By Roger E.A. Farmer
For the past nine months I have been presenting some new ideas at academic conferences where economists have been grappling with the current financial crisis. Boston, Montreal, Amsterdam, London, Cleveland, Sydney, Atlanta … Only the venues change. The participants and the papers are always the same.
Half of the papers are about the quantitative effects of fiscal policy. If government spending goes up by one dollar, how much will income go up? The answer varies from zero to three depending on the assumptions made by the economist to disentangle cause and effect. Administration economists claim that the multiplier is 1.5. Well at least we got it right on average!
This reminds me of the statistician joke. Two statisticians go deer hunting. One fires off a shot and misses by ten feet to the left. The second fires off a shot and misses by ten feet to the right. They both shout out triumphantly: We hit it!
Suppose that a government official is building a bridge and he needs to know the elasticity of steel because if he gets it wrong by 20 per cent or more the bridge will fall down. The official asks two engineers. One claims that it’s 20 and the other says no, it’s 40. No problem says the official, I’ll take the average. Don’t laugh. That’s how we’re running fiscal policy.
What about the other half of the papers that are theoretical rather than empirical? Here, the depressing feature of almost every conference I’ve recently attended is that most of my colleagues continue to use a discredited theory to analyze the problem of high unemployment; a problem for which the theory is clearly inadequate. That theory is called new-Keynesian economics.
For 30 years, macroeconomists have been of two stripes: new-classical and new-Keynesian. Neither has anything interesting to say about the current crisis.
In new-classical and new-Keynesian economics, all unemployment is temporary and unemployed workers will quickly find jobs. According to the Keynes of The General Theory, very high unemployment can persist forever. Nobody has taken this Keynesian idea seriously in respectable academic circles since the 1950s. But given the current jobless recovery, it’s an idea that makes sense and needs to be reconsidered.
Keynesian economics as we know it today is a watered down version of The General Theory given to us by American Keynesians like Paul Samuelson. Samuelson turned Keynesian economics into a digestible series of bite-sized pieces that the Cambridge economist and contemporary of Keynes, Joan Robinson, has referred to as “bastard Keynesianism”. Samuelson’s interpretation of Keynes evolved into a modern incarnation – new-Keynesian economics.
According to new-Keynesians, recessions occur because some firms are stubbornly unwilling to lower their prices in the face of a fall in demand. Workers quit their jobs and choose to take a prolonged vacation. This is not the main theme of The General Theory. But the idea that some firms are slow to change prices is central to new-Keynesian economics. To explain why firms don’t change prices, the new-Keynesians assume that a firm must wait until it’s randomly chosen to be given the privilege to change its price. This option is facetiously referred to as a ‘visit from the Calvo fairy’ after a paper by economist Guillermo Calvo who first introduced the idea into macroeconomics. I don’t believe in fairies.
The Calvo fairy is not the only unrealistic feature of new-Keynesian economics. Perhaps more damning is the fact that there is no unemployment in the benchmark new-Keynesian model. Instead, all variations in the employment rate occur as rational maximizing households choose to vary their hours in response to changes in the real wage. It is hard to take this model seriously as an explanation for the Great Depression or the current financial crisis. But it continues to dominate the discussion at academic conferences because – until now -there has been no good theoretical alternative.
It is more important than ever that our policy makers and the general public understand how economists’ beliefs influence the policies that are now having such a profound influence on our everyday lives. Many economists recognise that it is time for economics to change. But so far, theoretical economists are trotting out the same tired old solutions and empirical economists are a long way from a consensus on the magnitude of the multiplier. Let’s hope we get it right before the next bridge collapses.
The policies that new-Keynesian economists are advocating stem from a theory that is built on sand. Before economists become policy advocates we need a theory that is internally consistent and that can explain the evidence from the Great Depression, the stagflation of the 1970s and the current economic collapse. The Keynes of The General Theory was right about the problem, but he was wrong about the solution. High unemployment can persist forever unless we do something about it. But fiscal policy is not the way to restore full employment.
If new-classical and new-Keynesian economics are both wrong, where do we go from here? The classical economists argue that the economy will repair itself. The new-Keynesians argue for more fiscal stimulus. I agree with the Keynesians that very high unemployment will persist if we don’t do something about it. But I do not believe that large fiscal deficits that will be paid for by our children and our grandchildren are the answer.
The current crisis was caused by a self-fulfilling drop in confidence reflected in a drop in housing wealth and in the value of the stock market. Must we live with a jobless recovery? Why are recessions declared officially over when very high unemployment persists? I answer these questions from a new perspective in two new books, Expectations Employment and Prices (written for academics) and How the Economy Works: Confidence Crashes and Self-Fulfilling Prophecies (written for the general public). I argue that the solution is not to replace private demand by public demand through massive fiscal stimulus programs. A more effective policy solution is to maintain and extend the programs of quantitative easing that have been engaged in by central banks throughout the world.
Professor Farmer is the author of two books on the current crisis now available from Oxford University Press. How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, written for a general audience and Expectations, Employment and Prices written for academics and professional economists.