Saturday, December 21, 2013

Robert Solow Reviews Alan Greenspan's Recent Book

Robert Solow is a Nobel Prize winning economist.  He is gifted with the ability to express complex and difficult to understand ideas simply and with precision.  Alan Greenspan was Chairman of the Federal Reserve for 19 years.  Over that period he played a powerful role in determining the path of the US economy.  His reputation was severely damaged by the financial crisis which he helped to make possible.  His book is an attempt to restore his damaged reputation.  Robert Solow gives him credit for dealing admirably with two crises that occurred on his watch.  He then turns to the faults that he finds in Greenspan's book, and they are revealing.  For example, Greenspan argued that the payments that are made to social welfare programs reduce savings which are required for investment.  This aligns Greenspan with those who favor a reduction in social welfare programs.  Solow explains why Greenspan is wrong to infer a causal relationship between social welfare payments and lower savings and investment.  He also shows that savings do not necessarily result in investment.  Corporations are rich in cash, and interest rates are at an historical low, but business investment has been weak.  Greenspan believes that the lack of investment is due to fears about government regulation.  Solow believes that businesses invest when they need to expand their capacity in order to satisfy growing demand.  Greenspan's belief about the lack of investment reflects his bias against government regulation.  Clearly, a business that did not increase capacity to satisfy growing demand would not be around very long.  The same fate would befall a business that invested under conditions of weak demand.  Solow's explanation is more consistent with the operation of real businesses.

Greenspan also argues that income inequality is not a real problem.  He believes that individuals are compensated for their marginal contribution to production.  It would be unjust, and a distortion of the efficiency of the market system, to redistribute income.  Efficient markets provide an optimum level of social welfare.  Solow does a better job of destroying that argument than any that I have seen.  It is worth reading his review of Greenspan's book to see how he destroys the myth of Pareto optimization of social welfare.

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