Michael Woodford on the Interdependence of Monetary and Fiscal Policy

(I started writing this post a couple weeks ago and gave up after it got unreasonably long. I don’t feel like finishing it, but rather than let it go to waste I’m putting it up as is. So be warned, it goes on for a long while and then just stops.)

I sat down and read the Michael Woodford article on monetary and fiscal policy I mentioned in the earlier post. It’s very interesting, both directly for what it says substantively, and indirectly for what it says about the modern consensus in economics.

(For those who don’t know, Michael Woodford is a central figure in mainstream New Keynsian macro. His book Interest and Prices is probably the most widely used New Keynesian macro text in top graduate programs.)

The argument of this article is that the question of what monetary policy rule is the best route to price stabilization, cannot be separated from what fiscal rule is followed by the budget authorities. Similarly, any target for the public debt cannot be reduced to a budget rule, but depends on the policy followed by the monetary authorities — though Woodford is not so interested in this side of the question.

This is not a new idea for readers of this blog. But it’s interesting to hear Woodford’s description of the orthodox view.

It is now widely accepted that the choice of monetary policy to achieve a target path of inflation can …, and ought, to be separated from .. the chice of fiscal policy.

Woodford rejects this view — he insists that fiscal policy matters for price stability, and monetary policy matters for the debt-GDP ratio. Most economists think that monetary policy is irrelevant for the debt-GDP ratio, he says,

because seignorage revenues are such a small fraction of total government revenues. … [This] neglects a more important channel … the effects of monetary policy upon the real value of outstanding government debt, through its effects on the price level and upon the real debt service required, … insofar as monetary policy can affect real as well as nominal rates.

There are two deeper issues in the background here, that help explain why orthodox economics ignores the importance of monetary policy for the debt ratio and fiscal policy for price stability. First is the idea, which we can trace from Wicksell through Hayek to Milton Friedman and on to today’s New Keynesians, that the “natural” interest rate in the sense of the interest rate consistent with price stability, must be the same as the “natural” interest rate in the sense of the Walrasian intertemporal rate that would exist in a frictionless, perfect-information economy that somehow corresponded to the economy that actually exists. Few economists are bold enough or naive enough to state this assumption explicitly, but it is fundamental to the project of reconciling orthodox monetary policy with a vision in which money is neutral in the long run. If you want the same interest rate to be “natural” in both senses, it’s a problem if the price-stability natural rate depends on something like fiscal policy, which is not reducible to tastes, technologies and endowments.

Second is the notion of the “long run” itself. For economists, this refers to a situation in which the endogenous variables have fully adjusted to the exogenous variables. This requires a clean (or anyway order-of-magnitude) separation between “fast” endogenous and “slow” exogenous variables; it also requires a sufficiently long time between disturbances.

Woodford, in the passage above, refers to the effects of changes in inflation and interest rates on the burden of the outstanding government debt. This is an important departure from orthodoxy, since in a true “long run” situation, debt would have fully adjusted to the prevailing interest and inflation rates. Woodford, in tune with the practical concerns of central bankers, rejects the ubiquitous methodological condition of modern macroeconomics, that we should only consider fully adjusted long run positions. His whole discussion of public debt, in this paper and elsewhere, rejects the usual working assumption that the existing levels of inflation and interest rates have prevailed since time immemorial. He explicitly analyzes changes in interest and inflation in the context of a historically given debt stock.

Woodford’s attitude toward the “natural” rate is more complicated. He certainly doesn’t take it for granted that the price-stability and Walrasian “natural” rates are the same. But a big part of his project — in Interest and Prices in particular — is precisely to develop a model in which they do turn out to coincide.

Let’s continue with the paper. Most economists believe that:

“Fiscal policy is thought to be unimportant for inflation… [because] inflation is a purely monetary phenomenon,” or else because “insofar as consumers have rational expectations, fiscal policy should have no effect on aggregate demand.”

Woodford rejects both of these claims. Even if people are individually rational, the system as a whole can be “non-Ricardian.” By this he means that changes in government spending will not be offset one for one by changes in private spending. “This happens essentially through the effects of fiscal disturbances upon private sector budget constraints and hence on aggregate demand.” For this reason, “A central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is set.”

Traditionally, the orthodox view of inflation is that it is the result of the money supply growing at a different rate than real economic activity, the latter being independent of the money supply. This does allow for fiscal effects on the price level, but only insofar as public borrowing is monetized. In the familiar “fiscal dominance” scenario, the primary surplus or deficit is fixed by the budget authorities and if the implied issue of public debt is different from the desired holdings of the private sector, the central bank must finance the difference with seignorage. The resulting change in the money supply produces corresponding inflation.

As Woodford says, this is not a useful way of thinking about these issues in real economies, at least in developed countries like the United States. In reality, even when the central bank is subordinate to the budget authorities, as in wartime, this does not take the form of direct monetization of deficits. Rather, “fiscal dominance manifests itself through pressure on the central bank to use monetary policy to maintain the market value of government debt. A classic example is … U.S. monetary policy between 1942 and 1951. … Supporting the price of long-term [government] bonds seems to have been the central element of Fed policy through the late 1940s.” This policy did not affect the price level directly through the money supply, but rather because the target interest rate was too low during the war (although the resulting inflation did not show up until after 1945, due to price controls during the war itself), and too high during in 1948-1950, when the federal government was running large surpluses. In either case, Woodford emphasizes, the causality runs from interest rates, to the price level, to the money supply; the quantity of money plays no independent role.

The basic story Woodford wants to tell is the fiscal theory of the price level. If the stock of outstanding government bonds is greater than the public wants to hold at the prevailing interest rate, then the price of bonds should fall. Normally, this would mean an increase in rates. But if interest rates are pegged — or in other words, if the price of bonds relative to money is fixed — then the price of the whole complex of government liabilities falls. Which is another way of saying the price level rises. Another way of looking at this is that, if output is initially at potential and the volume of government debt rises  with no fall in its nominal price, this must

make households feel wealthier … and thus leads them to demand goods and services in excess of those the economy can supply. … Equilibrium is restored when prices rise to the point that the real value of nominal assets no longer exceeds the present value of expected future primary surpluses.

Of course, this begs the question of why government debt is voluntarily held at a positive price even when there is no reason to expect future primary surpluses. More broadly, it doesn’t explain why anyone wants to hold non-interest bearing government liabilities at all. Woodford could take a chartalist line, talk about tax obligations, but he doesn’t. But even then he’d haven’t of he wouldn’t have explained why people hold large stocks of government debt, which by definition is in excess of tax burden.  The natural answer is that government liabilities are a source of liquidity for the private sector. But if he says that, the rest of his argument is in trouble. First, if demand for government debt is about liquidity, then private actors should consider the terms on which other private actors will accept government liabilities. Second, if liquidity is valuable, then real outcomes will be different in a liquidity-abundant world than in a liquidity-scarce one. This is the fundamental problem with the idea that money is neutral. If money were truly neutral, in the sense that the exact same transactions happen in a world with money that would happen in a hypothetical moneyless world, then there would be no reason for money to be used at all.

Despite these serious logical problems, Woodford uses the orthodox apparatus to make some interesting points. For example, he argues that the reason the mid-century policy of fixing a nominal interest rate did not lead to price instability, was because of adjustments in the federal budget position. It is, he says, a puzzle how

a regime that … fixed nominal interest rates was consistent with relatively stable prices for so long. … According to the familiar Wicksellian view summarized by Friedman, an attempt to peg nominal interest rates should lead to either an inflationary or a deflationary spiral. … It is striking that people were willing to hold long-term Treasury securities at 2.5% during the temporary high inflation (25% annual rate) of 1946-1947; evidently there was little fear … [of] an explosive Wicksellian ‘cumulative process.’

Woodford is right that the consistency of fixed nominal interest rates with price stability even after the removal of wartime price controls is a problem for the simple Wicksell-monetarist view. Whether his preferred solution — an expectation of continued federal budget surpluses — is right, is a different question.

Turning to the other side, the dependence of the budget position on prevailing interest rates, Woodford gives an excellent critique of the prevailing notion of a government intertemporal budget constraint (ITBC), in which government spending must be adjusted so that the present value of future surpluses just equals today’s debt. It is widely believed, he says, that government must satisfy such a constraint, “just as in the case of households and firms. It would then follow that fiscal policy must necessarily be Ricardian,” that is, have no effect on the spending choices of rational, non-liquidity-constrained private actors. “It is true,” he continues, “that general equilibrium models always assume that households and firms optimize subject to a set of budget constraints that imply an intertemporal budget constraint, though they may be even more stringent (as it may not even be possible to borrow against all … future income.”

Note the careful phrasing: I’ve noticed this in Woodford’s other writing too, that he adopts rational expectations as a method without ever endorsing it as a positive claim about the world. Of course we shouldn’t talk about intertemporal budget constraints at all, it’s a meaningless concept for private as well as public borrowers, for reasons Woodford himself makes clear.

This is a nice part of the paper, Woodford’s treatment of the “transversality condition.” This, or the equivalent “no-Ponzi” condition, says that the debt of a government — or any other economic unit — must go to zero as time goes to infinity. The reason mainstream models require this condition is that they assume that in any given period, it is possible for anyone to borrow without limit at the prevailing interest rate. This invites the question: why not then consume an infinite amount forever with borrowed funds? The transversality condition says: You just can’t. It is still the case that at any moment, there is no limit on borrowing; but somehow or other, over infinite time net borrowing must come out to zero. This amounts to deal with the fact that one’s assumptions imply absurd conclusions by introducing another assumption, that absurd outcomes can’t happen. Woodford sees clearly that this does not offer a meaningful limit on fiscal policy:

What kind of constraint upon fiscal policy does this [theory] require? A mere commitment to “satisfy the transversality condition” is plainly unsuitable; this would place no constraints upon observable behavior over any finite time period, so that it is hard to see how the public should be convinced of the truth of such a commitment, in the absence of a commitment to some more specific constraint that happens to imply satisfaction of the transversality condition.

What Woodford doesn’t see, or at least doesn’t acknowledge, is that the transversality condition is equally meaningless as applied to private actors. Which means that you need some positive theory about what range of balance sheet positions are available in any given period — in other words a theory of liquidity. And, that the intertemporal budget constraint is meaningless, has no place in any positive economics.

But in any case, even if we accept the intertemporal budget constraint for private units, it is not applicable to sovereign governments since, (1) they are large relative to the economy and (2) they are not maximizing consumption. All that is needed is that someone ends up voluntarily holding the government’s debt. Even if the government is optimizing something, it is not doing so with respect to fixed prices — or fixed output, though Woodford never considers the possibility of unemployed real resources, a rather major limitation of all his work I’ve read.

Woodford notes, reasonably enough, that if the government issues more liabilities than the public wants to hold at the prevailing prices, then the price of government liabilities will fall; “but this is a condition for market equilibrium given the government’s policy, and not a precondition for the government to issue” new liabilities. In this respect, he suggests that the government is in the same position as a company that issues stock, or, more precisely, a company that repurchases shares rather than issuing dividends. (The formal argument that dividends and repurchases are interchangeable, for which Woodford cites Cochrane, is relevant for my “disgorge the cash” work.)

The advantage of this analogy [between the government a share-repurchasing corporation] is that it is clear in the stock case that the equation is an equilibrium condition that determines the share price, … and not a constraint on corporate policies. There is no requirement, enforced in financial markets, that the company generate earnings that validate whatever market valuation of its stock may happen to exist.

The government is different from the company only because prices happen to be “quoted in units of its liabilities.”

As a positive argument this is not useful, for two related reasons. First, it is still essentially a monetarist account of inflation, except with total government liabilities replacing “money.” And second, he deliberately leaves out any discussion of real effects of inflation. This means that he doesn’t give any explanation for price stability is important. More broadly, he doesn’t have any account of the inflation process that links up to real-world discussions. The article purports to be about a central bank following a Taylor rule, but the word “unemployment” does not occur in it. Nor does the word “liquidity”, inviting the question of why anyone holds money in the first place. As I mentioned earlier, this is a larger problem with the whole idea that money is neutral. In this case, Woodford suggests that one can fully explain inflation in a framework in which inflation is costless, and then introduce costs (to motivate policy) without the positive analysis being affected. Interest and Prices does not have this problem — it is carefully constructed precisely to ensure that conventional monetary policy is both welfare-optimizing, and produces an outcome identical to a Walrasian world without monetary frictions. But this isn’t general — the book’s central model is custom-designed to produce just that result.

The question raised by the article is: If both price stability and debt sustainability are functions of both the government budget and monetary policy, why do we have such a strong consensus in favor of stabilizing output solely via the interest rate, and adjusting the government budget position solely in view of the government debt? Woodford admits that in principle, price stability can be achieved in a “bond price-support regime” in which the government budget responds to shifts in private expenditure and the central bank is responsible only for interest payments on government debt. Formally, Woodford acknowledges, this type of regime should work just as well as the conventional “independent” central bank setup. The problem is that in practice

the nature of the legislative process in a democracy makes it unlikely that government budgets can subjected to the same degree of discipline as monetary policy actions. A nontrivial degree of random variation in the equilibrium price level would be inevitable under the price-support regime, both as a result of random disturbances to fiscal policy that could not be prevented, and as a result of inability to adjust fiscal policy with sufficient precision to offset the consequences of other real disturbances. 

There it is. The only argument for central bank independence is an argument against democracy. Woodford continues:

Controlling inflation through an interest-rate rule such as the Taylor rule represents a more practical alternative, both because it is more politically realistic to imagine monetary policy being subordinated wholly to this task, and because it is technically more feasible to “fine-tune” monetary policy actions as necessary to maintain consistency with stable prices.

The claim that interest rates can be adjusted more quickly than budgets is worth taking seriously. Though of course, one way of taking it seriously would be to contemplate arrangements under which taxes and spending could be adjusted more quickly. But look at the other point: The selling point of orthodoxy, says the pope of modern macroeconomics, is that policy can “subordinated wholly” to “controlling inflation.” Look at Europe today, and tell me they aren’t reaping what they sowed.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”

Strange Defeat

Following up on the previous post, below the fold is an article Arjun and I wrote last year for the Indian publication Economic and Political Weekly, on how liberal New Keynesian economists planted the seeds of their own defeat in the policy arena. 

I should add that Krugman is very far from the worst in this respect. If I criticize my soon-to-be colleague so much, it’s only because of his visibility, and because the clarity of his writing and his genuinely admirable political commitments make it easier to see the constraints imposed by his theoretical commitments. You might say that his distinct virtues bring the common vices into sharper focus.

Strange Defeat: How Austerity Economics Lost All the Intellectual Battles but Won the War
J. W. Mason[1] and Arjun Jayadev[2]
In 2010, policy makers in the advanced industrialized world pivoted sharply away from the Keynesian policies they had briefly espoused in the wake of the financial crisis of 2008-2009. A confluence of economic and political events meant that the fragile consensus in favor of expanding government expenditure broke apart.  Contributing factors included the sharp rise in public debt in much of Europe, largely due to government assumption of the liabilities of failing banks; the rise of “Tea Party” conservatives in the US following the November 2010 congressional elections; and the lack of a convincing political narrative about government expenditure. The Keynesian position was replaced, at least among elite policy makers, with a commitment towards fiscal consolidation and ‘austerity’.
With the hindsight of three years it is clear that this historical recapitulation of the Keynesian versus “Treasury view” debate, 80 years after the original, and the consequent implementation of orthodox policies, was both tragic and farcical. Tragic, because fiscal retrenchment and rectitude prolonged depression conditions in the advanced economies and sentenced millions to the misery of unemployment. Farcical, because the empirical and theoretical foundations of wholesale austerity policies were almost comically weak. A few implausible and empirically questionable papers were used to provide the intellectual cover for the pivot, despite the fact that each in turn was quickly discredited both on their own terms and by real life events. As Mark Blyth (Blyth 2013) put it “Austerity didn’t just fail – it helped blow up the world.”
In the first part of this paper, we review some of the most influential academic arguments for austerity, and describe how they collapsed under scrutiny. In the second, we broaden the focus, and consider the “new consensus” in macroeconomics, shared by most pro-stimulus economists as well as the “austerians.” We argue that this consensus – with its methodological commitment to optimization by rational agents, its uncritical faith in central banks, and its support for the norms of “sound finance” – has offered a favorable environment for arguments for austerity. Even the resounding defeat of particular arguments for austerity is unlikely to have much lasting effect, as long as the economics profession remains committed to a view of the world in which in which lower government debt is always desirable, booms and downturns are just temporary deviations from a stable long-term growth path, and in which – in “normal times” at least — central banks can and do correct all short-run deviations from that optimal path. Many liberal, New Keynesian, and “saltwater” economists have tenaciously opposed austerity in the intellectual and policy arenas.[3] But they are fighting a monster of their own creation.
INTRODUCTION
In April 2013, an influential paper (“Growth in a Time of Debt”) by Carmen Reinhart and Kenneth Rogoff (Reinhart and Rogoff 2010) that purported to show hard limits to government debt before causing sharp decreases in growth was the subject of an enormous amount of attention for the second time.  Whereas in its first airing, the paper became a touchstone paper for the austerity movement across the advanced industrialized world, this time it was for less august reasons. Papers by Herndon, Ash and Pollin (2013) and by Dube (2013) showed the paper to have had serious mistakes in both construction and interpretation. This was not the first time that the academic case for austerity had been shown to be invalid or overstated. Two years earlier the major source of intellectual, support for immediate fiscal retrenchment was provided by another paper (“Large Changes in Fiscal Policy: Taxes Versus Spending”), again by two Harvard economists-Alberto Alesina and Silvia Ardagna (Alesina and Ardagna 2009). This too was shown almost immediately to be deeply flawed, misapplying lessons from boom periods to periods of recession, wrongly attributing fiscal consolidation to countries undergoing fiscal expansion, wrongly applying the special conditions of small open economies to the world at large, and other egregious errors (IMF, 2010, Jayadev and Konczal 2010).
Below, we examine the claims of these key papers and their logical and empirical failings. But the weakness of these papers invites a broader question: How could the wholesale shift to austerity have been built on such shaky foundations? While some of the blame must go to opportunism by policy makers and confirmation bias by politically motivated researchers, a large share of the blame rests with what is often called the “new consensus” in macroeconomic theory, a consensus shared as much by austerity’s ostensible opponents as by its declared supporters. It is a matter of some amazement that the most effective theoretical counterpoint to the austerity position is provided not by cutting edge scholarship, but by a straightforward application of models that college students learn in their second year. Paul Krugman, for instance, most often makes his claims that “economic theory” has well-established answers to the problem of deep recessions, by referring t the IS-LM model. This was first written down by John Hicks in 1936, and has not appeared in graduate economics textbooks in 50years .That it is being trotted out now as the public face of a professional economics to which it bears no resemblance, is remarkable. But it’s perhaps less of a surprise when one recalls that the essential insights of Keynesian economics have long been  banished from mainstream economics, to linger on only in “the Hades of undergraduate instruction.” (Leijonhufvud, 1981)
Modern macroeconomic theory is organized around inter-temporal optimization and rational expectations, while policy discussions are dominated by a commitment to the doctrines of “sound finance” and a preference for ‘technocratic’ monetary policy conducted by ‘independent’ central banks. The historical processes that led to these commitments are complex.  For present purposes, what is important to note is that they severely limit the scope of economic debate.The need for “structural reform” and for long-term budget balance is agreed across the admissible political spectrum, from pro-austerity European conservatives to American liberals who savor the memory of Clinton era debt reduction. Even someone like Paul Krugman, who has been the foremost critic of austerity policies, treats the idea that governments do not face financing constraints, and that macroeconomic policy cannot be fully trusted to central banks, as special features of the current period of “depression economics,” which must sooner or later come to an end. Mainstream Keynesians then become modern day Augustines: “Give me chastity and continence, but not yet”.
THE RISE AND FALL OF AUSTERITY ECONOMICS
In 2010 Alberto Alesina from Harvard University was celebrated by Business Week for his series of papers on fiscal consolidation. This was ‘his hour,’ the article proclaimed (Coy, 2010). His surprising argument that the best way forward for  countries facing high unemplyment was to undertake “Large, credible and decisive spending cuts” was, for a while, on everyone’s lips. Such cuts, he reasoned, would change the expectations of market participants and bring forward investment that was held back by the uncertainty surrounding policy in the recession. Specifically, Alesina and Ardagna purported to show that across a large sample of countries, governments had successfully cut deficits, reduced debts and seen higher growth as a result. The mechanism by which this occurs  enhancing the confidence of investors in countries with “credible” governments, thereby raising investment —  has been derisively labeled ‘the confidence fairy’ by Paul Krugman.
This idea of ‘expansionary austerity’– the notion that cutting spending would increase growth–is both an attack on traditional notions of demand management, and also extraordinarily convenient for conservative macroeconomic policy makers. Not only would reducing the deficit and debt burdens of countries advancetheir  long term goal of reducing  the size of the state, it would riase spending even in the short term, since the confidence effects of fiscal surpluses on private expenditure would more than offset any drag from the public sector contraction. Even better, consolidation was better according to Alesina and Ardagna (2009) if it was weighted towards spending cuts, rather than tax increases. As Coy (2010) notes “The bottom line: Alesina has provided the theoretical ammunition fiscal conservatives want..”
As Blyth (2013) documents, this idea obtained immediate traction among policy-making elites and by mid 2010 the idea of deficit reduction in a period of weak demand (which might otherwise have been deemed nonsensical), was receiving support from high-level policy makers who spoke knowingly about the immediate need to restore ‘confidence’ in the markets.  Thus, for example Jean Claude Trichet, the president of the European Central Bank, observed that
“It is an error to think that fiscal austerity is a threat to growth and job creation. At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable”.[4]
As Blyth notes, while the argument for expansionary austerity was enthusiastically endorsed by policymakers (especially but not only in Europe), the intellectual case collapsed almost immediately. The paper was .. “dissected, augmented, tested, refuted and generally hauled over the coals” (Blyth 2013). First, Jayadev and Konczal (2010) noted that none of the alleged cases of expansionary austerity occurred during recessions. They also noted that in some cases Alesina -Ardagna had misclassified periods of fiscal expansion as periods of fiscal consolidation. Immediately following this, the IMF  (IMF, 2010) noted that the way in which Alesina -Ardagna had classified fiscal policy as being expansionary or contractionary seemed to have very little connection with actual fiscal policy changes. In terms of both effects and causes, the empirical work turned out to be valueless for policy.
Faced with mounting challenges to his work, Alesina appeared undeterred and defended his ideas while prognosticating on the future of Europe: “In addition, what is unfolding currently in Europe directly contradicts Jayadev and Konczal. Several European countries have started drastic plans of fiscal adjustment in the middle of a fragile recovery. At the time of this writing, it appears that European speed of recovery is sustained, faster than that of the U.S., and the ECB has recently significantly raised growth forecasts for the Euro area.” (Alesina 2010).
Three years on, this confident prognostication is an embarassment. The Washington Post,  taking stock of the argument, concluded “No advanced economy has proved Alesina correct in the wake of the Great Recession” (Tankersley, 2013). Not only did austerity not deliver higher growth: in the countries that tried it, output contracted more or less exactly in line with the degree of austerity they managed to impose. (Degrauwe and Ji 2013)
But just as the case for short-term fiscal consolidation was disintegrating in the eyes of all but a few diehard believers, a new set of arguments became the intellectual bulwark of the austerity movement. As the Greek debt crisis spun out of control and interest rates on sovereign debt rose   elsewhere in the European periphery, concern with public debt rose even in countries like the US, where  bond markets were untroubled and yields on government debt remained at record lows. For respectable opinion, the question was when, and not if, government debt needed to be cut, if we do’t want to “turn into Greece.”[5]
It was at this point that the paper by Reinhart and Rogoff struck its mark. Using a panel of data on growth and government debt over many decades, Reinhart and Rogoff came up with a magic number – a 90% government debt to GDP ratio — beyond which economies faced a sharp drop-off in growth rates.
As with expansionary austerity, this argument caught on very quickly with policy makers it was cited by David Cameron, Olli Rehn and Paul Ryan, among others,  to justify a push for deep, immediate debt reduction. Unlike the Alesina-Ardagna paper, this one was not easily refuted.  For one thing, the construction of the paper made it difficult for other researchers to try to replicate the results. But despite some early warnings about interpretations of the data (Bivens and Irons 2010. Ferguson and Johnson 2010), this difficulty was generally  interpreted as a reason to defer to its findings rather than as a basis for skepticism. Second, and more insidiously, there is a widespread agreement among mainstream economists that high government debt must eventually reduce growth, and so Reinhart and Rogoff’s work was received without much critical scrutiny. The 90% threshold seemed to simply confirm a widely accepted principle.
It is not surprising therefore that the errors in Reinhart and Rogoff’s work was discovered by researchers decidedly out of the mainstream. Thomas Herndon, Michael Ash and Robert Pollin, all from the University of Massachusetts Amherst—a department that has been called the ‘single most important heterodox department in the country’ — published a paper in April 2013 which showed that the Reinhart-Rogoff results were the consequence of coding errors and omissions and nonstandard weighting of data. The 90% drop-off in growth disappeared when these errors were corrected.
Even more devastatingly, Arindrajit Dube (also from the University of Massachusetts) showed that if at all there was a correlation between debt and growth, it was more likely that episodes of low growth led to higher levels of debt rather than the other way around. ( Dube, 2013) Again, this counter argument had been made by opponents of austerity, and could easily have been verified by supporters of austerity or Reinhart and Rogoff themselves, but simply hadn’t been taken seriously.
With the key intellectual arguments for the austerity consensus falling apart before their eyes, the commentariat went into overdrive, speculating on the reasons why such policies could be adopted with such little vetting.
The media proposed various  relatively benign reasons: confirmation bias, opportunism by politicians, etc.. But while these were surely factors, they surely do not explain the catastrophic failure of the economics profession to offer a rational basis for policy discussion.
James Crotty has provided a larger political economy framing of the austerity wars (Crotty, 2012). He suggests  that austerian policies should  be seen as class conflict—protecting the interests of the wealthy and attacking those of the poor, and that these battles should be seen as the latest skirmish in a longer war of ideas and priorities. Austerity, fro this viewpoint, is less an intellectual failure than a deliberate choice reflecting the political dominance of finance capital and capital in general[6].
Our purpose in this paper is to more deeply explore the battle of ideas and the extent to which the “macroeconomic consensus”, shared by mainstream economists across the political spectrum, must take a large part of the blame. Many liberal “New Keynesian” economists have done yeoman work in making the political case for stimulus and against austerity. But they have not yet come to terms with the role their own theoretical and policy frameworks played in the turn to austerity – and continue to impede realistic discussion of the crisis and effective responses to it.
THE HEGEMONY OF CONSENSUS MACROECONOMICS
While there is much to admire in the doggedness of the UMass-Amherst team (and the alacrity with which a network of left-leaning bloggers and media figures publicized their results) the truth is that knocking down Alesina and Ardagna and Reinhart and Rogoff’s results wasn’t difficult. The real question is, how was such crude work so successful in the first place?
The easy answer is that it was telling policymakers what they wanted to hear. But that lets the economics profession off too easily. For the past thirty years the dominant macroeconomic models that have been in used by central banks and by leading macroeconomists have had very little time and space for discussions of fiscal policy. In particular, the spectrum of models really ranged only from what have been termed real business cycle theory approaches on the one end to New Keynesian approaches on the other: perspectives that are considerably closer in flavor and methodological commitments to each other than to the ‘old Keynesian’ approaches embodied in such models as the IS-LM framework of undergraduate economics. In particular, while demand matters in the short run in New Keynesian models, it can have no effect in the long run; no matter what, the economy always eventually returns to its full-employment growth path.
And while conventional economic theory saw the economy as self-equilibrating, , economic policy discussion was dominated by faith in the stabilizing powers of central banks and in the conventional wisdom of “sound finance.” Perhaps the major reason Reinhart and Rogoff’s work went unscrutinized for so long is that it was only putting numbers on the prevailing consensus.
This is clearly seen when one observes that some of the same economists who today are leading the charge against austerity, were arguing just as forcefully a few years ago that the most important macroeconomic challenge was reducing the size of public debt. More broadly, work like Alesina -Ardagna and Reinhart – Rogoff has been so influential because the new Keynesians in the economics profession do not provide a compelling argument in favor of stimulus. New Keynesians follow Keynes in name only; they’ve certainly given better policy advice than the austerians in recent years, but such advice does not always flow naturally from their models.
There are two distinct failures here, one in economic theory and the other in discussions of economic policy.
The limited support for fiscal expansion in ‘frontier’ theory
On a theoretical level, professional economists today are committed to thinking of the economy in terms of intertemporal optimization by rational agents. In effect, the first question to ask about any economic outcome is, why does this leave people better off than any alternative? In such framework, agents know their endowments and tastes (and everyone else’s,) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously (“on the 8th day of creation”) the optimal path of labor, output and consumption (Leijonhufvud 1981)).
Given a framework in which explanation in terms of optimization is always the default, it’s natural to think that unemployment is just workers making an optimal choice to take their leisure now, in the knowledge that they will be more productive in the future. In this view — mockingly termed the ‘Great Vacation’ theory of recessions – stimulus is not only ineffective but unneeded, since the “problem” of high unemployment is actually what’s best for everyone. Most economists wouldn’t accept this claim in its bald form. Yet they continue to teach their graduate students that the best way to explain changes in investment and employment is in terms of the optimal allocation of consumption and leisure over time. . New Keynesians have spent a generation trying to show why the economy can move (temporarily) off the optimal path. The solution to these deviations is almost always found in monetary policy and only in very special circumstances can fiscal policy play a (limited)  role.
Degrauwe (2010) distinguishes ‘Old Keynesian’, ‘New Keynesian’ and Real Business cycle (Ricardian) models. He notes that the latter two ‘state of the art’ frameworks are similar in their framing and methodological commitments. As he puts it:

In the (Old) Keynesian model there is no automatic return to the long run output equilibrium. As a result, policy can have a permanent effect on output. The New Keynesian model, like the Ricardian model, contains a very different view of the economy. In this model fiscal policy shocks lead to adjustments in interest rate, prices and wages that tend to crowd out private investment and consumption. As a result, output is brought back to its initial level. In the Ricardian model this occurs very rapidly; in the New Keynesian models this adjustment takes time because of rigidities in wages and prices. But fundamentally, the structure of these two models is the same.

Moreover, in most cases, the ‘rigidities in wages and prices’ in New Keynesian models are best handled by monetary policy.  While these class of models are extremely large and varied, for the most part, in the New Keynesian approach, the key problem arises because periodically the interest rate generated by imperfect competition and pricing rigidities lead to a ‘wrong’ real interest rate.  As Simon Wren-Lewis (2012) argues:

Once we have the ‘wrong’ real interest rate, then (using imperfect competition as a justification) New Keynesian analysis determines output and perhaps employment only from the demand side, and the determination of effective demand becomes critical to the model. Perhaps a better way of saying this is that if real interest rates are at their natural level, we do not need to think about demand when calculating output. In most cases, it is the job of monetary policy to try and get the economy back to this natural real interest rate. This gives you the key insight into why, ZLB problems apart, it is monetary rather than fiscal policy that is the primary stabilizing policy.

Indeed, the New Keynesian models that provide any support for fiscal policy only do so at the zero lower bound, where monetary policy has stopped being effective. And even here, the models can provide some tremendously counterintuitive predictions that militate against common-sense. For example, in the canonical model of policy at the ZLB, a payroll tax cuts are contractionary, by the same logic that  government expenditure is expansionary. Since nobody actually believes this odd result – liberal economists universally supported payroll tax cuts as part of the Obama stimulus package in 2009, and bemoaned the demand-reducing effects of the cuts’ expiration at the beginning of this year – it appears that even New Keynesians don’t really believe their own models are useful guides to questions of stimulus and austerity.
Even if one does believe them, the truth is that New Keynesian models provide very little support for stimulus. With Ricardian equivalence built in, this is always going to be case-but as Cogan et al (2010) show, the majority of these models provide very little empirical support for fiscal policy. Instead, the estimates of effectiveness of fiscal expansion coming from the wide array of these models were very small indeed.
Taken as a whole then, neither the New Classical nor New Keynesian theoretical approaches—those that dominate modern macroeconomics– afford a robust case for fiscal expansion. It is not surprising therefore that Keynesians seeking support for stimulus have ‘retreated’ to older Keynesian frameworks like IS-LM. But this embrace of IS-LM is only for purposes of advocacy; in the journals and the graduate classrooms, New Keynesian models are as dominant as ever.[7]
On the specific question of government finances and the sustainability of debt, the analysis in any modern macroeconomics textbook is in terms of the intertemporal budget constraint. The core idea is that the present value of government spending across all future time must be less than or equal to the present value of taxation across all future time, minus the current value of government debt. This assumes that government must balance budget eventually: After infinite time (this is how economists think), debt must go to zero. And it assumes that interest rates and growth rates are can’t be changed by policy, and that inflation makes no difference — any change in inflation is fully anticipated by financial markets and passed through one for one to interest rates. At the same time, the budget constraint assumes that governments face no limit on borrowing in any given period. This is the starting point for all discussions of government budgets in economics teaching and research. In many graduate macroeconomics courses, the entire discussion of government budgets is just the working-out of that one equation.
But this kind of budget constraint has nothing to do with the kind of financial constraint the austerity debates are about.  The textbook constraint is based on the idea that government is setting tax and spending levels for all periods once and for all. There’s no difference between past and future — the equation is unchanged if you reverse the direction of time and simultaneously reverse the sign of the interest rate. This approach isn’t specific to government budgetconstraints, it’s the way most matters are approached in contemporary macroeconomics. The starting point for most macro textbooks is a model of a “representative agent” allocating known production and consumption possibilities across an infinite time horizon.[8] Economic growth simply means that the parameters are such that the household, or planner, chooses a path of output with higher values in later periods than in earlier ones. Financial markets and aggregate demand aren’t completely ignored, of course, but they are treated as details to be added later, not part of the main structure.
One important feature of these models is that the interest rate is not the cost of credit or finance; rather, it’s the rate of substitution, set by tastes and technology, of spending or taxing between different periods. The idea that interest is the cost of money, not the cost of substitution between the future and the present, was arguably the most important single innovation in Keynes’ General Theory. But it has disappeared from contemporary textbooks, and without it there isn’t even the possibility of bond markets limiting government budget options. As soon as we begin talking about the state of confidence in the bond market, we are talking about a financial constraint, not a budget constraint. But the whole logic of contemporary macroeconomics excludes the possibility of government financial constraints. At no point in either of the two most widely-used macro textbook in the US — Paul Romer’s Advanced Macroeconomics and Blanchard and Fischer’s Lectures on Macroeconomics — are they seriously discussed.
This framework at once overstates and understates the limits on government finances. On the one hand, it ignores the positive possibilities of financial repression to hold down interest rate, and of growing or inflating out of debt,[9] and also the possibility — in fact certainty — that government debt can be held by the public permanently rather than being eventually paid off. But on the other hand, it also ignores reasons why governments might not be able to borrow unlimited amounts in any given period. (This goes for private budget constraints too.) The theory simply doesn’t have any place for the questions about government borrowing
A faulty excel spreadsheet was able to carry the field on stimulus and austerity because the economics profession had already limited itself to conceiving of the main problems of fluctuations as either desirable or easily solved by monetary policy. But the limits of modern macroeconomic theory are only half the problem. The other half is the policy implications promoted by consensus macroeconomics — specifically, the consensus that all the hard policy questions can be delegated to the central bank.
The preference for technical monetary policy
In the view of consensus macroeconomics, Keynes was right that markets alone can’t ensure the full use of society’s resources. But that’s only because a single wrong price, the interest rate. Let a wise planner set that correctly, and everything else will fall into place. Historically, this view owes more to Wicksell than to Keynes. [See Axel Leijonhufvud, “The Wicksellian Heritage.” 1987] But Wicksell was deeply worried by the idea that the market rate of interest, determined by the financial system, could depart from the “natural” rate of interest required to balance demands for present versus future goods. For him, this was a grave source of instability in any fully developed system of credit money. For modern economists, there’s no need to worry; the problem is solved by the central bank, which ensures that the rate of interest is always at the natural rate. Lost in this updating of Wicksell is his focus on the specific features of the banking system that allow the market rate to diverge from the natural rate in the first place. But without any discussion of the specific failures that can cause the banking system to set the interest rate at the “wrong” level, it’s not clear why we should have faith that the central bank can overcome those failures.
Nonetheless, faith in monetary-policy ‘Maestros’, became nearly universal in the 1990s as the cult of Greenspan reached full flower in the US, the European Central Bank came into being as the commanding institution of the European Union, and central banks replaced government ministries as the main locus of economic policy in many countries.  Respectable mainstream economists flirted with fatuity in their paeans to the wisdom of central bankers. In a somewhat ill-timed issue of the Journal of Economic Perspectives, Goodfriend (2007) argued that

The worldwide progress in monetary policy is a great achievement that, especially when viewed from the perspective of 30 years ago, is a remarkable success story. Today, academics, central bank economists, and policymakers around the world work together on monetary policy as never before … The worldwide working consensus provides a foundation for future work because it was forged out of hard practical lessons from diverse national experiences over decades, and because it provides common ground upon which academics and central bankers can work to improve monetary policy in the future.

Christina Romer, a leading American New Keynesian who was soon to lead Barack Obama’s Council of Economic Advisors, was even more obsequious in her praise for the wisdom of central bankers:

The most striking fact about macropolicy is that we have progressed amazingly. … The Federal Reserve is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. … The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards… Real short-run macroeconomic performance has been splendid. … We have seen a glorious counterrevolution in the ideas and conduct of short-run stabilization policy. (Romer 2007)

This was, to put it mildly, an overstatement.
As far as the capabilities of central banks go, there’s reason to doubt that they have the decisive influence on real economic outcomes that the conventional wisdom of the 2000s attributed to them. Short-term interest rates appear to have ceased having much effect on longer rates and on economic activity well before they reached zero.  And if central banks could always guarantee full employment assuming positive interest rates, there would undoubtedly be ways to work around the problem of zero — committing to more expansionary policy in the future, intervening at longer maturities through quantitative easing, and so on. But while the Fed and other central banks – such as the Bank of Japan — have tried many of these unconventional approaches, they have had little impact. This failure should raise serious questions about whether the effectiveness of conventional policy was also exaggerated. The relative stability of output and employment prior to 2008 may not have been, as widely believed, due to the skillful hand of central bankers on the economy’s tiller, but to favorable conditions that were largely outside their control. And in any case, that stability is easy to exaggerate. In the US and Europe, the so-called “Great Moderation” featured asset bubbles and long “jobless recoveries,” while in much of the developing world it witnessed a series of devastating financial crises and repeated collapses in employment and output.
For economists who received their training under the monetarist consensus that has dominated policy discussions since the 1980s, the terms “effective demand failure” and “monetary policy error” were practically synonyms.  This notion that the central bank can achieve any level of money expenditure that it wishes, has always been a matter of faith rather than reason or evidence. But it was a very convenient faith, since it allowed the consensus to remove the most contentious questions of macroeconomic policy from the democratic process, and vest them in a committee of “apolitical” experts.
And that is the other problem with the cult of the central bankers: They have never really been apolitical. Mainstream economists have made the disinterestedness of central banks into an axiom — in standard macro models, the  “reaction function” of monetary policy has the same status as an objective fact about the world as, say, the relationship between unemployment and inflation. It’s taken for granted that while elected officials may be corrupt or captured by particular interests, central bankers are disinterested technicians who only want what’s best for everyone, or at least always follow their stated rules. For prominent liberal economists like Alan Blinder (who served on the Fed board under President Clinton), the performance of “apolitical” central banks is so exemplary that it becomes an argument against political democracy in general:

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. … the argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. … Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? … The justification for central bank independence is valid. Perhaps the model should be extended to other arenas. … The tax system would surely be simpler, fairer, and more efficient if … left to an independent technical body like the Federal Reserve rather than to congressional committees. (Blinder 1987)

The idea of leaving hard questions to “independent technical bodies” is seductive. But in practice, “independent” often means independent from democratic accountability, not from the interests of finance. Private banks have always had an outsize influence on monetary policy. In the early 1930s, according to to economic historians Gerald Epstein and Thomas Ferguson, expansionary monetary policy was blocked by pressure from private banks, whose interests the Fed put ahead of stabilizing the economy as a whole (Epstein and Ferguson, 1984). More recently, in the 1970s and ’80s, for the Fed of this era, holding down wages was job number one, and they were quite aware that this meant taking the of side of business against labor in acute political conflicts. And when a few high-profile union victories, like 1997’s successful strike of UPS drivers, briefly made it appear that organized labor might be reviving, Fed officials made no effort to hide their displeasure:

I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.” (Quoted in “Not Yet Dead at the Fed: Unions, Worker Bargaining, and Economy-Wide Wage Determination” (2005) by  Daniel J.B. Mitchell and Christopher L. Erickson.)

Europe today offers the clearest case of “independent” central banks taking on an overtly political role. The ECB has repeatedly refused to support the markets for European sovereign debt, not because such intervention might fail, but precisely because it might work. As Deutsches Bundesbank president Jens Weidman put it last year, “Relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act.” (“Monetary policy is no panacea for Europe,” Financial Times, May 7 2012.) In a letter to the Financial Times, one European bank executive made the same point even more bluntly: “In addition to price stability, [the ECB] has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.” In other words, it is the job of the ECB not simply to maintain price stability or keep Europe’s financial system from collapsing, but to inflict “pain” on democratically elected governments in order to compel them to adopt “reforms” of its own choosing.
What the ECB means by “reforms” was made very clear in a 2011 memo to the Italian government, setting out the conditions under which it would support the market in Italian debt.  The ECB’s demands included “full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; “reform [of] the collective wage bargaining system … to tailor wages and working conditions to firms’ specific needs…”;  “thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, “making more stringent the eligibility criteria for seniority pensions” and raising the retirement age of women in the private sector. (Quoted in: “Trichet e Draghi: un’azione pressante per ristabilire la fiducia degli investitori,” Corriere della Serra, September 29, 2011.[10]) Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This goes well beyond the textbook remit of a central bank. But it makes perfect sense if one thinks that central banks are not the disinterested experts but representatives of a specific political interest, one that stands to gain from privatization of public goods and weakened protections for workers.
Certainly many economists don’t support the kind of slash-and-burn “reform” being promoted by the ECB. But for the most part, consensus macroeconomics endorsed the delegation of all macroeconomic policymaking to central banks, insisted that monetary policy was a matter for technical expertise and not democratic accountability, and downplayed the real conflicting interests involved. This opened the way to a power grab by the central banks, on behalf of the owners of financial wealth who are their natural constituents.
The theoretical commitment to an economy where markets optimally arrange work, consumption and investment across all time, and the practical commitment to central banks as sole custodians of macroeconomic policy: These were undoubtedly the two most important ways in which the New Keynesian mainstream of economics prepared the way for the success of the austerian Right. A third contribution, less fundamental but more direct, was the commitment of economists to the tenets of “sound finance.”


Commitment to ‘Sound Finance’
The term “sound finance” was adopted in the 1940s by the pioneering American Keynesian Abba Lerner, to describe the view that governments are subject to the same kind of budget constraints as businesses and households, and should therefore guide their fiscal choices by the dangers of excessive debt. He contrasted this view with his own preferred approach, “functional finance,” which held that government budget decisions should be taken with an eye only on the state of the macroeconomy. High unemployment means higher spending and lower taxes are needed, high inflation the opposite; the government’s financial position is irrelevant.
Consensus macroeconomics has a strong commitment to the idea of sound finance. But this commitment is more reflexive, emotional or psychological than based on any coherent vision of the economy. As a result, liberal, “saltwater” economists waver between incompatible views depending on the rhetorical needs of the moment. . On the one hand, when stimulus is  required, they dismiss the idea of financial constraints, and reject the idea of some threshold above which the costs of pubic debt rise precipitously. This was the heart of the Reinhart and Rogoff dispute, and the 90% threshold was the (disproven) cliff. But on the other hand, they invoke the very same cliffs when arguing for surpluses in good times, that they dismiss when arguing for stimulus in bad ones.
This idea that the inflationary constraint to government spending is logically the primary constraint to government spending is rarely promoted. Instead appeals to unobservable ‘cliffs’, nonlinearities and future collapses in confidence dominate the conversation about government spending. Then ECB President Jean-Claude Trichet was roundly attacked by the pro-stimulus economists for arguing, in 2010, in the depths of Europe’s recession, that it was time to cut deficits and raise interest rates, on the grounds that:

The economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors. My understanding is that an overwhelming majority of industrial countries are now in those uncharted waters, where confidence is potentially at stake. Consolidation is a must in such circumstances. (Trichet:”Stimulate no more: Now is the time for all to tighten.” Financial Times, July 22, 2010.)

As the critics rightly pointed out, there is no evidence or systematic argument for these “nonlinear responses.” The Reinhart – Rogoff paper was intended to provide exactly such evidence; its usefulness to conservative policymakers like Trichet was undoubtedly part of the reason for its success. The problem is, the collapse of Reinhart-Rogoff has hardly touched the larger vision of even the richest countries governments as perpetually teetering on the edge of a financial cliff. And one reason for the persistence of this vision is that it is shared by many of Reinhart-Rogoff’s liberal critics.

Here again is Christina Romer — one of the country’s leading “Keynesian” economists—arguing in 2007 that the biggest macroeconomic problem facing the country is that policymakers are not sufficiently worried about holding down government debt. True, she admits, there is no direct evidence high public debt has caused any problems so far. But:

It is possible that the effects of persistent deficits are highly nonlinear. Perhaps over a wide range, deficits and the cumulative public debt really do have little impact on the economy. But, at some point, the debt burden reaches a level that threatens the confidence of investors. Such a meltdown and a sudden stop of lending would unquestionably have enormous real consequences.  (Romer 2007)

Soon after giving this speech, Romer would be one of the leading advocates within the Obama administration for a larger stimulus bill. Lined up against her were economists such as Larry Summers and Peter Orszag. The conservatives’ arguments in that debate recapitulated the language Romer herself had been using less than two years before. Summers, in a contemporary account, “believed that filling the output gap through deficit spending was important, but that a package that was too large could potentially shift fears from the current crisis to the long-term budget deficit, which would have an unwelcome effect on the bond market.”  (Lizza 2009)
Mainstream New Keynesian economists want to argue that lack of fiscal space is never a constraint on stimulus in bad times, but that gaining fiscal space is a reason to run surpluses in good times. Logically, these two views are contradictory. After all, “With low debt, fiscal policy is less costly” and “With high debt, fiscal policy is more costly” are just two ways of saying the same thing. But the mainstream of economists has so far failed to face up to this contradiction. Liberal American economists seem unable to accept that if they give up the idea of a threshold past which the costs of public debt rise steeply, they must also give up the main macroeconomic argument in favor of the Clinton surpluses of the 1990s. Most critics of austerity are reluctant to admit that if high debt is not a constraint on stimulus in bad times, then it is not sensible to talk about “paying for” stimulus with surpluses in good times. Instead, they remain committed to the idea that government surpluses are definitely, absolutely needed – not now, but at some point in the future, they say. But that only cedes the moral high ground to the principled austerians who insist that surpluses are needed today.
In the stimulus vs. austerity wars of the past four years, the New Keynesians who make up the left wing of the mainstream consensus have undoubtedly been on the right side of many big policy questions. Case by case, they certainly have the better arguments. But they have no  vision. And so their victories  overAlesina -Ardagna or  Reinhart- Rogoff, count for much less than you might expect, since in the end, the vision of the economy, of the economics profession, and of economic policy hardly differs between the two camps. Alternative views of the macroeconomy exist, but they are simply ignored.
In this light, it’s interesting to compare Krugman’s 2009 New York Times magazine piece with his recent New York Review of Books piece. In the earlier article, while he has plenty of criticism for politicians, he makes it clear that the  insidious problem is in economics profession. Even the best economists, he writes, prefer mathematical elegance to historical realism, make a fetish of optimization and rational expectations, and ignore the main sources of instability in real economies. In 2009, Krugman was scathing about “the profession’s blindness to the very possibility of catastrophic failures in a market economy,” and made it clear that better policy would require better economics. He was unsparing — and insightful — about his own school as well as his opponents. The New Keynesian models used by “saltwater” economists like himself, he wrote, still “assume that people are perfectly rational and financial markets are perfectly efficient.” He was scornful of the all-purpose excuse that “no one could have predicted,” insisting that the world faced “disasters that could have been predicted, should have been predicted.”[11]
In the 2013 piece,  this self-critical tone is gone. Now, the economics profession as a whole is almost completely exonerated. Their “failure to anticipate the crisis,” he writes, “was a relatively minor sin. Economies are complicated, ever-changing entities; it was understandable that few economists realized” the fragility of the system before the crisis. Instead, his fire is all aimed at politicians, who “turned their back on practically everything economists had learned.”[12]the economists who have given intellectual support for austerity are reduced in this telling to a few outliers, a marginal clique. As a whole, he now says, the profession understands the problem properly; the lack of a proper solution is a sign of “just how little good comes from understanding.” Building a better economics seemed both urgent and promising in 2009; four years later, that project has been abandoned.
CONCLUSION
It is too easy to dismiss the idea of the pivot to austerity as being the failure of flawed papers or as political opportunism alone. Such an analysis misses the fact that, for the majority of the economics profession, , the ideas of stimulus and especially fiscal policy have always been intellectually uncomfortable, while the arguments for austerity and sound finance come naturally. A conception of macroeconomic dynamics in which the economy was by its nature unstable, and central banks could not be relied on to stabilize it, was difficult even to describe in the language of the mainstream. This state of affairs is what Gramsci would identify as hegemony.
The 2008 financial crisis and the multiple subsequent crises it engendered did seem to shake that hegemony. For a brief period, it became obvious that writers such as Keynes, Bagehot, Minsky and even Marx had much more to provide in terms of explanation and solutions than were available from the kind of macroeconomic taught in graduate classes and published in the top journals. But as time has gone on and memories of the crisis have faded, the consensus has reasserted itself. Nowhere, perhaps, has this been more evident, and more consequential, than in the austerity wars.
If Krugman got it right the first time and macroeconomists have no answers today’s urgent questions, and not just that politicians won’t listen to them – the question, then, is what is to be done? There are those who argue that there is nothing intrinsically wrong with the ways in which macroeconomics is studied, that it is just a matter of adding a few more frictions. But this is simply the traditional cherished belief of intellectual endeavors that the discipline always improves on itself. As any historian of ideas might suggest, this narrative of continuously closer approximation to the truth is often a myth, and intellectual “progress” is often down a blind alley or wrong turn.
In Axel Leijonhufvud’s eloquent essay on the value of studying the history of economic thought (Leijonhufvud 2002), he offers the metaphor of a traveller who finds himself at a dead end in the road. If he is very bold, he might try to scale the walls (or bushwhack through the forest) blocking the path. But often, it’s better to backtrack, to see if there was a turnoff somewhere earlier on the road that looked less promising at the time but in retrospect might have been a better choice. This, he suggests, is the situation of economics today. In this case, further progress means, first of all, looking back to earlier points in the discipline’s evolution to see what of value might have been overlooked.
How far back we need to go — how long ago did economics take the wrong turn that led us to the current impasse? Was it 40 years ago, when the rational expectations revolution overturned Gordon’s  “Economics of 1978,” which had less faith in central banks and was perhaps better suited to describing economies as systems evolving in time? Or was it 75 years ago, when Keynes’ radical insights abut fundamental uncertainty and the inherent instability of the capitalist investment process were domesticated by writers like Hicks and Samuelson in the neoclassical synthesis? Or was it 150 years ago, when the classical tradition of Ricardo and Marx – with its attention to dynamics, and central concern with distributional conflict  — was displaced by the marginalist approach that made economics primarily about the static problem of efficient allocation? We do not here suggest that there is nothing worth keeping in the current macroeconomic canon, but we think these earlier traditions suggest important routes forward that have been abandoned. Indeed, those economists who worked in alternative traditions (Minskyan, Post-Keynesian, Marxist, and even Austrian) had a much more robust vocabulary for making sense of the crisis and the responses to it.
The industrialized world has gone through a prolonged period of stagnation and misery and may have worse ahead of it. Probably no policy can completely tame the booms and busts that capitalist economies are subject to. And even those steps that can be taken, will not be taken without the pressure of strong popular movements challenging governments from the outside. The ability of economists to shape the world, for good or for ill, is strictly circumscribed. Still, it is undeniable that the case for austerity – so weak on purely intellectual grounds – would never have conquered the commanding heights of policy so easily, if the way had not been prepared for it by the past thirty years of consensus macroeconomics.  Where the possibility and political will for stimulus did exist, modern economics – the stuff of current scholarship and graduate education –  tended to hinder rather than help. While when the turn to austerity came, even shoddy work could have an outsize impact, because it had the whole weight of conventional opinion behind it. For this the mainstream of the economics profession – the liberals as much as the conservatives — must take some share of the blame.
References
Alesina, Alberto (2010) ‘Fiscal Adjustments:  What do We Know and What are We doing?’ Mercatus Center Working Paper September 2010
Alesina, Alberto and Ardagna, Silvia (2009) ‘Large Changes in Fiscal Policy: Taxes Versus Spending’, National Bureau of Economic Research (NBER), Working Paper No. 15438.
Ball, Laurence, Davide Furceri, Daniel Leigh, and  Prakash Loungani
(2013) The Distributional Effects of Fiscal  Consolidation. IMF working paper

Bivens, Josh and John Irons (2010)’ Government Debt and Economic Growth’
 
Blinder, Alan S (1987) Is Government Too Political? Foreign Affairs Vol. 76, No. 6 (Nov. – Dec., 1997), pp. 115-126
 
De Grauwe Paul  (2010) Fiscal policies in “normal” and “abnormal” recessions. VoxEU, 30th March 2010
De Grauwe Paul and Yuemei Ji (2013) Panic-driven austerity in the Eurozone and its implications.  VoxEu 21st Feb 2013.
Kotlikoff, Laurence (2011).America’s debt woe is worse than Greece’s http://www.cnn.com/2011/09/19/opinion/kotlikoff-us-debt-crisis
Leijonhufvud, Axel (1981) Information and Coordination : Essays in Macroeconomic Theory by Axel Leijonhufvud (1981, Paperback)
Lizza, Ryan (2009)  “Inside the Crisis:Larry Summers and the White House economic team”, New Yorker October 2009.
 
Tankersley, James (2013).Sequester, to some economists, is no sweat, Washington Post, April 2013
Taylor, Lance (2004) Reconstructing Macroeconomics: Structuralist Proposals and Critiques of the Mainstream. Harvard University Pres.

  Economic Policy Institute, #271
Blyth, Mark (2013). Austerity: The History of a Dangerous Idea, OUP USA,
Cogan, John F. & Cwik, Tobias & Taylor, John B. & Wieland, Volker, 2010. “New Keynesian versus old Keynesian government spending multipliers,” Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 281-295, March
Coy, Peter (2010) ‘Keynes vs Alesina. Alesina Who?’ Bloomberg Business Week, June 3, 2010
Crotty, James (2012) The great austerity war: what caused the US deficit crisis and who should pay to fix it?Camb. J. Econ. (2012) 36 (1): 79-10
Dube, Arindrajit (2013) ‘Growth in a Time Before Debt: A Note Assessing Causal Interpretations of Reinhart and Rogoff (2010)’. Mimeo
Eggertsson, Gauti B., What Fiscal Policy is Effective at Zero Interest Rates? (November 1, 2009). FRB of New York Staff Report No. 402. Available at SSRN: http://ssrn.com/abstract=1504828 or http://dx.doi.org/10.2139/ssrn.1504828
Epstein, Gerald, and Thomas Ferguson (1984). “Monetary Policy,Loan Liquidation, and Industrial Conflict: The Federal Reserve and the Open Market Operations of 1932’ Journalof Economic History (December 1984), pp. 957-83.
Ferguson, Thomas and Robert Johnson (2010) “A World Upside Down? Deficit Fantasies in the Great Recession”. Roosevelt Institute
Goodfriend, Marvin. 2007. “How the World Achieved Consensus on Monetary Policy.” Journal of Economic Perspectives, 21(4): 47-68.
Gordon, Robert (2009). “Is Modern Macro or 1978‐era Macro More Relevant to the Understanding of the Current Economic Crisis?”. Mimeo
Herndon, Thomas Michael Ash and Robert Pollin, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute,  Working Paper 322. April 2013;
IMF (2010). “From stimulus to consolidation: revenue and expenditure policies in advanced and emerging economies” Mimeo
Jayadev, Arjun and Michael Konczal (2010) ‘The Boom Not the Slump: The Right Time For Austerity’, August 23, Roosevelt Institute
Leijonhufvud, Axel, (1997), The Wicksellian Heritage, No 9705, Department of Economics Working Papers, Department of Economics, University of Trento, Italia.
Leijonhufvud, Axel, (2002), The Uses of History. Department of Economics, University of Trento, Italia.
Reinhart, Carmen M and Kenneth S. Rogoff (2010), “Growth in a Time of Debt,” American Economic Review: Papers & Proceedings 100 (May 2010): 573–578

Romer, Christina (2007), “Macroeconomic  Policy in the 1960s: The Causes and Consequences of a Misguided Revolution” Speech delivered at the Economic History Association Annual Meeting
Wren-Lewis, Simon (2012).  What is New Keynesian economics really about? http://mainlymacro.blogspot.com/2012/07/what-is-new-keynesian-economics-really.html
[1]          University of Massachusetts Amherst and Roosevelt University
[2]          University of Massachusetts Boston and Azim Premji University
            We would like to thank, without implicating, Suresh Naidu, Jim Crotty, Mark Blyth, Peter Spiegler and an anonymous referee for very helpful comments.
[3]   There is a challenge of terminology here, since economists, perhaps even more than most academics, are committed to the idea of a professional consensus. For the purposes of this article, “liberal”  refers to the left side of mainstream U.S. politics, as opposed to conservative. “New Keynesian” refers to a particular methodology in macroeconomics, which combines the Walrasian general-equilibrium framework of neoclassical economics with a specific set of “frictions” that allow for superficially Keynesian results in the short run, including some form of aggregate demand. (This is opposed by “New Classical” economists, who believe that the long-run models they and the New Keynesians share should be used for the short run as well.) “Saltwater” refers to one side of a sociological divide within the economics profession, with saltwater economists more eclectic, more willing to modify their models as needed to describe particular events or support particular policies, while “freshwater” economists are more committed to logically consistent reasoning from first principles. While these three divisions are distinct in principle, in practice there is much overlap between them. The important point for our purposes is that a strong set of assumptions is shared across all these divides, especially with respect to methodology but also with respect to policy. There is a much wider field of economic beyond this consensus, from the postwar economics of Samuelson, Solow and Tobin; to the radical (or “heterodox”) Keynesian economics kept alive at places like UMass-Amherst, The New School, and the University of Missouri-Kansas City; to the various traditions of Marxism. But since these schools currently have little or no influence on policy in the US or in Europe, they are outside the scope of this article.
[4]          See European Central Bank, Interview with Jean-Claude Trichet, President of the ECB, and Liberation, July 8 2010
[5]          For example, Laurence Kotlikoff (2011) – a respected financial economist —  argued  “The financial sharks are circling Greece because Greece is small and defenseless, but they’ll soon be swimming our way.”
[6]          It is interesting in this regard that a recent paper by the IMF addresses the distributional effects of austerity (Ball et al. 2013) . The abstract alone confirms the Crotty viewpoint: “This paper examines the distributional effects of fiscal consolidation. Using episodes of fiscal consolidation for a sample of 17 OECD countries over the period 1978–2009, we find that fiscal consolidation has typically had significant distributional effects by raising inequality, decreasing wage income shares and increasing long-term unemployment. The evidence also suggests that spending-based adjustments have had, on average, larger distributional effects than tax-based adjustments
[7]   For a sense of what a serious academic development of “IS-LM-style” models could look like, the best starting point is probably the work of Lance Taylor, particularly Reconstructing Macroeconomics. Taylor (2004)
[8]   It is somewhat ironic that the specific growth model that is most often used is the version developed by Robert Solow, since Solow himself is quite critical of the turn toward intertemporal optimization as the core methodology of macroeconomics. http://www.nobelprize.org/nobel_prizes/economics/laureates/1987/solow-lecture.html
[9]          This is also ironic because Carmen Reinhart and Kenneth Rogoff have both argued (albeit unenthusiastically) for financial repression or inflation.
[10]        See also the discussion on the Triple Crisis blog: http://triplecrisis.com/from-technocrats-to-autocrats/
[11]        “How Did Economists Get It So Wrong,” New York Times Magazine, September 2, 2009.
[12] “How the Case for Austerity Has Crumbled,” New York Review of Books, June 6, 2013.

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it’s pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that’s irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different … and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the “self-correcting economy,” even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through “price flexibility.” In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That’s what “a return to full employment via price flexibility” means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run — in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a “surprising big” part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that’s what happens once you accept that your job as an educator is to produce ideological fables.

New Keynesians Don’t Believe Their Models

Here’s the thing about about saltwater, New Keynesian economists: They don’t believe their own theory.

Via John Cochrane, here is a great example. In the NBER Macroeconomics Annual a couple years ago, Gauti Eggertson laid out the canonical New Keynesian case for the effectiveness of fiscal policy when interest rates are at the Zero Lower Bound. In the model Eggertson describes there — the model that is supposed to provide the intellectual underpinnings for fiscal stimulus — the multiplier on government spending at the ZLB is indeed much larger than in normal conditions, 2.3 rather than 0.48. But the same model says that at the ZLB, cuts in taxes on labor are contractionary, with a multiplier of -1. Every dollar of “stimulus” from the Making Work Pay tax credit, in other words, actually reduced GDP by a dollar. Or as Eggertson puts it, “Cutting taxes on labor … is contractionary under the circumstances the United States is experiencing today. “

Now, obviously there are reasons why one might believe this. For instance, maybe lower payroll taxes just allow employers to reduce wages by the same amount, and then in response to their lower costs they reduce prices, which is deflationary. There’s nothing wrong with that story in principle. No, the point isn’t that the New Keynesian claim that payroll tax cuts reduce demand is wrong — though I think that it is. The point is that nobody actually believes it.

In the debates over the stimulus bill back at the beginning of 2009, everyone agreed that payroll tax cuts were stimulus just as much as spending increases. The CBO certainly did. There were plenty of “New Keynesian” economists involved in that debate, and while they may have said that tax cuts would boost demand less than direct government spending, I’m pretty sure that not one of them said that payroll tax cuts would actually reduce demand. And when the payroll tax cuts were allowed to expire at the end of 2012, did anyone make the case that this was actually expansionary? Of course not. The conventional wisdom was that the payroll tax cuts had a large, positive effect on demand, with a multiplier around positive 1. Regardless of good New Keynesian theory.

As a matter of fact, even Eggertson doesn’t seem to believe that raising taxes on labor will boost demand, whether or not it’s what the math says. The “natural result” of his model, he admits, is that any increase in government spending should be financed by higher taxes. But:

There may, however, be important reasons outside the model that suggest that an increase in labor and capital taxes may be unwise and/or impractical. For these reasons I am not ready to suggest, based on this analysis alone, that raising capital and labor taxes is a good idea at zero interest rates. Indeed, my conjecture is that a reasonable case can be made for a temporary budget deficit to finance a stimulus plan… 

Well, yeah. I think most of us can agree that raising payroll taxes in a recession is probably not the best idea. But at this point, what are we even doing here? If you’re going to defer to arguments “outside the model” whenever the model says something inconvenient or surprising, why are you even doing it?

EDIT: I put this post up a few days ago, then took it down because it seemed a little thin and I thought I would add another example or two of the same kind of thing. But I’m feeling now that more criticism of mainstream economics is not a good use of my time. If that’s what you want, you should check out this great post by Noah Smith. Noah is so effective here for the same reason that he’s sometimes so irritatingly wrong — he’s writing from inside the mainstream. The truth is, to properly criticize these models, you have to have a deep knowledge of them, which he has and I do not.

Arjun and I have a piece in an upcoming Economics and Politics Weekly on how liberal, “saltwater” economists share the blame for creating an intellectual environment favorable to austerian arguments, however much they oppose them in particular cases. I feel pretty good about it — will link here when it comes out — I think for me, that’s enough criticism of modern macro. In general, the problem with radical economists is they spend too much time on negative criticism of the economics profession, and not enough making a positive case for an alternative. This criticism applies to me too. My comparative advantage in econblogging is presenting interesting Keynesian and Marxist work.

One thing one learns working at a place like Working Families, the hard thing is not convincing people that shit is fucked up and bullshit, the hard thing is convincing them there’s anything they can do about it.  Same deal here: The real challenge isn’t showing the other guys are wrong, it’s showing that we have something better.

Aggregate Demand and Modern Macro

Start with a point on language.

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”. Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.

This way of thinking is logically incompatible with the way macroeconomics is taught in (almost) all graduate programs today, which is in terms of optimization under an intertemporal budget constraint. I’ll avoid semi-pejorative terms like mainstream and neoclassical, and instead follow Robert Gordon and call this approach modern macro.

In the Keynesian income-expenditure vision — which today survives only, as Leijonhufvud put it, “in the Hades of undergraduate instruction” — we think of economic actors as making decisions about current spending in terms of current receipts. If I earn $X, I will spend $Y; if I earn one dollar more, I’ll spend so many additional cents. We can add detail by breaking these income and expenditure flows in various ways — income from dividends vs. incomes from wages, income to someone at the top decile vs someone at the bottom, income to urban households vs income to rural ones; and expenditures on services, durable goods, taxes, etc., which generate income in their turn. This is the way macro forecasting models used by business and government were traditionally constructed, and may still be for all I know.

Again, these are relationships; they tell us that for any given level of aggregate money income, there is a corresponding level of aggregate expenditure. The level of income that is actually realized, is the one for which desired expenditure just equals income. And if someone for whatever reason adjusts their desired level of expenditure at that income, the realized level of income will change in the same direction, by a greater or lesser extent. (This is the multiplier.)

I should stress that while this way of thinking may imply or suggest concrete predictions, these are not themselves empirical claims, but logical relationships.

The intertemporal optimization approach followed in modern macro is based on a different set of logical relationships. In this framework, agents know their endowments and tastes (and everyone else’s, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously (“on the 8th day of creation” — that’s Leijonhufvud again) the optimal path of labor, output and consumption.

I realize that to non-economists this looks very strange. I want to stress, I’m not giving a dismissive or hostile summary. To anyone who’s done economics graduate work in the last 15 or 20 years (a few heterodox enclaves excepted) constructing models like this is just what “doing macroeconomics” means.

(For a concrete example, a first-year grad textbook offers as one of its first exercises in thinking like an economist the question of why countries often run current account deficits in wartime. The answer is entirely in terms of why countries would choose to allocate a greater share of consumption to periods when there is war, and how interest rates adjust to make this happen. The possibility that war leads to higher incomes and expenditure, some of which inevitably falls on imported goods — the natural answer in the income-expenditure framework — is not even mentioned. Incidentally, as this example suggests, thinking in terms of intertemporal allocation is not always necessarily wrong.)

In these models, there is no special relationship between income and expenditure flows just because they happen to take place at the same time or in any particular order. The choice between jam today and jam tomorrow is no different from the choice between blackberry and lingonberry jam, and the checks you get from your current job and from the job you’ll hold ten years from now are no more different than the checks from two different jobs that you hold right now are. Over one year or 50, the problem is simply the best allocation of your total income over your possible consumption baskets — subject, of course, to various constraints which may make the optimal allocation unachievable.

My point here is not that modern models are unrealistic. I am perfectly happy to stipulate that the realism of assumptions doesn’t matter. Models are tools for logical analysis, not toy train sets — they don’t have to look like real economies to be useful.

(Although I do have to point out that modern macroeconomics models are often defended precisely on the grounds of microfoundations — i.e. more realistic assumptions. But it is simply not true that modern models are more “microfounded” than income-expenditure ones in any normal English sense. Microfoundations does not mean, as you might imagine, that a model has an explicit story about the individual agents in the economy and how they make choices — the old Keynesian models do at least as well as the modern ones by that standard. Rather, microfoundations means that the agents’ choices consist of optimizing some quantity under true — i.e. model consistent — expectations.)

But again, I come not to bury or dispraise modern models. My point is just that they are logically incompatible with the concept of aggregate demand. It’s not that modern macroeconomists believe that aggregate demand is unimportant, it’s that within their framework those words don’t mean anything. Carefully written macro papers don’t even footnote it as a minor factor that can be ignored. Even something anodyne like “demand might also play a role” would come across like the guy in that comic who asks the engineers if they’ve “considered logarithms” to help with cooling.

The atomic units of one vision are flows — that is, money per time period — between economic units. The atomic units of the other are prices and quantities of different goods. Any particular empirical question can be addressed within either vision. But they generate very different intuitions, and ideas of what questions are most important. 

Still, it is true that the same concrete phenomena can be described in either language. The IS curve is the obvious example. In the Hades of the undergraduate classroom we get the old Keynesian story of changes in interest rate changing desired aggregate expenditure at each given income. While in the sunlit Arcadia of graduate classes, the same relationship between interest rates and current expenditure is derived explicitly from intertemporal optimization.

So what’s the problem, you say. If either language can be used to describe the same phenomena, why not use the same language as the vast majority of other economists?

This is a serious question, and those of us who want to do macro without DSGE models need a real answer for it. My answer is that default assumptions matter. Yes, with the right tweaks the two models can be brought to a middle ground, with roughly the same mix of effects from the current state and expected future states of the world. But even if you can get agreement on certain concrete predictions, you won’t agree on what parts of them depend on the hard core of your theory and what on more or less ad hoc auxiliary assumptions. So Occam’s Razor will cut in opposite directions — a change that simplifies the story from one perspective, is adding complexity from the other.

For example, from the income-expenditure perspective, saying that future interest rates will have a similar effect on current activity as current interest rates do, is a strong additional assumption. Whereas from the modern perspective, it’s saying that they don’t have similar effects that is the additional assumption that needs to be explained. Or again, taking an example with concrete applications to teaching, the most natural way to think about interest rates and exchange rates in the income-expenditure vision is in terms of how the the flow of foreign investment responds to interest rates differentials. Whereas in the modern perspective — which is now infiltrating even the underworld — the most natural way is in terms of rational agents’ optimal asset mix, taking into account the true expected values of future exchange rates and interest rates.

Or, what got me thinking about this in the first place. I’ve been reading a lot of empirical work on credit constraints and business investment in the Great Recession — I might do a post on it in the next week or so, though an academic style literature review seems a bit dull even for this blog — and three things have become clear.

First, the commitment to intertemporal optimization means that New Keynesians really need financial frictions. In a world where current output is an important factor in investment, where investment spending is linked to profit income, and where expectations are an independently adjusting variable, it’s no problem to have a slowdown in investment triggered by fall in demand in some other sector, by a fall in the profit share, or by beliefs about the future becoming more pessimistic. But in the modern consensus, the optimal capital stock is determined by the fundamental parameters of the model and known to all agents, so you need a more or less permanent fall in the return on investment, due presumably to some negative technological shock or bad government policy. Liberal economists hate this stuff, but in an important sense it’s just a logical application of the models they all teach. If in all your graduate classes you talk about investment and growth in terms of the technologically-determined marginal product of capital, you can hardly blame people when, faced with a slowdown in investment and growth, they figure that’s the first place to look. The alternative is some constraint that prevents firms from moving toward their desired capital stock, which really has to be a financial friction of some kind. For the older Keynesian perspective credit constraints are one possible reason among others for a non-supply-side determined fall in investment; for the modern perspective they’re the only game in town.

Second, the persistence of slumps is a problem for them in a way that it’s not in the income-expenditure approach. Like the previous point, this follows from the fundamental fact that in the modern approach, while there can be constraints that prevent desired expenditure from being achieved, there’s never causation from actual expenditure to desired expenditure. Businesses know, based on fundamentals, their optimal capital stock, and choose an investment path that gets them there while minimizing adjustment costs. Similarly, households know their lifetime income and utility-maximizing consumption path. Credit constraints may hold down investment or consumption in one period, but once they’re relaxed, desired expenditure will be as high or higher than before. So you need persistent constraints to explain persistently depressed spending. Whereas in the income-expenditure model there is no puzzle. Depressed investment in one period directly reduces investment demand in the next period, both by reducing capacity utilization and by reducing the flow of profit income. If your core vision of the economy is a market, optimizing the allocation of scare resources, then if that optimal allocation isn’t being achieved there must be some ongoing obstacle to trade. Whereas if you think of the economy in terms of income and expenditure flows, it seems perfectly natural that an interruption to some flow will will disrupt the pattern, and once the obstacle is removed the pattern will return to its only form only slowly if at all.

And third: Only conservative economists acknowledge this theoretical divide. You can find John Cochrane writing very clearly about alternative perspectives in macro. But saltwater economists — and the best ones are often the worst in this respect — are scrupulously atheoretical. I suspect this is because they know that if they wanted to describe their material in a more general way, they’d have to use the language of intertemporal optimization, and they are smart enough to know what a tar baby that is. So they become pure empiricists.

In Leon Fink’s wonderful history of the New York health care workers’ union 1199, Upheaval in the Quiet Zone, he talks about how the union’s early leaders and activists were disproportionately drawn from Communist Party members and sympathizers, and other leftists. Like other communist-led unions, 1199 was kicked out of the CIO in the 1940s, but unlike most of the others, it didn’t fade into obscurity. Originally a drugstore-employees union, it led the new wave of organizing of health care and public employees in the 1960s. Fink attributes a large part of its unusual commitment to organizing non-white and female workers, in an explicitly civil-rights framework, and its unusual lack of corruption and venality, to the continued solidarity of the generation of the 1930s. Their shared political commitments were a powerful source of coordination and discipline. But, says Fink, it was impossible for them to pass these commitments on to the next generation. Yes, in 1199, unlike most other unions, individual leftists were not purged; but there was still no organized left, either within the union or in connection to a broader movement. So there was no way for the first generation to reproduce themselves, and as they retired 1199 became exposed to the same pressures that produced conservative, self-serving leadership in so many other unions.

I feel there’s something similar going on in economics. There are plenty of people at mainstream departments with a basically Keynesian vision of the economy. But they write and, especially, teach in a language that is basically alien to that vision. They’re not reproducing the capacity for their own thought. They’re running a kind of intellectual extractive industry, mining older traditions for insights but doing nothing to maintain them.

I had this conversation with a friend at a top department the other day:

  what do you think? is this kind of critique valid/useful?
11:17 AM him: its totally true
11:18 AM and you wouldn’t know what was getting baked into the cake unless you were trained in the literature
  I only started understanding the New Keynsian models a little while ago
  and just had the lazy “they are too complicated” criticism
11:19 AM now I understand that they are stupidly too complicated (as Noah’s post points out)
11:20 AM me: so what is one supposed to do?
  if this is the state of macro
 him: i dunno. I think participating in this literature is a fucking horror show
 me: but you don’t like heterodox people either, so….?
11:21 AM him: maybe become a historian
  or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

This is where so many smart people I know end up. You have to use mainstream models — you can’t move the profession or help shape policy (or get a good job) otherwise. But on many questions, using those models means, at best, contorting your argument into a forced and unnatural framework, with arbitrary-seeming assumptions doing a lot of the work; at worst it means wading head-deep into an intellectual swamp. So you do some mix of what my friend suggests here: find a version of the modern framework that is loose enough to cram your ideas into without too much buckling; or give up on telling a coherent story about the world and become a pure empiricist. (Or give up on economics.) But either way, your insights about the world have to come from somewhere else. And that’s the problem, because insight isn’t cheap. The line I hear so often — let’s master mainstream methods so we can better promote our ideas — assumes you’ve already got all your ideas, so the only work left is publicity.

If we want to take questions of aggregate demand and everything that goes with it — booms, crises, slumps — seriously, then we need a theoretical framework in which those questions arise naturally.

[*] Keynes’ original term was “effective demand.” The two are interchangeable today. But it’s interesting to read the original passages in the GT. While they are confusingly written, there’s no question that Keynes’ meant “effective” in the sense of “being in effect.” That is, of many possible levels of demand possible in an economy, which do we actually see? This is different from the way the term is usually understood, as “having effect,” that is, backed with money. Demand backed with money is, of course, simply demand.  

UPDATE: The Cochrane post linked above is really good, very worth reading. It gives more of the specific flavor of these models than I do. He writes: In Old Keynesian models,

consumption depends on today’s income through the “marginal propensity to consume” mpc. 

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.  

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time. 

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Note, for example, that in a standard New Keynesian model, expected future interest rates enter into current consumption exactly as the present interest rate does. This will obviously shape people’s intuitions about things like the effectiveness of forward guidance by the Fed.

UPDATE 2: As usual, this blog is just an updated, but otherwise much inferior, version of What Leijonhufvud Said. From his 2006 essay The Uses of the Past:

We should expect to find an ahistorical attitude among a group of scientists busily soling puzzles within an agreed-upon paradigm… Preoccupation with the past is then a diversion or a luxury. When things are going well it is full steam ahead! …. As long as “normal” progress continues to be made in the established directions, there is no need to reexamine the past… 

Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the “frontier of the field” ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we get stuck. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might be content to accommodate themselves to it, spend their time tidying up the place, putting in modern conveniences… Braver souls will want out and see a tremendous leap of the creative imagination as the only way out — a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even probable, that some roads were more promising than the one that looked most promising at the time…

This is exactly the spirit in which I’m trying to rehabilitate postwar income-expenditure Keynesianism. The whole essay is very worth reading, if you’re interest at all in the history of economic thought.

Prices and the European Crisis, Continued

In comments to yesterday’s post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,

pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.

I don’t know. I suppose we all agree that exchange rate changes won’t help in the short run (in fact, I’m not sure Krugman does agree), but I’m not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was

We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.

We “know,” it “must”: not much wiggle room there.

So this is the question, and I think it’s an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It’s worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because

he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country’s currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: “A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country’s merchandise balance.” Keynes was convinced that for Britain exchange depreciation would be disastrous…

Keynes’ “elasticity pessimism” is distinctly unfashionable today. It’s an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade

Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries’ long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let’s look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece’s merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it’s hard to see a relationship between the exchange rate and trade flows. It’s especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s — quite a large movement as these things go — had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It’s very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It’s hard to judge this just by looking at a figure. (That’s why God gave us econometrics — though to be honest I’m a bit skeptical about the possibility of getting a definite answer here.) But here’s a suggestive point. Greece’s real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It’s hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it’s hard to see fixed exchange rates, in themselves, as an important cause of the crisis.

[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I’ve quoted this here before, but it’s worth repeating:

I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth… Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. … Thus we are driven to supply-side explanations…
The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.

UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country’s growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance — this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven’t had time to read the paper properly yet, but I wouldn’t be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, “But devaluation has to work. It just has to.” And she knows this stuff far better than I do, so, maybe.

Graeber Cycles and the Wicksellian Judgment Day

So it’s halfway through the semester, and I’m looking over the midterms. Good news: Learning has taken place.

One of the things you hope students learn in a course like this is that money consists of three things: demand deposits (checking accounts and the like), currency and bank reserves. The first is a liability of private banks, the latter two are liabilities of the central bank. That money is always someone’s liability — a debt — is often a hard thing for students to get their heads around, so one can end up teaching it a bit catechistically. Balance sheets, with their absolute (except for the exceptions) and seemingly arbitrary rules, can feel a bit like religious formula. On this test, the question about the definition of money was one of the few that didn’t require students to think.

But when you do think about it, it’s a very strange thing. What we teach as just a fact about the world, is really the product of — or rather, a moment in — a very specific historical evolution. We are lumping together two very different kinds of “money.” Currency looks like classical money, like gold; but demand deposits do not. The most obvious difference, at least in the context of macroeconomics, is that one is exogenous (or set by policy) and the other endogenous. We paper this over by talking about reserve requirements, which allow the central bank to set “the” money supply to determine “the” interest rate. But everyone knows that reserve requirements are a dead letter and have been for decades, probably. While monetarists like Nick Rowe insist that there’s something special about currency — they have to, given the logic of their theories — in the real world the link between the “money” issued by central banks and the “money” that matters for the economy has attenuated to imperceptible gossamer, if it hasn’t been severed entirely. The best explanation for how conventional monetary policy works today is pure convention: With the supply of money entirely in the hands of private banks, policy is effective only because market participants expect it to be effective.

In other words, central banks today are like the Chinese emperor Wang Wei-Shao in the mid-1960s film Genghis Khan:

One of the film’s early scenes shows the exquisitely attired emperor, calligraphy brush in hand, elegantly composing a poem. With an ethereal self-assurace born of unquestioning confidence in the divinely ordained course of worldly affairs, he explains that the poem’s purpose is to express his displeasure at the Mongol barbarians who have lately been creating a disturbance on the empire’s western frontier, and, by so doing, cause them to desist.  

Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets… Central bankers’ public utterances … regularly move prices and yields in the financial markets, and these financial variables in turn affect non-financial economic activity… Indeed, a widely shared opinion today is that central bank need not actually do anything. … 

In truth the ability of central banks to affect the evolution of prices and output … [is] something of a mystery. … Each [explanation of their influence] … turns out to depend on one or another of a series of by now familiar fictions: households and firms need currency to purchase goods and services; banks can issue only reserve-bearing liabilities; no non-bank financial institutions create credit; and so on. 

… at a practical level, there is today [1999] little doubt that a country’s monetary policy not only can but does largely determine the evolution of its price level…, and almost as little doubt that monetary policy exerts significant influence over … employment and output… Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. … There may well have been a time when the might of the Chinese empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders withdraw.

What looked potential a dozen years ago is now actual, if it wasn’t already then. It’s impossible to tell any sensible macroeconomic story that hinges on the quantity of outside money. The shift in our language from  money, which can be measured — that one could formulate a “quantity theory” of  — to discussions of liquidity, still a noun but now not a tangible thing but a property that adheres in different assets to different degrees, is a key diagnostic. And liquidity is a result of the operations of the financial system, not a feature of the natural world or a dial that can be set by the central bank. In 1820 or 1960 or arguably even in 1990 you could tell a kind of monetarist story that had some purchase on reality. Not today. But, and this is my point! it’s not a simple before and after story. Because, not in 1890 either.

David Graeber, in his magisterial Debt: The First 5,000 Years [1], describes a very long alternation between world economies based on commodity money and world economies based on credit money. (Graeber’s idiolect is money and debt; let’s use here the standard terms.) The former is anonymous, universal and disembedded, corresponds to centralized states and extensive warfare, and develops alongside those other great institutions for separating people from their social contexts, slavery and bureaucracy. [2] Credit, by contrast, is personal, particular, and unavoidably connected with specific relationships and obligations; it corresponds to decentralized, heterogeneous forms of authority. The alternations between commodity-money systems,with their transcendental, monotheistic religious-philosophical superstructures; and credit systems, with their eclectic, immanent, pantheistic superstructures, is, in my opinion, the heart of Debt. (The contrast between medieval Christianity, with its endless mediations by saints and relics and the letters of Christ’s name, and modern Christianity, with just you and the unknowable Divine, is paradigmatic.) Alternations not cycles, since there is no theory of the transition; probably just as well.

For Graeber, the whole half-millenium from the 16th through the 20th centuries is a period of the dominion of money, a dominion only now — maybe — coming to an end. But closer to ground level, there are shorter cycles. This comes through clearly in Axel Leijonhufvud’s brilliant short essay on Wicksell’s monetary theory, which is really the reason this post exists. (h/t David Glasner, I think Ashwin at Macroeconomic Resilience.) Among a whole series of sharp observations, Leijonhufvud makes the point that the past two centuries have seen several swings between commodity (or quasi-commodity) money and credit money. In the early modern period, the age of Adam Smith, there really was a (commodity) money economy, you could talk about a quantity of money. But even by the time of Ricardo, who first properly formalized the corresponding theory, this was ceasing to be true (as Wicksell also recognized), and by the later 19th century it wasn’t true at all. The high gold standard era (1870-1914, roughly) really used gold only for settling international balances between central banks; for private transactions, it was an age not of gold but of bank-issued paper money. [3]

If I somehow found myself teaching this course in the 18th century, I’d explain that money means gold, or gold and silver. But by the mid 19th century, if you asked people about the money in their pocket, they would have pulled out paper bills, not so unlike bills of today — except they very likely would have been bills issued by private banks.

The new world of bank-created money worried classical economists like Wicksell, who, like later monetarists, were strongly committed to the idea that the overall price level depends on the amount of money in circulation. The problem is that in a world of pure credit money, it’s impossible to base a theory of the price level on the relationship between the quantity of money and the level of output, since the former is determined by the latter. Today we’ve resolved this problem by just giving up on a theory of the price level, and focusing on inflation instead. But this didn’t look like an acceptable solution before World War II. For economists then — for any reasonable person — a trajectory of the price level toward infinity was an obvious absurdity that would inevitably come to a halt, disastrously if followed too far. Whereas today, that trajectory is the precise definition of price stability, that is, stable inflation. [4] Wicksell was part of an economics profession that saw explaining the price level as a, maybe the, key task; but he had no doubt that the trend was toward an ever-diminishing role for gold, at least domestically, leaving the money supply in the hands of the banks and the price level frighteningly unmoored.

Wicksell was right. Or at least, he was right when he wrote, a bit before 1900. But a funny thing happened on the way to the world of pure credit money. Thanks to new government controls on the banking system, the trend stopped and even reversed. Leijonhufvud:

Wicksell’s “Day of Judgment” when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death [in 1926]. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system’s total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.

But although Judgment Day was postponed it was not cancelled. … The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, “smart cards” are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting. “Reserve requirements already are becoming a dead issue.”

The second bolded sentence makes a nice point. Milton Friedman and his followers are regarded as opponents of regulation, supporters of laissez-faire, etc. But to the extent that the theory behind monetarism ever had any validity (or still has any validity in its present guises) it is precisely because of strict government control over credit creation. It’s an irony that textbooks gloss over when they treat binding reserve requirements and the money multiplier as if they were facts of nature.

(That’s more traditional textbooks. Newer textbooks replace the obsolete story that the central bank controls interest rates by setting the money supply with a new story that the central bank sets the interest rate by … look, it just does, ok? Formally this is represented by replacing the old upward sloping LM curve with a horizontal MP (for monetary policy) line at the interest rate chosen by the central bank. The old story was artificial and, with respect to recent decades, basically wrong, but it did have the virtue of recognizing that the interest rate is determined in financial markets, and that monetary policy has to operate by changing the supply of liquidity. In the up-to-date modern version, policy might just as well operate by calligraphy.)

So, in the two centuries since Heinrich van Storch lectured the young Grand Dukes of Russia on the economic importance of “precious metals and fine jewels,” capitalism has gone through two full Graeber cycles, from commodity money to credit money, back to (pseudo-)commodity money and now to credit money again. It’s a process that proceeds unevenly; both the reality and the theory of money are uncomfortable hybrids of the two. But reality has advanced further toward the pure credit pole than theory has.

This time, will it make it all the way? Is Leijonhufvud right to suggest that Wicksell’s Day of Judgment was deferred but not canceled, and now is at hand?

Certainly the impotence of conventional monetary policy even before the crisis is a serious omen. And it’s hard to imagine a breakdown of the credit system that would force a return to commodity money, as in, say, medieval China. But on the other hand, it is not hard to imagine a reassertion of the public monopoly on means of payment. Indeed, when you think about it, it’s hard to understand why this monopoly was ever abandoned. The practical advantages of smart cards over paper tokens are undeniable, but there’s no reason that the cards shouldn’t have been public goods just like the tokens were. (For Graeber’s spiritual forefather Karl Polanyi, money, along with land and labor, was one of the core social institutions that could not be treated as commodities without destroying the social fabric.) The evolution of electronic money from credit cards looks contingent, not foreordained. Credit cards are only one of several widely-used electronic means of payment, and there’s no obvious reason why they and not one of the ones issued by public entities should have been adopted universally. This is, after all, an area with extremely strong network externalities, where lock-in is likely. Indeed, in the Benjamin Friedman article quoted above, he explicitly suggests that subway cards issued by the MTA could just as easily have developed into the universal means of payment. After all, the “pay community” of subway riders in New York is even more extensive than the pay community of taxpayers, and there was probably a period in the 1990s when more people had subway cards in their wallets than had credit or debit cards. What’s more, the MTA actually experimented with distributing subway card-reading machines to retailers to allow the cards to be used like, well, money. The experiment was eventually abandoned, but there doesn’t seem to be any reason why it couldn’t have succeeded; even today, with debit/credit cards much more widespread than two decades ago, many campuses find it advantageous to use college-issued smart cards as a kind of local currency.

These issues were touched on in the debate around interchange fees that rocked the econosphere a while back. (Why do checks settle at par — what I pay is exactly what you get — but debit and credit card transactions do not? Should we care?) But that discussion, while useful, could hardly resolve the deeper question: Why have we allowed means of payment to move from being a public good to a private oligopoly? In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay any third party for permission to make the trade. Now, most of the time, we do. And the payments are not small; monetarists used to (still do?) go on about the “shoe leather costs” of holding more cash as a serious reason to worry about inflation, but no sane person could imagine those costs could come close to five percent of retail spending. And that’s not counting the inefficiencies. This is a private sales tax that we allow to be levied on almost every transaction,  just as distortionary and just as regressive as other sales taxes but without the benefit of, you know, funding public services. The more one thinks about it, the stranger it seems. Why, of all the expansions of public goods and collective provision won over the past 100 or 200 years, is this the one big one that has been rolled back? Why has this act of enclosure apparently not even been noticed, let alone debated? Why has the modern equivalent of minting coinage — the prerogative of sovereigns for as long as there’ve been any — been allowed to pass into the hands of Visa and MasterCard, with neoliberal regimes not just allowing but actively encouraging it?

The view of the mainstream — which in this case stretches well to the left of Krugman and DeLong, and on the right to everyone this side of Ron Paul — is that, whatever the causes of the crisis and however the authorities should or do respond, eventually we will return to the status quo ante. Conventional monetary policy may not be effective now, but there’s no reason to doubt that it will one day get back to so being. I’m not so sure. I think people underestimate the extent to which modern central banking depended on a public monopoly on means of payment, a monopoly that arose — was established — historically, and has now been allowed to lapse. Christina Romer’s Berkeley speech on the glorious counterrevolution in macroeconomic policy may not have been anti-perfectly timed just because it was given months before the beginning of the worst recession in 70 years, but because it marked the end of the period in which the body of theory and policy that she was extolling applied.

[1] Information wants to be free. If there’s a free downloadable version of a book out there, that’s what I’m going to link to. But assuming some bank has demand deposits payable to you on the liability side of its balance sheet (i.e. you’ve got the money), this is a book you ought to buy.

[2] In pre-modern societies a slave is simply someone all of whose kinship ties have been extinguished, and is therefore attached only to the household of his/her master. They were not necessarily low in status or living standards, and they weren’t distinguished by being personally subordinated to somebody, since everyone was. And slavery certainly cannot be defined as a person being property, since, as Graeber shows, private property as we know it is simply a generalization of the law of slavery.

[3] A point also emphasized by Robert Triffin in his essential paper Myths and Realities of the So-Called Gold Standard.

[4] Which is a cautionary tale for anyone who thinks the fact that an economic process that involves some ratio diverging to infinity is by defintion unsustainable. Physiocrats thought a trajectory of the farming share of the population toward zeo was an absolute absurdity and that in practice it could certaily not fall below half. They were wrong; and more generally, capitalism is not an equilibrium process. There may be seven unsustainable processes out there, or even more, but you cannot show it simply by noting that the trend of some ratio will take it outside its historic range.

UPDATE: Nick Rowe has a kind of response which, while I don’t agree with it, lays out the case against regarding money as a liability very clearly. I have a long comment there, of which the tl;dr is that we should be thinking — both logically and chronologically — of central bank money evolving from private debt contracts, not from gold currency. I don’t know if Nick read the Leijonhufvud piece I quote here, but the point that it makes is that writing 100-odd years ago, Wicksell started from exactly the position Nick takes now, and then observed how it breaks down with modern (even 1900-era modern) financial systems.

Also, the comments below are exceptionally good; anyone who read this post should definitely read the comments as well.

Noah Clue

Hey you guys! You know how unemployment has been, like, real high for years now, and nobody knows why? Noah Smith has figured it out:

an economic principle often overlooked by progressives: There is sometimes a tradeoff between wages and employment levels (which is another way of saying that labor supply curves slope up and labor demand curves slope down). If economic “frictions” or the actions of policymakers hold wages up when economic forces are trying to push wages down, unemployment will often result. 

I think he learned it in an economics class!

You remember how there were these economic forces in 2007 that decided wages had to go down, but we got all these new policies to raise wages like, you know, all those wage-raising things that Bush did? Well, that’s why unemployment went up by 5 points in less than two years. 

I mean, it’s so simple when you think about it. “Labor demand curves slope down,” that’s all you need to know. We learn that the first year of micro, supply curves slope up, demand curves slope down. Demand for labor, demand for cottage cheese, doesn’t matter, they’re just the same. Why do they even bother offering courses in macro?
It’s funny, though: Wasn’t there some guy who wrote a whole book about why lower wages don’t raise employment? Maynard, or some weird name like that? Well, Noah’s never heard of him, or of his book (the General Theory of something?) but he can’t be worth bothering with, can he? after all, he didn’t even realize that demand curves slope down! Which is all you need to know.
Of course, lower wages won’t help employment if there is already an excess supply of labor. If people are already willing to work for less than the going wage, telling them they should accept less than the going wage can’t be the solution. What would we call a situation like that? How about … “involuntary unemployment”? But Noah Smith is too smart for that, he knows that could never happen. He knows that markets always clear, employment is always at the intersection of the labor supply curve and the labor demand curve, so the only way to raise employment must be to move the labor supply curve downward. It’s just Econ 101, and Econ 101 is never wrong.
Of course, if you think that wages are equal to the marginal product of labor, the demand curve for labor will only slope downward when the marginal product of labor is falling — which might not be the case when output is far from potential. But Noah Smith knows that demand curves always slope downward, so there can’t be any range of output over which the mpl is more or less constant.
But wait, what if labor markets are monopsonistic? Then the observed labor demand curve can slope upward. And monopsony in labor markets doesn’t require a company town, all it requires is that a firm’s labor costs are rising in employment. Or in other words that if a firm cuts wages moderately, it will lose some but not all of its workers. (Crazy talk, I know.) Which is the natural result of labor market models with search frictions. This is one reason why the most rigorous empirical studies of legislated wage changes show no sign of a downward sloping labor demand curve. But Noah Smith doesn’t need to trouble his beautiful mind with empirical evidence, or learn any of that silly labor economics stuff, because he knows that labor demand curves slope downward. He learned it in introductory micro!
And then there’s that little difference between labor and cottage cheese, that wages make up the large majority of producers’ variable costs. So we have to think general equilibrium here, not just partial. Prices, in the first instance, are set as a markup over marginal costs. [1] So if you reduce money wages, you don’t reduce real wages by as much, because you reduce the price level as well. That means deflation, which is … let’s see, not always super great for employment. That Maynard dude wrote something about that too, I think, and so did some other old guy, Hunter or Trapper or something. Apparently there was this crazy idea that falling wages and prices were a problem back in Ancient Rome, or maybe the 1930s (same thing). But Noah goes to a good graduate school, so he knows that no real economist bothers with dusty old stuff like that. After all it’s not like there are any lessons we could learn from the Great Depression, or the Punic Wars or whatever it was. Not when we know that labor demand curves slope down!
Oh and hey, there’s another difference between labor and cottage cheese! (Who’d have thought?) Wages are also a source of demand. Pop quiz for Noah Smith: Which is a more important component of final demand, consumption out of wages, or net exports? Yeah, that would be door number one. So maybe, just maybe, whatever competitive advantage lower wages yield in lower unit labor costs might be offset by lower consumption demand by wage-earners? And that’s assuming that changes in wages are fully passed through into the relative price of tradables, and that trade flows are price-elastic. [2] But hey, you know what happens when you assume: it makes you an … economist. Now, if it were the case that wages were an important source of final demand, and if output is demand-constrained, then lowering wages might not raise demand for labor, even if labor markets were fully competitive and if changes in nominal wages translated one for one into changes in real wages. But that’s unpossible! because, as we all know, the demand curve for labor slopes down.
Well, but demand doesn’t matter, since Noah knows — he learned it in school — the economy is always at full employment. If we observe fewer people working, it can’t be because aggregate demand has fallen, it can only be because an artificially high price of labor has led to substitution away from labor to other factors of production. It couldn’t possibly be the case that when unemployment is high, capital is underutilized as well too, could it? Because that would mean that the wage share and the profit share were both too high, which is like saying that x>y and y>x. So no, we couldn’t possibly observe anything like this:
Because we know — it’s economics 101 — that high unemployment can only ever be the result of substitution away from labor because of changes in relative prices, not a lower level of output for the economy as a whole. Altho, gosh, it sure looks like capacity utilization falls in recessions just like employment does, which would suggest that cyclical unemployment has nothing to do with the relative price of labor.
So, ok, we can forget Keynes and all that old nonsense. And let’s ignore the effect of nominal wage changes on prices. And put out of our mind any question about whether the marginal product of labor is really declining over current levels of output, or about imperfect competition in labor markets. And we’ll ignore the role of wages as a source of demand. And we’ll unlearn any information we might have accidentally picked up about the empirical relationship between wages and employment, or about the Great Depression. And we’ll stick our fingers in our ears if anyone suggests that unemployment today is associated with demand constraints on output rather than substitution away from labor. And then we can be as smart as Noah Smith! And we’ll know how to fix unemployment:
In Germany, labor unions often negotiate wage cuts in order to preserve long-term employment levels. I think we should look at doing something similar.
You guys, wage concessions! Has anybody in the US labor movement ever thought of that? I bet it will work great! It’s pretty ballsy of Noah Smith to stand up against Big Labor, but someone’s got to, right? I mean, unions represent almost 7 percent of the private workforce. If someone is holding wages above the level that Economic Forces want them to be at, who else could it be?
Hey, I wonder if any other countries are getting advice from smart economists like Noah Smith, and are fixing all their problems by cutting wages? You know, I think there are some. How about Latvia? The authorities there were all, like, wages are going down. And guess what? While in the US unemployment has gone from 5% in 2007 to over 8% today, in Latvia it went from 5% to … 14%? Well, who cares about some little Baltic country, let’s talk about the UK. They got real wages down by 2.7 percent last years (2.1 percent nominal growth less 4.8 percent inflation.) And hey, look at employment — it’s skyrocketing continuing to fall, and now the lowest it’s been since 2003.
Um.
You know what? I’m beginning to think that “labor demand curves slope down” might not be the best way to think about unemployment. Maybe it is helpful to know something about macroeconomics, after all.

[1] Or equal to marginal costs if you like; the point is the same.

[2] I’ve presented some evidence on whether trade flows are responsive to relative costs in practice in these posts.

Glorious Counterrevolution

It’s September of 2007. Though almost no one realizes it, the so-called Great Moderation is ending. The housing bubble has just peaked, a rolling financial conflagration has already started, and the US economy is descending into its steepest downturn since the 1930s.

And a well-known economist is saying:

One of the most striking facts about macropolicy is that we have progressed amazingly. … In my opinion, better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. ..

The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.

Who is it?

Must be one of those smug right-wing Chicago types, right? Maybe Robert Lucas, whose claim that the “central problem of depression-prevention has been solved” was so widely mocked when the crisis broke out?

Nope. It’s Christina Romer, soon to be Obama’s top economist.

As Obama’s CEA chair, by all accounts Romer led the pro-stimulus forces in the administration against the forces of austerity. Yet there she is, in Berkeley in 2007, speaking without irony of the “glorious counterrevolution” against Keynes in the 1980s:

The 1960s represented the beginning of a long dark period for macroeconomic policy…. [But] since 1985, inflation has been below 4% every single year and has averaged just 2.5%. Real short-run macroeconomic performance has been similarly splendid. … As someone who started her career saying there had not been a stabilization of the postwar economy, I now have to admit there most certainly has been – it just started in 1985, not 1947. ..

What stops this story from being a good morality play is that good hasn’t triumphed entirely. At the same time that we have seen a glorious counterrevolution in the ideas and conduct of short-run stabilization policy, we have seen a remarkable lack of progress in long-run fiscal policy. In this area, the legacy of 1960s beliefs is still very much with us and may threaten the long-run stability of the American economy. … The revolutionary idea of the 1960s concerning long-run fiscal policy was that it was not important to balance the budget even over a period of several years. Rather, persistent budget deficits could actually be desirable because they would lower unemployment and move the economy toward a more desirable path for real output.

In other words, there is one flaw in the amazingly amazing progress in economic policy since the 1980s. It’s not rising private debt, financial deregulation, or stagnant wages and soaring income inequality, none of which she mentions. It’s that people need to worry more about the federal debt.

True, she admits, there’s no concrete evidence for any economic costs to public indebtedness over its historic range.[1] But that shouldn’t stop us worrying:

The consequences of persistent deficits may only be felt over a very long horizon. … It is also possible that the effects of persistent deficits are highly nonlinear. Perhaps over a wide range, deficits and the cumulative public debt really do have little impact on the economy. But, at some point, the debt burden reaches a level that threatens the confidence of investors. Such a meltdown and a sudden stop of lending would unquestionably have enormous real consequences.

Maybe. But ideas have consequences, too. For instance, Romer’s argument here is the same argument, almost verbatim, that would be used by her opponents in the administration just a year and a half later, when she was pushing for a larger stimulus:

Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion. The memo to Obama, however, detailed only two packages: a five-hundred-and-fifty-billion-dollar stimulus and an eight-hundred-and-ninety-billion-dollar stimulus. Summers … argued that the stimulus should not be used to fill the entire output gap; rather, it was “an insurance package against catastrophic failure.” … He believed that filling the output gap through deficit spending was important, but that a package that was too large could potentially shift fears from the current crisis to the long-term budget deficit, which would have an unwelcome effect on the bond market. In the end, Summers made the case for the eight-hundred-and-ninety-billion-dollar option.

That’s Ryan Lizza via Paul Krugman; in Krugman’s version, Romer is the hero. But what he doesn’t say is that the arguments being deployed against her here are ones she herself was making just a year or two earlier: Shortfalls in demand are less dangerous than policymakers think, but deficits are much more so; and thanks to nonlinearity you can’t wait until there’s some visible cost to deficit spending to curtail it.

Now, let’s be fair: We’d all be better off if Romer had won her debate with Orszag and Summers. (And if Summers had then been remanded to a job in chicken manure management.) Still, it’s important to remember how small is the gap between the wings of mainstream economics, despite the vitriol. 

In her Berkeley address, Romer says

The reason that I have talked in some detail about the economic beliefs that policymakers held in the 1950s is that I believe the policies they undertook and the economic outcomes derived largely from those beliefs.

I agree. In 2007, Christina Romer was using her podium to say that we don’t need to worry about major recessions, that the greatest mistake in economic policy in recent decades was faith in fiscal policy, and that the most important intellectual task for macroeconomists is to convince policymakers of the dangers of budget deficits. Now, those same arguments are being used to tell us we should accept 9-10% unemployment as far as the eye can see. If we didn’t want to end up here, we should have started somewhere else.

[1] Here is, literally, the entirety of her argument on the costs of higher deficits: “On the idea that persistent deficits don’t matter, I think there is widespread consensus that that is not true. There may be differences in our estimates of the size of the eventual effects, but most economists agree that deficits over decades unquestionably reduce national saving and have consequences for long-run standards of living.” No names, no cites, no data, no examples. Just, “most economists agree.”