter.

Romer's failure to address these points would be understandable if she were not an academic student of stimulus programs; but she is.

When I read her speech the first time, I missed this startling statement: "the fact that consumption fell slightly in the second quarter after rising slightly in the first quarter could be a sign that households are initially using the tax cut mainly to increase their savings and pay off debt" (emphasis added). Well, if that's what they're doing, they aren't doing much to stimulate economic activity. I agree with Keynes that consumption is the motor of the economy (one my critics says that "consumption does not produce," which rather misses the point), and that what government needs to do when personal consumption expenditures drop is to increase government consumption--and that means public works, which employ people, and not transfer payments, which may not translate into proportionately increased consumption, or at least not without a lag. Romer says that public works (she calls them "direct investments," but the meaning is the same) "have short-run effects roughly 60 percent larger than tax cuts." She doesn't indicate where she gets the number, but it is further evidence that she believes that transfer payments are not as efficient in stimulating economic activity as public works are.

Critics have been particularly unsparing of my having expressed the so-called $100 billlion in stimulus disbursements as a percentage of annual GDP. I think it's a fair criticism--and so it is amusing to note the identical procedure in the second sentence of Romer's speech, where she states that the $787 billion is "roughly 5 percent of GDP." It is roughly 5 percent of this year's GDP. But it is to be spent over at least two years.

The most serious problem with Romer's speech is evidence. She thinks she has shown that the economy lost 485,000 fewer jobs in the second quarter as a result of the stimulus. There is no evidence for that, because she makes no effort to adjust for other developments in the economy that affected employment, including other parts of the government's recovery program. I don't criticize her or anyone for the absence of evidence concerning the stimulus program's early effects. As I said in my book, when the government attacks a depression with several different programs, it is very difficult and maybe impossible to disentangle the causal efficacy of each one. I also said, and I have repeated this ad nauseam without my critics noticing, that it was right for the government to try a variety of measures for arresting the economic decline, including the stimulus, even though the result would be that the relative effectiveness of the different measures might be impossible to determine.

One of my critics, after calling me "obnoxious," states: "Does no one see how ridiculous Romer is, to be arguing that no one should blame her for missing how bad the economy was going to be, in one paragraph, and then, almost in the next, arguing that she knows precisely what the effect of the stimulus has been, because she knows what the course of the economy would have been, in its absence?"

I mentioned that Romer's academic work had included findings (not mentioned in her speech) that stimulus measures employed against the recessions that the United States has experienced since World War II have not been effective, because by the time the stimulus is implemented the recession is over. My critics point out that because this recession is already longer than any of its predecessors, those academic findings are irrelevant. That would be true if the stimulus program had been enacted in December 2007, when the recession (or, as I prefer to call it, the depression) began. At this writing, it seems that economic growth is about to restart, yet more than $700 billion of the stimulus money remains to be spent. If economic growth turns out to be rapid, the effect of stimulus spending, on top of our huge deficits, may be to create significant inflationary pressures.

I hope this is something that Romer is beginning to think about, but I am doubtful, because she remarks at the end of her speech that the President is trying to "rebuild the economy better," for example by "urging health care reform to slow the growth rate of spending, tame the budget deficit, and provide all Americans with the [sic] secure health insurance coverage." The first two objectives are inconsistent with the third. And increasingly it looks as if any ambitious health care program that Congress passes will not be funded, and so will add to the national debt and inflationary pressures.

I would like to leave the last word to Lawrence Indyk. Mr. Indyk is a frequent commenter on my blog. His comments, whether critical or supportive (some are the former, some the latter) are invariably thoughtful and lucid. Here is his comment on my discussion of Romer's speech:

"1. Dr Romer gave a speech on August 6th purporting to assess the success of the stimulus up to that point. The analysis she presented to The Economic Club of Washington was quite different from what she would have said had she remained a private academic and not an agent of the current administration.

"2. This difference is, essentially, one of less rigor and, paradoxically, more certainty, than one would otherwise expect, or would otherwise be considered acceptable by peers in the profession. To put it simply, she expressed an extraordinary amount of confidence in her conclusion that the political plan which had been enacted was having, and would continue to have, very close to an optimal effect on the overall economic situation. In other words--it was a Goldilocks stimulus--just right, and working as planned.

"3. She did all this with the reputation of an accomplished and highly esteemed Economist, and therefore with an understanding that her audience would consider anything she said to reflect only the highest standards of objective accuracy. That is why, after all, she was chosen to make this defense of the stimulus plan. Despite this, the analysis she presented was cursory and her conclusions fairly weak.

"4. Though everybody knows it, she did not disclose ahead of time that she was now acting as a political figure and that the statement she was making was not some sterile and disinterested academic seminar, but specifically designed to have a particular political effect. Such a failure to make such a disclosure brings her professional integrity into question in terms of whether we should believe what she says on the basis of her academic reputation so long as she remains in the employ of the government.

"Well, now that the summary is finished, it all seems like much ado over not much to me. Consider paragraph 4 above. Does anyone actually expect Dr Romer to say otherwise? People have been eating similar political-through-professional content with grains of salt for a long time.

"And as for Professor DeLong's outrage (debates over details aside) is the mild charge being levied here really so unbelievable or abominable? No one has said Dr. Romer is incompetent or a bald-faced liar, merely that she speaks for the President, and it seems (as should be expected by all adults) that, while short of outright dishonestly, she is selectively emphasizing a narrative that is favorable to him." 

(Photos: Christina Romer White House Official Portrait and Flickr User Ed Yourdon)

Romer answers the question in her title: "Absolutely." And despite the reference to "five months" in the subtitle, her focus is on the second quarter of 2009 (April, May, and June) and her claim is that the stimulus had a dramatic effect on output and employment during that quarter. I do not think her analysis is responsible, and I am concerned with the fact that academic economists, when they become either public officials or public intellectuals (like Paul Krugman), leave behind their academic scruples. (This is one of the themes of my book Public Intellectuals: A Study of Decline [2001])--and Krugman was one of my examples of the phenomenon.)

Let me make clear at the outset that I support the stimulus, though I wish it had been better designed. I support it for two reasons. The first is that, given the state of panic of the economy last winter, and the limited efficacy of the measures already taken to arrest the economic plunge--the expansion of the money supply and the bailouts of the banks and the two failing automobile manufacturers (Chrysler and GM)--the government had to make a dramatic commitment to try all means of arresting the plunge. It could not just say, "We've tried everything we think might work; it's not working; so we'll just have to tough it out." That would have been destructive of business and consumer confidence, and would have accelerated the downward spiral that many thought could have brought the economy to the depths it reached in the 1930s depression.

Second, there is a pretty good theoretical case, and some empirical backing, for deficit spending on public works as a means of combating a depression. Output (GDP) is the sum of personal consumption expenditures, investment (including savings), and government expenditures. When personal consumption expenditures and investment decline, so that (if government expenditures are constant or falling) total output declines, which in turn results in layoffs, which further reduce income and therefore output, thus triggering a downward spiral, an increase in government expenditures can arrest or at least slow the downward spiral by replacing some of the decline in private consumption and investment.

Now unfortunately the stimulus was poorly designed and has been (so far as an outside can judge) lazily implemented. Only about a third of the stimulus funds is for public works. Two-thirds are for tax credits and other benefits (including the popular "cash for clunkers" program) and for state governments. The problem with the two-thirds is that there is no guaranty that transfer payments will be put to productive use; they may be saved, directly or indirectly. Suppose a state uses the money for tax relief; then it is in effect putting money in people's pockets, and the recipients may decide to save, rather than spend, the bulk of what they receive. The personal savings rate has been rising, and additional cash received from the stimulus program may go largely to increase personal savings beyond what they would otherwise be. Or, in the case of the "cash for clunkers" program, the major effect may be that people buy cars a little sooner than they otherwise would, in which event auto sales may be depressed a few months from now; or they buy cars in lieu of other products, and the increase in auto sales is offset by a decrease in other sales.

In contrast, when the government pays a road contractor to build or repair a road, we know that the money is going to be spent to hire workers and buy materials, and so employment will rise.

Conservative economists argue that the effects of the stimulus in increasing output and employment will be undone by the fears of businessmen and consumers concerning the addition to the national debt of $787 billion in deficit spending. Those fears, these economists argue, will cause businessmen and consumers to hoard, knowing that their taxes will have to rise in the future (and their wealth therefore be lower--hence the need for greater savings now, so that they can use their savings to maintain their standard of living when the higher taxes take effect) to pay back the $787 billiion. Most economists, however, believe that it is unrealistic to suppose that people have enough information about the future to adjust their current behavior to expectations of higher taxes, inflation, devaluation, or other possible consequences of an increase in the national debt. There is too much uncertainty.

The point is not that people are irrational, but that they just don't have the information that would enable them to decide what adjustment in savings and consumption they should make today to optimize their economic situation if and when the national debt has to be paid down through higher taxes, inflation, or other measuires.

But Romer actually gives some credence to the unrealistic picture of the far-sighted consumer or businessman by arguing that recipients of tax credits authorized by the stimulus bill will spend rather than save the tax-credit money because they will assume that the credits are permanent. (The significance of this assumption is that people are more likely to spend a tax reduction that they think is permanent than a temporary reduction, because it would be a bother to adjust their spending patterns temporarily only to have to change them back when the surge of money--what economists call "transitory income"--runs out.) They will assume the credits will be permanent, she says, because the Obama Administration is committed to middle-class tax cuts. In fact no one knows whether the tax credits, enacted as part of a temporary measure--the stimulus--will be permanent; and it is extremely doubtful that many people are acting on the expectation that they will be.

Romer argues in her talk that by the end of the second quarter of this year, $100 billion of stimulus money had been spent. That is a suspiciously round number, and it is unclear how it was arrived at; but let us assume it is accurate. She then argues that this small expenditure--about two-thirds of one percent of the Gross Domestic Product--is responsible for the fact that the decline in GDP fell (on an annualized basis) from 6.2 percent in the first quarter of the year to 1 percent in the second quarter (though the latter figure is likely to be readjusted upwards).

This assertion is groundless. No one has the faintest idea what effect the stimulus has had. My guess is that it has had some positive effect, because of its confidence-enhancing character that I mentiioned earlier and because some of the $100 billiion--though no one seems to know how much--has been spent rather than saved. But it is impossible to determine the net impact of the stimulus on GDP or employment because so much else has been happening to stimulate an economic recovery. Some people have had to dissave--turn savings into expenditures--because their income has fallen (maybe because they have become unemployed) below the level necessary to cover their basic expenses. Some people have had to replace durables that wore out. Foreign demand for U.S. products has risen some. (Dissaving, replacing durables, and export growth if the domestic currency loses value are standard nongovernmental spurs to recovery from a depression.) And the government has been doing a lot to stimulate recovery besides the stimulus--has in fact expended or guaranteed trillions of dollars in an effort to increase the amount of lending, which is essential to economic activity.

Disentangling the various factors that are responsible for the reduction in the rate of decline of output in the second quarter is probably impossible, but in any event has not, to my knowledge, been attempted--and certainly not in Romer's talk.

This raises the question of the ethical responsibility of academic economists, such as Romer (and Krugman, and Lawrence Summers, and many others), who write for the media or join the government, either to adhere to academic standards in their nonacademic work or to make clear to the public that they are on holiday from those standards and that what they say in their public-intellectual or governmental careers should not be thought identical to their academic views. As an academic, Christina Romer was a respected student of the business cycle, and actually expressed skepticism, no longer in evidence, about the efficacy of stimulus programs in arresting economic downturns. The statement in her talk that she thinks the allocation of moneys by the stimulus bill is just right is hard to credit as her professional opinion. But as chairman of the Council of Economic Advisers, she is a spokesman for the Administration, and I would guess that her public statements are vetted by the President's political advisers.

(Photos: Flickr Users David Paul Ohmer and borman818)

It is remarkable how economists have been able to deflect blame for the economic crisis that erupted last September with the sudden collapse of the international banking industry and that continues to afflict the world's economies. Last November, Queen Elizabeth visited the London School of Economics and asked the faculty why "nobody [had] noticed [before September 2008] that the credit crunch was on its way?" Acting in the unhurried English fashion, on June 27 the British Academy convened a forum to examine the Queen's question, and the conclusions of the forum were summarized in a letter to the Queen of July 22 written by two professors at LSE, Tim Besley and Peter Hennessy. The letter, which can be read online at  http://www.docstoc.com/docs/9919279/3e3b6ca8-7a08-11de-b86f-00144feabdc0-1, is complacent. Responsibility for the oversight was attributed to "a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole." In other words, everyone was to blame, which means no one was to blame.

"Everyone seemed to be doing their [sic] own job properly on its own merit" but no one realized that the individual activities of the "many bright people" was creating a risk to the solvency of the entire global financial system. On the contrary, people were lulled into believing that "financial wizards" had purged risk from the system.

There is no reference in the letter to the economics profession, although one of the authors is an economics professor (Besley--Hennessy is a political historian) and the only economic models referred to appear to be "value at risk" models for calculating the risk of loss from an individual transaction.

Yesterday, another letter to the Queen, this one dated August 10 and signed by ten English and Australian economists, was released (it can be read online at http://www.docstoc.com/docs/9919280/queen2009b), also responding to the Queen's question of last November but taking issue with Besley and Hennessy's letter. The August 10 letter states that "their overall analysis is inadequate because it fails to acknowledge any deficiency in the training or culture of economists themselves." The nub of their criticism is that "in recent years economics has turned virtually into a branch of applied mathematics, and has...become detached from real-world institutions and events." They criticize economics education as excessively narrow, "to the detriment of any synthetic vision," and fault Besley and Hennessy for saying nothing about "the typical omission of psychology, philosophy or economic history from the current education of economists" and for mentioning neither "the highly questionable belief in universal 'rationality' nor the 'efficient markets hypothesis.'"

A more focused criticism would, in my opinion, be more effective. The Queen was asking about the failure to foresee the financial collapse of last September, rather than about the health of modern economics in the large. That failure was I think due in significant part to a concept of rationality that exaggerates the amount of information that people have about the future, even experts, and to a disregard of economic factors that don't lend themselves to expression in mathematical models, or are intractable to formal analysis. The efficient markets theory, when understood not as teaching merely that markets are hard to beat even for experts and therefore passive management of a diversified portfolio of assets is likely to outperform a strategy of picking underpriced stocks or other securities to buy and overpriced ones to sell, but as demonstrating that asset prices are always an adequate gauge of value--that there are not asset "bubbles"--blinded most economists to the housing bubble of the early 2000s and the stock market bubble that expanded with it. In modeling the business cycle, economists not only ignored, because difficult to accommodate in their mathematical models, vital institutional detail (such as the rise of the "shadow banking industry," which is what mainly collapsed last September)--often indeed ignoring money itself, on the ground that it doesn't really affect the "real" (that is, the nonfinancial) economy. They also ignored key concepts in Keynes's analysis of the business cycle, such as hoarding and uncertainty and business confidence ("animal spirits") and worker resistance to nominal (as distinct from real) wage reductions in depressions. Lessons of economic history were ignored, too, leading to a belief that there would never be another depression, let alone a collapse of the banking industry. Even when the collapse occurred, in September, many macroeconomists denied that it would lead to anything worse than a mild recession; the measures that the government has taken to recover from what has turned into a depression owe little to post-Keynesian economic thinking; and the economists cannot agree on what further, if anything, should be done, and which of the government's recovery measures has worked or will work.

Besley and Hennessy's letter, when first published, was described in some quarters as a letter of "apology" by English economists. It was not that; nor is the August 10 letter--the latter is a denunciation of mainstream economics.

The notion of a profession's apologizing for its failure in a letter to the monarch is charming, however. It would be an apology to the nation, personified in its monarch. The English monarch does not exercise political power, but does personify the nation, and it is easier to write a letter to a person than to a nation.

The English economics profession failed the United Kingdom; the American economics profession failed the United States. Not that the profession should be equated to its macroeconomic and financial divisions. The study of business cycles is only a small part of modern economics. Other areas of economics bear significantly on the study of business cycles, such as labor economics, without being implicated in the failures of response to the current crisis. But the control of the business cycle had until the present crisis been regarded as a principal triumph of modern economics and justification for regarding economics as the queen of the social sciences. We have no monarch; the President is not a personification of the nation but rather the head of the national government; there is no one to write the letter of apology to. No matter. The urgent need is for the part of the profession that concerns itself with business cycles to acknowledge its inadequacies and reorient its training and research.  

I have been remiss in responding to comments, many very interesting, that I have received in the past six weeks. I hope that readers of this blog will read the comments as well. Although comments cannot be posted without my approval, I have approved all but a couple that were either irrelevant or unintelligible.

There are too many comments for me to be able to respond to each one individually, but I will note some points that deserve emphasis, and respond to a few individual criticisms.

I like the comment (by Indy, June 26) that analogizes higher reserve and capital requirements for financial firms that create systemic risk (that is, that could bring down the financial system as a whole if they went broke) to strict building codes for earthquake- and hurricane-prone areas. The problem, as the comment points out, is that if the first line of defense--the reserve and capital requirements--fails to avert a collapse (just as building codes can fail to prevent serious damage from an earthquake or a hurricane), there would need to be "tremendous discretionary powers vested in some agency to respond and shut down [risky financial] activities in order to forestall a crisis." Vesting any agency with such powers is problematic, especially the Federal Reserve (where the Administration wants to vest them) because it would undermine the Fed's properly prized political independence. The comment also suggests that if the agency drafts contingency plans to deal with a future crisis, those plans should be made public so that the business community knows where it stands and can plan accordingly.

In a July 5 comment, the same commenter (Indy) expresses skepticism (as did I) that the proposed consumer financial protection agency would "promote significant changes in behavior among consumers...It is one thing to say 'people should save more, spend and borrow less' and another to add 'and they "would' if only they were better informed in simplified, easy-to-understand ways." Indy adds that "observing the magnitude in which consumer saving, spending, and borrowing behavior has changed recently during the economic downturn (and without any significant change in the types of financial products offered or the manner in which they are marketed) leads me to believe that economic conditions matter much more than anything the proposed agencies and new authorities can do." I agree.

UjK points out (July 13) that consolidating federal regulatory agencies or abolishing the financing of such agencies by fees imposed on the regulated firms will not eliminate shopping for lax regulators as long as banks can continue to choose whether to be regulated by state or federal banking agencies. This argues for preempting state banking regulation, but that is a radical step that will not be taken--at least not until the next financial meltdown.

Indy (July 20) wishes to distinguish between macroeconomic theory and practice, arguing that the failure of the macroeconomists was not noticing what was happening in the housing market. That was a serious failure, but I think the theory itself is defective because of the neglect of Keynes's theory of the business cycle, which I discussed in a blog entry on July 27. That entry gave rise to several interesting comments about the Austrian theory of business cycles. Members of the Austrian school of economics, such as Friedrich Hayek, argued that depressions can arise from unsound monetary policy--a policy that forces down interest rates, creating an artificial boom. Obviously I am sympathetic to that argument. But my impression (no more than that) is that, at least in the 1930s and perhaps still, Austrian economists do not advice any interventions designed to stop a depression--they regard the depression as just punishment for the unsound policy that precipitated it. That seems to me to give too little weight to the immense costs that a depression can impose on a society. But I am no expert on the Austrian school, and invite correction.

Greg Ransom, in a July 28 comment, calls my suggestion that liberal and conservative macroeconomists ignored Keynes until the banking collapse of September of last year "not only false, it's ridiculous." He argues that the tax credits in the spring of 2008 were a Keynesian stimulus and that the Greenspan-Bernanke policy of low interest rates in the early 2000s were Keynesian. I disagree. I tried to explain that what passes for Keynesian theory nowadays (or at least until the crash of last September), left or right, bears little resemblance to Keynes's actual theory of the business cycle, which emphasizes the role of uncertainty, of fear or lack of confidence, of the hoarding of cash in lieu of productive investment, and of recovery through deficit spending on public works (which he believed produced a multiplier effect on income)--not tax credits or other transfer payments.

The debilitating effect of depression-induced uncertainty on economic activity is well expressed in the very next comment, by gman (July 28): "As a small business owner I can tell you that this [my summary of Keynes's theory] describes today's reality. Our most recent fiscal year ended with record sales and profits, but trended downward during the last six months. Both our customers and suppliers are doing the same thing as we are--waiting. As a consumer, I am doing the same thing. The uncertainty is tremendous. Will any short-term recovery be snuffed out by a rise in interest rates? As far as I'm concerned, the recovery doesn't exist until we see what happens to interest rates once demand for credit returns."

Indy (July 28) has a long comment criticizing the mortgage-relief program. It is persuasive, but too long to quote, so I merely remind readers interested in the program of the comment.

Another interesting comment by Indy (August 1) criticizes the "cash for clunkers" program. He (if it's a he, as I am guessing) points out (something I had missed, perhaps because I don't like old cars) that many of the cars eligible for the program are so old that they would probably have been traded in within the next couple of years even without the inducement provided by the program. He expresses concern that, in that event, there may be a plunge in sales in a year or two, at which event there may be pressure for a new "cash for clunkers" program, and so on ad infinitum. It is a danger with the overall stimulus program. As he puts it, if "spending does not accomplish the goal of changing investors' moods and consumers' behaviors, then it merely brought forward government demand by means of debt which has to be paid for eventually out of future consumption...Without changing behaviors, without being able to get there in the absence of huge and extraordinary government expenditures, and without any obvious future 'growth engine' in the economy to remedy the huge amount of unemployment, getting to 0 doesn't seem to be such a cheery occasion."

My blog entry of August 1--"When Does a Recession or a Depression End?"--provoked several comments, including one by anne on August 3 in which she tells me: "Come down from your ivory tower and you'll realize there isn't a single person on 'Main Street' who defines 'recovery' as jobless, or ties it to GDP. Most people outside of Washington and Wall Street define 'recovery' as becoming gainfully employed in a job that will show real increases in income over time, not in a job that provides stagnant wages over decades." But as Max (August 3) replies to anne: "Isn't that the point that Posner was trying to make? That the ivory tower economists aren't using 'recession' and 'depression' in ways that really reflect the impact the economy is having on ordinary people's lives?" Yes, it is my point.

Pwnce (August 4) says that my statement that "singling out a particular class of taxpayers for higher taxes will be highly resented and strongly resisted" (as in the suggestion of a 1 percent surtax on persons earning over a million dollars a year, to pay for the Administration's proposed health care program) "makes no sense" because all progressive income taxes by definition single out particular classes of taxpayers to pay higher taxes. That is correct, but I see a difference, if perhaps only in a greater appearance of class conflict, between altering marginal rates in a progressive income tax system and imposing a special tax on the wealthiest people.

A theme of my blog, as of my book "A Failure of Capitalism: The crisis of '08 and the Descent into Depression," which gives its name to the blog, is the failure of economists to anticipate or even imagine the possibility of the financial collapse of last September, or to agree on how to deal with the collapse. Government officials (many of them economists), business economists, economic journalists, and academic economists alike were, with rare exceptions, taken by surprise by the bursting of the housing bubble (they didn't know it was a bubble), the ensuing banking collapse, the stock market crash, the sharp decline in output and employment, the global scope of the crisis, and the onset of deflation in the late fall of 2008 that created fears of a depression comparable to the Great Depression of the 1930s. The reason for the surprise was that leading macroeconomists and financial economists had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted by the Fed's reducing the federal funds rate, that the international banking industry was robust, and that our huge national debt was nothing to worry about, nor our very low personal savings rate. All these beliefs have turned out to be mistaken, along with extreme versions of the rational expectations hypothesis, the efficient-markets theory, and real business cycle theory.

One of the most distinguished of these economists, Robert Lucas of the University of Chicago, a Nobel prize winner, has just published a short piece in the Economist magazine entitled "In Defence of the Dismal Science" (that is, of economics--dubbed the "dismal science" because of the pessimistic though insightful economic theory of Thomas Malthus).

Lucas argues that economists will never develop models that will forecast "sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September." The reason is the "efficient markets" theory, which teaches that the prices of financial assets impound the best information about their value. But Lucas's detour into efficient-market theory misses the point. The criticism (my criticism, anyway) of macroeconomists and financial economists is not that they failed to predict that the collapse of Lehman Brothers would lead to a fall in stock prices (they were already falling), but that they disbelieved in asset bubbles. (Eugene Fama, whom Lucas relies on for his remarks on the efficient-markets theory, has been explicit in his disbelief.) So they were not alert to signs that the rise in housing prices in the early 2000s was a bubble phenomenon. Also, because of a lack of knowledge of or interest in institutional detail (a lack that may reflect the increasing mathematization of economics), the economics profession did not understand the degree to which the banking industry (including nonbank banks such as Lehman Brothers) was invested in housing finance and would collapse along with housing prices when the bubble burst. The profession believed, moreover, that at the first sign of trouble the Federal Reserve could avert a serious recession by reducing the federal funds rate through the purchase of short-term Treasury securities from commercial banks. This belief turned out to be completely mistaken.

The efficient-markets theory shares with Lucas's distinctive contribution to macroeconomics--the "rational expectations" hypothesis--what appears to be an exaggerated belief in the knowledge and foresight of investors and other economic actors. Not that Fama or Lucas believes that markets are omniscient. The steep rise in oil prices in the wake of the 1973 war of Egypt and Syria against Israel had macroeconomic consequences, yet could not have been foreseen. But that is an example of an external shock. No external shock caused the fall in housing and stock prices and the collapse of the banking industry. The housing bubble, the risky capital structures of the banks, lax regulation, and the low personal savings rate were internal U.S. economic phenomena that had been building for many years. Neither the markets nor the economists foresaw the consequences.

Lucas argues that until the collapse of Lehman Brothers, the risk of a financial crisis was so small that to have recommended "pre-emptive monetary policies on the scale of the policies that were applied later on would have been like turning abruptly off the road because of the potential for someone suddenly to swerve head-on into your lane." That is a poor analogy. The probability of such a sudden swerve is too small to justify not driving. The financial crisis had been building since mid-2007 and had turned acute in March 2008 with the collapse of Bear Stearns, yet the Federal Reserve and most economists (including Lucas) did not believe that the risk of a financial collapse was serious. They didn't see a crisis that was swerving head-on into their lane.

Indeed, a few days after Lehman collapsed, Lucas expressed skepticism that the economy would slip into a recession. A few days before the collapse he had expressed skepticism that the subprime mortgage crisis would contaminate the entire mortgage market. Even though he disbelieves in forecasts, he was making forecasts, and they were erroneous.

Lucas says in his article in the Economist that the Federal Reserve saved the day by pumping cash into the banking system and persuading the Treasury Department to do likewise. He does not mention the other measures taken by government. He praises Ben Bernanke, the chairman of the Fed, for having "formulated contingency plans ready for use when unforeseeable shocks occurred." In fact the Fed had no contingency plans for the housing and stock market shocks that rocked the economy. Its response when the shocks hit with full force last September was prompt, but also improvised and spasmodic--hence the failure to bail out Lehman Brothers, a failure that deepened the financial crisis by seizing up the commercial paper market.

That was one blunder Bernanke made, and there are others, none of which Lucas--who is unstinting in his praise of Bernanke--mentions. Nouriel Roubini, while urging Bernanke's reappointment as Fed chairman, notes (in "The Great Preventer," in the New York Times of July 25) that Bernanke "supported flawed policies when Alan Greenspan pushed the federal funds rate...too low for too long and failed to monitor mortgage lending properly, thus creating the housing and credit and mortgage bubbles"; "kept arguing that the housing recession would bottom out soon"; "argued that the subprime problem was a contained problem when in fact it was a symptom of the biggest leverage and credit bubble in American history"; "argued that the collapse in the housing market would nto lead to a recession"; "argued that monetary policy should not be used to control asset bubbles"' and "attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the finanical systems played." These mistakes are surprising, since Bernanke is the leading economics student of the Great Depression of the 1930s.

Robert Lucas, because of his distinction, and because of his famous (or should it be notorious?) statement in 2003 that macroeconomists had solved "the central problem of depression-prevention" and should move on to other subjects, contributed to the economics profession's, and the government's, complacency about the vulnerability of the economy to severe crashes, and contributed also to deflecting economists from improving their understanding of the risks of economic instability.

But the mistakes of Lucas and Bernanke and Fama and other leading macro- and financial economists should not be regarded as personal failings. The three I have named and others I could name really are brilliant economists. Their mistakes largely reflect the inherent difficulty of the economic issues with which their specialized fields of economics wrestle. This is important to understand so that we do not exaggerate the contribution that the economics profession, at least as constituted and oriented at present, can make to averting economic calamity.