(Earlier this week, I gave a virtual presentation at an event organized by the Roosevelt Institute and the Green New Deal Network. Virtual events are inferior to live ones in many, many ways. But one way they are better, is that they are necessarily on video, and can be shared. Anyway, here is 25 minutes on why the economic situation calls for even more spending than the (surprisingly ambitious) proposals from the Biden administration, and also on why full employment shouldn’t be seen as an alternative to social justice and equity goals but as the best way of advancing them.)
Tag: advertisements for myself
A Few Followup Links
The previous post got quite a bit of attention — more, I think, than anything I’ve written on this blog in the dozen years I’ve been doing it.
I would like to do a followup post replying to some of the comments and criticisms, but I haven’t had time and realistically may not any time soon, or ever. In the meantime, though, here is some existing content that might be relevant to people who would like to see the arguments in that post drawn out more fully.
Here is a podcast interview I did with some folks from Current Affairs a month or so ago. The ostensible topic is Modern Mone(tar)y Theory, but the conversation gave me space to talk more broadly about how to think about macroeconomic questions.
A pair of Roosevelt reports (cowritten with Andrew Bossie) on economic policy during World War II are an effort to find relevant lessons for the present moment: The Public Role in Economic Transformation: Lessons from World War II, Public Spending as an Engine of Growth and Equality: Lessons from World War II
Here is a piece I wrote a couple years ago on Macroeconomic Lessons from the Past Decade. Bidenomics could be seen as a sort of deferred learning of the lessons from the Great Recession. So even though this was written before the pandemic and the election, there’s a lot of overlap here.
This report from Roosevelt, What Recovery? is an earlier stab at learning those lessons. I hope to be revisiting a lot of the topics here (and doing a better job with them, hopefully) in a new Roosevelt report that should be out in a couple of months.
If you like podcast interviews, here’s one I did with David Beckworth of Macro Musings following the What Recovery report, where we talked quite a bit about hysteresis and the limits of monetary policy, among other topics.
And here are some relevant previous past posts on this blog:
In The American Prospect: The Collapse of Austerity Economics
A Baker’s Dozen of Reasons Not to Worry about Government Debt
Good News on the Economy, Bad News on Economic Policy
A Demystifying Decade for Economics
Announcement: Money and Things
Arjun Jayadev and I are writing a book. The working title is Money and Things: How Finance Shapes the World. Here’s what it’s about:
Money is one of our most ubiquitous social technologies. It is also one of the most misunderstood. Economics students in college are taught that money is just a convenience to avoid the clumsiness of barter – that prices and incomes depend on underlying “real” values, and money is just a veil. Academic economists insist that money is “neutral” – that the long-run development of the economy depends on “real” factors like population growth and technological progress, which have nothing to do with money or credit. Many people still have some vague notion that money is backed by something “real”, perhaps vaults of gold under Fort Knox, while those who do understand that money is nothing but an entry on bank ledger, often feel this is dangerous and unnatural, and demand that a sharp line be drawn between credit and money. For the vast majority of people money is simply the background hum of the world they live in, something that they pay attention to only occasionally, if perhaps with a sense of unease.
This book seeks to open up the world of money as it really is and its relationship to the world. Dawing on the work of Karl Marx, John Maynard Keynes, Hyman Minsky, and other “heterodox” economic thinkers, the book argues that there is no real economy behind the monetary one. In economic questions, money itself is what is real.
This claim is developed through two related arguments. First, that money and finance are autonomous — that changes in money flows, assets and debt do not just reflect underlying activities of production and consumption but have their own independent dynamics. And second, that money does not merely facilitate economic activity, but reshapes it in far-reaching ways. This is a challenge to the conventional wisdom that money payments and quantities offer a transparent window onto the concrete, material world – that a certain amount of money must correspond to an equivalent amount of stuff. And it is a challenge to the economics orthodoxy that money is “neutral” in relation to the larger economy. On the contrary, monetary phenomena like debt and exchange rates have profound and lasting effects on the development of economies and the broader society.
The book is organized in three sections, moving from the abstract to the concrete. The first section explores the rules and logic of money as a distinct social activity, starting with the most basic building blocks of economic units and payments and building up to balance sheets, interest, exchange rates, and other more complex features of money-world. It then explores how these money terms do — and don’t — match up to the material and social world around us, critically examining concepts like “real” GDP. While numbers like this are often thought of as measuring some physical quantity, this is logically incohenerent and practically misleading.
In the second section, the book turns to the institutions that operate at the interface between money-world and society. This section explores the links between money and society, the tensions and conflicts between them, and the ways that they are actively managed. It includes chapters on the politically contested questions of reforms to the monetary system, and the sustainibility of private and public debt. The section’s main focus is on central banks and corporations as two key actors that manage the tension between an economic world imagined purely in terms of money claims and payments, and the concrete human activities of production and reproduction.
In the final section, the book explores how the tension between society and the world of money plays out politically. With chapters on Europe in the wake of the euro crisis, the US, the developing world, and the problem of climate change, it shows how many political developments can be understood in terms of a fundamental conflict between enforcing the logic of money, on the one hand, and meeting the concrete needs of human societies on the other. Much of what is called neoliberalism can be seen as an effort to compel politics and society to conform to the logic of money. At the same time, these constraints provoke counter responses, and the institutions constructed to maintain the dominance of money can themselves become vehicles for collective action toward other ends.
The book is an attempt to build a more sustained argument out of various things Arjun and I have written, especially this and this. It will also incorporate material from a great many posts on this blog over the past decade, including these and these and these.
If all goes according to plan, the book will be out from University from Chicago Press in early 2022.
Video: Monetary Policy since the Crisis
On May 30, I did a “webinar” with INET’s Young Scholar’s Intiative. The subject was central banking since the financial crisis of a decade ago, and how it forces us to rethink some long-held ideas about money and the real economy — the dstinction between a demand-determined short run and a supply-determined long run; the neutrality of money in the long run; the absence of tradeoffs between unemployment, inflation and other macroeconomic goals; the reduction of monetary policy choices to setting a single overnight interest rate based on a fixed rule.My argument is that the crisis — or more precisely, central banks’ response to it — creates deep problems for all these ideas.
The full video (about an hour and 15 minus, including Q&A) is on YouTube, and embedded below. It’s part of an ongoing series of YSI webinars on endogenous money, including ones by Daniela Gabor, Jo Mitchella nd Sheila Dow. I encourage you, if you’re interested, to sign up with YSI — anyone can join — and check them out.
I didn’t use slides, but you can read my notes for the talk, if you want to.
Some Interviews
One new one, and two older ones I should have posted here a while ago.
The new one is with Seth Ackerman at Jacobin. Its starting point is a new article (co-authored with Arjun Jayadev and Enno Schroeder) I have coming out in Development and Change. But it’s also a continuation of the argument I made in my earlier Jacobin piece on the socialization of finance [*], and in my talk at this year’s Left Forum. (I still hope to get a transcript of that one at some point.)
The older two are both in response to my “What Recovery?” report for the Roosevelt Institute. This one, with David Beckworth at the Mercatus Institute, was a wide-ranging conversation that touched on a lot of topics beside the immediate question of whether we should regard the US economy as having reached full employment or potential output. This one, with Joe Weisenthal and his colleagues at “What Did You Miss” on Bloomberg, was much briefer but still managed to cover a lot of ground.
Supposedly there’s also an interview with me coming out in Der Standard, an Austrian newspaper, but I’m not sure when it will appear.
If you’re reading this blog, you’ll probably find these interviews interesting.
[*] Incidentally, my preferred title was that: The Socialization of Finance. I understand why the editors changed it to the catchier imperative form, but what I liked about my original was that it could refer both to something done to finance, and something done by finance.
At Dissent: A Cautious Case for Economic Nationalism
I have an article in the new issue of Dissent, arguing that “As long as democratic politics operates through nation-states, any left program will require some degree of delinking from the global economy.”
My piece is part of a special section on “Capitalism Today.” There will be an accompanying event at the New School on May 22, with Jamie Galbraith, Julia Ott, Mark Levinson and me.
I’ve made similar arguments to this article’s in a number of posts on this blog:
Capital Mobility as Trojan Horse
Only the Debt Is National
How to Think about the Balance of Payments
What Is Foreign Investment For?
Lessons from the Greek Crisis
Prices and the European Crisis, Continued
One thing that’s probably not as clear as it should be in the Dissent piece, is that the case for delinking is much stronger for most other countries than for the United States. For most countries, free trade and, even more, free capital mobility, drastically reduce the choices available to national governments. (This “disciplining” of the state by foreign investment is sometimes acknowledged as its real function.) For the US, I don’t think this is true – I don’t think the threat of capital flight meaningfully constrains policy here. And in particular I don’t think it makes sense to see a more positive trade balance as necessary or even particularly desirable to boost demand, for reasons laid out here and here.
Piketty Post at Crooked Timber
Crooked Timber is having a book event on Piketty’s Capital in the 21st Century. My contribution is here. A few supplemental bits:
First, I need to point out a problem in my post. I write: “It’s striking, for instance, that the book does not contain a table or figure comparing r and g historically.” But of course, as David Rosnick points out in email, this is not true. There are three figures in chapter 10 that purport to give historical values for r and g. The inadequacy of these figures to bear the weight put on the r > g apparatus is, I think, evident. Why are there no cross-country comparisons? Why the odd periodizations? Why so much emphasis on the data-free values invented for the distant past and future? Perhaps most damningly, what about the fact that r > g is no more true in the increasingly unequal second half of the 20th century than in the increasingly equal first half? But none of that changes the fact that my sentence, as I wrote it, is wrong.
Some people may be interested in other things I’ve written relating to Piketty on this blog over the past couple years:
Piketty and the Money View: A Reply to MisterMR
Wealth Distribution and the Puzzle of Germany
Three Ways of Looking at alpha = r k
With respect to the Crooked Timber piece, I should say — should have acknowledged in the post itself — that it all comes out of conversations I’ve been having with Suresh Naidu over the past year or so. Suresh himself has written various things about Piketty; he’s working on a piece now on these same themes of capital, Piketty and the money view that should move the conversation significantly forward.
I should also have pointed out the Real World Economic Review’s superb special issue on Piketty. Jamie Galbraith’s, Merijn Knibbe’s, and Yanis Varoufakis’ contributions made many of the same points I tried to make in the Crooked Timber post. Knibbe’s piece in particular is a tour de force, everyone interested in these debates should read it.
Finally, I should say: I’ve been reading Crooked Timber since it began, in 2003. For a long while I was a regular commenter there, most of that time pseudonymously as Lemuel Pitkin. Now twelve years is a long time in internet time. Not so long in real life but still long enough for me to go back to graduate school, get my PhD and various teaching jobs, and to start this blog. Crooked Timber was probably my main inspiration to try to write in this format. So I can’t deny it, I’m thrilled to finally have a post up there.
On Other Blogs, Other Wonders
Some links for Nov. 1:
A few links
This Friday, November 6, Mike Konczal and I will be releasing the next piece of the Roosevelt Institute Financialization Project, two reports on “short-termism” in American corporations and financial markets. One report, written by me, is a followup to the Disgorge the Cash report from this spring, addressing a bunch of the most common objections to the argument that pressure for high payouts is undermining investment. (Some of this material has appeared here on the blog, but a lot of it is new.) The other report is a ten-point policy proposal for addressing short-termism, written by Mike, me, and my former student Amanda Page-Hongrajook. There will be an event for the release in DC, featuring Senator Tammy Baldwin. Hopefully it will get some attention from policymakers and the press.
*
I was pleased to see this new paper from the central bank of Norway, which draws on my work with Arjun Jayadev on debt dynamics. The key point in the Norges Bank paper is that we have to think of debt as evolving historically, not chosen de novo in response to the current “fundamentals.” More concretely: given significant debt inherited from the past, an increase in interest rates will lead to higher, not lower, debt. The shorthand that change in debt is the same as new borrowing, is not a reliable guide to the historical evolution of leverage.
From the paper:
Macroeconomic models typically assume that households refinance their debt each period … with the implication that the entire stock of debt responds swiftly to shocks and policy changes. This simplifying assumption might be useful and innocuous for many purposes, but cannot be relied upon in the current policy debate, where a central question regards if and how monetary policy should respond to movements in household debt. The likely performance of such policies can only be evaluated within frameworks that realistically account for debt dynamics. …
The evidence that perhaps most convincingly points toward the need for distinguishing between new borrowing and existing debt, is the empirical decomposition of US household debt dynamics by Mason and Jayadev (2014). They account for how the “Fisher” factors inflation, income growth and interest rates have contributed to the evolution of US debt-to-income, in addition to the changes in borrowing and lending, since 1929. Their findings clearly show how the dynamics of debt-to-income cannot be attributed to variation in borrowing alone, but has been strongly influenced by the Fisher factors, and often has gone in the opposite direction of households’ primary deficits. …
Discussions of household debt tend to implicitly assume that variation in debt-to- income ratios reflect active shifts in borrowing and lending, which is misguided…. With plausible debt dynamics, interest rate changes have far weaker influence on household debt than a conventional one-quarter debt model implies. Moreover, with long-term debt the qualitative effect of a policy tightening on household debt-to-GDP is likely to be positive..
The bulk of the paper is an attempt to incorporate these ideas into a DSGE model, which I have misgivings about. But that hardly matters since they’ve so clearly grasped the important point.
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In the other-than-economics department, here’s a New York Observer article by Will Boisvert from a little while back on universal pre-K. Will is not a big fan of New York’s universal pre-K program, or of the education-based arguments used to promote it. Now, as a New York City parent of a small child, I’m very grateful that UPK exists. And I’m very impressed that the DeBlasio team were able to roll it out as fast as they did — it’s hard to think of another universal entitlement that was implemented so quickly. But Will’s central critique seems on the mark to me. UPK is primarily a benefit for parents — we should mainly think of it as publicly funded daycare. But for various reasons, it’s been sold by its contribution to the human capital formation of 4-year olds, not by the ways it makes parenthood less of a burden for working- and middle-class families. Will’s argument — and here I’m not sure I’m with him — is that this has had real costs in the way the program is structured.
(Incidentally, one of my first published pieces was a rather unfriendly article about current Observer editor Ken Kurson.)
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Over at the Angry Bear blog, the very smart Robert Waldmann has got himself worked up over the fact that real private investment has for the first times since 1947 surpassed real government consumption and investment (I > G in the language of the national income identity.) Unfortunately, there is no such fact.
“Real” I and G are index numbers; you cannot compare their magnitudes. All you can compare is dollars. And in terms of dollars, government consumption and investment, at $3.2 trillion, remains slightly higher than private domestic investment, at $3 trillion. In fact, Waldmann’s claim is almsot the opposite of the truth: the current expansion is the first one since the early 1970s in which private investment has not passed government final spending, at least not yet.
“Real” values are supposed to refer to quantities of stuff, not quantities of money. So Waldmann’s claim that real I is greater than real G is equivalent to the claim that the country is producing more kindergarten classes than steel. Talking about the change in the “real” quantity of steel, or in the “real” number of kindergarten classes, is in principle straightforward: just add up tons or bodies in classrooms, as the case may be. But how do you compare the two? Only via their prices. The problem is, the relative price of kindergarten classes and steel varies over time. So which is greater than which, and by how much, will depend on which year’s prices you use. In the case of I and G, if we use current prices, we find that G is slightly greater than I. If we use 2009 prices, as Waldmann does, we find that I is slightly greater than G. If we use, say, 1950 prices, we find that I is almost three times G. Which of these is “true”? None of them — when you’re comparing index numbers, absolute magnitudes are completely arbitrary. And again, when we compare dollar amounts, which are objective, we see that G remains comfortably above I. [1]
I’m not calling attention to this just to pick a fight. (UPDATE: Waldmann now agrees, so no fight to pick.) It’s because I think it’s revealing about the way inflation adjustment confuses people, and especially economists. Even someone as smart and critical-minded as Waldmann can get sucked into treating “real” values as objective measures of physical stuff.
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I haven’t been following the Argentine elections closely, but it seems clear that the resolution of the Argentine default is an important frontline in the war between money and humanity. So we have to be interested in whether the elections are won by the candidate promising surrender to the creditors. On the larger set of issues at stake there, I recommend this piece by Marc Weisbrot, whose stuff on Argentina is in general very good.
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There’s an interesting conversation going on about the “natural rate of interest.” Here’s one way to think about it. If the government buys enough peanuts, it can presumably raise aggregate demand to the economy to full employment, and/or to a level consistent with some inflation target. Should we call whatever peanut price results from this policy “the natural price of peanuts”? And is there any reason to think that this price, whatever it might be, will be the same as in a Walrasian economy that somehow corresponds to our own “in the absence of distortions or rigidities”? Now substitute bonds for peanuts — to talk about the natural rate of interest means answering both questions Yes.
Anyway, I think Tyler Cowen is mostly on target here.
*
I was talking about econ blogs at the bar the other night, and there was a general consensus that none of us read as many of them as we used to. Maybe the econblogging moment is over? Still, there are lots of them that are worth your time, if you’re reading this. Here are a few economics blogs I’ve recently started reading regularly: Perry Mehrling; Brian Romanchuk; Marshall Steinbaum. Perry has of course been writing great stuff for decades but he’s only recently taken up blogging. So I think there’s still some life in the format.
[1] Altho it is striking how the trajectory of G has flattened out under Obama. 2010-2015 is the first five-year period since World War II in which there was zero growth in nominal government consumption and investment. The only reason G is still above I, is because private investment fell so steeply between 2006 and 2010. So maybe Waldmann is onto something after all?
An Interview with Me
The other day I sat down with Dave Parsons for his podcast The Nostalgia Trap. You can find the resulting interview here. It’s partly about politics, partly about economics, partly about me and my various adventures on the US left.
You should check out some of Dave’s other interviews as well — he gets some very interesting people to sit down with him and has conversations with them that are more expansive and wide-ranging than your usual interview.
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
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.
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[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.