What I'm Reading
By Arnold Kling
How the Economy Works, by Roger Farmer. The publisher sent me a review copy. Farmer seems to be trying to accomplish what I have tried to do with a series of blog posts on macroeconomics. That is, he wants to explain how he thinks about macro, in the context of how he thinks others think about macro. And he wants to do it in prose, not in equations. He also includes mini-profiles of various economists, which helps the narrative (although he gets the date of Solow’s Nobel Prize wrong). If he were a blogger, I would recommend reading his blog and I would enjoy batting ideas back and forth. However, coming across it as a book set in cold type, my attention tends to focus on areas of disagreement. More below.p. 17:
A central part of my new theory is that the beliefs of market participants in the value of the stock market matter, and they can have an independent influence on economic activity…A loss of confidence can become a self-fulfilling prophecy and lead to a downward spiral in economic activity that ends in a depression.
He avoids the obvious jargon, which would be multiple equilibria. That is, if everyone is confident, we will have a good equilibrium, and if everyone loses confidence, we will have a bad equilibrium. He also could have chosen to appropriate the term “animal spirits.”
whatever the origin of the shock, classical theory implies that the economy should quickly return to full employment.
Note the term quickly. No economist, Keynesian or Classical, has a satisfactory theory of economic adjustment. We’re all hand-wavers. To read Farmer, the difference is that the Classicals wave their hands and say that adjustment to full employment happens quickly, and the Keynesians raise their hands and say “no, it happens slowly.”
I think that may very well describe the state of play between Classicals and Keynesians, and you can see why it becomes hard to settle empirically. The Keynesians can point to the Great Depression as an example of slow adjustment. Classicals can point to the 1970’s as an example where the economy responded to increases in aggregate demand with adjustments to inflation expectations that were quite rapid, thank you very much. Or they can point to episodes during the Great Moderation, such as the Dotcom crash, where a seemingly large wealth shock was absorbed fairly easily (Farmer says it was offset by an increase in housing wealth, but that works better as a story for 2005-2006 than it does for 2000-2002.)
Deficit spending on a large scale started in earnest when the United States entered World War II, and at this time, Keynesian policies were dramatically successful.
If we grant this, then we are entitled to ask how the economy managed to adjust from 1945 to 1955, when government deficits shrank. Many Keynesians predicted at the time that we would suffer another bout of high unemployment. The unexpected, unexplained postwar boom is one of those episodes of history that folks are prone to gloss over.
By stressing the role of income as a determinant of consumption, instead of wealth, Keynesian economists are led to advocate fiscal policy…to restore full employment. I believe that they are wrong…it will lead governments to accumulate large debts that our grandchildren are asked to repay.
Oh, I think those debts will be unpayable before our grandchildren even get established in the their careers. But basically, I agree on this point.
The correct response to the crisis is to set in place, in every country in the world, an institution to control the value of national stock market wealth by targeting the rate of growth of an index fund.
Let’s leave aside the libertarian objections to this. From a practical point of view, what would such a fund do in the United States today? If you look at the price-earnings ratios for stocks, I do not think that there is a case that stocks are horribly underpriced. The risk premiums in the market do not strike me as exorbitant. Yet, the unemployment rate is close to 10 percent. If the government-run index fund were to stand pat now, then it would be irrelevant to dealing with the recession. On the other hand, if the point of the government-run index fund is to fight the recession, we should be bidding the S&P 500 up from today’s level of 1100 to something like…1800? 2000? Where would the fund get the resources to do that? How would Farmer answer the criticism that his proposal amounts to a mandate to create a stock market bubble?
Farmer’s book is much better than I am making it sound. It really does give a reasonable, prose-based account of the evolution of mainstream thinking in macroeconomics. What bothers me about it is the mainstream thinking, not so much Farmer’s treatment of it.
I strongly believe that GDP-factory macro, where we are all representative agents producing a homogeneous good, is a delusion and a dead end. My main problem with Farmer’s account is that he stays within the GDP-factory paradigm. Yes, you know what’s coming–another commercial for Recalculation. Maybe it’s time for me to start thinking about getting that idea outside the medium of blogs in which Tyler hatched it and I ran with it–and into cold type.