The Future of Macroeconomics
1. There will be much less emphasis on monetary policy, and much more emphasis on financial institutions and financial regulatory policy.
2. There will be much less emphasis on fiscal policy, and much more emphasis on sectoral reallocation and labor adjustment policy.
3. The process of changing the paradigm in macroeconomics will be frustratingly long and difficult. As physicist Max Planck once said, science advances “one funeral at a time.”1. Macroeconomics has been overly monetarist over the past thirty years. We believed in the Taylor Rule, which said that the Fed can keep unemployment and inflation close to target values by raising the Federal Funds rate when employment and inflation stray too high and lowering the Fed Funds rate when they stray too low.
What this thinking ignores is the impotence of monetary policy when inflation rates are low. The money that the Fed creates by expanding its balance sheet is a close substitute for other short-term low-risk assets. However, short-term, low-risk assets are not close substitutes for long-term, high-risk assets. Changes in the market mix of short-term, low-risk assets can have little or no effect on interest rates for commercial loans, mortgage loans, and other interest rates that are important determinants of economic activity.
Only when inflation is high do we see highly imperfect substitutability between money and other short-term assets. When inflation is high, the Fed can step on the brakes by raising short-term interest rates.
On the other hand, the economics profession has paid too little attention to financial institutions and to regulatory policy. As I pointed out in lectures on macroeconomics, the nonfinancial sector would love to issue risky long-term liabilities to fund investments, while consumers would love to hold riskless short-term assets to maintain liquidity. The financial sector intermediates by holding risky long-term assets and issuing riskless short-term liabilities. The more the financial sector expands, the more long-term investment is undertaken in the economy.
In order for the financial sector to do its job properly, it needs to enjoy the right amount of confidence from the public. With too little confidence, the economy suffers from credit scarcity and insufficient long-term investment. With too much confidence, the economy suffers from bubbles and excess credit creation, followed by crashes.
The key policy question is what, if anything, the government can do to prevent episodes of over-confidence or under-confidence in financial institutions. Historically, what we have seen is that after each crisis episode, new forms of guarantees and regulation are introduced. Over time, these institutions seem to degrade and a new crisis occurs. Can that cycle be overcome?
2. I believe that confidence in generic fiscal policy is also misplaced. Superficially, it makes sense that government spending can replace private spending when the latter breaks down due to a crisis in the financial sector. However, the fiscal-stimulus theory fails to take into account the fact that what is going on in the real economy, particularly after a financial shock, is a reallocation of resources out of dying sectors and into emerging sectors.
Instead of looking at fiscal stimulus, I think that economists should focus directly on the adjustment process, particularly in labor markets. How do new industries emerge to absorb the resources that are released from industries that collapse during a financial crisis? What sorts of policies can make this transition take place more quickly and with less difficulty? What labor market institutions are most conducive to economic recovery? Should government try to create policies that mitigate the cyclical behavior of income shares, so that profits rise less during a boom and fall less during a recession?
3. I believe that these questions–how to achieve financial stability and how to facilitate inter-sectoral transitions–will be the main issues in macroeconomics in the future. However, it may take many funerals before these questions make it to the top of the research agenda.