Classical economics and recession in many countries (wonkish)

Sharp tests of economic theories are rare and hard to find, particularly in macroeconomics. Any examination of particular episodes in economic history necessarily involves counterfactuals, and these provide room for endless dispute. As an obvious example, assessing the impact of the Obama Administration’s 2009 stimulus requires an estimate of how things would have gone without the stimulus, and that is obviously hard to do.

Similarly, arguments about unemployment in the US get bogged down in disputes over whether it is structural or demand-driven and the extent to which policies such as the extension of unemployment benefits to 99 weeks have contributed. 

There is, though, one way in which the current Great Recession/Lesser Depression provides a sharp test of a critical proposition in economics. All forms of classical economics involve, in one form or another, the claim that the causes of unemployment are to be found in labour markets, and not in  macroeconomic variables such as the level of aggregate demand. That’s equally true of the Say’s Law version of classical economics criticized by Keynes, the New Classical macroeconomics of Robert Lucas and the attempts by Real Business Cycle theorists like Kydland and Prescott to explain cyclical fluctuations in terms of labor market shocks.

The crucial problem for all these theories is that labor markets and the associated institutions operate mainly at the national level. Even within the EU, different countries have very different labor markets. So, it is essentially impossible for labor markets in many different countries to move together, except as the result of macroeconomic influences operating at an international level[1]. That means that the occurrence of a sharp and sustained increase in unemployment, taking place in many countries at once, is inconsistent with classical economics.

This point seems trivially obvious, but as far as I can tell hasn’t been made, or at least not clearly. Once it’s conceded, it seems impossible to avoid a view of the world that is basically Keynesian in its analysis of the macroeconomy.  It is possible to hold such a view and reject Keynesian policies on pragmatic grounds, as in Friedman’s critique of ‘fine-tuning’. But the longer and deeper the recession the harder it is to sustain this view.

This seems like a good time to plug the fact that a paperback edition of Zombie Economics will be out soon (May 6) with a brand-new chapter on Austerity, bits of which have been seen here. On 9 May, I’ll be launching an Australian edition, where the added material is a chapter on Economic Rationalism. And a week or two ago, I received some copies of the Italian edition

http://www.stampa.unibocconi.it/articolo.php?ida=9724&idr=6

 

 

 

 

 

 

 

 

 

fn1. Of course, you can cheat and label these macro influences “technology shocks”, then assume them to be internationally correlated. But in the ordinary meaning of technology, there is no plausible way in which economies as disparate as, say, the US and Greece can experience a common technology shock.

95 thoughts on “Classical economics and recession in many countries (wonkish)

  1. Johnathan Portes is very perceptive.

    Karl Popper said, cruelly but accurately, of Marxism:
    [it] is no longer a science; for it broke the methodological rule that we must accept falsification, and it immunized itself against the most blatant refutations of its predictions. Ever since then, it can be described only as nonscience—as a metaphysical dream, if you like, married to a cruel reality.
    He then likens this to Austerity types at present. Steve Kates comes to mind when one reads the line.

    Keynes approved of Austerity but at the right time like Australia now not Europe, UK or the US . Austerity at the wrong time merely increases the budget deficit and public debt.

  2. JB Cairns, Thomas Humphrey wrote an excellent 250 year long literature survey of the rules versus discretion debate in the 1998 Richmond Fed Quarterly.

    He wanted to know if macroeconomics was a progressive science in the sense that superior new ideas relentlessly supplanted inferior old ones.

    Humphrey found that:
    • Keynesian ideas and their many antecedents gain currency when unemployment was the main concern.
    • Monetarist ideas tended to reign when price stability was the main problem.

    The policy debate keeps recycling because
    1. people forget the lessons of the past and
    2. For better or worse, politicians and the public tend to believe that central banks, the focus of his studies, have the power to boost output, employment, and growth permanently.

    Humphrey showed that stable policy rules are popular in good times to contain inflation, and when unemployment was rising, discretionary policies returned to policy vogue.

    Humphrey concluded that doctrinal historian knows that much of what passes for novelty and originality in monetary theory and policy is ancient teachings dressed up in modern guises.

    Haberler, Jacob Viner and frank knight also all pointed out in their reviews of the General Theory that it lacked originality, and presented old ideas, often incorrectly, in confusing new vocabularies that made the book difficult to read.

  3. @Jim Rose

    The summary you give from Sunstein is pretty good. Being a conspiracy theorist and believing that conspiracies occur are not inevitably the same thing. It’s the use of conspiracy as a theory of society or its major political faultlines that is decisive in marking something out as a conspiracy theory.

    Sunstein is right in noting the overestimation conspiracy theories make of the competence and discretion of officials, bureaucracies and others. More broadly, conspiracy theories locate events within metanarratives — commonly metaphysical ones — that stretch across decades and even centuries, imposing themselves onto the conduct of people who have never met and did not even live at the same time. Most ingeniously, all events have a “Morton’s Fork” quality about them, since apparently anomalous behaviopur by parties to the conspiracy are seen as mere instants of some even more overarching narrative — the game within the game. This makes them unfalsifiable. All of human history is reduced to one coherent narrative, rather than the product of human conflict.

    The problem is of course that if everyone is on the same page — wittingly or otherwise, one might wonder why apparent conflict would be needed at all. The whole point of actual conspiracies is to gain an advantage againts some rival — which means there must be rivals — i.e. people who are not parties to the conspiracy.

  4. Jim,

    Keynes had it right. Most of the time you let monetary policy be the main lever in economic policy. It is only when it doesn’t work ( I would add impaired) that you use active fiscal policy.

    Type in Hard Keynesianism on this blog and get a better understanding.

    As Farrell and Quiggin show when you move away from from that you get problems.

    Classical economics has a problem in that there are no successful examples to observe.

    This is not surprising as Classical economics is pro-cyclical.

    By attempting to keep the budget in balance no matter where in the cycle a country is you will exacerbate the business cycle.

    If a country has a slowdown and attempts to keep its budget in balance then it mist mean it is tightening policy because it cuts structurally. After-all in cyclical terms there is an easing.

    So a slowdown becomes a recession.

    On the other hand as the economy is strong any attempt to keep the budget in balance will mean a structural loosening.

    Booms and busts!!

  5. when the classical policy rules applied prior to 1929, most governments were little more that a post office and a military. government spending would have struggled to get into the mid-teen double digits of GDP.

    the threat of inflation to implicitly repudiate debt was more real.

    during the period from 1870 to 1914 adherence to the gold standard was a signal of financial rectitude, a good housekeeping seal of approval, that facilitated access by peripheral countries to capital from the core countries of western Europe.

    countries with poor records of adherence were charged considerablym ore than those with good records

  6. @JB Cairns

    However, statements like “let monetary policy be the main lever” are more poetic concepts than say – adjusting interest rates, selling bonds and currencies etc.

    But the real problem is not Keynesian responses to ‘boom and bust’, but the fact that this is a temporary fix that is incomplete and passes the problem onto the next generation. While this would be obvious in a closed economy, not even open economies are immune. Over decades the general instability expands and expands. See:

    http://tinyurl.com/capitalist-crisis

    We now inhabit a world dominated by looming unemployment, at least 100 trillion dollars of excess ‘money’ and population and climate pressures – the result of excessive lusts for growth.

    All this reality in the 21st century – when those like Nicholas Kaldor claimed in the 1930’s they were developing policy that could “mitigate economic instability” and Samuelson claimed we could escape boom and bust. Anyone can paper over instability if you hand out dollars to capitalists and increase the population. This is a temporary fix that necessarily ratchets.

    I know our Keynesians are feeling a bit smug at the moment as the predicted inflation has not stormed across Western economies. They still think they can:

    redevelop Keynesian economics in a way that overcomes these failings

    presumably by a ‘mixed economy’ where you mix public and private, or so the story goes.

    This just ain’t so. This is mixing non-profits with capitalist enterprises – lambs with dingos.

  7. @JB Cairns

    However, statements like “let monetary policy be the main lever” are more poetic concepts than say – adjusting interest rates, selling bonds and currencies etc.

    But the real problem is not Keynesian responses to ‘boom and bust’, but the fact that this is a temporary fix that is incomplete and passes the problem onto the next generation. While this would be obvious in a closed economy, not even open economies are immune. Over decades the general instability expands and expands. See:

    http://tinyurl.com/capitalist-crisis

    We now inhabit a world dominated by looming unemployment, at least 100 trillion dollars of excess ‘money’ and population and climate pressures – the result of excessive lusts for growth.

    All this reality in the 21st century – when those like Nicholas Kaldor claimed in the 1930’s they were developing policy that could “mitigate economic instability” and Samuelson claimed we could escape boom and bust. Anyone can paper over instability if you hand out dollars to capitalists and increase the population. This is a temporary fix that necessarily ratchets.

    I know our Keynesians are feeling a bit smug at the moment as the predicted inflation has not stormed across Western economies. They still think they can:

    redevelop Keynesian economics in a way that overcomes these failings

    presumably by a ‘mixed economy’ where you mix public and private, or so the story goes.

    This just ain’t so. This is mixing non-profits with capitalist enterprises – lambs with dingos.

  8. @Jim Rose

    Where precisely did Frank Knight point out in his review of:

    the General Theory that it lacked originality, and presented old ideas, often incorrectly, in confusing new vocabularies that made the book difficult to read.

    .

  9. Knight reviewed the general theory in the canadian journal of economic sin 1937.

    classical macroeconomics was very familiar with business cycles and deflation. most obviously, from postwar resumptions of convertability such as in the UK in 1821, 1879 and 1925.

    see Classical deflation theory by Thomas M. Humphrey at http://ideas.repec.org/p/fip/fedrwp/03-13.html and
    Getting pegged: comparing the 1879 and 1925 gold resumptions by Tamim Bayoumi and Michael D. Bordo

  10. “In this chapter and throughout the book, his references under this phrase are, in general, the sort of caricatures which are typically set up as straw men for purposes of attack in controversial writing.

    I mean, of course, that that is the way in which they impress me. In the great majority of cases the doctrines so labelled seem to be quite at variance with, and often contradictory
    to, anything I was ever taught as classical doctrine in any modern sense—and I went through the academic “mill”; and they are certainly alien to anything I have ever taught as
    such, and I have been rated, and have supposed myself, an adherent of the general type of position referred to by the term.

    many of Mr. Keynes’s own doctrines are, as he would proudly admit, among the notorious fallacies to combat which has been considered a main function of the teaching of economics. ”

    Frank Knight 1937.

  11. Jim

    Just what sort of growth rate would satisfy Lucas and co? RGDP grew 11% in 1934, 9% in 35, 13% in 36 and 5.1% in the recession year of 37 before hitting the wall in late 37. The continuing high unemployment was a product of the 45% drop in income between 29 and 33. Rising productivity during a recovery should not be a surprise.

    The rise in real wages during the recovery was nowhere near as damaging as the drop in nominal income during the slump. Falling income reduces the private sector’s ability to service pre-existing debt. The higher the debt level the bigger the problem.

    Sorry Jim Lucas, Ohanian and co are off the mark. Quite staggeringly so.

  12. @sdfc

    “Falling income reduces the private sector’s ability to service pre-existing debt. The higher the debt level the bigger the problem.”

    Exactly. And non-service of debt – default – results in discontinuities somewhere in the system. (This is not obvious in models which do not have a financial sector or models which exclude, by design, the possibility of default.)

  13. @Jim Rose

    Your sources do not substantiate your statements w.r.t. Knight. However Keynes ‘vocabularies’ is an issue. However the GT was original.

    It is not clear what your project is – Are you engaging in an Austrian criticism of Keynes?

  14. thanks Fran, yes, conspiracy theorist’s attribution of great competence and discretion to politicians, bureaucracies and others is amazing.

    Their ability to uncover the secret plot without investigative resources is more amazing.

    The police, crime and anticorruption commissions take years of careful detective work.

    Watergate was uncovered because of rather indiscreet conspirators doing brazenly clumsy things. Even then, the investigation was several years long. the current UK phone tapping scandal is another example.

    The air of corruption can be thick before any evidence is found worthy of going to trial.

    Hong Kong had to invent the crime of having unexplained earnings in the 1960s to break the back of police corruption, as I recall. Article 20 of a UN Convention defines the offence of “a significant increase in the assets of a public official that he or she cannot reasonably explain in relation to his or her lawful income”

  15. Chris, the Knight quote was a cut and paste.

    as for Harbeler, consider his 1938 letter to Keynes:

    “As regards the quotation from your article in the first sentence of my note to which you object I should like to say this: I understood you to have promised not to use the term classical economist any more, because it covers a multitude of different views; the admission, in other words, that what you called the `classical theory’ covers a number of heterogeneous propositions–erroneous ones in your opinion–carries with it, I thought, the promise not to call all these different views indiscriminately `classical’.

    In this assumption I am evidently mistaken, and I have accordingly changed the first paragraph of my note as indicated on the enclosed paper.”

    the links also notes that

    “In a recent contribution to this Journal, Mr Keynes admitted the validity of Mr Robertson’s complaint that his condemnation of classical economics is tantamount to “shying at a composite Aunt Sally of uncertain age”

    see http://economia.unipv.it/~dbesomi/haberler/output/Haberler.b9.html

  16. chris, another nice quote from a Haberler letter to Keynes:

    “I am glad that you interpret `classical economist’ now in such a broad sense. If Hawtrey, Robertson, Ohlin are not classical economists, then Wicksell isn’t one either, nor Pigou in his Industrial Fluctuations, and not even Marshall in many passages.

    Everybody is then classical and non-classical at the same time.

    In business cycle theory Say’s Law is quite out of place and there is no doubt that cycle theory has more and more encroached upon general economic theory, relegating full-employment equilibrium to a special case.

    On your definition I do not regard myself as an adherent of the classical school.

    It seems to me that the difference between your theory and of writers which you call classical, is still smaller, if a number [of] purely verbal misunderstandings are removed–of which an almost complete collection is contained in Mr Kahn’s paper on my book.

    There is one further point: Would you agree that an equilibrium with involuntary unemployment is incompatible with perfect competition in the labor market?

    If namely competition there were perfect, money wages would fall all the time so long as unemployment existed and any conceivably desired level of liquidity could be reached.

    If that could be agreed upon–and I think you say it yourself in a later part of your book–most classical economists would agree with you, because nobody denies that unemployment can persist, if money wages are rigid.”

    See http://economia.unipv.it/~dbesomi/haberler/output/Haberler.bb.html#pgfId=2972

  17. @Ernestine Gross

    Ernestine says; “Exactly. And non-service of debt – default – results in discontinuities somewhere in the system. (This is not obvious in models which do not have a financial sector or models which exclude, by design, the possibility of default.)”

    By implication, Ernestine is saying that valid models of the economy must include the financial sector and financial sector operations including defaults. Again, I agree. By further implication, heterodox economists like Steve Keen, who are trying to model the economy with financial system elements in it, would appear to be on the right track. Now, Steve Keen claims that orthodox equilibrium models ignore the money system and financial system. I do not know if Steve Keen is correct in this assertion. Keen goes further and claims he is modelling dynamic disequilibria whereas the orthodox “neoclassical” models (attempt to) model only a static equilibrium. Again, I am not widely read enough to know if Keen is setting up the mainstream “orthodox neoclassical” position as a simplistic homogenous (mono-culture?) straw man or not.

    Others more widely read and educated in economics may be able to enlighten me on these points.

    More broadly, I would say this. Four Australian academic economists whose views I have some awareness of and some understanding of (however slight) are John Quiggin, Ernestine Gross, Steve Keen and Bill Mitchell. However, strongly these economists might disagree on certain points empirical, practical and theoretical (and the disagreement would be very strong on some issues), I suspect they would be unanimous on the issue that pro-cyclical budget policy of the kind now proposed by Wayne Swan (seeking a surplus when the economy is slowing, employment growth is weak to non-existent and inflation is tamed) is anathema to good economic policy and real economic outcomes. I think they would also agree that at a point of private debt overload and net deleveraging (taking spending out of the economy) then public spending (deficits) is necessary to ameliorate and reverse the recessionary pressure.

    Why are Wayne Swan and the Gillard government too obtuse to see this or admit it when all the more credible economists can see it? What is driving this pro-cyclical “austerity” stupidity? Professional economists (academic or business) can you answer these questions?

    It is terribly frustrating even as a non-qualified, non-entity “lay economist” to see this rank stupidity holding sway in public policy. It must be much more frustrating for well credentialled professional economists to see all their well-funded prescriptions ignored.

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