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Macroeconomic theory and policy after the meltdown

What Difference Does a Crisis Make?



An economic crisis is like an earthquake: it wreaks havoc while opening up massive fissures that allow investigators to peer through the layers, revealing a dynamic past that has been covered over with dirt, time and human construction. Thus, much can be learned about the history of macroeconomic theory and policy by peering down the economic crater caused by the financial meltdown of 2008. This story, as told by Crotty (2009), Taylor (2010) and others, is one of ruling economic ideas and elites diverting research, doctrine and policy to sing the praises of a liberalized financial and macroeconomic system, thus facilitating a massive redistribution of wealth from workers and the majority, to a tiny minority, while creating a crisis prone economy in the process. Much of this was driven by ideology and cognitive capture of the economics profession by these interests. But some top financial economists exhibited more material conflicts of interest, taking money from financial interests, while engaging in research that downplayed the serious problems banks had created in the run-up to the crisis (Ferguson, 2009, Carrick-Hagenbarth and Epstein, 2012).

It wasn’t always this way. Keynes (1936) developed an analysis of the modern capitalist macroeconomy which identified a financial system that, if left unchecked, could misallocate capital toward speculative ends, could contribute to financial instability, and could lead to insufficient investment, unemployment, and long-term stagnation. He explained why the market mechanisms that classical economists assumed would stabilize the capitalist economy and eliminate involuntary unemployment such as nominal wage and interest rate flexibility could actually lead to more instability, not less. In the process, Keynes emphasized that a highly financialised economy, as modern capitalism was, operated profoundly differently from the Platonic “barter economy” imagined to be the “real” economy hiding behind the veil of money, as envisaged in the classical monetary theories that tried to pass as macroeconomic theory. In Keynes’s monetary economy, Say’s law (supply creates its own demand) was inoperative (since suppliers of goods would demand money, not other goods at all) , and downward price and wage adjustments were just as likely to create debt deflations and insufficient demand, as they were to restore the economy to full employment.

Methodologically, Keynes’ analysis was also a radical challenge to the emerging mathematically focused and pseudo-scientific approaches to economics prevalent at the time. (It should have been an even bigger challenge to these views that completely dominated macroeconomics in the late 20th century and early 21st (see below)) (Crotty, 2013). Keynes argued that the macroeconomy was characterized by fundamental uncertainty, so that capitalists, investors and workers could not make “forecasts” using probability theory about important, irreversible and costly decisions, but rather had to use rules of thumb, social conventions, and other behavioral and social decision rules to pierce the darkness of the future and take action (Crotty, 1994). This meant that macroeconomic decisions such as investment could be subject to fads, fashions and radical breaks, though they could also be quite stable and smoothly functioning for long periods of time. And given the inherent instability of a highly financialised capitalism, various institutionalized structures were needed to stabilize the economy, including government intervention.

Given this set up, it should come as no surprise that Keynes’s methodology required that economists develop an institutionally rich and historically specific analysis based on realistic assumptions about the operations of the economy, not a macroeconomics based on abstract assumptions, regardless of realism, such as “individual rationality”, “rational expectations”,  or the existence of a “Walrasian auctioneer” that prevented all trades until the entire set of prices prevailing in the economy were at their perfect, equilibrium levels! (Crotty, 2013). Imagine that.

Retaining a perspective from the classical economists, Keynes acknowledged the role of social groups (classes) in macroeconomic dynamics, focusing specifically on both the impacts of income and wealth distribution on consumption spending and aggregate demand (those with less income tended to spend a higher percentage of each additional dollar); he also understood the importance of class differences in attitudes toward macroeconmic policy, often railing against financiers and rentiers as desiring higher interest rates, over-valued exchange rates, and excessively low inflation. (Taylor, 2010).

Finally, and less well known, is that Keynes, an academic, practitioner and close observer of the capitalism of his day, believed that capitalism, in Britain, at least, had strong tendencies toward longer term stagnation. He argued that  restructuring the British economy was required to put Britain on a prosperous growth path. This, along with the speculative tendencies in financial markets, would require, according to Keynes, long term government management of investment, through government control, or direction of non-capitalist institutions such as local governments, cooperatives, and building societies (Crotty, 1999). Keynes’ view of the need for long terms “socialization” of investment contrasts sharply with the mainstream interpretation of Keynes’ “policy” recommendations as consisting largely of short-term, temporary “deficit spending” as a solution to involuntary unemployment. Since it was not known exactly how to accomplish this transition, Britain would have to enter a period of policy experimentation. Capital flight could be waged by capitalists opposed to these policies, so capital controls would be necessary as a complement to these policies. (Epstein, 2009).

This neo-classical counter-revolution to Keynes turned these propositions on their head. Fundamental uncertainty implies that, for many key macroeconomic variables, the future is unknowable; for the Walrasian approach and the “rational expectations” on which it is based, the future is known (stochastically) perfectly. For Keynes, financial markets are speculative, and unstable; for the neo-classical, they are perfectly efficient. Demand is often a key constraint; for the mainstream, supply creates its own demand. For Keynes, a monetary economy is profound and problematic; for the mainstream, money is a veil and important only for the price level; for Keynes, the market forces bringing about full employment are weak; for the mainstream, full employment is the norm. For Keynes, distributional issues are crucial for macroeconomic outcomes; for the mainstream, it is sufficient to model the economy as if distribution does not exist with only one, representative agent, who can neither a borrower nor a lender be – except to himself.

As a group, these mainstream assumptions implied – whether by design or not is of secondary importance –  a whole set of macroeconomic policies that culminated in the great financial crisis: financial liberalization, limited counter cyclical macroeconomic policy, monetary policy oriented to maintaining a low and stable rate of commodity inflation and not worry about asset price inflation (‘inflation targeting”) and the elimination of capital controls to facilitate the free flow of financial capital across borders.

When the crisis hit, the dominant approach by governments, still under the sway of the dominant mainstream approach to macroeconomics, was to make a half-hearted and  temporary return to a modestly  Keynesian-style policy: a short term coordinated fiscal expansion. But this approach was quickly abandoned, leaving all the burden of recovery on the shoulders of central banks. The tepid fiscal response was rationalized by flawed economic research by Rogoff and Reinhart among others (see Herndon, Ash and Pollin, 2012) but its driving force was a deep political antipathy by elites toward a counter-veiling role for the state that could serve as a counter-weight to their own political and economic power. (Crotty, 2012).

As for the central banks, their response was varied, but over all, this was accompanied by a financial response by some central banks that was paradoxically both  too much and too little. Standard central bank tools are not adequate to shoulder this massive burden, leading to near zero interest rates that increased bank profits, but were not sufficient to restore high levels of employment, wage growth, or economic growth (Montecino and Epstein, 2014). Maintaining such low interest rates for so long may be leading to excessive increases in some asset prices, and risky capital flows to so-called “emerging markets” that can easily reverse in “sudden stops”. But these policies are also too little in that, apart for a few small initiatives, the central banks have not engaged in active credit allocation techniques to direct credit to activities that would both generate jobs and investment in socially critical activities (Pollin, et. al. 2010.)

So what changes do we need in Macroeconomic Theory and Policy? First, mainstream macroeconomic theory, which failed in its most important task – foreseeing and comprehending the forces that would lead to the greatest economic crisis since the great depression – must be abandoned (Buiter, 2009). In its place, a macroeconomics that has comprehended building on the work of Marx, Keynes, Minsky (Minsky, 2008) and other more contemporary economists, must replace it.

Second, in terms of policy, monetary and fiscal policy must take on the key tasks facing society, and develop new tools and dust off old tools to substitute for failed financial intermediation and market systems that are not up to the task. Foremost among these is the existential challenge of confronting climate change. Robert Pollin and colleagues at the Political Economy Research Institute (Pollin, et. al,  2014), for example, describe what transformations need to be made in our energy and consumption systems, and what kinds of policy tools can be implemented by governments and central banks to, while generating large amounts of good jobs in the process. These should include cap and dividend policies to put a price on carbon by selling permits and returning the revenue to the owners of the air: the people who inhabit the planet (Boyce, 2014).

It would be far better for humanity if macroeconomists grappled with the real world, including its most important problems, rather than dabble with fairy tale stories of representative agents, endowed with rational expectations, and facing perfect financial markets. This is true even if these are slightly amended with rigidities and cognitive shortcomings here and there, as the current mainstream approach to dealing with its failure to comprehend the crisis. These theoretical “fixes” will not be sufficient to put macroeconomics on sound footing.

Gerald Epstein

Professor of Economics and a founding Co-Director at the Political Economy Research Institute (PERI) at the University of Massachusetts, Amherst. He was awarded a grant by the Institute for New Economic Thinking to study, with the collaboration of his colleague James Crotty, the impacts of financial regulations on functionally efficient finance, productivity growth and income distribution.

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