For heterodox economists
In my first post on the heterodox/mainstream divide, I suggested that there sometimes seemed to be a blanket rejection of mainstream economics by the heterodox, equivalent to the de facto rejection of heterodox economists by most of the mainstream. As someone who is both supportive and critical of mainstream macroeconomics (i.e. I believe it has strengths and weaknesses), I found this attitude disconcerting.
But impressions can be wrong, so in a second post I presented a simple piece of analysis, that used both a representative agent and rational expectations, and I asked heterodox economists how their own analysis would differ. I repeated the challenge in a subsequent post, redoing my analysis using sector financial balances. Unless I’ve missed something, no one has – in my view at least – provided an answer. (However comments on these posts have seen some welcome interchanges between the two points of view on other issues, for which I am grateful.)
My question was what the impact of a temporary increase in government spending, financed by taxes, would do to output in an open economy. It was not a trick question – I just happened to be thinking about a presentation on exactly this issue to policymakers, so it was on my mind. Now policymakers, in response to such a question, do not want long lectures on the sins of representative agents, rational expectations or whatever, and they certainly do not want to be told it is a bad question. They want some simple macro analysis.
So, what do consumers do if they are told that taxes are rising temporarily? First, do they take any notice of what they are told, or do they assume the tax increase is permanent? It really matters which. If the former, do they smooth the impact on consumption, as the representative agent intertemporal model (and other earlier models) suggests, which by the way means that the consumer sector goes into deficit.
If they do, output will tend to rise. How do traders in the FOREX market react? Do they try and work out if interest rates will rise, and if they do what are the results of this calculation? Do they say that in the past when output has increased the central bank has raised interest rates, or do they recognise that (as I assumed) we are at the zero lower bound and so no interest rate increase was likely?
There are no obviously right answers to these questions, but I’m genuinely curious about how you would answer them without some appeal to representative agents. You could avoid rational expectations by assuming something simple like static expectations, but that would imply for consumers (after the initial surprise at taxes rising) the same thing as taxes rising permanently – until they were surprised by taxes falling again. And is the idea of consumption smoothing misguided, or just the idea that it results from optimisation?
The point to all this is my belief that mainstream macro is not some kind of inevitably interlinked construct, that you either have to buy into completely or reject completely. I believe using a representative agent is OK for some questions, but not for others. I think it’s appropriate to assume rational expectations some of the time, but not all of the time. Any analysis has to make assumptions, and it is not clear to me why the assumptions I have made are worse than others. If you think this belief is wrong, the best way to convince me is to give an alternative story of how a temporary tax financed increase in government spending would work. But of course if you are happy to just give lectures about the evils of mainstream economics, then no response is necessary.