Economics: A Million Mutinies Now, Part Three
Monday, April 16, 2012
In the fall of 2011, the University of Chicago Business School, as part of its Initiative on Global Markets, created an expert panel of mainstream economists. The website states: "Our panel was chosen to include distinguished experts with a keen interest in public policy from the major areas of economics, to be geographically diverse, and to include Democrats, Republicans and Independents as well as older and younger scholars. The panel members are all senior faculty at the most elite research universities in the United States ... a group with impeccable qualifications to speak on public policy matters."
On March 6, 2012, the website reported on the results of asking this panel to agree or disagree with the following statement:
Because the U.S. Treasury bailed out and backstopped banks (by injecting equity into them in late 2008, and later committing to provide public capital to any banks that failed the stress tests and could not raise private capital), the U.S. unemployment rate was lower at the end of 2010 than it would have been without these measures.
The results were that 27 percent strongly agreed that the bailouts helped cushion the medium-term employment effects of the financial crisis, 51 percent agreed, 7 percent were uncertain, and the remaining 15 percent did not answer. Not a single panelist disagreed.
While I would grant that this represents the consensus today, one can imagine how the panel might have responded five years ago to a statement such as the following:
Monetary and fiscal policy tools are not sufficient for dealing with shocks to aggregate demand, such as asset market bubbles and crashes; these tools must instead be supplemented by other measures, such as injecting capital into banks and committing public capital to any banks that fail stress tests.
I would wager that many of the panelists, quite probably the majority, would have disagreed, even though this is basically the same statement as the one to which they voiced consensus agreement in March. For mainstream economists, the financial crisis has produced a new intuitive model of the economy which has yet to be articulated in any formal theory.
Scott Sumner, on his blog The Money Illusion, articulates what I believe would have been the consensus five years ago, which is that fiscal and monetary policy (he emphasizes the latter)—as opposed to bank capital management—are the tools of macroeconomic stabilization. Today, his views are classed as “heterodox.”1
In fact, had the consensus been otherwise, economists would have paid more attention to the house-of-cards financial structure that emerged in the decade leading up to the crisis. The standard theoretical framework was one in which the characteristics of banking and securities markets are institutional details that, in the overall scheme of things, do not really matter.
Had the consensus been otherwise, economists would have paid more attention to the house-of-cards financial structure that emerged in the decade leading up to the crisis.
What we can expect going forward is a lot of research devoted to filling the gaps between the standard theory of five years ago and the intuitive consensus of today. Indeed, this is already happening. In the February 2012 issue of the American Economic Review, the three lead articles all attempted to show how intervention in a banking crisis helps to correct a market failure.
In economics, market failure is a technical term. It is not just “Some people have bad experiences,” or “Some decisions turn out badly,” or “I don't like how markets work.” A market failure is an adverse outcome that could have been prevented by short-circuiting in some way the self-interested behavior of individuals.
For example, suppose that a bank's deposits are uninsured, and a false rumor spreads that the bank's financial condition is unsound. It is in the interest of each individual depositor to run to take their money out of the bank. This self-interested behavior will, in the aggregate, cause the bank to collapse. However, if there were no panic, it would turn out that the bank is solvent. In that case, deposit insurance would avert the market failure, because depositors would not panic. (Whether deposit insurance is the best approach for addressing this potential market failure is a separate issue.)
The new theories attempt to provide this sort of justification for bailing out financial institutions under circumstances something like those in 2008. In the theoretical models, banks can be forced to dump securities rapidly on the market, artificially depressing prices and creating a form of market failure. The bailouts can be viewed as correcting this market failure.
To me, such theoretical models of market panic suggest that securities can prove difficult to sell for a few days, a few weeks, or at most a few months. Yet nearly four years later, the level of government intervention and support in financial markets remains high, and the Federal Reserve still has instruments on its balance sheet that look nothing like anything it had acquired prior to the crisis. This situation leads me to ask four questions:
—If the problem was a short-term liquidity panic, and the bailouts fixed that problem, then why are we not back to normal?
—Why were the securities that the Fed acquired during the crisis not disposed of sooner?
—Why is the mortgage securities market still a government enterprise?
—If capital injections to banks were the solution, why did bank lending fall off so sharply? Should even more capital have been injected?
Presumably, there are good answers to these questions. However, it will take time and effort to articulate a reasonably complete and rigorous theoretical framework that justifies the consensus intuition that the bailouts cushioned the economy.
The Deep Hole
Another topic that I expect will draw a lot of research is the question of what caused such a severe recession to follow from the financial crisis. Consider:
—As noted above, the consensus view is that the bailouts limited the financial damage.
—Both fiscal and monetary stimulus was undertaken, with results that greatly disappointed the general public.
The mainstream view is not that these measures failed. Rather, it is that the economy turned out to need much more stimulus than was actually applied.2
Thus, the mainstream view is that the financial crisis put the economy in such a deep hole that neither bank bailouts nor sizable fiscal and monetary policy could dig us out. However, this “deep hole” story is simply a way of reconciling a view that stimulus works with the fact that economic performance remains weak, particularly in terms of employment. There is little in the way of analysis that directly explains how the financial crisis put us into the “deep hole.”
The mainstream view is that the financial crisis put the economy in such a deep hole that neither bank bailouts nor sizable fiscal and monetary policy could dig us out.
One branch of theory, which includes some of the academic work of Federal Reserve Chairman Ben Bernanke, suggests that when a financial institution goes under, some “relationship capital” is lost, resulting in economic damage. However, not many financial institutions were allowed to go under. Moreover, three decades ago, when many institutions did go under during the Savings and Loan Crisis, nothing like a “deep hole” resulted.
For mainstream economists trying to explain the “deep hole,” the popular terms to throw around are “balance-sheet recession” and “de-leveraging.” Consumers, because of losses in wealth in the housing and stock markets, have been trying to limit spending and boost saving. Businesses, because of tight credit conditions, have been trying to limit capital spending and boost retained earnings.
Those explanations work at the level of vague hand-waving. However, macroeconomists have set standards for analysis that involve expressing ideas in quantitative terms that attempt to bracket the plausible effects of hypothesized causal factors. These standards are meant to impose some rigor on the analytical process; otherwise, a macroeconomic theory will just consist of whatever explanations an economist chooses to pull out of the air, without giving other economists any objective rationale for accepting or rejecting that theory.
At first, “balance-sheet recession” and “de-leveraging” were explanations pulled out of the air. I expect them to receive a more careful treatment in the years ahead, and no doubt some progress already has been made.
To recap, in macroeconomics, mainstream policy analysis today is somewhat disconnected from mainstream theory as it stood five years ago. There are at least two big holes which need to be patched, one concerning the role of financial institutional structure in macroeconomic performance, and the other concerning the source of the steep drop in aggregate demand during and after the financial crisis, presumably fleshing out the notions of “balance-sheet recession” and “de-leveraging.”
However, I personally am not investing in the project to patch mainstream macro. Instead, I question at a deeper level what I see as the project to tune the economy using fiscal, monetary, or other macroeconomic knobs. I call this viewpoint, which is shared by others in the tradition of Friedrich Hayek, the anti-modernist perspective.
Earlier this year, Bloomberg News had an article on the large number of graduates of the MIT economics department in charge of central banks or holding other important posts in Europe and elsewhere. The article delved into the outlook that MIT economists tend to share on the relationship between theory and policy. The article quotes from an essay by Paul Krugman.
The “MIT style,” according to Nobel laureate Paul Krugman, who received a doctorate from the university in 1977 and who is now a New York Times newspaper columnist, is the “use of small models applied to real problems, blending real-world observation and a little mathematics to cut through to the core of the issue.”
The article also describes the seminal role played by Paul Samuelson in the MIT economics department. Samuelson steered the department, and indeed the whole economics profession, toward using modes of analysis and discourse laden with mathematics, making it appear to resemble physics. Indeed, Samuelson was often accused of suffering from “physics envy.”
What I call the ‘modernist’ view in economics is the view that small models give economists and policymakers the tools with which to explain, predict, and control economic growth and employment.
As with physics, the goal of many macroeconomists has been to predict and control economic phenomena on the basis of a minimal set of equations, the “small models” referred to by Krugman above. What I call the “modernist” view in economics is the view that small models give economists and policymakers the tools with which to explain, predict, and control economic growth and employment. I call it “modernist” because it is patterned after the development of physical sciences in the 17th, 18th, and 19th centuries, which permitted this sort of explanation, prediction, and control in chemistry, physics, and, to a lesser extent, biology.
Like the economy, the modernist economic project goes through cycles. When the economy has undergone a long period of low unemployment, macroeconomists become increasingly confident that their models and policy prescriptions are working. Like the rooster believing that his crowing brings the sunrise, they take credit for the good times. Thus, in the 1960s, it was fashionable to boast about “fine-tuning” the economy. The boom that began in the late 1980s and took off in the 1990s was proclaimed “The Great Moderation,” and Federal Reserve Board Chairman Alan Greenspan was viewed as “the maestro” by macroeconomists of all political persuasions.
When something goes wrong, the macroeconomic profession enters a period of brooding introspection, with patches applied to the previous models. For example, in the 1970s, the fine-tuners were beset by a combination of high inflation and high unemployment that was inexplicable within the models that had worked so well in the 1960s. The 1970s and 1980s were spent arguing and patching. Many of the patches introduced a role for the “supply side” of the economy, including “oil shocks” and “inflation expectations.” When the patching was complete, the consensus emphasized both the ability and desirability of managing “inflation expectations.”
Now that we are experiencing another major downturn in the economy, the mainstream modernists will be doing another round of patching. (Note, however, that in part two of this series I described the “stubborn Keynesians” and “stubborn monetarists,” who would instead revert to the views they held prior to the round of patching that took place after the 1970s fiasco.) As I suggested above, I expect to see a lot of patching in the realm of the interaction between financial phenomena and real macroeconomic performance.
Once the economy recovers, I predict that the patching exercise will settle down. At some point, economic strength will have persisted long enough that macroeconomists will believe that they have overcome their previous shortcomings and arrived at models that are robust. A consensus will form, and leading macroeconomists will write once again that “the state of macroeconomics is good.”
Then, something unexpected will happen, and the economy will turn down again. And the whole cycle of brooding, patching, and eventual complacency and hubris will be repeated.
When something goes wrong, the macroeconomic profession enters a period of brooding introspection, with patches applied to the previous models.
This darker view is what I mean by anti-modernism. Those of us who hold this view do not believe that small models can be used to explain and control a complex economy. Instead, we believe that the complexity is irreducible. The economy is too intricate to be understood by any one individual. As Leonard Read famously wrote, nobody knows how to make a pencil.3 By the same token, nobody knows how to create a job.
I have tried to sketch the ways in which a complex economy can suffer unemployment in a couple of papers on what I call Patterns of Sustainable Specialization and Trade (PSST).4 The implication of these ideas is that job creation requires local knowledge of entrepreneurs, and this must be acquired through time-consuming trial and error. It is not clear what fiscal or monetary policy can do, if anything, to speed this process.
The PSST explanations for unemployment cannot attain the modernist standards of mathematical precision. By those standards, it is another exercise in hand-waving or pulling explanations out of the air. However, I think this may be the best that anyone, modernist or otherwise, can do.
I conclude this three-part survey of some of the major contemporary points of view in macroeconomics on an anti-modernist note. If I am correct, then the “million mutinies” we are experiencing are the normal cyclical response of the economic profession to adverse events that are beyond our ability to control. The economy presumably will recover, and professional self-confidence will rise along with it. But the modernist project of technocratic tuning of a complex economy is, as Hayek warned, beyond our ability to undertake successfully.
Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for EconLog.
FURTHER READING: Kling also writes “Economics: A Million Mutinies Now,” “Economics: A Million Mutinies Now, Part Two,” and “The Political Implications of Ignoring Our Own Ignorance.” Alex J. Pollock explains “Default and the Nature of the Government.” Nick Schulz asks “How Effective was the 2009 Stimulus Program?”
1. See “Marginal Revolutionaries,” The Economist, December 31, 2011.
2. For example, the IGM expert panel nearly all agreed that “Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.”
4. “PSST: Patterns of Sustainable Specialization and Trade,” Capitalism and Society, Vol. 6, No. 2 (2011); and “Patterns of Sustainable Specialization and Trade: A Smith-Ricardo Theory of Macroeconomics,” Adam Smith Institute, January 2012.
Image by Rob Green / Bergman Group