Sunday, July 19, 2009

The State of Economics

Must reading for IB1 to IB2 students of Economics as well as for any of my recent graduates (if you are ever checking out this blog...-I know that you are, Dimitri K.!!). A-level Economics candidates will also greatly benefit from reading it.

Reproducing from The Economist:

...Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.

Among the passionate are Mr DeLong and Mr Krugman. They turn for inspiration to Depression-era texts, especially the writings of John Maynard Keynes, and forgotten mavericks, such as Hyman Minsky. In the humanities this would count as routine scholarship. But to many high-tech economists it is a bit undignified. Real scientists, after all, do not leaf through Newton’s “Principia Mathematica” to solve contemporary problems in physics.

They accuse economists like Mr DeLong and Mr Krugman of falling back on antiquated Keynesian doctrines—as if nothing had been learned in the past 70 years. Messrs DeLong and Krugman, in turn, accuse economists like Mr Lucas of not falling back on Keynesian economics—as if everything had been forgotten over the past 70 years. For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the “General Theory of Employment, Interest and Money”, which was published in 1936, in an “unnecessarily controversial tone”, according to some readers. But it was a controversy the author had waged in his own mind. He saw the book as a “struggle of escape from habitual modes of thought” he had inherited from his classical predecessors.

That classical mode of thought held that full employment would prevail, because supply created its own demand. In a classical economy, whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle.

Keynes appreciated the classical model’s elegance and consistency, virtues economists still crave. But that did not stop him demolishing it. In his scheme, investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply, leaving willing workers on the shelf. It fell to governments to revive demand, by cutting interest rates if possible or by public works if necessary.

The Keynesian task of “demand management” outlived the Depression, becoming a routine duty of governments. They were aided by economic advisers, who built working models of the economy, quantifying the key relationships. For almost three decades after the second world war these advisers seemed to know what they were doing, guided by an apparent trade-off between inflation and unemployment. But their credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to “stagflation”, a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.
In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks. In the summer of 2007, a few weeks after the August liquidity crisis began, Frederic Mishkin, a distinguished academic economist and then a governor of the Fed, gave a reassuring talk at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming. He presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model, and add only a tenth of a percentage point to the unemployment rate. The reason was that the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”.

Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.

Mr Krugman and others advocate a bold fiscal expansion, borrowing their logic from Keynes and his contemporary, Richard Kahn. Kahn pointed out that a dollar spent on public works might generate more than a dollar of output if the spending circulated repeatedly through the economy, stimulating resources that might otherwise have lain idle.

Today’s economists disagree over the size of this multiplier. Mr Barro thinks the estimates of Barack Obama’s Council of Economic Advisors are absurdly large. Mr Lucas calls them “schlock economics”, contrived to justify Mr Obama’s projections for the budget deficit. But economists are not exactly drowning in research on this question. Mr Krugman calculates that of the 7,000 or so papers published by the National Bureau of Economic Research between 1985 and 2000, only five mentioned fiscal policy in their title or abstract
Read the whole article here.

No comments: