Monday, September 5, 2011

Does Anyone Understand How Macroeconomics Works?

There is an important point that is mostly missed by analysts trying to understand the divide between Democrats and Republicans or between progressives and conservatives. The different sides have different economic textbooks, based on fundamentally different assumptions about how the economy works - and specifically, how macroeconomics works.

When people look at the physical world, there are still many "laws of physics, nature, etc." that all sides in the political debate accept. Gravity causes things to fall, moving toward the source of that gravity, which in our case, is the mass of the earth. The distance (D) we travel can be determined by multiplying our speed (R) times the time (T) that we travel (D = R x T). We could compile a very long list of these generally shared, mostly scientific assumptions, precepts and rules.

There are some areas of divergence: where no consensus has been achieved, or where a rival scientific hypothesis has been developed - evolution and climate change come to mind. But in these two cases, if you poll the scientific community, you would find practical consensus: over 90% of the scientific community would agree with Darwin (versus Intelligent Design) and global warming as humanly caused (versus global cooling, or no proof of human causation of warming).

In economics, there is no professional consensus. Back in the 1930s', Keynes attacked the classical consensus that said government spending could not effect demand, and therefore would not help in a recession. Through the 1940s', 1950s', and 1960s', it looked like Keynes had carried the day: there was a consensus that government had a responsibility to support demand and thus maintain employment, when the country moved into recession. Government should spend aggressively in the downturn, then pull back and move towards balance. But then came the 1970s', and stagflation (which Keynesian theory seemed unable to explain), and the consensus fell apart.

Milton Friedman brought us monetarism which argued that fiscal policy was mostly ineffective. Remember that this was the decade of high inflation, that was only brought to heel with Volcker's tough Fed leadership and high Fed interest rates, beginning in 1979. Friedman's central dictum that "inflation is always and everywhere a monetary phenomenon" has made a deep and lasting impact on our economic consciousness, even though Keynesians would say Friedman was only partly correct.

But what developed with and after Friedman was "the Chicago School", led by Robert Lucas and Eugene Fama. This School argued for rational expectations, efficient markets, and general equilibrium theory. Macroeconomics as developed by Keynes was completely discarded, and replaced with new Macro theories that came out of generalizing from single firm or individual  microeconomic maximizing algorithms, that were ramped up to a general economy level. Government could never help (government spending would be offset by a reduction in private spending); it could only hurt(regulations would always interfere with the efficient market). Markets always cleared; the price set in the market was always the right price; there never was and never could be any such thing as an asset bubble. Markets tend toward equilibrium; and they can be very effectively modeled. Risk, like other market dynamics, can be quite predictably modeled, and therefore mitigated. Deficits were always inflationary. And a pattern of continuing and escalating deficits will lead to hyperinflation, currency revulsion, and sovereign default.

The Chicago School was renamed Freshwater Economics (to account for a number of Economic Departments at midwestern universities that supported the Chicago arguments) and was seen to be in competition with Saltwater Economics (where economists at coastal universities still argued the Keynesian case). In my impression, the Freshwater folks are far ahead of the Saltwater Keynesians: they have most of Wall Street, all of the Republican Party, and seemed to have converted our President. Obama came into the Presidency a Keynesian; but his calls for austerity and deficit reduction and his "story" that the government is just like an individual household - all of this moves him, at least for a time, into the Freshwater camp.

Why does this matter? If you believe that it is an economic truth that government spending cannot help in a recession, you will fight tooth and nail to prevent stimulus spending. If you believe deficits are always inflationary, deficits like those we are experiencing will terrify you. And if you believe too many deficits and too much mounting debt will eventually lead to the death through default of the United States, you will be in a state of panic. And this, of course, is just what Republicans are counting on.

As folks who read this blog surely know, I am with the Seawater folks. And more specifically, I am a recent convert to MMT (Modern Monetary Theory), which stands unequivocally on the side of government spending to support demand; the manageability of inflation; and the inability for a sovereign nation like the US with its own currency to go broke. But in this age of political polarization, it is important to remember that our opponents do often speak from what they feel are solid scientific and economic foundations.

Tomorrow, will work through a short list of questions, where the different economic schools take very different positions.


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