Contra Krugman II

I generally agree with Paul Krugman, so it is exiting that I am outraged by something he wrote (I’ve calmed down now).

Paul Krugman says that scratchpads are useful. They are sloppy easy models which are not taken seriously. Or maybe which shouldn’t be taken seriously, but it’s not a big problem that many powerful people take them literally. I lose my temper.

IS-LM isn’t the prime example of a scratchpad. What is?

The answer is, supply and demand.

It is not easy to derive supply and demand curves for an individual good from general equilibrium with rational consumers blah blah. And it’s definitely not easy to justify consumer and producer surplus as measures of welfare. And there have always been some purists who condemn any use of the S and D curves we all grew up with, the use of triangles to measure welfare loss, and all that.

But for the most part nobody pays attention. The supply-and-demand framework is so convenient, while pretty much getting at what you want to get at, that it’s what almost everyone uses to get a first-pass analysis of economic issues.

Which is perfectly fine as long as you keep the limitations of the scratchpad in mind.

No it isn’t !!! It is perfectly fine so long as you and all the people who read or skim what you right keep the limitations in mind. What is in, say, Krugman’s mind can’t protect us from people who don’t have those limitations in their mind.

Before I really get going, I note the first example of a scratch pad IS-LM. Here many people (including Jeff Sachs) think Krugman argues that fiscal stimulus is always a good approach to disappointing growth. In fact, Krugman argues that monetary policy is better except when the economy is in a liquidity trap. Policy makers forgetting what Krugman remembers but doesn’t always stress about the limitations of IS-LM will lead to trouble. The fact that Krugman knows what Krugman thinks won’t protect us.

OK so he also has some use for supply and demand curves. Here there is a problem. Economists know that the assumed slopes of curves based on utility maximisation is just one possibility. Basic micro includes the explanation of substitution effects and income effects. But policy makers generally act as if there are no income effects. The fact that economists know about them doesn’t make policy better.

The thing which outraged me (I’m calm now) is the reference to the sum of consumer and producer surplus as a measure of welfare. This makes sense so long as the distribution of income has no effect on welfare. Of course Krugman doesn’t think that or else he wouldn’t have written the post immediately below. The idea that inequality is not a negligible problem should not be confined to purists. The idea that economic analysis and economic efficiency are based on consumer surplus plus producer surplus is extremely powerful and damaging.

What economists keep in mind doesn’t matter much. What matters is what is in policy makers’ minds. The habit of treating consumer plus producer surplus as welfare while keeping the fact that it isn’t in mind has done vast damage.