Refuted economic doctrines #9: Real Business Cycle Theory

Yet another in my series of articles on economic theories, empirical hypotheses and policy programs that have been refuted, or undermined, by the Global Financial Crisis. This one, on Real Business Cycle Theory, is a bit econowonkish, but I’m putting it up here because
(a) I hope some econowonks among the readers might find errors and correct me
(b) Judging by some other recent commentary, RBC still has some interest.

* As indeed, they have. My suggestion of a link between calibration and the GMM has been roundly refuted both here and at Crooked Timber. I can only say, it seemed like a good idea at the time. Thanks for the very useful comments on this point, and on RBC more generally.

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Refuted economic doctrines #8: US labor market superiority


According to the latest data, the unemployment rate in the US was equal to that in the EU-15 in March, and is now likely to be higher. Writing in the NY Times, Floyd Norris refers to the conventional wisdom that flexibility inherent in the American system — it is easier to both hire and fire workers than in many European countries implies that unemployment should be lower (at any given point in the business cycle) in the US than in Europe.

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Refuted economic doctrines #6: Central bank independence

The idea that central banks can and should act independently of governments is, fairly clearly, inoperative for the duration of the crisis in many countries. The combination of massively increased liquidity provision and large-scale bank bailouts requires close co-ordination between central banks and national treasuries, though the form of this co-ordination is inevitably different in different countries.

But the failure of central bank independence goes much deeper than this. The underlying idea was that monetary policy should be left to independent experts, and should be the main tool for macroeconomic stabilisation. Governments were expected to avoid active fiscal policy, focusing primarily on maintaining budget balance (there were some differences in view as to whether governments should target annual balance, or balance over the course of the macroeconomic cycle). The shift to independent central banking was closely associated with the adoption (implicit or explicit) of inflation targets as the primary focus of monetary policy, and with interest rates as the primary tool.

Not much of this appears sustainable in the light of the crisis. Inflation targeting failed to prevent unsustainable asset price booms, and it now seems clear that these could not have been prevented without much more direct control over unsound financial innovations. That’s a task where interaction between governments and central banks appears unavoidable. On the one hand, expertise is crucial. On the other hand, as with war, financial innovation is to important, and too dangerous, to be left to finance experts.

The idea that monetary policy alone is sufficient for macroeconomic stability might have looked appealing during the Great Moderation, but does not stand up when examined over a longer period. To put it bluntly, central bank independence appears to work well except when it is most needed.

A more difficult question relates to the separation between monetary policy and prudential regulation. The need to take systematic risk into account suggests that monetary policy must be closely integrated with prudential policy. On the other hand, Australia, with a clear separation between monetary and prudential regulators has done better than countries where central banks are more closely involved. My feeling is that the correct separation is between strategic issues, such as monitoring of systemic risk and the regulation of financial innovations, which belongs with the central bank, and institution-level supervision, which belongs with a specialist agency.

Refuted economic doctrines #5: Trickle down

The idea that policies favorable to the wealthy, such as financial deregulation and favorable tax treatment of capital income, will ultimately benefit everybody has been described, pejoratively, as ‘trickle down’ economics.

The same idea been summed up, more positively, in the aphorism ‘a rising tide lifts all boats’ attributed to John F Kennedy, and a favorite of  Clinton advisers such as Gene Sperling and Robert Rubin. (It should be noted that this phrase is also used in the context of debates over free trade and over the effects of macroeconomic expansion. While it generally implies that we should focus on expanding aggregate income without too much concern over distribution, it is less sharply focused than the ‘trickle down’  pejorative.

Whatever you call it, trickle down economics is one of the casualties of the financial crisis. I’m not the first to point this out, and I’m sure I won’t be the last, but here’s a piece summing up my thoughts.

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Refuted economic doctrines #4: individual retirement accounts

The news that, on average, superannuation investments lost nearly 20 per cent of their value last year Johnny Got His Gun movie download comes as no surprise, and its likely that there are plenty of unrealised losses still on the books. Still, while the losses on the stockmarket have been as bad here as anywhere, we can take some comfort in the fact that Australian superannuation funds, like Australian banks, don’t seem to be in the same trouble as some of their overseas counterparts. As the government scrambles to keep the financial system operational, it’s natural to ask what, if anything can be done about this.

In the short term, the answer appears to be, nothing, or very little. Fortunately, for most people the losses are, in a sense, notional, wiping out the spurious gains of previous years. It’s only for those at or near retirement that the crash presents an immediate economic problem. Given that the demand for labour is plummeting, the government could perhaps consider an ex gratia payment to people who choose to retire now. There are all sorts of problems with this, and in normal times, such a proposal would never pass muster, but plainly, these aren’t normal times.

Looking to the longer view, this is more than a bad year for superannuation funds. The crash and the way it came about undermines the fundamental premise that has driven Australian retirement income policy for the past decade: that allowing individuals, with good financial advice, to make their own investment decisions on the basis of defined contributions from employers to personal accounts, is the best way of financing retirement. The old age pension, in this view, serves as a residual for those who don’t manage to save enough.

This privatised approach (also represented in Bush’s failed attempt to reform Social Security in the US) is has been largely discredited by the crash. Financial advisers, even the honest ones, have proved to be useless. Lots of investments that were marketed as low-risk have turned out to be little more than junk. Morover, the idea that stocks will always perform better than bonds over the medium term (say a decade) has been proved false. This is a central premise of long-term investment advice.

We need to look again at the alternatives: either a return to employer-based defined benefit schemes, with portability of service, or some kind of national superannation schemes. In the short term, the call for an increase in the aged pension will also gain strength.

Update 27/1/09 The New York Times agrees. And today’s Fin has a piece from Robert Shiller denouncing the efficient markets hypothesis. I’d better get cracking with more refutations, while there are still plenty of doctrines left to refute.

Refuted economic doctrines #3: The Great Moderation

The “Great Moderation” is a phrase coined by Ben Bernanke in 2004 to describe one particular interpretation of evidence showing that the volatility of output has declined over time in the US and other developed countries (though not, by then, Japan). Bernanke starts by citing the work of Blanchard and Simon, who offer both a different view of the evidence and a different explanation. Blanchard and Simon say that output volatility has been declining since the 1950s (fn: reliable national accounts don’t go back before WWII, but obviously output volatility was very high in the 1920s and 1930s), with an interruption in the 1970s and 1980s. However, they note that the data could also be interpreted as having a single structural break in the mid-1980s, and this is the view of the evidence taken by Bernanke.

A variety of explanations have been put forward for the Great Moderation. To the extent that the Moderation has been seen as more than a run of good luck, it has typically been explained either by a combination of improvements in macroeconomic management associated with central bank independence and reliance on monetary rather than fiscal policy and the benefits of economic liberalism, as in this piece by Gerard Baker

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smoothe out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s. It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even if the recession ends by mid-2009, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, if a deep recession is avoided in 2009, this will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.

Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.

Refuted economic doctrines #2: The case for privatisation

This is the second in a planned series of posts assessing the implications of the global financial crisis for the economic ideas and policies that have been dominant for the past few decades. The large-scale privatisation of publicly-owned enterprises both in capitalist countries like the UK and Australia and in formerly communist countries after 1989 played a big role in promoting the kind of triumphalism that characterised much commentary about free-market capitalism in the 1990s and (to a somewhat lesser extent) in the years leading up to the crisis. How well do arguments for privatisation stand up in the light of the financial crisis.

The case for privatisation had two main elements. First, there was the fiscal argument for privatisation, namely, that governments could improve their financial position by selling government business enterprises. This argument assumed that privately owned firms would have higher levels of operating efficiency, and therefore that the value of those firms would be increased by privatisation. The second argument was a dynamic one, that the allocation of capital between alternative investments would be improved if governments were not involved in the process. Both of these arguments have been fatally undermined by the collapse of the efficient markets hypothesis.

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Refuted economic doctrines #1: The efficient markets hypothesis

I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago

), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.

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Refuted/obsolete economic doctrines #7: New Keynesian macroeconomics

I’m writing a review article about Akerlof and Shiller’s new book, Animal Spirits. In doing so, it struck me that I had most of a new entry for my list of refuted economic doctrines, except that the target this time has not been refuted so much as rendered obsolete by events. I’m talking about New Keynesianism an approach to macroeconomics, to which Akerlof and Shiller have made some of the biggest contributions, but which they have now, on my interpretation, repudiated.

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Bookblogging: Privatisation – Beginnings (updated)

I’m on the final chapter of my long-promised Zombie Economics, dealing with ideas refuted by the Global Financial Crisis. My target this time is privatisation – more precisely, the idea that privatisation will always yield an improvement over public ownership, and, therefore that market liberalism is an advance on the mixed economy that developed in the during the post-1945 long boom.

As always, comments, criticism and suggestions much appreciated.

Updated In response to comments, I’ve added a bit more material on the 1970s and the background to privatisation.

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