Jo Michell has a long post in which he enters in a debate between Ann Pettifor and myself about the role of mainstream macroeconomics in austerity. Ann wanted to pin a large part of the blame for austerity on mainstream macroeconomics, and Jo largely sides with her. Now I have great respect for Jo’s attempts to bridge the divide between mainstream and heterodox economics, but here he is both wrong about austerity and also paints a rather distorted picture of the history of macroeconomic thought.
Let’s start with austerity. I think he would agree that the consensus model of the business cycle among mainstream Keynesians for the last decade or two is the New Keynesian (NK) model. That model is absolutely clear about austerity. At the zero lower bound (ZLB) you do not cut government spending. It will reduce output. No ifs or buts.
So to argue that mainstream macro was pushing for austerity you would have to argue that mainstream economists thought the NK model was deficient in some important and rather fundamental respect. This was just not happening. One of, if not the, leading macroeconomist of the last decade or two is Michael Woodford. His book is something of a bible for those using the New Keynesian model. In June 2010 he wrote “Simple Analytics of the Government Expenditure Multiplier”, showing that increases in government spending could be particularly effective at the ZLB. The interest in that paper for those working in this area was not in that this form of fiscal policy would have some effect - that was obvious to those like myself working on monetary and fiscal policy using the NK model - but that it could generate very large multipliers.
This consensus that austerity would be damaging and fiscal stimulus useful was a major reason why we had fiscal stimulus in the UK and US in 2009, and why even the IMF backed fiscal stimulus in 2009. There were some from Chicago in particular who argued against that stimulus, but as bloggers like DeLong, Krugman and myself pointed out, they simply showed up their ignorance of the NK model. Krugman in particular was very familiar with ZLB macro, having done some important work on Japan’s lost decade.
What changed this policy consensus in 2010 was not agitation from the majority of mainstream academic macroeconomists, but two other events: the Eurozone crisis and the election of right wing governments in the UK and US Congress.
Jo tries to argue that because discussion of the ZLB was not in the macroeconomic textbooks, it was not part of the consensus. But textbooks are notorious for being about 30 years out of date, and most still base their teaching around IS/LM rather than the NK model. Now it might just be possible that right wing policy makers were misled by the consensus assignment taught in these textbooks, and that it was just a coincidence that these policy makers chose spending cuts rather than tax increases (and later tax cuts!), but that seems rather unlikely. You do not have to be working in the field to realise that the pre-financial crisis consensus for using changes in interest rates as the stabilisation tool of choice kind of depended on being able to change interest rates!
Moving on from austerity, Jo’s post also tries to argue that mainstream macroeconomics has always been heavily influenced by neoliberal ideology. To do that he gives a short account of the post-war history of macroeconomic thought that has Friedman, well known member of the Mont Pelerin society, as its guiding light, at least before New Classical economics came along. There is so much that could be said here, but let me limit myself to two points.
First, the idea that Keynesian economics was about short term periods of excess or deficient demand rather than permanent stagnation pre-dated Friedman, and goes back to the earliest attempts to formalise Keynesian economics. It was called the neoclassical consensus. It was why the Keynesian Bob Solow could give an account of growth theory that assumed full employment.
Second, the debates around monetarism in the 1970s were not about the validity of that Keynesian model, but about its parameters and policy activism. Friedman’s own contributions to macroeconomic theory, such as the permanent income hypothesis and the expectations augmented Phillips curve, did not obviously steer theory in a neoliberal direction. His main policy proposal, targeting the money supply, lost out to policy activism using changes to interest rates. And Friedman certainly did not approve of New Classical views on macroeconomic policy.
Jo may be on firmer ground when he argues that the neoliberal spirit of the 1980s might have had something to do with the success of New Classical economics, but I do not think it was at all central. As I have argued many times, the New Classical revolution was successful because rational expectations made sense to economists used to applying rationality in their microeconomics, and once you accept rational expectations then there were serious problems with the then dominant Keynesian consensus. I suppose you could try to argue a link between the appeal of microfoundations as a methodology and neoliberalism, but I think it would be a bit of a stretch.
This brings me to my final point. Jo notes that I have suggested an ideological influence behind the development of Real Business Cycle (RBC) theory, but asks why I stop there. He then writes
“It’s therefore odd that when Simon discusses the relationship between ideology and economics he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. The beliefs of the latter group are, Simon suggests, ideological, while those of the former group are based on ideology-free science. This strikes me as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable.”
This misses a crucial distinction. The whole rationale of RBC theory was to show that business cycles were just an optimal response to technology shocks in a market clearing world. This would always deny an essential feature of business cycles, which is involuntary unemployment (IU). It is absurd to argue that NK theory denies all the things on Jo’s list. Abstraction is different from denial. The Solow model does not deny the existence of business cycles, but just assumes (rightly or wrongly) that they are not essential in looking at aspects of long term economic growth. Jo is right that the very basic NK model does not include IU, but there is nothing in the NK model that denies its possibility. Indeed it is fairly easy to elaborate the model to include it.
Why does the very basic NK model not include IU? The best thing to read on this is Woodford’s bible, but the basic idea is to focus on a model that allows variations in aggregate demand to be the driving force behind business cycles. I happen to think that is right: that is what drives these cycles, and IU is a consequence. Or to put it another way, you could still get business cycles even if the labour market always cleared.
To suggest, as Jo seems to, that the development of NK models had something to do with the Third Way politics of Blair and Bill Clinton is really far fetched. It was the inevitable response to RBC theory and its refusal to incorporate rigid prices, for which there is again strong evidence, and its inability to allow for IU.
That’s all. I do not want to talk about globalisation and trade theory partly because it is not my field, but also because I suspect there is some culpability there. I would also never want to suggest, as Jo implies I would, that ideological influence is confined to the New Classical part of macroeconomics. But just as it is absurd to deny any such influence, it is also wrong to imagine that the discipline and ideology are inextricably entwined. 2010 austerity is a proof of that.
This is largely you protecting your model, your identity and your mates. Krugman actually in the early 90s argued that Japan's government spending was too large and its behaviour not worthy of a great nation (I will find those links later). It was Japanese economists who were fighting like mad to say that this was nonsense (fighting in the Japanese language against an MIT economist from the world's superpower - you can guess how far they got). NK economics is based on an empty philosophy and this exceptionalism about the ZLB is a red herring. You do not need such nonsense to argue that it is justified to have fiscal expansions when borrowing costs are low and their risk aversion to new lending in the private sector. Krugman uses gadgets to "show" this, but he never actually explains the real causal mechanisms about what was going on.ReplyDelete
The ultimate problem with mainstream economics is its a-historicism and lack of interest in real knowledge.
Simon, in relation to austerity I think you are talking from a different angle. What (I think) jo says is that mainstream economics, from Friedman up to nowadays, hay relegated the role fiscal policy has on aggregate demand. He is talking about fiscal policy in normal times, in the last 30 years (not what happens when the economy hits the ZLB.ReplyDelete
Saying that fiscal policy should not be used to manage aggregate demand is ideological, because evidence says otherwise.
There are lots of reasons most economists have monetary policy as the stabilisation tool of choice. If you want to convince they are wrong, you need to address them. I have no ideological reason to prefer one to another, so can be convinced.Delete
Strong auto stabilisers are surely the best way.Delete
The mainstream approach is that government should try to boost demand (i.e. total spending) by doing anything other than actually spend. And it should try to minimize any inflation risk associated with the interest owed on public debt by means other than tailoring interest-rate settings to that purpose.
"Functional finance" and fiscal policy is a “radical” reversal of this logic.
It amounts to saying, the surest way to boost demand (spending) is for government actually to spend. And the best way to ensure that interest payments on public debt pose no inflation risk is through the appropriate setting of interest rates.
The problem with the current mainstream approach is at least twofold.
In terms of demand, the approach is indirect and weak. It tries to influence private spending through variations in interest rates. Not only is this method indirect, but the influence of interest rates on spending is not uniform. For instance, the spending of interest recipients is likely to be negatively affected by a cut in interest rates, whereas a prospective borrower may be more likely to borrow in order to spend. Overall, the effect of interest-rate policy appears not to be large, especially when the aim is to boost demand through cuts in interest rates.
In terms of managing the potential inflation risk involved in making interest payments on public debt, the focus on the fiscal balance is counterproductive. What matters, in terms of inflation risk, is the flow of interest payments as a proportion of GDP. By the prevailing mainstream logic, excessive interest payments call for fiscal contraction, which will have the unfortunate effect of dampening demand and hence GDP. As a consequence, growth in the denominator of the ratio decelerates, making it more difficult to reduce interest payments as a percentage of GDP
What do you think of Tony Yates' suggestions on improving auto stabilisers:Delete
Auto-stabilisation requires *no* human intervention whatsoever. You decide the policy rate and it is completely free running and self-balancing. It is direct, immediate - and best of all it works a treat.
I agree with SW-L that the small print of economics text books does not advocate austerity in a recession. But that’s not necessarily what Ann Pettifor is referring to, far as I can see from her article: that is, she is arguably referring to the messages coming from the senior / most voluble members of the economics profession during the crisis. She might have been clearer on that point.ReplyDelete
Assuming she IS REFERRING to the latter economists, then she is spot on. For example there was Kenneth Rogoff and Carmen Reinhart who were advocating consolidation / austerity. Plus the IMF and OECD were advocating the same.
As for SW-L’s claim that “the IMF backed fiscal stimulus in 2009” it is difficult to reconcile that with Bill Mitchell’s claim that the IMF were advocating consolidation / austerity. E.g. see:
Perhaps SW-L and Bill Mitchell should get together to sort that one out.
Furthermore, as Robert Skidelsky himself admits, even those 58 [100?] less prominent economists were only advocating milder austerity. The greater the error and the lesser the intellectual integrity the worthier the economist, apparently. Stupid, arrogant ignorance FTW.Delete
"Michael Woodford...... wrote “Simple Analytics of the Government Expenditure Multiplier”, showing that increases in government spending could be particularly effective at the ZLB."ReplyDelete
His conclusion was more nuanced than that.
He concluded that under Depression conditions, fiscal policy would be effective but the case for using fiscal policy in less extreme circumstances was much weaker, even when monetary policy was constrained by a ZLB not deemed to be persistent.
Not that this weakens your argument. He wasn't at all supporting austerity in that paper but then again he wasn't a raging bull for government spending to pull any economy out of recession.
Adding to what I said immediately above, he also argues that monetary policy is "costless" relative to fiscal policy. Fiscal policy he says, drags private resources off optimal usage. (Although, if an economy is in recession, private resources are underutilized, so I can't see what the problem is.)Delete
Anyway, I guess the point is that his arguments are seemingly devoid of ideology.
I think you set up a straw man with the 'raging bull' stuff. He would argue that we need enough fiscal stimulus to close the output gap. We didn't get enough, so by implication he would have advocated more with full information.Delete
On your second point, he is indeed right, as I with colleagues have shown more formally in a paper. The argument is that if you use increases in government spending to get an economy back to its natural level, when you have achieved that the ratio of public to private spending is not optimal.
" I with colleagues have shown more formally in a paper."Delete
Do you have a link to the paper?
"He would argue that we need enough fiscal stimulus to close the output gap."Delete
Do you agree with that? You would be happy with permanently high unemployment/underemployment rates?
Natural output rates are fictional and dangerous. Really what is needed is an understanding of the causes of problems like deindustrialisation. Once we understand the causes (which will mean a very thorough and multi-disciplinary model-free historical study) we can target government policy, including fiscal policy, to directly deal with it.
"He would argue that we need enough fiscal stimulus to close the output gap."Delete
Is there an 'output gap'?
“Why hasn’t it worked? Because real growth today is constrained by real resource shortages, while in the 1930s traditional Keynesianism’s assumption of unemployed resources was reasonable. There is still unemployed labor to be sure, but not unemployed natural resources, which have become the limiting factor in today’s full world.”
I'm a fan of Woodford's tome. In terms of interpreting where IU might fit in the basic NK model, could we represent IU as the negative output gap resulting in cases when the ZLB formally binds - when the natural rate is less than the negative of the inflation target?ReplyDelete
And that's a pleasing distinction between abstracting from something and denying its existence!
" In June 2010 he wrote “Simple Analytics of the Government Expenditure Multiplier”"ReplyDelete
IN JUNE 2010.
In June 2010.
In June 2010.
Since when was ZLB effectively present in western economies?
Please do not pretend now that mainstream economists were thinking about ZLB effects since it started.
I was reading Krugman since mid 2008 and he did not get it right away, and after he got it he had such major problems to persuade other economists to accept such reality. Not even all saltwater economists wanted to accept it. Not, untill Lawrence Summers came with his Secular Stagnation speach at IMF in November 2013.
Now you are saying that ZLB was know since came into effect. Based on what? On only few economists knowing about it.
How would economists know that ZLB is in effect? Do you have any standard model that tells you that ZLB is in effect in the real world?
"a crucial distinction. The whole rationale of RBC theory was to show that business cycles were just an optimal response to technology shocks in a market clearing world. "ReplyDelete
What technology shocks were in 1982 in US? In 1991?
Ok some in 1999. What in 2003? What in 2007?
Oh, you have no idea? or you just call it that since you do not know what is in the real world? Just some wague notion that gives an excuse to keep using unrealistic models.
There is another reason for RBC, the real reason is interest payments to financial industry. But since you do not bother with studying money and debt and banking, which everyone accepts that runs the world, but it is not in any model how would you know about it?
How are new technologies implemented? By using borrowing to finance the startups. Since we still talking about public debt instead of private debt, how would you know it?
What are the consequences of debts on firms when banks refuse to refinance their old debts? Why is that not included in studying about RBC? Or when banks raise their interest payments, not because something changed in a firm, but becouse something changed in a bank system? Interest rates or new policies of banks?
Nooooo, lets not study that, we will just call it a "technology shock" so that we do not look at private debts, only at public debts.
"but the basic idea is to focus on a model that allows variations in aggregate demand to be the driving force behind business cycles. I happen to think that is right:"ReplyDelete
But, what drives agregate demand?
AD is driven by wages and borrowing. You accept sticky wages from watching the real world, ok, buty why they are sticky?
Because people are burdened by debt/ old borrowing and any reduction in wages reduces their disposable income left after paying monthly payments. And such effect on AD you call "sticky wages" even tough wages are not sticky. Many people went onto lower paying jobs after loosing old better paying one before the shock.
Wages are not sticky but the effect on AD looks like wages indeed are due to old debts, private debts.
So that says that wages as a part of AD are dependent on borrowing and second part of AD is borrowing.
That says that borrowing is what crucially affects AD. But lets talk about public debt, not about private debt... because all that is fuly relegated to Central Banks and official interest rate management.
But banks do not offer official interest rate to economies anymore. That what ZLB is and that what Secular Stagnation is caused by.
But economists still do not know that monetary policy is ineffective now and why. They will still relegate all that to CBs and monetary policy.
The study about borroving and private debts, the matter that is the most influential in economy is still relegated to CBs only, and economists should not bother with it since it might give them second thoughts about what they are doing with their energy: missleading people about the real world.
In 2007, Neel Kashkari, present president of Minneapolis FRB, said that it would have been easier and cheeper to let the banks fail and create new public banking system and that it would help economy recover quickly. I still agree with that statement, FDR did agree also in 1933.ReplyDelete
What happened after his statement on CNBC in 2007. FED ordered banks to fix their ballance sheets (which they can do only by taking more profits from the real economy) while publicly lowered interest rates.
Banks did follow orders to make more profits and liquidated people and firms while increasing their lending conditions. Banks also increased interest rates they offered to economy while FED was lowering rates. This connundrum is still not changed: banks do not offer official rates to the economy, only to states and other banks.
FDR realized that and opened many public banks that offered official rates to economy and even to new publicly owned entreperises that used very low interest rates offered by state owned banks. Fannie Mae, Fredie Mac are just two examples of the thousand examples how FDR transmitted official interest rates to the economy and to the people.
This fact is forgotten. WHY? WHY? WHY? WHY?
Because you economists do not study money, debt and banking. Which is all that makes world go around. And also RBC, not some wague "technology shock"
That is how FDR's Marriner Eccles solved austerity constrain after getting off gold standard, off course; by opening public banks, but it took over 10 years to solve the deppression/ RBC/ ballance sheet recession/ ZLB/ Secular Stagnation .ReplyDelete
How did Germany's Hjalmar Schacht solve deppression and austerity problem in only two years from 1933-35?
Why is history forgotten? Especially by economists?
"A Mefo bill (sometimes written as MEFO bill), named after the company Metallurgische Forschungsgesellschaft (Metallurgical Research Corporation), was a promissory note used for a system of deferred payment to finance the German rearmament, devised as a legal fraud by the German Central Bank President, Hjalmar Schacht, in 1934.
Mefo bills followed the scheme for which the Öffa bills were the blueprint."
"Schacht has later said that the device "enabled the Reichsbank to lend by a subterfuge to the Government what it normally or legally could not do"."
"Hjalmar Schacht formed the limited liability company Metallurgische Forschungsgesellschaft, m.b.H., or "MEFO" for short. The company's "mefo bills" served as bills of exchange, convertible into Reichsmark upon demand. MEFO had no actual existence or operations and was solely a balance sheet entity. The bills were mainly issued as payment to armaments manufacturers.
Mefo bills were issued to last for six months initially, but with the provision for indefinite three-month extensions. The total amount of mefo bills issued was kept secret.
Essentially, mefo bills enabled the German Reich to run a greater deficit than it would normally have been able to. By 1939, there were 12 billion Reichsmark of mefo bills, compared to 19 billion of normal government bonds.
This enabled the government to reinflate their economy, which culminated in its eventual rearmament."
That is how first Auto-Bahn was paid for, it was not only for armament as Wikipedia says.
And we can do Global Warming prevention instead of armament, while repairing private ballance sheets, and also banking problems.
Why this historical fact is ignored by economists?
Why, Why, Why, Why??????????????????
Because economists do NOT DARE to think about what turns the world around; money, debt and banking.
Hi Simon, I'm generally a big fan of your views and style but must digress here. Being a government economist and going through the recession and recovery/austerity period I recall the path of the transition. The most vocal economists (not just the right-wing yahoos) were those very concerned with deficits as were the major international institutions. I remember discussing with colleagues how it was insane that governments were not latching onto cheap credit to fund infrastructure expansion (as my second-year undergrad tome from the 1990s advised). By 2010, the argument had been lost and by the time more moderate mainstream economists had found their voice austerity was being rolled out.ReplyDelete
I suspect people need advice ahead of the curve, not behind it and the accusation of macroeconomics constantly re-fighting the battles of the 1970s and 80s tends to ring true. One can always find counterexamples here and there but this sort of episode should prompt some serious self-reflection (not just a minor re-tweaking of our go-to models).
All the best.
I fear you are falling into a trap here: that economists you call 'most vocal' are those who are given a voice by the media and politicians. Krugman was pretty 'vocal' during this period, arguing that the US 2009 stimulus was not enough - does he not count?Delete
Where I think you are right is that economists need a better collective voice. As this period shows, imagining that politicians or the media will present that collective view all by themselves is naive.
Hi Simon, thanks for your reply. And, you are probably correct about having my blinders on.Delete
I did speak with academics and staffers at the central bank over the period in question and the feeling, up until around 2011-2012 really was a very cautious approach to budget balances(yes Krugman was quite vocal but his stridency did not seem to peak until well after the horses had fled the barn). Part of this I think had to do with Reinhardt and Rogoff and this 90% cutoff of theirs (I mean, who's to argue with these two, right?).
While it may be correct that most macro guys were aghast at this, that was certainly not my experience at the time and certainly not what was conveyed in the press and blogs. I felt strongly at the time, as I do now, that most of the academics were not concerned about the recession or had nothing to say because the models used were not flexible enough to provide guidance. In hind sight this is now rectified, but in real-time I think it was a spectacular failure and I say this as someone who truly enjoys and supports macroeconomics (particularly it's ugly cousin - forecasting).
At any rate, we can all hope that the coming decade sees a return to more balanced views of the roles of fiscal and monetary policy. The whole post-80s thing with no room for fiscal policy seems to have run it's course now that long-term rates have finally been run into the ground (what's a central banker to do if the neutral rate falls to 2%? The illusions of the past will quickly get stripped away should we face a growth like Japan's).
All the best.
Simon, I think you are correct that "the debates around monetarism in the 1970s were not about the validity of that Keynesian model, but about its parameters and policy activism", but I believe this debate is not relevant to the problems we face today. What is relevant, however, is "the idea that Keynesian economics was about short term periods of excess or deficient demand rather than permanent stagnation . . . and goes back to the earliest attempts to formalise Keynesian economics."ReplyDelete
While the GT was primarily concerned with short-run equilibrium, the central theme of the book was what Robertson dubbed the long-period problem of saving which gets to the core of Keynes' ideas about "permanent stagnation". This is what Keynesians and non-Keynesians alike have ignored.
I have examined the Robertson/Keynes debate on this issue in detail in http://www.rweconomics.com/htm/LPLFLPPS.htm and have provided a brief summary of my conclusions with regard to the implications of the failure of mainstream economists to come to grips with this problem along with a discussion of Keynes' failure to appreciate the parallel between loanable fund increasing debt and investment increasing capital in http://www.rweconomics.com/EVKGT.htm .
I would also note that I believe Keynes was only partially right when he said "In the long run we are all dead." He is dead, but we are not, and it seems to me that Keynes' long-run problem of saving has caught up with us. I would really appreciate any critical comments that anyone might have on these papers.
Is this paper useful Simon?ReplyDelete
Let me state the problem, as I see it, as succinctly as I can: When the existing institutions within society are such that it requires an increase in debt relative to income to fully employ our resources, attempting to achieve full employment through increasing debt, whether public or private, is a fool’s errand that will inevitably lead to a financial crisis that develops into an economic, political, and social catastrophe. This kind of problem can only be addressed through a change in institutions, not through an increase in debt.ReplyDelete
I would also note that this is the kind of problem that will arise in the face of what Robertson dubbed Keynes’ long-period problem of saving, and I think it is worth noting that even though Keynes did not discuss this problem in terms of debt, his conclusion with regard to the long-period problem of saving was: “I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.” (GT, Ch. 24-III)
As far as I can tell economists have been unwilling to consider this possibility. Why is that? It seems to me the answer is obvious. Out of a fear that Keynes may be right. That's no excuse. If Keynes is right, and we ignore the truth, it seems most likely that it is going to lead to Armageddon.