John Quiggin: The Macro Wars

The macro wars
September 17th, 2009

Paul Krugman’s piece on “Why did economists get it so wrong” has attracted a vitriolic response from John Cochrane, reproduced here. Krugman’s piece was strongly worded, but the reply ups the ante, and I expect further escalation. Economics conferences in the next few years are going to be interesting events.

Given that, as Krugman himself notes, disagreements between economists were notably mild until the crisis erupted, what is going on here?

I’m visiting Berkely at present and just had a chat with Brad DeLong. These are some of the thoughts I had about the great macroeconomics wars as a result.

One important element that can’t be ignored is the effect political partisanship, which is much more bitter in the US now than in most other places. It’s not so much Republicans vs Democrats as Republicans vs anti-Republicans. Krugman has been a leading figure in rejecting the idea that the Republican party represents a serious viewpoint that should be accorded respect, even in disagreement. Not surprisingly, the members of the intellectual class still associated with the Republican Party (relatively few, these days, but still dominant in Chicago) intensely dislike Krugman’s writing for the NYT.

But more important, I think, is the hole in the intellectual landscape opened up by the crisis. As regards macroeconomics, the pre-crisis near-consensus described by Krugman included a lot of “freshwater” macroeconomists whose intellectual roots go back to the New Classical/Real Business Cycle literature of the late 1970. This literature initially suggested that there was no possible role for monetary or fiscal policy unless people had mistaken expectations and drew the implication that a sufficiently credible and determined government could eliminate inflation without any serious cost in terms of output and employment, a theory tested to destruction by the Thatcher government.

Given the empirical difficulties encountered by strong forms of these views, most of the freshwater economists were prepared to make some concessions. As regards monetary policy, they were willing to accept some use of interest rates to target inflation, while arguing against “fine tuning” designed to stabilise the economy – during the Great Moderation it was easy enough to conclude that macro instability was a problem of the past, a claim made explicitly by Robert Lucas.

Similarly, it was easy enough to accept the implication that, in certain extreme circumstances like those of the Great Depression, the standard tools of monetary policy might prove ineffective necessitating direct use of fiscal policy to expand the money supply. In the absence of any perceived risk of a Depression, it was easy enough to make this concession while arguing against any use of active fiscal policy.

In the wake of the crisis, this position was untenable. If you supported fiscal policy at all, it was clear that a massive stimulus was needed. In fact, the arguments of Barro and others that Keynesians had overestimated the multiplier effects of fiscal stimulus implied that the required stimulus was even larger than Keynesian estimates would suggest.

Moreover, there is, as Brad DeLong and others have pointed out, no coherent position under which fiscal policy is totally ineffective while monetary policy is at least partly effective. And the only plausible conditions under which policy is totally ineffective is if the macroeconomy is always in (or close to) equilibrium. So, it’s essentially impossible to believe in recessions and unconditionally oppose fiscal policy.[1]

So we see Cochrane forced all the way back to Say’s Law, the claim that it is logically impossible for (planned) supply to exceed (planned) demand, since willingness to supply, say, labour implies willingness to demand goods. Cochrane accuses Krugman of wanting to scrap the macroeconomics of the last forty years[2] but then makes it clear enough that he wants to dump Keynes and everything that has been written since.

Arguments about Say’s Law are unlikely to be resolved by logical disputation. The only way to address them is to look at the historical record of the economy over the last couple of centuries. If you see stability, interrupted only by the occasional ill effects of government policies, you’ll accept Say’s Law. If you see regular crises, except for a few exceptional periods when macroeconomic stabilization policies have appeared to work, you’ll reject it.

fn1. Except for those who can always find some government program or another to blame, even for a case as clear cut as the 1890s Depression in Australia.

fn2. This charge is broadly correct, but I think the correct answer is the one anticipated by Cochrane. Economics did indeed take a wrong turn in the 1970s, responding to the breakdown of (one version of) Keynesianism. We need to find a new and better response, and much of the work of the past 40 years will have to be be discarded or reinterpreted as a result.

MoneyWeek: How debt could sink the US economy

How debt could sink the Us economy

May 02, 2006

Many people still don't think the amount of debt the US government has amassed is anything to worry about, most commonly because it is still inconsequential relative to the US economy.

As much as the nominal debt may have grown, the growth in the US economy has ensured that servicing and carrying the debt is not a problem.

Stated another way, the US debt as a percentage of US GDP (gross domestic product) has not grown out of hand and therefore the nominal amount of debt is nothing to worry about.

Let us examine that proposition for a minute.

Below is a chart of the annual US GDP, the US government debt, and the US government's debt as a percentage of the US GDP.

The exploding debt during the Second World War is obvious, but notice how long it took the debt to GDP ratio to decline to pre-war levels. The level of actual debt has never declined, except for an insignificant $1 billion decline in 1946 and an equally insignificant $2 billion decline in 1949. The US debt has expanded every year since World War II.

Another interesting fact is that from around 1945 to about 1985 the US economy was growing at a faster pace than the US debt. This is evident from the decline in the debt to GDP ratio. Since 1985, however, the situation is exactly the opposite: the US debt is growing much faster than the US GDP.

The debt to GDP ratio improved during the late 1990s and the current rate of growth in the ratio is much less than it was during the eighties. But that reversal of the ratio in the late 1990s was due to the influx of foreign capital into the US and the subsequent stimulus this influx of capital had on the US economy. As a result tax receipts by the US government rose dramatically (all those capital gains during the tech bubble and stock market boom). That's over and the debt to GDP ratio is once again on the rise. Also, we have not seen the reversal of those international capital flows -- something that has been discussed at length in these pages -- and when that reversal occurs it will not only cause the dollar to decline, but will also cause the US debt to increase.

Regardless of what the Fed, the White House, the Senate or the press want you to believe, if China and Japan stop supporting the US dollar, US medium to long-term interest rates are going to rise. That would put a drag on the already anemic US economy, which means tax receipts by the US government will decline at the same time as the interest charges on the US debt will rise. The problem is that the US government is more likely to increase its deficit spending than to cut it, in an attempt to add stimulus.

The current debt to GDP ratio is almost twice as high as the debt to GDP ratio during the final stages of the Vietnam War and compared to Vietnam the US' current military adventures are skirmishes. If we combine increasing military spending with an increase in domestic deficit spending, higher interest rates and lower government tax receipts, then the debt to GDP ratio could rapidly approach World War II levels.

Anyone who is not alarmed by the increase in US government debt is living with his head in the sand.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Graphs and Charts for Prof Edelstien