The Northwest Passage
By Arnold Kling
Below are two pages of the hypothetical book on macro. Once (If?) I get to the main part of the book, I will need good sources for analysis of pre-1920’s macroeconomic events and for postwar events in other countries.In Search of the Northwest Passage
Macroeconomics is concerned with the causes and cures for fluctuations in output, employment, and inflation. However, this does not make macro a self-contained subject. Instead, macroeconomic thinking is shaped by overlaps with many other fields of economics, including several branches of microeconomics. The differences among major schools of thought in macro can be described in terms of which overlaps are emphasized and which are disregarded.
Think of the macroeconomist as an explorer, in search of a Northwest Passage that will provide clear, direct analysis of fluctuations in output, employment, and inflation. Other branches of economics represent possible paths to take to try to locate this Northwest Passage. For example, because unemployment is such a mystifying phenomenon, a case can be made that one should search for answers along the path of labor economics. By the same token, many economists have gone down the path of monetary theory–seeking explanations for macroeconomic fluctuations in the peculiar characteristics of money and its role in the economy.
This chapter will describe the many ways in which other branches of economics have provided paths that at least some macroeconomists thought were worth pursuing in order to find the elusive Northwest Passage. These branches include general equilibrium theory, labor economics, industrial organization, international trade, growth theory, finance theory, capital theory, monetary economics, behavioral economics, rational expectations and mathematical optimization, and econometrics. Before discussing these overlaps, I want to mention an overlap that shapes my own current thinking about macro.
The Recalculation Problem
In December of 2008, George Mason University Professor Tyler Cowen wrote on his blog,
Is the financial crisis — which is rapidly becoming the “real economy” crisis — somehow the “dual” of the socialist calculation problem?
…Are there conditions, however rare, under which market adjustment and convergence does not occur? If a few of the vertices get stuck, can it become impossible for the economy to fulfill its mutating pinwheel program of change and adaptation?
This suggests a rather surprising overlap, between macroeconomics and what is known as the socialist calculation debate. That debate, which was sparked in the 1920’s, burned hotly in the 1930’s, and settled to embers by the 1960’s, concerned the question of whether a socialist planner could ever have enough information to manage an economy efficiently. The anti-socialists, notably Mises and Hayek, argued that without market prices a planner would be making wild guesses as to the best use of productive resources. Pro-socialists, notably Oskar Lange and Wassily Leontief, argued that a planner could tease out the information by cleverly querying managers of socialist enterprises in order to map out the production possibilities and trade-offs in the economy.
Both sides of the socialist calculation question were focused on whether central planners could obtain the information needed to allocate resources efficiently. But neither side doubted that markets were capable of generating and disseminating the relevant information. This assumption could have been challenged, in which case the socialist calculation question would have been accompanied by a market calculation question.
The market calculation question is whether the information needed to allocate resources effectively is generated and disseminated by markets. It seems likely that if the market were close to general equilibrium, then prices would represent accurate signals of where resources belong. However, if the economy finds itself far from general equilibrium, there is no mechanism ensuring that it will find its way to general equilibrium quickly In the meantime, prices could easily be sending signals to market participants that are unclear, inadequate, or even misleading.
In a modern economy, patterns of specialization are complicated. These patterns evolve over time, but typically the changes are gradual. The price system does an effective job of guiding the gradual, evolutionary changes in the patterns of specialization that take place near general equilibrium.
On the other hand, suppose that a dramatic shock renders the current pattern of specialization untenable, requiring major adjustments in terms of how productive resources are allocated. Is the market up to the task? Mathematical economists who looked at dynamic adjustment of the economy outside of general equilibrium did not provide encouraging results. However, with a few exceptions, notably Robert Clower and Axel Leijonhufvud, most economists did not take up the issue of disequilibrium dynamics as a factor in macroeconomics.
Models of disequilibrium dynamics lack mathematical tractability. I cannot fix that. I would say that insisting on mathematical tractability is behaving like the drunk who refuses to search for his watch where he lost it because it is too dark there If the best place to look for explanations of recessions is in disequilibrium dynamics, then the fact that this path of economics is poorly lit by the lamp post of mathematical tractability should not drive us to search elsewhere.
My term for disequilibrium dynamics is Recalculation. This is reminiscent of a GPS navigation system which, after you deviate from its route, will say “Recalculating.” I also think in terms of a project manager at a construction site who discovers a problem with some of the work that has been completed. The manager halts all activity in order to recalculate how to proceed in view of the need to go back and fix the problem.
I will be returning to the Recalculate Story later in this book, because it is one of the paths to the Northwest Passage that I consider important. However, let us leave this path for now and go back to consider other, more well-trodden paths.