I’m adding a little section to each of the chapters in my Zombie Economics book called “Reanimation”, about the attempts that are already under way to revive economic ideas killed (at least according to the standard rules of hypothesis refutation) by the global crisis. I wasn’t surprised to find plenty of examples for the efficient markets hypothesis (easy to render immune from any kind of refutation by an appropriate formulation) or for policy ideas that yield big benefits to the rich and powerful, such as privatisation and trickle-down economics. But I was surprised a little while ago to see the crisis described as a transitory blip in the continuing Great Moderation. Still that pales into insignificance compared to this piece by Casey Mulligan of Chicago (h/t commenter Daniel ), in which (I swear this is true!) the crisis is the result of financial markets correctly anticipating the adverse labour market impacts of possible legislation under Obama, such as a health plan that might include means tests.
The crucial point in a good zombie movie is the moment when zombies who seem to have been blasted into the next world by the hero’s shotgun, pull themselves up from the ground and come shambling forward. In the writing of this book, that moment came for me when I read Casey Mulligan’s paper ‘Aggregate Implications of Labor Market Distortions: The Recession of 2008-9 and Beyond’
Looking at the way real business cycles theorists have tried to write the Great Depression out of macroeconomic history, presenting instead as a government-induced dislocation of labour markets it was obvious that, sooner or later, something similar would be attempted with the Global Financial Crisis. But, Great Depression revisionism did not take hold until the Depression had faded out of living memory, to the point where hardly any economists who had actually experienced it were still active.
I thought a similar process of fading memory would be required for the GFC. As long as the subprime fiasco, and the chaos of late 2008 remained vivid memories, it would be impossible to deny that this was, indeed, a crisis made in the financial markets.
I underestimated the speed and power of Zombie ideas. As early as Sep 2009, Casey Mulligan was willing to claim that the entire crisis could be explained in terms of labor market interventions. According to Mulligan, financial markets anticipated a variety of measures from the Obama Administration, observing ‘Arguably, the 2008 election was associated with an increase in the power of unions to shape public policy, and thereby the labor market. Congress has considered various legislation that would raise marginal income tax rates, and would present Americans with new health benefits that would be phased out as a function of income.’
This is truly impressive. So perspicacious are the financial markets, that even the possibility that Congress might raise taxes, or incorporate a means test in health care legislation that might be passed some time in the future (at the time of writing this in Feb 2010, the bill was still tied up) was sufficient to bring down the entire global financial market. And, even though the McCain-Palin ticket was widely seen as having a good chance (at least before the September 2008), the markets didn’t wait for the election returns to come in. Applying some superstrong version of market efficiency, market participants predicted the election outcome, applied Mulligan’s neoclassical model to the predicted policies of the Obama Administration and (perfectly rationally) panicked.
There is one problem with Mulligan’s neat explanation. Writing in October 2008, when the crisis had already erupted and when Obama’s victory was virtually assured Mulligan had this to say about proposals for economic stimulus
So, if you are not employed by the financial industry (94 percent of you are not), don’t worry. The current unemployment rate of 6.1 percent is not alarming, and we should reconsider whether it is worth it to spend $700 billion to bring it down to 5.9 percent.
This piece, which got the endorsement of his Chicago colleague, Freakonomist Steven Levitt, doesn’t even mention the possibility that a Democratic Congress might raise taxes, or that the health plan that was a central plank of candidate Obama’s platform might include means test. Yet he now claims that these possibilities (still hypothetical as of 2010) caused a massive increase in unemployment, the anticipation of which caused the crash!
H/T Brad DeLong