Macroeconomics need not be boxed into a new consensus
Search for new consensus is futile, way ahead is more conversations between different macroeconomic schools
Mumbai: The Jack Ryan story is back on screen. The American spook created by writer Tom Clancy has been reimagined as an analyst with a doctorate in economics. The irony is unmissable—an economist is trying to save the world almost a decade after his peers were accused of nearly destroying it because of their role in the global financial crisis.
The meltdown after September 2008 presented profound challenges to economists, who were widely seen as one of the guilty parties. The attack has led to a rethinking about the discipline that has proceeded fitfully over the past decade.
A few months ago, an unusual hashtag trended on Twitter— #WhatEconomistsDo. Professional economists took to social media to underline the fact that their daily work is not about macroeconomic forecasting. Modern economics is a vast area encompassing diverse subjects such as game theory, institutional economics, development economics, taxation theory, welfare economics, organization theory, economic history, labour economics, network economics and much more. Too many critics have lazily equated modern economics with a certain style of macroeconomic thinking that was dominant in the financial markets as well as in central banks, especially the ability to forecast future outcomes. It is a bit like criticizing all of modern medicine because oncologists are not yet capable of predicting when cancer will strike.
The hubris in macroeconomics is undeniable. In an unfortunately timed paper published in August 2008, a few weeks before Lehman Brothers imploded, Massachusetts Institute of Technology economist Olivier Blanchard wrote in The State of Macro that economists had a shared vision of economic fluctuations as well as the methodology to study them. The consensus soon crumbled. Blanchard would later become chief economist of the International Monetary Fund, and host of a series of conferences on how to rebuild macroeconomics after the crisis, a testimony to his intellectual honesty.
The road to the consensus macroeconomics that has now splintered was a complicated one. Sustained stagflation in the 1970s undermined the previous dominant thinking derived from the work of John Maynard Keyes during the Great Depression. Three developments within academic economics were especially important.
First, the monetarists led by Milton Friedman showed that governments cannot keep buying extra growth with the help of higher inflation once expectations are considered. Citizens will respond to the prospect of higher prices by demanding higher wages right away. The result will be an inflationary spiral that central banks would have to control by restricting money supply, though financial liberalization would later make interest rates rather than money supply the favoured policy variable for central banks.
Second, the Keynesian behavioural models used by macroeconomists fell prey to the powerful Lucas Critique. These old models would eventually be replaced in central banks by DSGE (dynamic stochastic general equilibrium) models that were built around consumers and firms—aka representative agents—with rational expectations about the future.
Third, a stream of work beginning with Finn Kydland and Edward Prescott cast light on the fact that discretionary macro policy tends to be inconsistent through time, where policy commitments made at one point of time are ditched later. Such time inconsistency raises the costs of macroeconomic stabilization. That created the intellectual arguments for independent central banks with inflation targets.
The new macroeconomics had its 25 years of success—as economic fluctuations eased in what came to be known as the Great Moderation. To what extent was the Great Moderation a result of the new macroeconomics? It will never be an easy question to answer, especially since failures are easier to identify than successes. It is a bit like the spy trade. Failures such as terror attacks become talking points while successes in terms of preventing such terror attacks are by definition unknowable. However, some critics have quite convincingly argued that the episode of low inflation plus high economic growth in the years to 2008 could be explained by the impact of China entering the global economy rather than deft macroeconomic policy.
The global financial crisis has thrown the door wide open once again. There is no credible alternative to the dominant macroeconomics as yet—nothing similar to the Keynesian revolution of the 1930s and the Friedmanite revolution of the 1970s. The first response has been the revival of interest in older economists. Hyman Minsky was almost forgotten till the Lehman crisis brought back his theory of financial stability, and especially about how long periods of economic calm encourage people to take extra risks that eventually lead to the next storm. Irving Fisher made a comeback as his warnings in the early decades of the 20th century—that excess debt combined with deflation could pull an economy into a deep recession—got a new resonance. Michal Kalecki showed that income distribution in a country is dependent on the degree of monopoly, and that greater inequality can cut into aggregate demand; the theme of the recent central banking shindig at Jackson Hole was straight out of Kalecki.
Attempts to break new ground have accompanied the revival of the old. The January 2018 issue of the Oxford Review of Economic Policy—thankfully not behind a paywall—is one of the best places to dip into to get a sense of the new direction. In their introductory essay, David Vines and Samuel Wills note: “Four main changes to the core model are recommended: to emphasise financial frictions, to place a limit on the operation of rational expectations, to include heterogeneous agents, and to devise more appropriate microfoundations… In our view, the result will not be a paradigm shift, but an evolution towards a more pluralist discipline”.
The key is pluralism. Macroeconomics is an incredibly rich discipline that need not be boxed into a new consensus. There is a lot of angst about the fact that no new Keynes or Friedman has emerged in the aftermath of the 2008 financial crisis—as happened in the 1930s and 1970s, respectively. Maybe the search for a new consensus is a futile one, and the way ahead is more conversations between different schools of macroeconomics. There is a third way between intellectual monopoly on the one hand and unending street fights on the other.
And so back to Jack Ryan. In an article on the new series, Sophie Gilbert of The Atlantic reminds readers of the recurring diffidence of the protagonist, who often has to remind his superiors that he is actually a mere analyst. “I am an analyst…I’m not trained for that,” Alec Baldwin says in the movie adaptation of The Hunt for Red October. Ten years after the global financial crisis, a similar attitude would also serve economists well.
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