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Friday, May 28, 2010

WHAT CAN BE DONE TO IMPROVE MACROECONOMIC THEORIES AS POLICY GUIDES?

Today's Buggy Topic

The topic was started, as usual, in a thread at Economist's View, where a lot of huffing and puffing followed in the dozens of comments left by posters . . . little more than strings of assertions and counter-assertions by the defenders of old Keynesian theory and New Keynesian theory, with a few posters preferring New Classical theory that rejects both versions of Keynesianism.

Some Clarifying Remarks

Essentially, old Keynesianism ---- which really means the versions worked out by two outstanding followers, John Hicks of Oxford and Paul Samuelson at MIT ---argued that in a recession both monetary and fiscal stimuli should be used to bring short-term economic growth back to its long-term path of potential growth . . . the latter set by strictly aggregate supply-side matters: the growth of the labor force and its quality, the growth of capital stock (a result of cumulative business and public investment), and technological advances.  Government efforts to improve the long-term potential by influencing aggregate demand --- which means keeping interest rates artificially low or using government deficit spending deliberately to raise aggregate demand --- can't influence the three components of long-term economic growth and, if anything, could harm it by igniting inflationary tendencies.

By contrast, in a deep recession as in the 1930s Great Depression --- or in the global recession of 2008-2009 --- both Old and New Keynesianism argue for some kind of government or monetary stimulus.  

New Keynesians 

New Keynesians, who have been influenced by the Chicago school of New Classical economics, delve into the impact of fiscal and monetary policymaking on individual economic agents ---- consumers, workers, businesses, and financial investors; assume rational expectations --- which means that the differences in the behaviors of millions or tens or hundreds of millions of individual economic agents cancel out, so that the average economic agent not only behaves rationally in line with economic postulates of rational, self-seeking individuals, but also behaves with as much likely foresight and knowledge as the average economist; and yet, unlike New Classical economists who see the market economy as self-adjusting and self-regulating, believe that there are macro-level or aggregate market-failures that keep the market economy from hewing to potential growth without either excessive unemployment or without rising inflation. 

Click on the continue bar just below to find the rest of this buggy commentary.

As a result, government policymaking is needed --- but really only effective monetary policy: in recessions, lower interest rates to accelerate business investment and consumers' buying houses and other durable goods in order to bring about low and acceptable unemployment.  In inflationary periods, by contrast, the expectations of future inflation held by rational economic agents need to be altered, and so credible monetary policymaking that follows rules to keep price-rises in line with acceptable levels --- roughly 2-3% annually (anything lower could lead to deflation, a big problem if it accelerates) --- should be curbed by predictable, rule-based rises in interest rates.

As a general thing, though, New Keynesians doubt that fiscal stimuli work in a recession other than, possibly, tax-cuts for both consumers and businesses. 

Old Keynesians

Old Keynesians, who were influenced by Keynes own work in the 1930s --- but who were criticized by New Classicals and New Keynesians alike for have no theoretical foundation in the behavior of individual rational economic agents, whose expectations of the future on an average were in line with economists who expect short- and mid-term economic growth to be in line with long-term potential growth (remember, set strictly by supply-side inputs of labor, capital investment, and technological progress) --- have reappeared in the last three years or so of serious recession and its aftermath of slow GDP growth.  They argue that nominal (non-inflationary adjusted) interest rates are already as low as the Federal Reserve can drive them --- to very close to the zero-bound limit; and so not only was a first-round of fiscal stimuli necessary to shorten the recession, but go on to argue that new fiscal stimuli might be necessary.  At a minimum, we shouldn't on this view worry right now about excessive governmental deficits.  It's more important to bring high-levels of unemployment down from 10% to 5.0% or less --- as in the late 1990s Clinton era or the Bush era of 2004 to late 2007  --- by stimulating GDP growth and larger tax revenue in the upshot that will bring federal deficits down to acceptable levels and not cause long-term damage.

Remember: the  key to the revived Old Keynesianism is that monetary policy can't be used to offset high unemployment in a recession and its aftermath if it's already at the zero-bound.  Whether it's sound or not is a matter of intense debate.

New Classical Macroeconomics

In effect, its position in the debate is a pox on both houses.  Some new classical theorists might, it's true, espouse expansive monetary policy --- low interest rates --- as acceptable, but even that view is at odds with the major macroeconomic theoretical work of the new classical exponents known as Real Business Cycle theory.

The theory's key point?

Recessions are caused by sudden changes in technology or other "shocks" external to the self-regulating, self-adjusting tendencies of the free-market economy to work at full employment and on its long-term growth path set by supply side components.  The other shocks?  They could be due to an abrupt surge in oil prices as happened, say, twice in the 1970s and caused two recessions, plus price-rises.  Or due to uncertainties among business investors and financial investment institutions caused, say, by worries about the euro-crisis spreading to the USA and global economy.  Or, in any case, whatever the shocks, there will be a need for sector-adjustments because of excessive investments in, say, construction and housing as earlier in the last decade; or due to old technologies exhausting themselves or, if standardized production technologies, being transferred abroad and requiring "creative destruction": freeing up skilled labor, capital, and management from declining industries like steel --- or autos (where both big leaps in productivity and production by foreigners had undermined much of the profitability of the Big-3 corporate firms in the USA) --- and transferring it into new, more advanced information-and-communications service-industries of all sorts.

What Buggy Did

In a lengthy post at Economist's View, where all of the above remarks were taken for granted by him, he summarized a recent talk by a pathbreaking economist who is now the new president of the Federal Reserve branch at Minneapolis . . . a fount of high-quality research for 30 years or so, mainly but not entirely in New Classical theory.  The new president criticizes both New Classical theory and modern New Keynesian theory as being unable to give effective policy advice of the sort the the Federal Reserve and the Bush and later Obama fiscal policymakers really needed. 

The chief reason?

Well, among the various reasons he cites, mainly both theoretical models fail to integrate their work on the real economy --- whether the demand side or the supply side --- with the fluctuations in the financial sphere of the economy  . . . this even though financial shocks have been the major source of dislocations in the US and global economy for the last 30 years or so.  The president, not surprisingly, is the pioneer scholar of Dynamic New Public Finance and hopes that all schools of macroeconomics work to integrate the financial side into their models; strive to be more realistic about the actual behavior of individual economic agents --- consumers, workers, business managers, financial institutional heads of banks and investment funds and mortgage brokers, and of course government regulators; strive too to update their modeling for focusing on the complex interactions of these better understood agents; and above all work hard to communicate their findings to policymakers in clear, easy-to-follow English.

Click here for the buggy summary and analysis of the new president's work . . . his name a real tongue-twister:  Narayana Kocherlakota, born believe it or not in Baltimore.