Undergraduate economics teaching moves into 21st century

The CORE economics curriculum, designed to provide an introduction to economics that reflects economics as it is today rather than as it was decades ago, has won justified praise from John Cassidy. I also think it is brilliant, not just for first year undergraduates but also for interested non-economists. To wet your appetite, read this short account by two of the leading lights behind the project.

Rather than spend the rest of this post singing its praises, I want to ask why first year undergraduate textbooks represent a clear example of market failure. The failure I have in mind is the inability to teach economics as it currently is, rather than as it was decades ago. If you look at the standard first year, Econ 101 textbook, it does contain more modern stuff, but normally in later chapters after presenting the basic models/frameworks which have not changed for 30 years or more. As a result, textbooks tend to be both dull, seemingly irrelevant and much too large. (This is a blanket generalisation and I’m sure there some exceptions.)

Here is my theory, which I will try and explain in plain english rather than with economics jargon. Although the ultimate consumers of textbooks are students, they are chosen by teachers who set the course textbook. So why are Econ 101 teachers not demanding textbooks that are less dull and more up to date?

Suppose someone had written something like the Core material, and a publisher (as publishers do) had sent it out to people currently teaching Econ 101 for comments. The reaction they will have got from a good proportion of Econ 101 teachers would have been ‘that is interesting, but can we include at the start some of the stuff I have taught for the last five years’. They, naturally, do not want to completely rewrite their courses, and I fear in a few cases learn material that is new to them.

The publisher reports back to the author: ‘we cannot publish this as it stands, but if you start with the traditional material then maybe’. It is a market failure because publishers are looking at the current set of Econ 101 teachers, and not those who will one day teach it and would love to have something more up to date. Another force for conservatism is that the big names who dominate the market find it much easier to add new stuff on at the end as extra chapters than rewrite their textbook from scratch.

I could add more, but I have been rude to enough of my colleagues already. Let we add two other specific points about CORE. The first is that it is clearly mainstream: this is not the pluralist text that many heterodox economists would like. That I fear is inevitable: economics is mainly a vocational subject, not a liberal arts subject. (Thats upset a few more.) But I was surprised to see MMT people describe this textbook as not for them. I have, after all, argued that MMT is just standard macro without what I have called the Consensus Assignment. [1] So I had a look.

In the section on government finances (14.8) we get

“When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure. The government borrows by selling bonds.”

This is not correct, and nor does it follow modern macro. [2] There we write the government budget constraint to include a term in the change in the stock of high powered money. (If money does not appear, it is because the paper explicitly chooses to work in a moneyless world for simplicity.) In short, the government can finance the gap between revenue and expenditure by creating money. Ignoring money in this section is obviously an oversight, as the discussion in section 10 clearly shows. But it is an oversight that should be corrected. [3]

That apart, I was already a fan of the macro approach adopted in CORE, because it is a simplified version of the Carlin and Soskice textbook. I like the consistent claims approach as a way of talking about inflation. It emphasises the elementary point that you need both wage and price inflation to get sustained increases in inflation, something monetary policy makers seem to keep forgetting right now.

I like, as some may remember, abandoning the LM curve and explicitly talking about central bank policy. I also like the way that banks are now incorporated as part of the monetary transmission mechanism. If there was a clear manifestation of how outdated (at best, we could also say just plain misleading) most textbooks are, it is their continued use of LM curves and the money multiplier.

I really hope that CORE continues to be successful. It is time we stopped boring and confusing first year undergraduates, and started inspiring them with an understanding of the economic ideas that allow them to address the countless real world economic issues that they will have to face.

[1] The Consensus Assignment gives monetary policy the goal of macroeconomic stabilisation and fiscal policy the goal of stabilising government debt.

[2] We can go back to the work inspired by Carl Christ together with Blinder and Solow. I should add that CORE is not alone among textbooks in failing to properly set out the government’s budget constraint.

[3] Now we all know (and as MMT also clearly states) that there are limits to money financing: too much of it is inflationary. But this should not be internalised by teachers to the extent that money financing is ignored. In particular it gives the impression that to finance a deficit a government has to find someone to lend them money, an incorrect belief that can have very misleading consequences if the government controls its own currency. It is more complicated with independent central banks, but again they are not an excuse to ignore money financing.  

Macro teaching and the financial crisis

Some macro textbooks (not all) are a bit like extensively modified code. You can see the structure of the original code, even after extensive software development. This can mean that, as new capabilities were added to the programme, rather than rewrite the software from scratch, extra routines were just added on top. Not only is this inefficient, but the whole thing ends up looking like a confused mess.

Perhaps this is why we end up with textbooks that still have the completely out of date LM curve at their heart (and associated AD curves, plus Mundell Fleming, and even money multipliers), but additional chapters where the AS curve becomes a Phillips curve, and money targeting gives way to Taylor rules. The student ends up totally confused, if they ever get to those later chapters. And after the financial crisis, a new edition will have a chapter devoted to that crisis, but not much in earlier chapters will change.

This is not the case with the third textbook by Wendy Carlin and David Soskice. It has been around for a few months, but I at last got a chance to take a good look. 

I say third textbook rather than third edition because they do not do editions. This is a complete rewrite of their earlier ‘Macroeconomics: Imperfections, Institutions, and Policies’. Luckily all the features of that earlier book that I really liked are retained. For example, a supply side based on imperfect competition rather than perfect competition (although alas the price setting curve is still flat!). But most importantly, a core model (the 3 equation model) which dispenses with the LM curve, and replaces it with a ‘monetary rule’ curve, based on a central bank using interest rates to hit an inflation target. This is similar to the approach championed by David Romer. (So the 3 equations are the IS curve, the Phillips curve, and the monetary rule curve.)

There are also some major improvements compared to the second book. The open economy analysis is now fully integrated with the 3 equation model, and the remnants of Mundell-Fleming are gone. The Euler equation appears on page 22, as one of the foundations of the IS curve. It is a shame that the Phillips curve is still based on the traditional (this period’s expected inflation) rather than New Keynesian (next period’s expected inflation) version, but you cannot have everything.

But by far the most important change concerns the financial sector. After initial chapters on the demand side, supply side and 3 equation model, plus a fourth on expectations, we have three chapters on the financial sector. The first looks at the banking sector, and makes the key alteration to the 3 equation model: there is a wedge between the ‘policy’ interest rate and the interest rate relevant for the IS curve. You can see this chapter as looking at how the financial system works in ‘normal’ times, when the system is not a source of instability. The second chapter then looks at how the financial system can be a source of instability, through mechanisms like the financial accelerator or asset price bubbles. The third chapter applies this analysis to the financial crisis of 2008.

When I taught most of the finals macro course at Oxford, I used their earlier book. I did have a lecture on the financial crisis, but it was an add-on of the type I described above. This new book is almost enough to make me wish I was still teaching this course. It gives finance the position in macro that recent events suggest it deserves. Mark Gertler on the back cover writes: “This is an exciting new textbook. Overall, it confirms my belief that macroeconomics is alive and well”. That pretty well sums up my reaction.

Except to add that the front cover is a painting by Paul Klee. Perfect!

Bank says money multiplier is wrong - should we be shocked?

For teachers and students of economics

A post I wrote nearly two years ago had the emphatic title “Kill the money multiplier!” A recent article in the Bank of England’s Quarterly bulletin, by Michael McLeay, Amar Radia and Ryland Thomas, is a little more circumspect, but the message is essentially the same. One of their ‘headlines’ is: “Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”

The article has created quite a stir. (See this post from Frances Coppola.) Some have tried to suggest that it represents a fatal blow to mainstream theory, or current policy. David Graeber writes that the article has “effectively thrown the entire theoretical basis for austerity out of the window.” This is nonsense. What the article does is outline the understanding of most of those currently involved in monetary policy (including academics), and contrasts this with how monetary policy is taught in undergraduate textbooks. (I should add that the article does this rather well, and is well worth reading.)

So why is there this disconnect between current thought and the undergraduate textbooks? The textbook approach does have its supporters: see this post by Nick Rowe for example. I could try and portray this as a continuing battle between Wicksellians and Monetarists, and discuss whether Quantitative Easing is a win for either side. That would make a nice discussion. However I think using textbooks as a pretext would be wrong.

Think of another standard part of textbook macro besides the LM curve and money multiplier. One of the first things students also learn is the Keynesian multiplier, where changes in government spending can lead to much larger changes to output because the marginal propensity to consume is closer to one than zero. Again this does not correspond with how most macroeconomists today think about the real world. Is this disconnect because of a rearguard action by old fashioned Keynesians who insist that the 1960s way of doing macro must survive? Of course not. (Any new readers please note, I am not arguing against Keynesian economics or that the multiplier is zero - see here. I just think we would be better off with new undergrads assuming a multiplier of one, and focusing instead on why output was demand determined in the first place.)

In both cases, this disconnect between undergraduate textbook macro and current practice has a far simpler explanation - the textbooks are out of date. The core of what is taught to undergraduates has not changed in fifty years, whereas macroeconomic thinking has changed substantially. However we are not using fifty year old textbooks. You will actually find a great deal of the more modern stuff in the textbooks, but essentially in the form of add-ons. So first students are taught that central banks fix the money supply, and then they learn about Taylor rules. First they are taught about a Keynesian consumption function (with a large mpc), and then they learn about consumption smoothing.

This is silly. It is also dangerous, because the problem with add-ons is that they may not get added on. In particular, students who learn all about the money multiplier may never go on to be taught that if banks are not short of reserves or have easy access to them, they can simply create deposits by issuing loans. I suspect it is this lacuna which helped motivate the Bank’s authors to write their article. 

So how does this silly and dangerous situation persist? One clue is that the same gap between what is taught and current practice does not exist at masters level. Masters teaching is much less dependent on the textbook. So I think we really need to look at the production of textbooks to understand what is going on. Now what follows is a theory, and as I have never written a textbook or talked about this to those who have it is based on no empirical evidence - but my theory is microfounded!

Suppose a leading macroeconomists wants to write a textbook, and they want to throw away the LM curve, and the Keynesian consumption function - or at least not start off with these out of date bits of kit. The publisher will do some market research. The market will consist of two types. There are the young radicals, who are just starting out and are desperate to teach in a more modern way. There are also the older traditionalists, who have been teaching macro according to the existing textbooks for some time. They will tell the publisher that while they have no objection to this more modern stuff appearing somewhere - indeed they think it is a good idea - they really need a textbook that starts off in the traditional way so that they do not need to rewrite their whole course. The publisher then persuades the author that, to make any money, they need to start with the traditional stuff.

If this textbook writer is representative, then the radicals will only have traditional textbooks to choose from. They have to be very radical indeed to teach without a textbook, so they start teaching in the traditional way. This unfortunately means that the radical becomes over time a traditionalist, and the process continues. The once radical will tell themselves that assuming money is fixed, while clearly not literally true, is not so misleading. The marginal propensity to consume may in practice be nearer zero than one, but at least it gets the kids to do some simple algebra and think about system feedbacks. And hey, a reserve constraint on banks issuing money could exist in some situations.

As a result, some students end up believing that banks just lend out deposits and that the central bank controls the money supply via a multiplier. And a central bank feels it needs to write an article pointing out that this is not so. That I think is a bit shocking.  

Tim Harford’s new book on macroeconomics

Let me first deal with a potential conflict of interest. Tim has a wide twitter following, and quite often tweets a reference to my blog posts. This might lay me open to the charge that I would be inclined to favourably review his new book to return this favour. Actually it has the opposite implication. The fact that he finds my blog interesting simply shows he appreciates good macroeconomics, which is just as well for someone who has just written a book about the subject. What it does mean is that if I had found anything in his book which I had clearly shown to be fallacious in one of my posts, I would be doubly disappointed.

A difficult hurdle to pass, that. I suspect the only person who could write a book that agreed with everything in your blog is yourself, and even you might find that difficult

Ah, that reminds me of the second thing I should say at the start. The book employs the dialogue format that Tim uses in his FT columns so well. This is more unusual in a book and might potentially bother some, although most of the time it is used much more sparingly than in the columns. Otherwise it is written in just the same style that makes his other books so readable.

Yes, but microeconomics and the other subjects he has written about before are potentially interesting. This book is all about macroeconomics: yawn, yawn.

Indeed. Up until now it was unclear whether it was possible to write a general explanatory (rather than specifically topical) book on macro that did not have the eyelids dropping after a few chapters, or which began to stretch the reader quite quickly. Given Tim’s ability to write about economics in an engaging way, with this book he could settle the matter one way or another. Now in one sense I’m probably not the best judge, given my prior knowledge, but it seems to me Tim has pulled it off.

Oh come on. How can you make understanding Keynesian economics enjoyable?

With a mixture of stories about economists of the past, and lots of useful analogies and examples. So, not surprisingly, Bill Phillips and his machine play a major role, as do shortages of ‘money’ in baby sitting circles and Iphones when discussing price stickiness. Some I knew about, but others (like Henry Ford’s application of efficiency wages) I had forgotten about.

But I bet it is highly selective in the stuff it covers. All the juicy topical issues, but nothing on RBC models or how you measure GDP.

Actually no. Chapter 11 is all about measuring GDP, and it beats most treatments you will find in the textbooks hands down. The Lucas critique, and how that changed the way macroeconomists use evidence, is there. The importance of commitment is illustrated with quotes from the film Dr. Strangelove. That allows him to cover not just how commitment can help, but also when it goes wrong. Let me quote: “That is the problem with commitment devices: if something goes unexpected wrong and a crisis happens anyway, the commitment device guarantees that it will escalate into Armageddon. Unfortunately we have an important parallel in economics: it is called the Eurozone.”

Hmm, very amusing, but hardly the neutral account you might find in a textbook.

Which means Tim is not afraid to occasionally call it how he sees it. For example you will find the equivalent of the standard discussion of the optimal rate of inflation early on, but Tim makes it pretty clear he thinks raising inflation targets above 2% would be a good idea. You will also not find any equations in this book, but it does cover much of the same ground as a textbook. 

So it is like a readable and amusing textbook without the maths

Is that so surprising? Tim wants to discuss the material that will enable readers to understand the big macro issues of the day, and I’ve always argued that textbook macro does a pretty good job of doing that (although with a few obvious gaps). But you will also find some things here that would not normally be in a macro textbook. There is a chapter of management, for example, drawing on the work of Bloom, van Reenen and others. There is a chapter on happiness, and one on inequality. Finally Tim has the advantage of not being part of the macro tribe, which he argues has become far too insular and narrow in the last forty years. So he can maintain a healthy critical perspective. Here is one example. “Robert Shiller told me that while the microeconomists would show up to argue when he gave seminars on behavioural finance, the macroeconomists just haven’t showed up at all.”

Which means macroeconomists will not be adopting this book as their set text then!

That is not the market he is aiming for. It is ideal for the interested non-economist who wants to understand something of macroeconomics in an easy and enjoyable way. However I also think it is a great supplement to the textbooks for students. All too often, students reading textbooks focus on the formalism, and fail to understand the key concepts, or relate them to the real world. Tim’s book is an excellent antidote to that. And last but not least, it provides a wealth of material  for academics to make those lectures much more fun for students.

So it’s both thumbs up from you then

Absolutely, although I’m still not sure about that dialogue style.

The Liquidity Trap and Macro Textbooks

Over the last eleven days something unusual has happened – I have not only failed to post a blog of my own, but I have not even read anyone else’s posts. Instead I have taken advantage of a sabbatical term to take a break [1] in Umbria, during a time of year when it is still cool enough to walk, but not too cold in the Piano Grande. Before I left I did write a couple of things that I thought I might quickly post while away, but with the help of the Italians’ penchant for starting dinner late and eating four (or more) courses that idea somehow got lost.  

So I’m spending part of today catching up, and reminding myself why Paul Krugman and Martin Wolf are such great writers. (For example, from the former, a masterful analysis of the decent into worldwide austerity, and from the latter, a perfect short account of why when it comes to government debt the Eurozone really is different.) What I want to pick up on here is this Krugman post, where he questions the description in a Nick Crafts piece of higher inflation as a way out of the liquidity trap as being ‘textbook’. (See also Ryan Avent.)

So is raising inflation expectations to avoid the liquidity trap textbook or not? Let’s take the 2000 edition of the best selling undergraduate macro textbook. Here ‘liquidity trap’ does not appear in the index. There is a page on Japan in the 1990s, and in that there is one paragraph on how expanding the money supply, even if it was not able to lower interest rates, could by raising inflation expectations and therefore reducing real interest rates stimulate demand. One paragraph among 500+ pages is not enough to make something ‘textbook’, so it seems as if Paul Krugman has a point.

Yet how can this be? It is not one of those cases where textbooks struggle to catch up with recent events, because the Great Depression was a clear example of the liquidity trap at work. How can perhaps the major macroeconomic event of the 20^th century, which arguably gave rise to the discipline itself, have so little influence on how monetary policy is discussed? Yet it is possible to argue that the discussion is there, in an oblique form. A standard way of analysing the Great Depression within the context of IS-LM, which this popular textbook takes, is to contrast the ‘spending hypothesis’ with the ‘money hypothesis’: was the depression an inevitable result of a negative shock to the IS curve, or as Freidman argued could better monetary policy have prevented this shock hitting output?

A standard objection to the money hypothesis is that nominal interest rates did (after a time) fall to their lower bound. The counterargument – which the textbook also suggests - is that, if the money supply had not contracted, long run neutrality would imply that eventually inflation would have to have been higher, and therefore real interest rates on average would be lower. So in one way the story about how higher inflation could avoid a slump is there.

What is missing is the link with inflation targeting. Because textbooks focus on the fiction of money supply targeting when giving their basic account of how monetary policy works, and then mention inflation targeting as a kind of add-on without relating it to the basic model, they fail to point out how a fixed inflation target cuts off this inflation expectations route to recovery. Quantitative Easing (QE) does not change this, because without higher inflation targets any increase in the money supply will not be allowed to be sustained enough to raise inflation. In this way inflation targeting institutionalises the failure of monetary policy that Friedman complained about in the 1930s. Where most of our textbooks fail is in making this clear.    

[1] Sometimes known as holidays, these are things that we Europeans are forced to take many more of than Americans, leading to great frustration and misery (or maybe not).