IV. THE TROUBLE WITH MACRO
“We have involved ourselves in a colossal muddle, having blunderedin the control of a delicate machine, the working of which we do notunderstand. The result is that our possibilities of wealth may run towaste for a time — perhaps for a long time.” So wrote John MaynardKeynes in an essay titled “The Great Slump of 1930,” in which he triedto explain the catastrophe then overtaking the world. And the world’spossibilities of wealth did indeed run to waste for a long time; ittook World War II to bring the Great Depression to a definitive end.
Why was Keynes’s diagnosis of the Great Depression as a “colossalmuddle” so compelling at first? And why did economics, circa 1975,divide into opposing camps over the value of Keynes’s views?
I like to explain the essence of Keynesian economics with a truestory that also serves as a parable, a small-scale version of themesses that can afflict entire economies. Consider the travails of theCapitol Hill Baby-Sitting Co-op.
This co-op, whose problems were recounted in a 1977 article in TheJournal of Money, Credit and Banking, was an association of about 150young couples who agreed to help one another by baby-sitting for oneanother’s children when parents wanted a night out. To ensure thatevery couple did its fair share of baby-sitting, the co-op introduced aform of scrip: coupons made out of heavy pieces of paper, eachentitling the bearer to one half-hour of sitting time. Initially,members received 20 coupons on joining and were required to return thesame amount on departing the group.
Unfortunately, it turned out that the co-op’s members, on average,wanted to hold a reserve of more than 20 coupons, perhaps, in case theyshould want to go out several times in a row. As a result, relativelyfew people wanted to spend their scrip and go out, while many wanted tobaby-sit so they could add to their hoard. But since baby-sittingopportunities arise only when someone goes out for the night, thismeant that baby-sitting jobs were hard to find, which made members ofthe co-op even more reluctant to go out, making baby-sitting jobs evenscarcer. . . .
In short, the co-op fell into a recession.
O.K., what do you think of this story? Don’t dismiss it as silly andtrivial: economists have used small-scale examples to shed light on bigquestions ever since Adam Smith saw the roots of economic progress in apin factory, and they’re right to do so. The question is whether thisparticular example, in which a recession is a problem of inadequatedemand — there isn’t enough demand for baby-sitting to provide jobs foreveryone who wants one — gets at the essence of what happens in arecession.
Forty years ago most economists would have agreed with thisinterpretation. But since then macroeconomics has divided into twogreat factions: “saltwater” economists (mainly in coastal U.S.universities), who have a more or less Keynesian vision of whatrecessions are all about; and “freshwater” economists (mainly at inlandschools), who consider that vision nonsense.
Freshwater economists are, essentially, neoclassical purists. Theybelieve that all worthwhile economic analysis starts from the premisethat people are rational and markets work, a premise violated by thestory of the baby-sitting co-op. As they see it, a general lack ofsufficient demand isn’t possible, because prices always move to matchsupply with demand. If people want more baby-sitting coupons, the valueof those coupons will rise, so that they’re worth, say, 40 minutes ofbaby-sitting rather than half an hour — or, equivalently, the cost ofan hours’ baby-sitting would fall from 2 coupons to 1.5. And that wouldsolve the problem: the purchasing power of the coupons in circulationwould have risen, so that people would feel no need to hoard more, andthere would be no recession.
But don’t recessions look like periods in which there just isn’tenough demand to employ everyone willing to work? Appearances can bedeceiving, say the freshwater theorists. Sound economics, in theirview, says that overall failures of demand can’t happen — and thatmeans that they don’t. Keynesian economics has been “proved false,”Cochrane, of the University of Chicago, says.
Yet recessions do happen. Why? In the 1970s the leading freshwatermacroeconomist, the Nobel laureate Robert Lucas, argued that recessionswere caused by temporary confusion: workers and companies had troubledistinguishing overall changes in the level of prices because ofinflation or deflationfrom changes in their own particular business situation. And Lucaswarned that any attempt to fight the business cycle would becounterproductive: activist policies, he argued, would just add to theconfusion.
By the 1980s, however, even this severely limited acceptance of theidea that recessions are bad things had been rejected by manyfreshwater economists. Instead, the new leaders of the movement,especially Edward Prescott, who was then at the University of Minnesota(you can see where the freshwater moniker comes from), argued thatprice fluctuations and changes in demand actually had nothing to dowith the business cycle. Rather, the business cycle reflectsfluctuations in the rate of technological progress, which are amplifiedby the rational response of workers, who voluntarily work more when theenvironment is favorable and less when it’s unfavorable. Unemploymentis a deliberate decision by workers to take time off.
Put baldly like that, this theory sounds foolish — was the GreatDepression really the Great Vacation? And to be honest, I think itreally is silly. But the basic premise of Prescott’s “real businesscycle” theory was embedded in ingeniously constructed mathematicalmodels, which were mapped onto real data using sophisticatedstatistical techniques, and the theory came to dominate the teaching ofmacroeconomics in many university departments. In 2004, reflecting thetheory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University.
Meanwhile, saltwater economists balked. Where the freshwatereconomists were purists, saltwater economists were pragmatists. Whileeconomists like N. Gregory Mankiw at Harvard,Olivier Blanchard at M.I.T. and David Romer at the University ofCalifornia, Berkeley, acknowledged that it was hard to reconcile aKeynesian demand-side view of recessions with neoclassical theory, theyfound the evidence that recessions are, in fact, demand-driven toocompelling to reject. So they were willing to deviate from theassumption of perfect markets or perfect rationality, or both, addingenough imperfections to accommodate a more or less Keynesian view ofrecessions. And in the saltwater view, active policy to fightrecessions remained desirable.
But the self-described New Keynesian economists weren’t immune tothe charms of rational individuals and perfect markets. They tried tokeep their deviations from neoclassical orthodoxy as limited aspossible. This meant that there was no room in the prevailing modelsfor such things as bubbles and banking-system collapse. The fact thatsuch things continued to happen in the real world — there was aterrible financial and macroeconomic crisis in much of Asia in 1997-8and a depression-level slump in Argentina in 2002 — wasn’t reflected inthe mainstream of New Keynesian thinking.
Even so, you might have thought that the differing worldviews offreshwater and saltwater economists would have put them constantly atloggerheads over economic policy. Somewhat surprisingly, however,between around 1985 and 2007 the disputes between freshwater andsaltwater economists were mainly about theory, not action. The reason,I believe, is that New Keynesians, unlike the original Keynesians,didn’t think fiscal policy — changes in government spending or taxes —was needed to fight recessions. They believed that monetary policy,administered by the technocrats at the Fed, could provide whateverremedies the economy needed. At a 90th birthday celebration for MiltonFriedman, Ben Bernanke, formerly a more or less New Keynesian professorat Princeton, and by then a member of the Fed’s governing board,declared of the Great Depression: “You’re right. We did it. We’re verysorry. But thanks to you, it won’t happen again.” The clear message wasthat all you need to avoid depressions is a smarter Fed.
And as long as macroeconomic policy was left in the hands of themaestro Greenspan, without Keynesian-type stimulus programs, freshwatereconomists found little to complain about. (They didn’t believe thatmonetary policy did any good, but they didn’t believe it did any harm,either.)
It would take a crisis to reveal both how little common ground therewas and how Panglossian even New Keynesian economics had become.