VI. THE STIMULUS SQUABBLE
Between 1985 and 2007 a false peace settled over the field ofmacroeconomics. There hadn’t been any real convergence of views betweenthe saltwater and freshwater factions. But these were the years of theGreat Moderation — an extended period during which inflation wassubdued and recessions were relatively mild. Saltwater economistsbelieved that the Federal Reserve had everything under control.Fresh­water economists didn’t think the Fed’s actions were actuallybeneficial, but they were willing to let matters lie.
But the crisis ended the phony peace. Suddenly the narrow,technocratic policies both sides were willing to accept were no longersufficient — and the need for a broader policy response brought the oldconflicts out into the open, fiercer than ever.
Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero.
During a normal recession, the Fed responds by buying Treasury bills— short-term government debt — from banks. This drives interest rateson government debt down; investors seeking a higher rate of return moveinto other assets, driving other interest rates down as well; andnormally these lower interest rates eventually lead to an economicbounceback. The Fed dealt with the recession that began in 1990 bydriving short-term interest rates from 9 percent down to 3 percent. Itdealt with the recession that began in 2001 by driving rates from 6.5percent to 1 percent. And it tried to deal with the current recessionby driving rates down from 5.25 percent to zero.
But zero, it turned out, isn’t low enough to end this recession. Andthe Fed can’t push rates below zero, since at near-zero rates investorssimply hoard cash rather than lending it out. So by late 2008, withinterest rates basically at what macroeconomists call the “zero lowerbound” even as the recession continued to deepen, conventional monetarypolicy had lost all traction.
Now what? This is the second time America has been up against thezero lower bound, the previous occasion being the Great Depression. Andit was precisely the observation that there’s a lower bound to interestrates that led Keynes to advocate higher government spending: whenmonetary policy is ineffective and the private sector can’t bepersuaded to spend more, the public sector must take its place insupporting the economy. Fiscal stimulus is the Keynesian answer to thekind of depression-type economic situation we’re currently in.
Such Keynesian thinking underlies the Obama administration’seconomic policies — and the freshwater economists are furious. For 25or so years they tolerated the Fed’s efforts to manage the economy, buta full-blown Keynesian resurgence was something entirely different.Back in 1980, Lucas, of the University of Chicago, wrote that Keynesianeconomics was so ludicrous that “at research seminars, people don’ttake Keynesian theorizing seriously anymore; the audience starts towhisper and giggle to one another.” Admitting that Keynes was largelyright, after all, would be too humiliating a comedown.
And so Chicago’s Cochrane, outraged at the idea that governmentspending could mitigate the latest recession, declared: “It’s not partof what anybody has taught graduate students since the 1960s. They[Keynesian ideas] are fairy tales that have been proved false. It isvery comforting in times of stress to go back to the fairy tales weheard as children, but it doesn’t make them less false.” (It’s a markof how deep the division between saltwater and freshwater runs thatCochrane doesn’t believe that “anybody” teaches ideas that are, infact, taught in places like Princeton, M.I.T. and Harvard.)
Meanwhile, saltwater economists, who had comforted themselves withthe belief that the great divide in macroeconomics was narrowing, wereshocked to realize that freshwater economists hadn’t been listening atall. Freshwater economists who inveighed against the stimulus didn’tsound like scholars who had weighed Keynesian arguments and found themwanting. Rather, they sounded like people who had no idea whatKeynesian economics was about, who were resurrecting pre-1930 fallaciesin the belief that they were saying something new and profound.
And it wasn’t just Keynes whose ideas seemed to have been forgotten.As Brad DeLong of the University of California, Berkeley, has pointedout in his laments about the Chicago school’s “intellectual collapse,”the school’s current stance amounts to a wholesale rejection of MiltonFriedman’s ideas, as well. Friedman believed that Fed policy ratherthan changes in government spending should be used to stabilize theeconomy, but he never asserted that an increase in government spendingcannot, under any circumstances, increase employment. In fact,rereading Friedman’s 1970 summary of his ideas, “A TheoreticalFramework for Monetary Analysis,” what’s striking is how Keynesian itseems.
And Friedman certainly never bought into the idea that massunemployment represents a voluntary reduction in work effort or theidea that recessions are actually good for the economy. Yet the currentgeneration of freshwater economists has been making both arguments.Thus Chicago’s Casey Mulligan suggests that unemployment is so highbecause many workers are choosing not to take jobs: “Employees facefinancial incentives that encourage them not to work . . . decreasedemployment is explained more by reductions in the supply of labor (thewillingness of people to work) and less by the demand for labor (thenumber of workers that employers need to hire).” Mulligan hassuggested, in particular, that workers are choosing to remainunemployed because that improves their odds of receiving mortgagerelief. And Cochrane declares that high unemployment is actually good:“We should have a recession. People who spend their lives poundingnails in Nevada need something else to do.”
Personally, I think this is crazy. Why should it take massunemployment across the whole nation to get carpenters to move out ofNevada? Can anyone seriously claim that we’ve lost 6.7 million jobsbecause fewer Americans want to work? But it was inevitable thatfreshwater economists would find themselves trapped in this cul-de-sac:if you start from the assumption that people are perfectly rational andmarkets are perfectly efficient, you have to conclude that unemploymentis voluntary and recessions are desirable.
Yet if the crisis has pushed freshwater economists into absurdity,it has also created a lot of soul-searching among saltwater economists.Their framework, unlike that of the Chicago School, both allows for thepossibility of involuntary unemployment and considers it a bad thing.But the New Keynesian models that have come to dominate teaching andresearch assume that people are perfectly rational and financialmarkets are perfectly efficient. To get anything like the current slumpinto their models, New Keynesians are forced to introduce some kind offudge factor that for reasons unspecified temporarily depresses privatespending. (I’ve done exactly that in some of my own work.) And if theanalysis of where we are now rests on this fudge factor, how muchconfidence can we have in the models’ predictions about where we aregoing?
The state of macro, in short, is not good. So where does the profession go from here?