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More bookblogging

September 20th, 2009

I’m starting now on what will I think be the hardest and most controversial chapter of my book – the argument that the search for a macroeconomic theory founded on (roughly) neoclassical micro, which has been the main direction of macro research for 40 years or so, was a wrong turning, forcing us to retrace our steps and look for another route. As always, comments and criticisms accepted with gratitude.

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Micro-based macro

We are now all Friedmanites, Lawrence Summers, (former US Treasury Secretary, now Director of the White House’s National Economic Council, and prominent New Keynesian economist) and

At the end of the 19th century, British Liberal politician Sir William Harcourt observed “we are all socialists now”. Harcourt was referring to a radical land reform measure that had been denounced as socialist when it was introduced, but was generally accepted by the time he was speaking (a couple of years later). Harcourt’s point was applicable to the whole trend of economic and social policy, in Britain and elsewhere, from the 1867 Reform Bill that gave millions of working class men the vote (women had to wait until after World War I) to the crisis of the 1970s. From progressive income taxes to publicly-owned infrastructure services (both prominent items in the 10-point program of the Communist Manifesto)) ideas that were unthinkable in mainstream politics became issues of political contention and then established institutions.

As a pithy summary of the way ideas that were once radical become acceptable, and are ultimately embodied in conventional wisdom, Harcourt’s quip has never been bettered. As a result, it has been reused many times over.

One of the most notable adaptations of Harcourt was that of Time Magazine in 1965, which noted, following the successful use of fiscal policy to stabilize the economy that “we are all Keynesians” now. This statement was made by Keynes’ greatest modern critic, Milton Friedman (though he later said it had been taken out of context). Even more famously, it was repeated by Richard Nixon in 1971.

But whereas Harcourt was speaking at the beginning of a nearly a century of reform that did indeed take economic policy in a socialist, or at least social-democratic direction, Nixon’s statement marked the end of the era of Keynesian dominance.

In fact, Nixon was citing Keynes’ aversion to the gold standard (a “barbarous relic”) as a justification for abandoning the pegging of the US dollar to gold, which was a central feature of the Bretton Woods system of fixed exchange rates that had underpinned Keynesian economic management since World War II. The outcome was not a system of stable exchange rates backed by a basket of commodities rather than gold, as Keynes had proposed, but the complete breakdown of Bretton Woods and a shift to the floating exchange rate system advocated by the greatest critic of Keynesian economics, Milton Friedman.

In the course of the 1970s, Friedman and his supporters, centred on the University of Chicago, won a series of political and intellectual victories over the Keynesians. Following the failure of attempts to stabilise the economy using Keynesian fiscal policy, governments around the world switched to Friedman’s preferred remedies based on controlling the growth of the monetary supply. Even though this did not work particularly well, and was later replaced by policies based on managing interest rates, the resurgence of the Chicago School was not reversed. Their case against government intervention, both to stabilise the macroeconomy and to address market failures in particular industries, was widely accepted.

The Keynesians conceded Friedman’s central points: and that macroeconomic policy can affect real variables, like the levels of employment and unemployment, only in the short run. They sought to develop a ‘New Keynesian’ economics, by showing that, given small deviations from the competitive market assumptions of the basic neoclassical economics model, it would be possible to explain the recurrence of booms and recessions and to justify the modest stabilisation policies pursued by central banks during the Great Moderation. Because prominent representatives of this group were located at Princeton and Harvard on the East Coast of the US, and at Berkeley on the West Coast, they were sometimes called the ‘saltwater school’ as opposed to the ‘freshwater school’, located in the lakeside settings of Chicago and Minnesota.

Members of the freshwater school sought to push Friedman’s conclusions even further, arguing that macroeconomic policy could not be beneficial even in the short run. They tried to show that government intervention could only add uncertainty and instability to the economic system, and that, in the absence of such intervention, economic fluctuations like booms and slumps were actually good things, reflecting economic adjustments to changes in technology and consumer tastes. The resulting models went by various names, but the most popular was ‘Real Business Cycle Theory’.

Despite their often heated disagreements, saltwater and freshwater economists were in agreement on one fundamental point: that macroeconomic analysis must be based on the foundations of neoclassical microeconomics. And, although they disagreed about economic policy, these disagreements could be contained within a very narrow compass. With a handful of exceptions, both schools took it for granted that macroeconomic management should be implemented through the monetary policies of central banks, that the only important instrument of monetary policy was the setting of short-term interest rates and that the central goal of monetary policy should be the maintenance of low and stable inflation. Granting these premises, saltwater economists argued that stability could only be achieved if central banks paid attention to output and employment as well as inflation, while the freshwater school favored an exclusive focus on price stability.

The global financial crisis did not so much confirm or refute the elaborate arguments of the competing schools as render them irrelevant. The saltwater school could claim vindication for their view that the economy is not inherently stable, but their models had little to say about the kind of crisis we have actually observed, driven by an interaction between macroeconomic imbalances and massive financial speculation.

The freshwater-saltwater disputes were similarly irrelevant to the policy debate which was conducted in terms that would be familiar to someone who had not looked at an economics book since 1970. (In fact, the freshwater side of the dispute rapidly reverted to arguments from the 19th century, which had been debunked by Keynes and Irving Fisher).

As Gregory Clark of UC Davis observed ‘ The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.’

If we are to develop a macroeconomic theory that can help us to understand, and hopefully prevent the recurrence of, crises like the current one, and help us to improve policy responses, economics must take a different road from that it has followed since the 1970s. The appealing idea that macroeconomics should develop naturally from standard microeconomic foundations must be recognised as a distraction. In its place, we must accept, in the language of systems theory that macroeconomic phenomena are emergent, arising from complex interactions of behaviors we do not fully understand, but must nevertheless respond to.

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  1. Ernestine Gross
    September 30th, 2009 at 18:26 | #1

    Freelander @50,

    What you call ‘externality’ in sentence 1 would be called ‘interdependent preferences’ possibly with reciprocity in economics. These are well defined concepts in mathematical economics, particularly in the game theory area.

  2. Freelander
    September 30th, 2009 at 18:55 | #2

    @Ernestine Gross

    Maybe but some things are done in mathematical economics and game theory are done for mathematical convenience. As for ‘interdependent preferences’ this, the eye of the beholder thing, does not require this. Think, for example, two individuals whose (identical) ‘choice sets’ are changed (identically) by another person’s actions (other than through on ordinary market exchange with them, also excluding pecuniary externalities). Assume the preferences for individual A are such that the change to their set matters to them, either because it provides more preferred options or eliminates the existing most preferred option(s). For individual B with different assumed preferences, the change to their ‘choice set’ is irrelevant because the change involves inclusion or exclusion of choices they would never make. A experiences an externality and B doesn’t. Moreover, some externalities are forced in that they do not involve choice, an example here is CO2 in the atmosphere. Here whether it is an eternality or not depends on your preferences towards the impacts of the CO2. If you don’t care, no externality for you. If you do, theirs your problem. Moreover, as you can’t really know what other’s preferences or feelings really are, you can only infer them, in the case of ‘interdependent preferences’ the reaction to a human rights abuse or to an act of charity is knowledge of the acts (or presumed knowledge if you are a sceptic). This means that it doesn’t really rely on a dependence of one individual’s preference on another individual’s preferences. Further, you could even object to human right abuse in a situation where you know the person suffering the abuse likes it but you object to the abuse regardless of the attitude of the abused.

    Lastly, there are several other economist who, for example, look at charity as providing positive externalities.

  3. Ernestine Gross
    October 1st, 2009 at 05:40 | #3

    Freelander, it seems to me you are making a case for the convenience of words to blur and you are good at it.

  4. Freelander
    October 1st, 2009 at 05:59 | #4

    @Ernestine Gross

    No. The point is that when modelling assumptions are made,sometimes they are made for tractability. That is why you have to be the master of a model rather than the slave which has been a problem for some economists.
    As for words, I like clarity, and as a sage once said “It all depends on what the meaning of ‘is’ is.” And again Lewis Carroll had the same attitude to words that I have to models.

  5. Ernestine Gross
    October 1st, 2009 at 07:23 | #5

    Freelander @50, p4

    If you believe you made the point you say you made, then so be it. I can’t accept it. But this doesn’t matter.

    Glenn @42, p3

    The challenge you set for economists is a version of what one of the great economists has described as follows:

    “Competent economists are the rarest of birds…The master-economist must possess a rare combination of gifts…He must be mathematician, historian, statesman, philosopher — in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.”

    We owe this job description to John Maynard Keynes and the situation hasn’t changed since he wrote it nearly a century ago. Source: http://www.standpointmag.co.uk/node/2164/full.

    I don’t claim to have all this qualities. So I start with something simpler.

    The Tragedy of the Commons. The survival of the eco-system (in an evolutionary sense) is, to the best of my knowledge, acknowledged to be of interest to economics at the philosophical and basic theoretical level where economics is concerned with the material (as understood by natural scientists) welfare of humans. The definition of ‘externalities’ by Blad and Keiding, which I cited, is more general then may appear from the verbal description, once it is made precise in an explicit theoretical model of an economy. However, having said this, I also acknowledge that the method of ‘internalising externalities’, which I’ve briefly outlined, cannot deal with the complex information structure you mentioned. At present, one approach in theoretical economics, which I find quite interesting, consists of models that explain the evolution of diverse traditions. A simple example of a tradition that deals with a negative externality is the eating of crunchy apples in public. It is discouraged – or at least it used to be. Another example is diverse agricultural practices. Appropriate traditions would simplify the informational requirement for individual decision makers. But what is appropriate surely is not to be left to economics for that would require each economist to have the aggregate knowledge of all humans. So, at least for now, I don’t think a prescriptive approach is appropriate for economics.

  6. Glenn Tamblyn
    October 1st, 2009 at 22:35 | #6

    @Ernestine Gross

    Ernestine

    “But what is appropriate surely is not to be left to economics for that would require each economist to have the aggregate knowledge of all humans. So, at least for now, I don’t think a prescriptive approach is appropriate for economics.”

    The judgement of ‘What we should do?’ is not simply the domain of Economists. However Economics and Economists are some of the principle players in the provision of analysis and information on which answers to that question are based. And Economics as a profession does have a duty of care when its insights are applied by others. A doctor may tell you that taking some paracetamol will ease your pains. If they do not also advise you about the fact that taking too much paracetamol in one day may cause liver damage they have failed in their duty of care. In fact the doctor has a responsibility to not just tell you this, but to take all reasonable steps to ensure you understand.

    And I am not suggesting it is up to any individual Economist. Rather it is the responsibility of the whole profession.

    As for “I don’t think a prescriptive approach is appropriate for economics”. Unfortunately, Economics is prescriptive by its very nature. This may not be the intent of its practitioners, but it most definitely the reality for your clients. You are the Shamen, reading the bones. And the tribe hangs on your every word to decide whether we should go hunting tomorrow.

    So perhaps one thing Economics needs, as a profession, is to reassess the nature of its role in society and take on a professional structure more akin to Medicine.

    As I said in my previous post, the world needs the insights of a ‘Quantum Mechanics of Economics’. I believe Humanity is in the early stages of its Crisis of Survival, and, like it or not, Economics is one of the disciplines at the epicentre of understanding our problems. All Care, No Responsibility may not be good enough. The world needs you guys.

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