The macroeconomic elite is definitely wrong about something
By Scott Sumner
Ben Southwood directed me to a paper by Lawrence Christiano, with the following executive summary:
The Great Recession was particularly severe and has endured far longer than most recessions. Economists now believe it was caused by a perfect storm of declining home prices, a financial system heavily invested in house-related assets and a shadow banking system highly vulnerable to bank runs or rollover risk. It has lasted longer than most recessions because economically damaged households were unwilling or unable to increase spending, thus perpetuating the recession by a mechanism known as the paradox of thrift. Economists believe the Great Recession wasn’t foreseen because the size and fragility of the shadow banking system had gone unnoticed.
The recession has had an inordinate impact on macroeconomics as a discipline, leading economists to reconsider two largely discarded theories: IS-LM and the paradox of thrift. It has also forced theorists to better understand and incorporate the financial sector into their models, the most promising of which focus on mismatch between the maturity periods of assets and liabilities held by banks.
I find this incredibly depressing, as I think it’s almost entirely wrong. (And yet I don’t doubt that Christiano is expressing something close to the consensus view.) In my view, the Great Recession was caused by a sharp decline in NGDP, which was triggered by a flawed monetary policy regime (mostly a lack of level targeting, but other problems as well.)
In this post, however, I’d like to focus on another issue. It seems to me that even if Christiano is completely correct about the lessons of the Great Recession, his claim still represents a major indictment of the macroeconomic profession, particularly at its most elite levels. More specifically, these two views cannot both be correct:
1. The Great Recession requires a major rethink of macro theory, in the way outlined above by Christiano.
2. Elite grad programs in macro should require students to study lots of math and statistics, but should not require a course on macroeconomic history, or the history of macroeconomic thought.
(I’d say both are incorrect.)
The basic problem here is that we’ve been through this once before:
1. We had a very long depression.
2. The very long depression was associated with severe financial turmoil.
3. The financial turmoil was seen as the principle cause of the very long depression.
4. Interest rates fell to zero.
5. Monetary policy was viewed as largely ineffective.
6. There was renewed interest in fiscal stimulus.
7. There was renewed interest in financial regulation.
8. Theories of a paradox of thrift were developed.
9. Theories of secular stagnation were developed.
10. Classical (opportunity cost) approaches to economic were de-emphasized.
Does this sound familiar? It’s exactly what’s happened over the past 10 years.
It’s hard to overstate just how embarrassing this state of affairs really is. We have the highest levels of the profession of macroeconomics doing a major rethink of their profession, based on “new information” that isn’t new at all. This “new information” was readily available to anyone with a passing knowledge of macroeconomic history. We’ve been here before. It’s OK for an art form to by cyclical, but not a science.
But it’s even worse—far worse. Consider the standard view of the Great Depression, soon after it had ended. Many of the world’s top economists would have had views of the Great Depression that are quite similar to these revisionist views associated with the Great Recession. Most would not have blamed the Fed for causing the Great Depression with a tight money policy. Indeed most would not have seen monetary policy as being tight at all.
Now fast forward to 1963. Friedman and Schwartz publish a landmark study showing that the Fed was largely to blame for the 50% fall in NGDP between 1929-33. Now fast forward to 2003. Fed governor Ben Bernanke admits that the Fed was to blame for the Great Contraction:
I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
Bernanke’s right. But consider that this implies that between 1929 and 1963 the macroeconomic profession had a completely false theory of what caused the Great Depression. A false theory almost identical to the current consensus view of the causes of the Great Recession.
We re-evaluated the Great Depression once we realized that near-zero interest rates and lots of QE don’t mean easy money. We re-evaluated the Depression once we understood that the Fed missed lots of opportunities to stimulate the economy. We re-evaluated the Depression once we saw (after WWII) that the economy was not suffering from secular stagnation. We re-evaluated the Depression once we saw (in 1968-70 and again in 1981-83) that monetary policy was far more powerful than fiscal policy. We re-evaluated the Depression once we realized (in the 1970s) that high interest rates don’t mean tight money.
So today we’ve removed economic history courses from elite economics PhD programs. Then we have the consensus view of elite macroeconomists shift in a “Keynesian” direction, in almost exactly the same way it shifted in the period from 1930 to 1960. I used to have a low opinion of that era in macroeconomics. But what’s going on today is far worse, for three reasons:
1. The Great Depression really did represent new information. The zero bound issue was new and unfamiliar. In contrast, the Great Recession has not provided any sort of new information that would lead an educated macroeconomist to rethink his or her views of the core theory. It was just a smaller version of the Great Depression, caused by smaller versions of the same policy errors that caused the Great Depression.
2. After the 1960s, we gradually learned that the original consensus view of the Great Depression was wrong. Now we’ve made those same mistakes twice. That’s even less excusable.
3. In earlier decades, economists still valued economic history, and the history of thought. Economists used to be taught what went wrong when the Fed adopted a policy that boosted demand for bank reserves in 1937. With the exception of David Beckworth, I saw almost no one making that connection in October 2008, when the Fed again adopted a policy that boosted the demand for bank reserves.
New month I will attend a conference in DC, feature lots of members of the macroeconomic elite (Bernanke, Summers, etc.) It will be very interesting to observe how their view of the current situation compares to the original (and later discredited) standard view of the Great Depression. I’ll keep you posted.
PS. FWIW, I believe the Fed triggered the Great Recession when it stopped printing money after July 2007, for a period of 10 months. (I.e., froze the base). The (initially mild) recession then further depressed an already weak real estate market, lowering the Wicksellian equilibrium interest rate. Then the Fed worsened the recession during April 2008-October 2008 by refusing to cut their interest rate target as the Wicksellian rate declined. They worsened it further by refusing to engage in “level targeting” (of prices or NGDP). In early October 2008, they worsened it further by adopting IOR.
The Fed inexplicably failed to cut IOR to zero, or better yet negative levels, despite a slow recovery. They repeatedly ended QE programs prematurely, despite an inadequate recovery. They refused to adopt monetary stimulus even when the economy was no longer at the zero bound after 2015, despite the price level being far below the trend line. Even worse, they refused to adopt monetary stimulus when no longer at the zero bound, even though even the rate of inflation remained below target, The Fed’s massive policy failure of 2008 cannot be blamed on the zero bound issue, because we weren’t at the zero bound in 2008. Ditto for the sub-2% inflation during the period since 2015.
The Great Recession had the same cause as the Great Depression, many years of tight money. The rest are symptoms.