An Access Advertising EconBrief:
Will Macroeconomics Survive the Aftershocks of the Great Recession?
Today there are courses on Macroeconomics in the Economics departments of every American university. It was not ever thus. Macroeconomics was born in the agony of the Great Depression. Before that, economists worked with aggregative concepts like the Quantity Theory of Money, but there was no holistic study or theory of economic aggregates. It was not clear why there should be, since all economic action originated in the minds of individual human beings and statistical data have no life of their own apart from the people embodied within them.
The Depression focused public attention on economics and economists, who were previously obscure. People wanted to know what went wrong and how to recover from it. When reigning economic theory proved unavailing and the Depression resisted the frantic resuscitative efforts of government, the economics profession threw professional decorum to the winds and started chasing after any explanation that seemed either plausible or palatable. The winner in this guess-the-theory sweepstakes was John Maynard Keynes, whose General Theory of Employment Interest and Money offered an apparent answer to the more important of the two big questions; namely, how do we get out of this fix?
Keynes’ prescription was deficit spending by government – the more, the better until the cloud of Depression lifted. Keynes won the professional competition, but World War II made his victory anticlimactic; when the smoke cleared after the war and normal life resumed, the Depression was over. But the economics profession had taken the bit between its teeth. It had organized a new system of national income accounts around the aggregative theory of income and employment advanced by Keynes and his burgeoning school of disciples. Professional journals bulged with articles on Keynesian economics, triggering a forty-year odyssey of research.
Economics split in two. Formerly, economics studied individual economic entities like the consumer, the producer and the worker. Now the theory of consumer demand, the theory of the firm and the theory of input supply and demand were pigeonholed under the study of Microeconomics. Monetary theory, which had formerly sought to express the barter theory of pure exchange in the language of indirect monetary exchange, was now converted into Macroeconomics – the study of national economic aggregates using the language of Keynesian economics.
Keynesian economics fell into disrepute in the early 1980s and textbooks were revised accordingly. But its skeletal structure and aggregative logic still survives, as does the Micro/Macro split.
The Great Recession and its stubbornly lingering aftermath have midwived a lengthening string of books and articles purporting to explain what went wrong and how to prevent it from happening again. In that respect, we are witnessing a replay – or perhaps “remake” might be more accurate – of the founding story of Macroeconomics. This time, though, we are heading for an entirely different ending. Whereas the Great Depression fused the study of Macroeconomics around the core of Keynesian theory, the Great Recession has fragmented the subject almost to the limits of recognition.
The Fragmentation of Macroeconomics
Of course, the fragmentation process began even earlier, with the organized opposition to Keynesian theory. That began in the 1950s with the rise to prominence of Milton Friedman. Friedman’s revival of the Quantity Theory of Money as a Monetarist theory that competed with Keynesian economics made him famous. He vied with John Kenneth Galbraith in public recognition and popularity and nearly single-handedly restored free-market economics to respectability in America. His promotion of floating exchange rates for international currencies and the permanent-income theory of consumption established an academic reputation that eventually earned him the Nobel Prize.
In the 1970s, Friedman’s Monetarism was joined by the Rational Expectations theory of Robert Lucas and Thomas Sargent, each of whom later earned the Nobel Prize. In a sense, Rational Expectations competed with both Keynesian economics and Monetarism, since both previous theories shared a common analytical framework. Rational Expectations theory denied that policymakers could systematically trick the public by printing money and inflating the currency as Keynes had advocated in a famous passage of the General Theory.
Keynesian economics fell, but rose again in the form of the New Keynesian Economics. This version was created to purge the failings of its ancestor, so it has more in common with Monetarism and Rational Expectations than it does with its namesake. But its most striking feature is its ecumenism. Perusing a list of economists who style themselves New Keynesians is an exercise in cognitive dissonance. The members have as little in common as did the members of opposing schools of thought in the 1970s.
Paul Krugman is an unreconstructed, big-spending Keynesian and defender of big government. N. Gregory Mankiw could just as easily be called a “New Monetarist.” John Taylor is the inventor of the “Taylor Rule,” the successor to Milton Friedman’s “monetary rule” that tied the hands of Federal Reserve policymakers by prescribing fixed annual increases in the quantity of money. Stanley Fischer is a famous central banker and textbook author who combined Rational Expectations theory with New Keynesian economics. David and Christina Romer are a husband and wife who frequently form a research team. As individuals, they have sometimes expressed skepticism about the effects of activist Keynesian policy measures that other New Keynesians like Krugman approve, such as tax increases. Indeed, Christina once authored a well-known paper doubting the efficacy of post-World War II federal-government macroeconomic policy intervention. (This viewpoint was nowhere to be heard, though, when she became head of President Obama’s Council of Economic Advisors.) About the only thing uniting these economists is a belief that government should take some active measures on a regular basis to improve economic outcomes. But they are dramatically, not to say violently, at odds over exactly what those measures should be.
Free-Market Economists and Macroeconomics
Historically, free-market economists have always been outliers. Unlike everybody else, they never accepted Keynes, nor did they accept his aggregative methods. Indeed, the great free-market economist F.A. Hayek was the principal rival of Keynes during the 1930s. Hayek was the only economist to offer a coherent explanatory theory of recessions and depressions. While Keynes offered an active measure to cure the Great Depression without pretending to explain why it had occurred, Hayek did just the opposite. He provided a logical explanation for the onset of the Depression, but maintained that – like the common cold – the Depression could not be cured, only endured. More specifically, Hayek insisted that active fiscal and monetary measures would merely make things worse.
This kind of stubborn independence persisted throughout succeeding decades. At least superficially, it remains intact to this day. While unreconstructed Keynesian like Joseph Stiglitz ascribe the Great Recession to “deregulation” that allowed the commercial and shadow-banking sectors to run amok, free-market economists demur by noting the nearly complete absence of any deregulatory initiatives other than the comparatively trivial Gramm-Leach-Bliley Act of 1999. But upon closer inspection of the numerous free-market exegeses of the financial crisis and Great Recession, it emerges that free-market theorists have broken ranks. They have become individualists analytically as well as temperamentally. They now appear every bit as fragmented as the rest of the economics profession.
A recent book (Boom and Bust Banking: The Causes and Cures of the Great Recession, edited and Introduced by David Beckworth; Independent Institute, 2012) collected the views of prominent free-market economists on the Great Recession and financial crisis. The Introduction, by one of the leading exponents of the school, conveys the impression that all of the contributors are on the same page. This is true in only one respect: they all disapprove of actions taken by the Federal Reserve prior to and during the crisis. Beyond that, however, they are almost as diverse in their views as are the New Keynesians. This movement toward ideological and analytical atomism is unprecedented in modern economics.
Every Man Is an Island
Lawrence White is a longtime Austrian economist whose specialty is money and banking. Along with colleague George Selgin, he is a leading proponent of free banking, the advocacy of free competitive banking over the heavily regulated and protected banking that exists now.
White attributes the Great Recession and financial crisis not to “laissez faire or deregulation” but rather “the interaction of an unanchored government fiat monetary system with a perversely regulated financial system.” The Federal Reserve’s cheap credit policy “…kept interest rates too low for too long… in 2001-2006” to create the “…housing boom and bust cycle of “2001-2007.” Real interest rates (that is, nominal rates minus the rate of inflation) were negative from 2002-2005. Nominal spending was artificially high in 1998-2000, leading to a boom that went bust in 2001. This pattern was repeated in 2002-2004, leading eventually to recession in 2007-2009. The second time around, the bubble created by artificially high demand disproportionately surrounded the housing sector. Housing prices shot up during 2001-2006, leveled off, then crashed. The resulting problems were amplified by political and regulatory mistakes that produced bailouts for financial firms and dilution of credit standards for house buyers. Overall, though, the Fed’s actions were the proximate cause of disaster. Thus, the Fed has worsened the chronic currency problems it was created to cure.
White believes that we need an alternative set of monetary institutions, with free banking leading the list.
David Beckworth is a New Monetarist. In one of his two contributions, he wonders why Fed policy was too loose for too long. He finds the answer in the Fed’s mishandling of the U.S.’s “productivity boom” from 2002-2004. During those years, U.S. total factor productivity rose by an average annual rate of about 2.5%. This compares with an average rate of 0.9% over the previous 30 years in the U.S. This sounds like good economic news if anything ever did. Yet, incredible as it seems, Federal Reserve policy turned it into bad news.
The Fed was – and still is – dead set on avoiding “deflation” at all costs. The quotation marks reflect uncertainty about just what constitutes the sort of falling overall price level we are, or should be, trying to avoid. In practice, the Fed and other central banks treat the prospect of even a tiny overall fall in prices as a catastrophe of the first order. Supposedly, deflation fatally strains borrowers, who are thereby forced to repay debt with dollars of successively greater value. In any case, a general increase in productivity causes costs to fall and, all else equal, will tend to cause prices to fall, too. Rather than allow this to happen, the Fed increases the money supply to lower interest rates, increase inflation and raise the general level of prices. And that is what happened in 2002-2004 to offset the productivity boom. This tended to create an artificial increase in the general level of demand. The Fed was assuming that the falling price level was the precursor of a decrease in aggregate demand, lower investment, lower real income, less employment and more unemployment. It believed that its actions were needed to prevent a recession. Wrong; the Fed generated an artificial increase in aggregate demand and an increase in inflation instead. Then, later on, the boom turned into a bust.
Beckworth believes that the Fed makes so many mistakes because it lacks a proper source of feedback from markets. He advocates targeting of Nominal Gross Domestic Product (NGDP) by the Fed. NGDP is simply the nominal level of spending in the economy, which Beckworth believes should be held to as constant a level as possible for optimal results.
Beckworth’s ideas are elaborated further by Scott Sumner, the leading New Monetarist who writes one of the most widely followed economics blogs in the world. Sumner proposes the creation of a NGDP futures market to give the Fed market feedback on the level of NGDP. Sumner finds the cause of the Great Recession and financial crisis in “misdiagnosis by macroeconomists,” not mistakes made by bankers and regulators. Indeed, he exhibits touching faith in the willingness of central bankers to strive for favorable economic outcomes – if only they would see the light! Alas, macroeconomics is ruled by “superstitions, including the view that good economists are those that can predict the business cycle, or asset-market crashes.” Stop relying on policymakers being smarter than markets, Sumner pleads; instead, “restructure macro around market expectations.”
Hedge-fund manager and finance theorist Diego Espinosa believes that the Fed created the housing bubble and ensuing financial crisis by creating an environment that not only allowed, but actively encouraged, traders to pursue a “carry trade” in mortgage securities. Carry trading implies the notion of borrowing in a short-term financial asset and lending long-term. Leverage is used to juice up the return since the spread earned by the trader is usually small. The mortgage securities used were provided by investment-banking houses rather than commercial banks because investment bankers had the necessary experience and expertise to “securitize” mortgages in packaged form, supervise their rating and distribute them widely. The distribution in tranched form from highest to lowest rated allowed the greatest possible distribution among all risk classes of buyers. After all, with small spreads, there were only two ways to increase returns – ever-greater leverage and ever-greater volume. Volume was further enhanced by diminution of credit standards in every way: lower down payments, higher loan-to-value standards, lower income requirements, lower consumer-credit-rating standards, low or no verification of consumer application statements.
This recipe – increasing leverage, increasing volume and wide distribution of indebtedness, abandonment of any semblance of credit standards – was predestined to end in disaster. So why did traders embrace it so fervently? Espinosa confides that the mastermind of this scheme was the Federal Reserve. In 2002, the Fed announced a policy of maintaining a low Fed funds (overnight) rate long after a recession. It promised to raise rates only slowly, in small increments, to give market participants time to unwind positions taken in response to this policy. Thus, traders believed that “the fix was in” – they couldn’t lose the carry-trade game in the usual way, by being caught short when interest rates rose. Instead, they ended up losing in ways they didn’t anticipate. When the crisis arrived, their ability to borrow short was impaired and the securities they owned became illiquid and/or worthless.
Of course, the Fed was motivated by its own political aims. The Fed was bound and determined to prevent deflation in the worse way. That’s exactly what it did – by leading the country into a huge financial crisis and recession. It provoked traders into demanding its short-term funds and buying mortgage securities, thereby achieving both its policy aims and the administration’s political aims simultaneously.
Espinosa knows that the Fed’s actions were utterly unprincipled. But his only policy recommendation is that the Fed should “recognize the limits of its own powers.”
Jeffrey Rogers Hummel is an economic historian who has evolved into a leading monetary theorist. His study of Ben Bernanke completely overturns the mainstream view of Bernanke’s tenure as Federal Reserve Chairman. Bernanke is famous for his homage to Milton Friedman, so much so that he gained the sobriquet “Helicopter Ben” in reference to Friedman’s insistence that the Fed could drop money from helicopters if needed. But Hummel shows that Bernanke actually repudiated Friedman’s legacy by bailing out particular banks while refusing liquidity for the banking system in general. Bernanke epitomized the FDR prototype of a leader: a whirlwind of action, always willing to experiment with other people’s money and welfare and confident that his good intentions would justify any result. He centralized control of the financial system within the Fed, thereby earning Hummel’s title of “central planner in chief.” Bernanke completed the transition of the Fed from the role it played in its first decades, a banker’s bank and custodian of the money supply, to that of financial central planner for the economy and even for the world at large.
Lawrence Kotlikoff is an old-line Chicago economist who has held various academic, research and journalistic posts. His contribution reflects his heritage. He recognizes the disastrous role played by fractional-reserve banking in the economic history of the U.S. and the world. Why do we continue to put up with banking panics, recessions and the accompanying dislocations, he complains? There is only one way out of this box. We must reform the practice of banking itself.
“The economic moral is simple. If you want markets to function, don’t let critical market-makers… gamble with their businesses. Apply the moral to banks and the regulatory prescription is clear. Don’t let banks take risky positions. Make banks stick to their two critical functions – mediating the payments system and connecting lenders to borrowers.”
Kotlikoff’s solution is limited-purpose banking, a proposal with roots in the old “Chicago Plan” of 1933. By law, banks would be limited to two types of activity: a plain vanilla banking operation that operated as a mutual fund with an interest-paying checking-account service only; and another, entirely separate, operation that operates a mutual fund offering opportunities in bonds, mortgages, stocks, private equity, real estate, and other financial securities.” The cash mutual fund would hold 100% reserves and would thus require no taxpayer protections of any kind, including government deposit insurance. In the investment form of banking, banks would initiate but not hold their own loans. A Federal Financial Authority would hold the loans and audit all books. According to Kotlikoff, “never again would a Bernie Madoff be free to custody his own accounts; i.e., to lie about the actual investments being made with investor money.”
George Selgin is one of the modern proponents of free banking. Implicitly, he rebuts Kotlikoff by asking the question: Suppose central banks and banking regulation did not exist; what arrangements would take their place? “Banks would issue banknotes that would be backed by some kind of reserve,” which could be specie or the U.S. monetary base. These banknotes would circulate and clear as checks do today. Interbank clearing and reserve transfers would stem overissue of banknotes by any individual bank. This system would handle the level of money demand by the public. It would provide an automatic system of equating the supply of money to the amount of money demanded. That is to say, it would automatically solve the central problem of monetary theory. In turn, this would automatically stabilize the total level of nominal dollar spending. Presto! At a stroke, the key problems of monetary theory, banking and Macroeconomics are solved.
Selgin then explains at length how the history of central banking reveals the inherently destabilizing nature of that institution. Not only does a central bank such as the Federal Reserve lack any automatic feedback system allowing it to equate the quantity of money demanded and supplied – this is in and of itself a fatal flaw of central banking – but central banks are also inherently compromised by their political connections. Originally, central banks were created to pander to the financial needs of the sovereign. Thus, the needs of the government took precedence over the needs of the public at large. Even today, we see the Fed catering to the financing needs of the government by holding interest rates artificially low for years to allow the federal government to finance its outsize public debt.
A Mass of Contradictions
A quick perusal uncovers the mass of contradictions among the free market contributors. Kotlikoff and Selgin are poles apart in their insistence on a rigid, government-controlled approach to banking (Kotlikoff) as opposed to a free-market-feedback approach (Selgin). Sumner and Beckworth are both prominent New Monetarists; both favor the latest Macroeconomic-stabilization-policy gimmick, Nominal Gross Domestic Product stabilization. So they have to be in agreement, right? Wrong. Sumner sees falling prices in the Depression as a sign of “deflation” that the Fed should have corrected with loose monetary policy. But Beckworth regards 2002-2004 as a “productivity boom” for the U.S., not a time of disastrous deflation. Well, the 1920s saw a similar boom in productivity, with similar effects on prices. Presumably, Beckworth would regard them similarly – which puts him squarely at odds with Sumner.
White and Selgin are both determined to put markets in control and depose the Fed. Sumner is equally keen to utilize the principle of market feedback because macroeconomists have disastrously misdiagnosed the ills of the economy. Moreover, he believes passionately that policymakers are not smarter than the market. But he proposes to take his carefully cultivated, pet panacea of NGDP stabilization and put it in the hands of the Fed – the very policymakers and macroeconomists he bad-mouths! And those same people are bossed around by… politicians! That puts Sumner somewhere on the opposite side of the world from White and Selgin.
As for Espinosa and Hummel… well, their analysis may be the most detailed, penetrating and acute of any being offered on the market today. But when it comes drawing implications from their conclusions, they opt out.
Increasingly, the operative principle of Macroeconomics is becoming “to each his own (theory).”