Arnold Kling  

Theory, Explanation, and Policy

Education, Ideology, and Awkwa... Banana Republic Economics, Con...

Josh Hendrickson writes,

there are many so-called Keynesians who have been out there promoting policies that are quite the opposite. They have been promoting the re-capitalization of banks, forcing banks to lend, automotive bailouts, and a push toward developing "green" jobs. These attempts to micromanage the supply side of the economy are not consistent with Keynesian stimulus or that of modern macroeconomic theory.

In my mind, there are three dots that need to be connected:

1. theory
2. the explanation for the recent crisis
3. policy to get us out of the crisis.

Hendrickson is worried about the disconnect between (1) and (3). I agree. But I also worry that there is a disconnect between (1) and (2) and between (2) and (3).

Neither textbook macro nor modern theory is focused on sudden shifts in the risk premium, although I think it is impossible to describe the recent crisis without referring to such a shift. In a sense, what we have is a a "just so" story, and not a theory. That in turn makes the connection between theory and policy rather tenuous.

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CATEGORIES: Macroeconomics

COMMENTS (2 to date)
El Presidente writes:

One might say we need:

1. A goal
2. An inventory
3. A plan

But, if we want theory before we move forward, I would suggest that we acknowledge the gaping hole in our theory underlying growth models. The nexus between income distribution, rates of growth, and subsequent collapses needs to be worked out a little better. Solow, the cornerstone of our professional dogma, is not only indifferent, but intentionally dismissive of the effects of distribution on growth. We can posture and claim that long-run models shouldn't take into account short-run disparities in income and wealth distribution, but what is the long run but a series of consecutive shorter intervals? Do the laws of physics change for 20-year as opposed to 20-minute or 20-second observations? Why should the laws of economics be presumed to behave differently?

I've seen it argued that "overinvestment" precipitated the Roaring Twenties and the subsequent crash. I think the wording is clumsy, but they're on to something. There is a fairly stable rate of growth that our economy can sustain (approximately 3%/yr). If we try to overshoot the mark through, say, imbalanced taxation that subsidizes land over capital, and both over labor, then we get what we pay for: higher rents and profits and lower median income. Reducing the progressivity of marginal rates also tends to polarize wealth distribution. Credit bridges the gulf but can only stretch so far. Eventually, as Robert Reich would say, something can "snap" causing us to fall into a canyon.

Chmn. Eccles put it this way:

The United States economy is like a poker game where the chips have become concentrated in fewer and fewer hands, and where the other fellows can stay in the game only by borrowing. When their credit runs out the game will stop.

We achieve a critical value in our consumption function. This is a shift in consumers' willingness to continue spending and taking on debt, hoping that they will eventually get ahead if they play along. When this shift in baseline consumption and MPC occurs, velocity slows dramatically, output declines, and it requires a considerable change in prices and then stabilization to cause people to increase spending again. The problem isn't so much that we achieved the critical value, but rather that we sought to approach it without reaching it rather than seeking a sustainable equilibrium. It's going into the casino thinking you'll be a big winner that often ends with the deed to your house riding on black 17. Change the expectation, and the behavior changes too.

We should also work out a production function that includes explicit reference to the productivity of land, not just capital and labor.

That's where I would start with the theory.

I am reminded of alchemists trying to find ways to make gold. The discoveries of modern chemistry have been far more valuable to humanity than all the gold alchemists could have imagined. Let's make the transition from greed to discipline in our theories. We'll probably all be better for it.

fundamentalist writes:

"Neither textbook macro nor modern theory is focused on sudden shifts in the risk premium, although I think it is impossible to describe the recent crisis without referring to such a shift."

If you're lost, sometimes it's best to go back to familiar ground and try again. In the case of macroeconomics, we need to go back to 1939 to Hayek's description of the business cycle in "Profits, Interest and Investment", which I think is far more clear than was "Prices and Production." "Profits" is harder to find; it's not online anywhere, but it is much better. In addition, Hayek's "Monetary Theory and the Trade Cycle" does a good job of explaning financial crises. Though written in 1931, you'll feel like he wrote it about today's crisis.

Economics abandoned important knowledge when it followed Keynes. That knowledge was never incorporated into mainstream econ because it does not fit the Keynesian paradigm. So it was abandoned.

To respond Dr. Kling's issue of "shifts in the risk premium," Hayek might say that investor vision was clouded by the expanding money supply, which causes people to reduce the risk premium. But a growing money supply does not create more capital goods, so when the shortage of capital goods becomes clear near the end of the boom, and businesses start failing, investors return to more reasonable assessments of risk premia.

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