Posted 2:13 PM by Robert

Hair Doktorprofessor: Ape And Essence

Kevin Drum has been criticized recently - especially by Steve Verdon - for aping Paul Krugman. But in today's column, Paul Krugman apes Kevin Drum - without essential improvement. One is reminded of a striking image from the Huxley novel.

The tale begins back in early September of this year, when Lehman Brothers issued a press release regarding what was described as "Damocles," a proprietary early warning system to identify the likelihood of countries entering into financial crises. The press release included a curious acknowledgement that Damocles deliberately omits what it authors consider to be the "biggest risk" in the very subject Damocles is supposed to model:

"Looking beyond the current ambit of Damocles, perhaps the biggest risk to the emerging market economies at present stems from the developed countries, many of which are exhibiting large economic imbalances. .... that would set Damocles' alarm bells ringing." Most conspicuous of these threats is the United States, where any financial crisis could cause considerable spillover effects to the rest of the world.

Damocles' lead author cautioned: "Damocles should be used but not abused ... it must be embedded in a broader analysis..." Media coverage has indeed been widespread but nonabusive. The Nation magazine ran an article based on the release. Other media broadly reported on Damocles. Calpundit quoted this passage from the article on Damocles that finally appeared on October 2 in Economist:

When Lehman ran America's economic numbers through Damocles, the outcome was striking. With its rapidly climbing current-account deficit and foreign debt, among other worries, America's Damocles index is just shy of 75. There are, points out Russell Jones, the bank's international economist, problems applying Damocles to America, which enjoys the luxury of having the world's reserve currency. Granted. Poorer countries tend to owe dollars, and therefore suffer when their currencies fall. Lucky America, of course, owes its own currency.

Today Damocles fell belatedly into under the pen of Herr Doktorprofessor Paul von Krugman, and the abuse feared by Damocles' makers has begun.

As a preliminary matter, Steve Antler has already pointed out that Herr Doktorprofessor misrepresents Damocles as an "economic model," where it is an index (Lehman Brothers terms it "a proprietary early warning system," not a model) - and has other interesting things to say about Herr Doktorprofessor's use of the Lehman work.

But Herr Doktorprofessor's abuse of Damocles is deeper and more serious. He begins by frankly misquoting the authors to exaggerate the exceptional position of US. The press release refers to the developed world where many countries are exhibiting imbalances "that would set Damocles' alarm bells ringing." Most conspicuous of these threats is the United States, where any financial crisis could cause considerable spillover effects to the rest of the world.

This passage is not saying that the United States is most conspicuous because it is most at risk - the passage is saying that the United States is most conspicuous because a US financial crisis could cause greater "spillover effects" than a crisis in one of those other "many" developed countries with imbalances.

But in Herr Doktorprofessor's column this passage becomes :

[A]pplying the same model to some advanced countries "would set Damocles' alarm bells ringing." Lehman's press release adds, "Most conspicuous of these threats is the United States."

So "many countries" becomes "some advanced countries," and the reference to the "conspicuous" United States eliminates the part of the sentence that makes clear that the "conspicuousness" relates to the extent of the consequences of a crises, not the likelihood of a crisis.

But, as all too usual with Herr Doktorprofessor, it gets worse.

Lehman regards the "problems" applying Damocles to the United States and other developed countries as very real and important qualifiers, but Herr Doktorprofessor invites his readers to minimize their significance:

O.K., let's run through some reassuring counterarguments.

First, economists are very good at devising models that would have predicted past crises, but each new crisis tends to happen where and when they didn't expect it. So even though our budget deficit is bigger relative to the economy than Argentina's in 2000, and our trade deficit is bigger relative to the economy than Indonesia's in 1996, our experience needn't be the same.

Second, ... America's burgeoning foreign debt is in our own currency.

Finally, financial markets are generally willing to give advanced countries the benefit of the doubt. ...

Third world countries typically suffer from institutional weaknesses. They have poor corporate governance: you can't trust business accounting, and insiders often enrich themselves at stockholders' expense. Meanwhile, cronyism is rampant, with close personal and financial links between powerful politicians and the very companies that benefit from public largesse. Luckily, in America we don't have any of these weaknesses. Oh, wait. . . . (Isn't that all history? No. According to The Wall Street Journal, we are again hearing warnings that "optimism is based on massaged earnings.")

Aside from distorting the Damocles authors' warning by minimizing the degree of difference they indicate for the United States condition, Herr Doktorprofessor fails to present - never mind answer - the basic question: From an empirical standpoint, why do the Damocles authors think there are problems in applying Damocles to the United States?

The press release states that Damocles is based on a sample of past crises. That is a normal way of testing economic theories. That there are "problems" in applying Damocles to the United States suggests that Damocles overpredicts "financial crises" when applied to the United States - and other developed countries - on the basis of past historical information. Herr Doktorprofessor doesn't ask, but doesn't it matter if Damocles' alarm rings when it is fed US data from, say, the 1980's or 1990's?

It is just absurd to suggest - as Herr Doktorprofessor does - that American problems with corporate governance, business accounting, insider self-enrighment through fiduciary breach, cronyism, regulatory capture and government/industry collusion are remotely as serious as those of, say, Indonesia, China or other developing countries. Moreover, financial crises are strongly correlated to insufficietly free markets - which is not generally considered to be a serious feature of the United States.

But the most peculiar aspect of Herr Doktorprofessor's column is its reliance on a cartoon:

But at a certain point we'll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

Really? Even granting the significance of every one of Herr Doktorprofessor's assumptions, why isn't it more much likely that world financial markets will respond to mounting American imbalances with mounting resistance to the Dollar and US investments? Yes, a "plunge" might happen, but it's unusual. The Euro sank against the Dollar, and then the Dollar against the Euro. Earlier, the Pound gradually lost it's role as a true "reserve currency" and Britain ceased to be a true economic superpower. There was no "plunge" in either case. That's normal. Herr Doktorprofessor thinks the United States has cronic problems. But if that's true, the world financial markets should respond with corresponding cronic, increasing resistance to American problems.

So why must we at some time see a sharp fall in the dollar and a sharp rise in interest rates?

Herr Doktorprofessor says its because that's the way it happens to the Coyote in the Roadrunner cartoons.

MORE: Don Luskin has lots more very good analysis.

STILL MORE: From Hoystory.

AND STILL MORE: Excellent material from Antler.