Three events shook the U.S. economy to its foundations during the past two decades, each different in nature but with a common lesson for investors and policy makers: Listen to the skeptics.
China’s emergence as a world trading power in the early 2000s; the world financial system’s near collapse from bad mortgage debt in the late 2000s; and the re-emergence of inflation after Covid: In each case, a reasonable voice warned ahead of time that trouble was coming, and in each case that skeptic was widely dismissed by the economics profession and others. If the warnings had been taken more seriously, perhaps the world would look a little different today.
The lesson emerges in a biography I have written of Janet Yellen, the Treasury secretary, former Federal Reserve chair and former chair of the White House Council of Economic Advisers. No person has been on the bridge of the ship at as many consequential moments in modern economic history, making her career a unique window into a turbulent era.
Consider the case of China, which was welcomed by the U.S. into the World Trade Organization in 2001 with strong support from the economics profession.
By the late 1990s most mainstream economists were convinced by the theory of comparative advantage — the idea that both sides win in a free trade agreement — and that warnings of job loss from trade opponents were overwrought. The U.S. had opened trade to Mexico and the economy flourished in the 1990s, delivering fast growth, low unemployment, low inflation, record high stock prices, accelerating worker productivity and budget surpluses.
Economics professors from the right and the left of the political spectrum, including Yellen as CEA chair to Bill Clinton and as an academic economist, urged Washington policy makers to finish a deal with China.
The skeptic in this case, Harvard Professor Dani Rodrik, wrote a book asking, “Has Globalization Gone Too Far?” In it, he warned that free trade helped educated, mobile workers, but was leaving less skilled workers behind and in the process was creating dangerous social division.
In interviews and his subsequent writing, Rodrik recalled one leading trade theorist, Paul Krugman, refusing to endorse the findings of the book because Krugman feared it would enable nationalists who he saw as “barbarians.”
“The economists had become advocates rather than analysts,” Rodrik said later.
Research has since shown that a flood of imports from China led to millions of U.S. job losses and intensified backlash against globalization. Had Rodrik’s warning been taken more seriously, the U.S. might have developed more robust programs to help those workers hurt by trade, or it might have more aggressively enforced rules meant to prevent Chinese manufacturers from flooding U.S. markets with disruptively cheap imports, or it might have taken the whole process more slowly.
About a decade after Rodrik, the skeptic on the outside was the International Monetary Fund’s chief economist, Raghuram Rajan, who was also a business professor at the University of Chicago’s business school. He warned in a 2005 paper delivered to central bankers in Jackson Hole, Wyoming, that financial market innovation might be endangering the global banking system by giving firms more opportunities to hide and amplify risk.
The speech was sacrilege at that time. He delivered it at a conference honoring Fed Chairman Alan Greenspan, whose view that banks were adept at regulating themselves, prevailed in the economics profession. Lawrence Summers, then president of Harvard University, called Rajan’s premise luddite and misguided. The banking system nearly collapsed three years later.
Yellen was president of the Federal Reserve Bank of San Francisco at the time. She saw warning signs of dangers sooner than many others at the Fed, but she acknowledged later she hadn’t been able to stop it.
Ironically, in the latest flare up of inflation, Summers has played the role of skeptic rather than that of the dismissive consensus. Last year he warned that floods of federal stimulus designed to lift the economy after the Covid outbreak might instead yield inflation. Many economists saw this as unlikely, given that the U.S. was about two decades into a period of very low inflation and had only recently escaped a decade of painfully high unemployment.
“The best thing we can do is act big,” Yellen told Congress.
The point here isn’t to knock Yellen, as much as to highlight the value of challenging one’s assumptions.
Yellen made her biggest mark in economics in the decade after the 2007-2009 financial crisis, when she played a leading role pushing the economics consensus in a new direction. In that case, she correctly forecast low inflation and urged her colleagues at the Fed to move aggressively to bring unemployment down.
The strategy appeared to have worked in that case. During her four-year term as Fed chair, which ended in 2018, the unemployment rate dropped from 6.7% to 4.1%, the consumer price index averaged 1.3% and the exchange rate of the dollar rose against other currencies.
It’s not easy to know when to listen to skeptics and when to judge that their arguments are just noise. Some economic skeptics are like broken clocks, warning of the same problem over and over again for years or decades, and then declaring victory when a problem eventually appears. Others are loud or defiant for the attention or the notoriety.
Rodrik and Rajan didn’t fit the description. They were low-key people. Summers is outspoken, but he is no broken clock. Each of the three can be called reasoned skeptics, because they seem to have come to their conclusions with some reservation. In the years before warning of inflation, Summers had popularized the idea of “secular stagnation,” which hinged on the notion that inflation was too low, not too high.
As economist Paul Samuelson once said, “Well, when events change, I change my mind. What do you do?” Samuelson, who later attributed the words to John Maynard Keynes, ironically was the uncle of Summers.
Yellen seems to have internalized the lesson, too.
“You have to remain alert to really understanding the facts on the ground and what makes a particular episode different than what you’ve encountered in the past,” she told me.
Taking her observation one step further, it helps to remain alert to the skeptics, and asking oneself from time to time: Do they have a point here?
Jon Hilsenrath is a Wall Street Journal economics writer. This column is adapted from his book, “Yellen,” to be released by HarperCollins Nov. 1.