Why Is Macroeconomics Such A Mess?

Tuesday, October 11, 2011

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Yesterday, I took some of our pupils down to the excellent LSE Public lectures to hear Professor John Eatwell lecture on the topical issue of “Why is Macroeconomics Such A Mess?”. (This at a time when the Nobel Prize in Economics was awarded to two macroeconomists for their modelling work… Ahem).

With the caveat that a lot of the propositions he discusses in his new book and mentioned in this lecture were controversial and not generally accepted – so not to go into the exam room and regurgitate them all!

A staunch (and unashamed) Keynesian, Eatwell did a fantastic job of synthesising the whole of economic ideologies in the space of 10 minutes, from the classical invisible hand, through sticky money wages, mark up pricing, via adaptive expectations to Lucas’ rational expectations, on to general equilibrium theory.

His main point was that under the classical (and its various manifestations since) model, prices clear the market, and equilibrium quantities are found – as per any supply and demand model that we teach at AS economics.

Ultimately whilst macroeconomics is made up of a catalogue of models, the existence result, the idea that prices gravitates towards the full employment level underlies them.

But in his new book (The Fall and Rise of Keynesianism) he considers how powerful Keynesian ideas can be when applied to our past and present economic problems; showing how helpful these ideas are in explaining why we came to find ourselves in the mess we are in.

They examine where and how the analytical and methodological foundations of conventional macroeconomic wisdom went wrong, with an alternative controversial proposition to understanding how markets work, as well as highlighting the interpretive shortcomings that have come to characterize Keynes scholarship itself. He argues that prices do not gravitate to an equilibrium (hence why unemployment persists), but maybe that is because there is no equilibrium to gravitate towards.

Essentially, the Rational Expectations guys argued that you can’t keep systematically pushing up growth by inflating the economy because people are not stupid - they realise that they are not getting richer but that the pound is just worth less, hence explaining stagflation, when mixed with other market impediments. Since then though, these guys have stuck staunchly to models which are basically totally unrealistic. Real business cycles, the impossibility of asset bubbles and so on.

He covered Keynes’ General Theory key propositions, including that the level of output is determined by the demand in an economy; the investment dog wags the savings tail; the role of the financial sector to provide finance to rest of society; and that the economy can settle in less an equilibrium less than full employment.

He took answers from the floor, giving some good insight into the key problems facing governments currently:

* The issue of fiscal deficits has been addressed all wrong. He gave the example of Singapore who runs a fiscal surplus, but as a result has no government bonds issued, which is what provides liquidity to the system, and allows pension funds to invest in safe assets

* Comparing the U.S monetary union to Europe’s to explain fundamental differences: such as the U.S’ system has a proper federal budget (20% of GDP, vs Eurozone’s 1.5% of GDP), which allows for more redistribution from rich to poor States (something that politically/culturally is difficult in the Eurozone). ; the Greeks are not even a proper sovereign in the sense it cannot even print its own money (Greece is the West Virginia of America…);

* The U.S debt crisis back in August: despite their partisan reasons on not increasing the debt ceiling, they failed to understand that over half of U.S debt is owed to the U.S. Federal Reserve!! That is, most of U.S debt is owed to the U.S.

*Monetary policy in the 21st Century: It is clear from numerous examples, including Japan who has had a zero interest rate policy for 15-20 years, that interest rates alone will not help an economy to recover. Indeed, the last two times that the Japanese have tried fiscal expansion, it seemed to help the economy, until markets got jitters and confidence waivered, forcing the Japanese to cut short their expansionary plans. The Japanese have a debt:GDP ratio of c.200% but the key difference is that it is owed to its own citizens (Japanese savers).

Japan Real GDP

*The quantitative easing solutions proposed thus far have been fundamentally flawed, since QE may increase the money balance of firms, but it fails to increase output or investment expenditure if the expectations of future profits are not there, that is they do not anticipate demand to rise for the goods/services. UNLESS QE is altered so that instead of firms/banks being asked to spend, it is the central bank that issues the bonds, and raises money, monetizing the deficit, and then allowing the government to spend this money itself (a la Keynesians).

*Expansionary fiscal contraction: Does EFC work? This view contends that a credible and permanent program of government spending or tax reductions will stimulate a large increase in private demand, working through the expectations of permanently lower tax liabilities. Private spending may increase sufficiently to offset the direct effects of the fiscal contraction, so that it is actually expansionary in the longer term.

Eatwell gave the example of Canada and the UK. Thatcher’s fiscal contractionary policies of the 1980s are cited as an example of what happens when a government sorts its fiscal deficit out, but often people fail to quote that at the same time as her fiscal restraint policies, she also removed many controls on lending and liberalised monetary controls, allowing for the availability of credit to boom, which increased consumer indebtedness and stimulated a recovery. Also, Canada is cited as another example, but people forget to mention that its neighbour, the U.S economy, was undergoing rapid expansion at the same time as the Canadians pursued fiscal contraction.

(An aside: In the 2010 IMF World Economic Outlook, IMF analysts looked at all known instances of fiscal adjustment in OECD countries. They found only two episodes in which economies expanded as deficits were cut: Denmark in 1983 and Ireland in 1987. )

UK Government Bond Yields

*George Osborne and a Plan B: Fiscal expansion won’t work on an individual level, because if one government expands, whilst others do not, all that will happen is we will absorb/import their deficits, as we export less and import more. Thus it needs a concerted / coordinated effort (which was on the way in a G20 summit in 2008, but seemed to have lost its way by the Seoul meeting). The UK does need to address its 20%+ youth unemployment figures, by providing direct employment; and creating a ‘national investment bank’ to offer proper QE loans.

UK long term youth unemployment

*Can we de-politicise economic policy making? It is tricky for politicians to take long term views, or to necessarily argue using rational logic. The British governments debt/GDP ratio of c.61% of GDP (with a budget deficit of around 8-10% of GDP this year); but most of this borrowing is from pension funds/insurance companies, that is mostly from Brits. But it is hard to convince the average person that ‘borrowing now to indebt future children’ is a flawed logic in this case.

Monetary policy in the UK was de-politicised in 1997 by the Labour government, and the MPC didn’t spot the financial crash coming – indeed they were quite behind the curve, cutting back their financial regulation division, and focusing purely on interest rates to control inflation. Politics tends to only change in face of irresistible situations – such as the 1930s Great Depression. Hence his plea for economists to enter the political domain, so they can take their economic training and apply it in political frameworks.

*Should we aim for zero growth? There are some who call for governments to aim for zero growth. Eatwell cited that the1890s there was a scare in the UK that we would run out of coal, but we haven’t because the market mechanism plays its role, price rise, innovations occur, the economy restructures. At a time when 12% of Americans go to bed hungry, we do still need to aim for more production (or at the very least more redistribution). But like many things, it requires political concerted action.

Tags: recession, unemployment, innovation, economics, euro, investment, confidence, banks, expectations, keynes, quantitative easing, fiscal stimulus, keynesianism, keynesian economics, depression economics, fiscal strategy, bond yields, lse public lectures, john eatwell

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Why Is Macroeconomics Such A Mess?

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