Macro Beliefs and Reality
I am leaning toward a view of macroeconomics in which firms, households, and government face a collision between beliefs and reality.
Beliefs tend to be formed out of habitual observation. If certain types of investments in human and physical capital have paid off in recent years, then keep making those sorts of investments. A problem arises when beliefs tend to be self-fulfilling for a while, but turn out to be unsustainable. The obvious example I have in mind is house prices and mortgage lending in the U.S. before the crisis. As long as everyone believed house prices would continue to rise, lending became easier, more people bought houses, and house prices in fact rose. These beliefs became more and more out of touch with long-term reality, and so the adjustment to reality was harsh.
Probably my favorite Scott Sumner post is the one where he offered what I called a cyclical monetary theory, meaning that monetary theory is itself cyclical. In good times, people are monetarists. They believe that the Fed is all-powerful and can always produce great economic outcomes. When a crash hits, people become Austrians, believing that the previous prosperity was false and that now we must pay the price. When the bad times have been around for a while, people become Keynesians, convinced that government must be able to do something but that monetary policy has been tried and does not work. I would note that this time around, many people are coming around to the view that fiscal policy has been tried and does not work.
I think that my least favorite Sumnerian proposition is that the Fed can affect the economy by announcing a long-term target for a nominal variable. I think that in order for this to work, you have to assume that people are forward-looking and focused on future monetary policy. On the other hand, his mechanism by which monetary policy works is the conventional story in which nominal wages are sticky, so that with higher aggregate demand you get lower real wages and more real output. But for nominal wages to be sticky, workers cannot be forward-looking and focused on monetary policy. So, on the one hand, for targets to matter, people have to be forward-looking. On the other hand, for monetary policy to matter, people cannot be forward-looking. I cannot past what I see as a basic contradiction. For what it’s worth, in case you cannot tell already, I do not think that people are forward-looking. I think that they are habit-driven and backward-looking.
Because I believe that people are habit-driven and backward-looking, I think it is possible for real wages to fluctuate. However, I do not think that real wage movements have been very important in post-war economic fluctuations.
I do not think of the prosperity we experienced a few years ago as inherently false. It happened to be false because it relied on unsustainable beliefs. If we had not had a housing bubble, I think it is possible that instead firms and households could have created patterns of specialization and trade that resulted in full employment and affluence that were more sustainable. Ultimately, I think that the Recalculation will result in such new patterns of specialization and trade.
As it is, a lot of people’s plans have been disrupted by the collision between prior habits and reality. I do not think that there is much that government can do about it. Extending unemployment benefits, stimulating road construction, or giving money to state governments to maintain high levels of compensation for public employees will not do anything that I can see to establish new patterns of trade and specialization. I do not see open market operations by the central bank as doing anything to establish new patterns of trade and specialization.
The empirical basis for the belief that government can do something about output and employment is quite thin. If you really want to believe that, say, fiscal policy works, you can focus on those examples where it appeared to work (say, military spending in World War II and the Kennedy tax cut in the early 1960’s) and try to explain away all the examples where it appeared to fail (which is pretty much every other time and place that it has been tried).
My father used to say that the First Iron Law of social science is, “Sometimes it’s this way, and sometimes it’s that way.” My reading of the record on fiscal and monetary policy is that it follows the First Iron Law. Sometimes, we see economic improvement when fiscal expansions are attempted. Sometimes we don’t. The same with monetary policy expansions. I think it is reasonable to read history as saying that economic outcomes are pretty much orthogonal to macroeconomic policy moves, which is a fancy way of saying that the economy does what it does without regard to fiscal and monetary policy.