Krugman’s No April Fool’s Joke — Unfortunately

April 26, 2011

by Mario Rizzo

I have been on an enforced vacation by the failure of my previous laptop. Now that I have access to my old files, permit me to begin where I left off at the beginning of April. The topic is of “eternal” significance.

In an April 1st (print edition) opinion article Paul Krugman complained about the revival of so-called Mellonism. This is the idea that liquidation of over-expanded industry and a fall in prices and wages will somehow re-generate economic activity after a recession has begun.As Krugman duly notes, it is unclear that President Herbert Hoover’s Secretary of the Treasury Andrew Mellon had anything to do with this vague idea and even what his putative rationale was. Nevertheless, Krugman believes that Mellonism is still with us, some eighty years later.

But one thing is clear to any informed economist. The issue in pre-Keynesian economics was not whether prices and wages in general should fall or whether a large number of enterprises should fail. Keynes liked to summarize the “classical” position as allowing (encouraging?) the general fall in wages and prices to revive economic activity. While there was a basis for the view in the work of A.C. Pigou and some others, this was not representative of the major tradition.

What many contemporary economists do not see is that pre-Keynesian economics was not macro-economics in the current sense. The largest school of thought based on the traditional understanding of Say’s Law was that business cycles were characterized by sectoral  disproportionality. (Austrians should note that the Mises-Hayek-Wicksell theory was not unique in that  respect.)

Wesley Clair Mitchell made this point in Business Cycles: The Problem and Its Setting (1927) in connection with the classical rejection of theories of general overproduction or general insufficient demand.

To most of the classical economists, the theory of general overproduction was a heresy, which they sought to extirpate by demonstrating that the supply of goods of one sort necessarily constitutes demand for goods of other sorts. But maladjusted production they allowed to be possible, and their brief references to crises usually aimed to show how production becomes maladjusted through the sinking of capital in  unremunerative investments. They often held that such misuse of capital was one result of “the tendency of profits to a minimum.” When the current rate of profits has fallen to an unaccustomed level, the less sagacious capitalists, become dissatisfied and embark on ill-considered schemes. There result the production of goods for which no market can be found, business failures, and loss of confidence—in short, a crisis which extends over all lines of trade. (p. 8, emphasis added)

The Harvard economist Frank W. Taussig who wrote a widely used economics textbook in the pre-Keynesian era was clear that the nature of crises was to be found in sectoral maladjustment. In the 1921 edition of his textbook, Principles of Economics, he says:

We have already noted the successive division of labor: the marshaling of different stages in the processes of production. Thence ensues an interval, often long, between the first stages of production and the final emergence of the consumable commodity. Thence comes the possibility of mistake and maladjustment, and also the possibility that themaladjustment will not be promptly ascertained. Here is one great cause of the industrial crisis, – ill-adjusted production. (vol.1, p.403, emphasis added)

The upshot of all of this is the Mellonism is not a serious economic doctrine held by the majority of the “classical” economists (in either in the nineteenth century or in the early twentieth century). It functions in Krugman’s world view as a useful caricature – shall I say a strawman? – to draw attention away from the allocation problems in recessions and to emphasize the promiscuous fiscal-stimulus approach to solving current economic problems. Why else bring it up?

The truth is that pre-Keynesian economics was, in most ways, more sophisticated than the aggregate demand framework bequeathed to us by Keynes and his official interpreters.

Therefore, it is wrong to infer that before Keynes economists believed in widespread liquidation of enterprises and general reductions in prices and wages as a “cure” for depressions. However, the reasonable implication of the then-dominant view was that some industries were, in fact, over-expanded as a result of the boom period’s excesses. And wages and prices in those affected sectors would have to fall in relative terms. This, however, is nothing strange from the economic point of view. If there are sectoral imbalances, how else can they be remedied?

13 Responses to “Krugman’s No April Fool’s Joke — Unfortunately”


  1. I’ve always thought it strange that the idea of sectoral imbalances should only be thought up in the early 20th century.. Thanks for the history lesson.

    Question: Given the more pedestrian nature of aggregate analysis over the more complex, and more accurate analysis of sectoral adjustments, what do you think caused the majority of economists to become Keynesians if they were influenced by Taussig and his generation?

  2. Daniel Kuehn Says:

    re: “The upshot of all of this is the Mellonism is not a serious economic doctrine held by the majority of the “classical” economists (in either in the nineteenth century or in the early twentieth century). It functions in Krugman’s world view as a useful caricature – shall I say a strawman? – to draw attention away from the allocation problems in recessions and to emphasize the promiscuous fiscal-stimulus approach to solving current economic problems. Why else bring it up?”

    The article didn’t seem to say pre-Keynesian economists adopted Mellonism. The article seemed to say that politicians today are adopting Mellonism (like many politicians in Mellon’s time). You frame this as Krugman against the economists, when it seems to me to be Krugman against the politicians.

  3. Mario Rizzo Says:

    Mattheus,

    In fact, sectoral-imbalance theories go back to the 19th century.

  4. Mario Rizzo Says:

    Daniel,

    You may be right about Krugman. But I am not sure because this is a common caricature of the price-flexibility viewpoint.

  5. Martin Says:

    It seems to me that the disagreement between Keynes and the Classicals was then that the Classicals did not recognize that this re-balancing was accompanied by a general decline in prices. Keynes, I believe, did not disagree with the Classicals on the rebalancing, but on the necessity of having this accompanied by a general decline in prices. Viewed in that light, the Keynes caricature of the Classics seems justified.

    I believe Hayek (later?) called this phenomenon the secular deflation of general prices and considered it to be harmful as well?


  6. Is there a possible policy that would foster relative price reduction in the overexpanded sectors without affecting sectors that are “just about right”?

    I understand that there is a difference between saying there is a need for an all across the board cut and saying that a few sectors relatively received too much investment. But wouldn’t the result of the implied policy proposal of matching, or at least matching more closely savings and investment, affect pretty much all sectors across the board? If so, Krugman’s description isn’t so far from the truth…

  7. bill butos Says:

    Nice post, Mario. Your post is entirely consistent with Hayek’s assesment -going back to his review of the Treatise on Money and repeated later on that Keynes’s fixation on aggregates precluded the fuller and correct understanding of market forces. I like to refer to Keynes’s aggregative approach as the “flat tire” theory of macro: when the tire gets flat (i.e., recession), just pump more air into it. The premise, which flies in the face of pre-Keynesian sensibilities, is that recessions are due to a generalized deficiency of aggregate demand with the corresponding policy recommendation that a uniform expansion of the tire will solve the problem.


  8. Nonsense. All markets, however measured, continuously fluctuate about an arbitrary “equilibrium.” If your Supply-Demand curves were plotted in three dimensions, the equilibrium would be a squiggly sinusoid in the Z-axis XY-plane.

    The problem is that some markets attract more attention by people with high social status. Economists advise governments.

    Ahead of the Great Recoinage, Locke and Wren served on a committee of notables who attempted to “solve” the problem. Gratefully, no such committee met to wring their hands over the production of ale, the import of lapis lazuli, or the thatching of roofs.

    So-called booms and busts or “sectoral imbalances” are always transient and transitory. They have become pervasive because the government, both as a huge player, and also as the only one with a gun, forces us to live by its horoscopes and tea leaves.

    The so-called “Long Depression” was a time of exciting discoveries, wonderful inventions, and expanding opportunities. There was no “readjustment” necessary. The current Great Recession is a different story, entirely.

  9. chidemkurdas Says:

    There may be something else behind Krugman’s harping on this point. In his statist view, government action substitutes for market adjustments. So he does not favor price reductions as a way of getting rid of excesses. Indeed, this is partly what happened in the past few years, for instance in the housing market, where Fannie, Freddie and other agencies propped up prices.


  10. […] Mario Rizzo, who’s written a number of great posts on contemporary macroeconomic thought: The truth is […]

  11. srp Says:

    Why is there such resistance to the idea that part of the problem during downturns is a coordination problem caused by specialization? Specifically, my optimal output of product X depends on what I expect your output of product Y to be (with duals for the employment of labor and capital). If you don’t produce much, then I won’t be able to trade very much with you; if fewer workers are employed, there will be fewer people to buy my output. So there are likely to be multiple equilibria of aggregate production across all goods X, Y, Z, etc.

    This is isn’t the only mechanism operating during downturns, by a long stretch, and the reallocation problems focused on here are also important, both in terms of causing and in terms of prolonging the downturn in resource employment. And different downturns work differently–this one clearly did not start with any kind of general coordination failure as described above and its maintenance seems to me to be less due to that problem than many previous downturns. But the stubborn denial that this general coordination problem exists at all seems…excessive.

  12. paul e. Says:

    The sectoral balance approach has attracted plenty of modern macroeconomists (remember, Krugman is not a macro guy, his specialty is international trade, so its understandable he is not up to speed, though he shouldn’t misrepresent himself as an expert). We have James Hamilton in 1988 (A Neoclassical Model of Unemployment); Long and Plosser in 1983 (Real business cycles); Fischer Black (Exploring General Equilibrium); Caballero and Hammour (Cleansing Effect of Recessions);
    Acemoglu (Cascades and Volatility 2010), Gabaix and Canales (2010). There’s also empirical work by Davis and Haltiwanger.

  13. Mario Rizzo Says:

    Thank you! (Neither am I a macro guy.)


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