Affiliation Drives Theory

Quantitative Easing became sensible because Ben Bernanke did it; Postwar economics arose to justify FDR

In How People Choose Beliefs, I cited Oliver Traldi’s idea that people choose some of their political beliefs based on their trust in charismatic political leaders. One might assume that he is talking about the uneducated masses. But I can think of instances in which economics gravitated toward theories that justified the actions of charismatic individuals.

Quantitative Easing Explained*

Ben Bernanke started grad school a year or two ahead of me. So did Paul Krugman.

Suppose that back then someone had said, “I am starting a book discussion group (not focused economics). I am looking for nice, intelligent men and women. Who among the econ grad students at MIT would be charming to have in the book club?”

With the word “charming,” the first person to come to mind would have been Bernanke. Krugman would have been last.

I think that this helps explain why the quantitative easing undertaken in 2008 is treated in mainstream economics as a creative and necessary addition to the central banker’s toolkit. We want to affiliate with Ben. If Ben was afraid that we were headed to another Great Depression without dramatic policy moves, then we should believe him. If he thought that we needed quantitative easing, then we should adapt macroeconomic theory accordingly.

Suppose that in 2007 you had asked leading macroeconomists the following two questions:

(1) What, if anything, can the central bank do to fight a recession when short-term interest rates drop to zero?

(2) If the central bank injects reserves into the banking system but pays interest on those reserves to discourage banks from increasing lending, what will be the impact on the economy?

The answer to (1) would have been that the central bank can inject money by purchasing long-term government bonds, corporate bonds, equity, or foreign exchange. There are plenty of ways to conduct stimulative monetary policy when short-term interest rates drop to zero. Ben himself had joked about dropping currency from a helicopter.

The answer to (2) would have been that paying interest on reserves effectively neutralizes the injection of reserves. To a first approximation, such a policy (which came to be called quantitative easing) will have no macroeconomic impact.

I think that if someone less charming than Ben Bernanke had undertaken the same policies, the answers to those two questions would have carried more weight. Economists might have homed in on the way that quantitative easing served as a bailout for fragile banks. Research would have wrestled with the question of how the result of a bank bailout compared with a hypothetical alternative of a conventional monetary expansion.

Instead, since 2008 most macroeconomic research has been written to try to build theories under which Bernanke’s policies were a salve to the economy as a whole, not just the big banks. I do not think he really wants such sycophantism, but he can’t help but attract it.

*Borrows from the title of a terrific YouTube cartoon.

Roosevelt’s Economists

Going back farther in history, I would suggest that the economic consensus that emerged after World War II was a response to the charm of Franklin Roosevelt. Roosevelt was groping for a “third way” between small-government capitalism and Communism. His policies veered from the corporatist (the National Recovery Administration and the “Blue Eagle”) to the populist (Social Security).

Paul Samuelson, Robert Solow, and others built an economic framework around Roosevelt’s improvisations. Their set of theories and policy prescriptions, unlike Roosevelt’s, was coherent. I believe that they strongly wanted the country to follow in Roosevelt’s footsteps. In this regard, they were like many other Jewish intellectuals of that era.

In the 1930s, many well-educated Jews in the West were attracted to Communism. My aunt Sarah and my mother (until she met my father) were among those.

But others, including many economists, saw Communism’s dark side. My father, who was not an economist, was typical of the anti-Communist left. He became a committed supporter of Roosevelt.

Although many in the Roosevelt Administration were indifferent to the plight of the Jews in Europe, and his policies regarding refugees from the Holocaust were callous, Roosevelt could nonetheless appear to be a friend toward Jews. This was a politician, after all, who held together a coalition that included both the nascent Negro Civil Rights movement and the “solid south” of segregationist Democrats. In any case, Jews looked on Roosevelt as a gallant savior at a time when this country seemed to be inundated with a flood of anti-Semitism , most notoriously from Father Coughlin. I see Samuelson and Solow as coming out of this Jewish intellectual pro-Roosevelt milieu.

When it came to adopting Keynesian deficit spending, Roosevelt was timid and hesitant. But Samuelson handed Roosevelt’s successors a powerful intellectual defense of deficit spending. He expressed great fear that demobilization after World War II would throw the economy back into depression. Although this proved wrong, his textbook taught a generation of college students the virtues of Keynesian budget deficits.

Keynesian economics was supposed to help stabilize the economy. The government would run small deficits to offset declines in private investment, and it would run balanced budgets or small surpluses otherwise. As it turned out, deficit spending became chronic, because politicians have come to see Keynesian economics as a license to buy votes with what seems like free money. In the event, macroeconomists have raised few protests.

Samuelson and Solow also made maximum use of the neoclassical production function (NPF). Where Marxists depicted capital exploiting labor, the NPF purportedly shows how labor and capital each come to be rewarded according to its contribution to output.

Previously, Wassily Leontief, Solow’s teacher and a Marxist, had deployed input-output analysis, in which the marginal products of labor and capital are undefined. In standing up for the NPF, Solow was rebelling against his mentor. Solow and Samuelson also fought a long battle (the Cambridge Capital Controversy) with Marxist-adjacent British economists over the meaning and uniqueness of the marginal product of capital.

Ironically, I would say that the NPF shares with Marxism an overly simplistic division of productive factors into capital or labor. In fact, “labor” is highly heterogeneous, ranging from the unskilled worker washing dishes in the back of a restaurant to the lowly assistant store manager to the software engineer to the specialized surgeon. And economists have spent the last fifty years adding modifiers to the word capital: human capital, social capital, network capital, brand-awareness capital, and on and on. I think that the NPF has been oversold empirically, deployed by proponents who claim far more precise knowledge of the trends and determinants of productivity than the data can support.

Finally, Samuelson and his followers tried to develop a theoretical framework that could encompass Roosevelt’s many random economic interventions, emanating from the alphabet soup of agencies that he created. For this purpose, they elaborated on the theory of public goods, market failure, and the Social Welfare Function. The SWF, a supposed mathematical tool for the government to optimize policy, eventually came up against the Arrow Impossibility Theorem and Lipsey and Lancaster’s Theory of the Second Best. But the dominant theme of mainstream economics continues to be interventionist.

Of course, prior to FDR, there were economists in the progressive movement. And Keynes was a champion of government spending on public works well before The General Theory appeared. But I would go so far as to suggest that FDR had far more influence on economics than the other way around. The technocratic road that most economists now take arose from their desire to explain, justify, and standardize the interventionist approach that was characteristic of a charming, improvisational leader.