Arnold Kling  

The Future of Macroeconomics

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Three predictions:

1. There will be much less emphasis on monetary policy, and much more emphasis on financial institutions and financial regulatory policy.

2. There will be much less emphasis on fiscal policy, and much more emphasis on sectoral reallocation and labor adjustment policy.

3. The process of changing the paradigm in macroeconomics will be frustratingly long and difficult. As physicist Max Planck once said, science advances "one funeral at a time."

1. Macroeconomics has been overly monetarist over the past thirty years. We believed in the Taylor Rule, which said that the Fed can keep unemployment and inflation close to target values by raising the Federal Funds rate when employment and inflation stray too high and lowering the Fed Funds rate when they stray too low.

What this thinking ignores is the impotence of monetary policy when inflation rates are low. The money that the Fed creates by expanding its balance sheet is a close substitute for other short-term low-risk assets. However, short-term, low-risk assets are not close substitutes for long-term, high-risk assets. Changes in the market mix of short-term, low-risk assets can have little or no effect on interest rates for commercial loans, mortgage loans, and other interest rates that are important determinants of economic activity.

Only when inflation is high do we see highly imperfect substitutability between money and other short-term assets. When inflation is high, the Fed can step on the brakes by raising short-term interest rates.

On the other hand, the economics profession has paid too little attention to financial institutions and to regulatory policy. As I pointed out in lectures on macroeconomics, the nonfinancial sector would love to issue risky long-term liabilities to fund investments, while consumers would love to hold riskless short-term assets to maintain liquidity. The financial sector intermediates by holding risky long-term assets and issuing riskless short-term liabilities. The more the financial sector expands, the more long-term investment is undertaken in the economy.

In order for the financial sector to do its job properly, it needs to enjoy the right amount of confidence from the public. With too little confidence, the economy suffers from credit scarcity and insufficient long-term investment. With too much confidence, the economy suffers from bubbles and excess credit creation, followed by crashes.

The key policy question is what, if anything, the government can do to prevent episodes of over-confidence or under-confidence in financial institutions. Historically, what we have seen is that after each crisis episode, new forms of guarantees and regulation are introduced. Over time, these institutions seem to degrade and a new crisis occurs. Can that cycle be overcome?

2. I believe that confidence in generic fiscal policy is also misplaced. Superficially, it makes sense that government spending can replace private spending when the latter breaks down due to a crisis in the financial sector. However, the fiscal-stimulus theory fails to take into account the fact that what is going on in the real economy, particularly after a financial shock, is a reallocation of resources out of dying sectors and into emerging sectors.

Instead of looking at fiscal stimulus, I think that economists should focus directly on the adjustment process, particularly in labor markets. How do new industries emerge to absorb the resources that are released from industries that collapse during a financial crisis? What sorts of policies can make this transition take place more quickly and with less difficulty? What labor market institutions are most conducive to economic recovery? Should government try to create policies that mitigate the cyclical behavior of income shares, so that profits rise less during a boom and fall less during a recession?

3. I believe that these questions--how to achieve financial stability and how to facilitate inter-sectoral transitions--will be the main issues in macroeconomics in the future. However, it may take many funerals before these questions make it to the top of the research agenda.


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CATEGORIES: Macroeconomics



TRACKBACKS (2 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/1605
The author at Discuss Economics & Finance in a related article titled The Future of Macroeconomics writes:
    Interesting articles for you to peruse. Arnold Kling on the future of Macroeconomics; interesting piece especially given the current attention to the economy and the growing popularity of economics in post-secondary institutions. While you're there wh... [Tracked on March 12, 2009 1:05 PM]
The author at Interfluidity in a related article titled A think-nugget from Arnold Kling inspires a very long riff... writes:

    Arnold Kling offers a very concise view of the financial intermediation:

    [T]he nonfinancial sector would love to issue risky long-term liabiliti...

    [Tracked on March 13, 2009 12:44 AM]
COMMENTS (22 to date)
Troy Camplin writes:

I'm afraid the future of macroeconomics will continue to be a series of disastrous experiments until we come to understand macroeconomic behavior as emergent features of a complex system. Understanding the economy as a complex system that evolves -- and can evolve into a new kind of complex system -- is what is necessary. Recessions are transition states from one stable economy to another (see catastrophe theory for the proper model of this). As changes and errors accumulate in a stable economy, it becomes unstable, a shift occurs, and the economy leaps into a new stable order. This is part of Joseph Schumpeter's “creative destruction." During recessions, though, there's an emphasis on the destruction part. But this is necessary. In natural ecosystems (to which an economy can be fruitfully compared), mass extinctions are needed to make space for new forms of life.

Ormerod's "Butterfly Economics" sets us on the right path, but he still falls a little short, still missing the forest for the trees. His ideas need to be combined with Hayek's spontaneous order model of the economy, as well as Prigogine's dissipative structures, and Gould's punctuated equilibrium model of evolution. Indeed, the punctuated equilibrium model I think brings us much closer as to why there are business cycles in market economies. It also explains why we have so many scandals at the time of recessions -- as cheaters (those contributing to the errors accumulating in the system) are exposed. Cheaters have to be swept away for the next, healthy system to come into existence.

Gary Rogers writes:

I am not going to hold my breath, but the first thing I would like to see is for economists to understand debt what debt does to the economy.

bjk writes:

Regulatory capture means that "more regulation" is likely to lead to more capture. So the solution is in fact "less regulation," maybe eliminating FDIC insurance for institutions that take bigger risks.

I wonder what EconLog thinks about this Henry Simons-like proposal.

http://www.rgemonitor.com/globalmacro-monitor/255279/limited_purpose_banking_putting_an_end_to_financial_crises

"Make banks stick to their two critical functions – mediating the payments system and connecting lenders to borrowers.

To safeguard the payment system, banks must hold 100 percent reserves against their deposits either in cash or short-term U.S. Treasuries. With 100 percent reserves, banks runs will be history. This is not true of the current system, notwithstanding FDIC insurance. The FDIC’s potential liability exceeds $4 trillion; its assets are less than $50 billion. A run on the banks would require massive money creation and engender greater economic panic.

To ensure their second function – the uninterrupted connection of suppliers of and demanders for funds -- banks should be limited to a) packaging conforming mortgages and conforming business loans (commercial paper) within mutual funds and b) marketing these mutual funds to the public; the model here is Fidelity, not Lehman."

Bill Woolsey writes:

What determines nominal income?

Why can't the price level be 100 times higher than now?

Why not 1/100 of its current level?

"monetary policy" is not the same thing as using open market operations with T-bills to target the Federal Funds rate. That is one approach to monetary policy.

When long term securites are not being funded, what do the people who were funding them do with that money?

When people pay down debts, what to those who were lending to them do with the money?

When "leverage is increasing, where to the lenders get the money they lend? What would they have done with the money?

What do people spend? What happens when there is an imbalance between the quantity of the medium of exchange and the amount peopel what to hold?

The allocation of resources in the production of different things is what microeconomics is all about.

fundamentalist writes:

"What this thinking ignores is the impotence of monetary policy when inflation rates are low."

It's not just the impotence of monetary policy that needs to be reconsidered, but the assumption that the Fed never does any harm by manipulating interest rates. If economists always assume that the Fed can do no harm, then macroecon will never improve.

Dave Schuler writes:
However, the fiscal-stimulus theory fails to take into account the fact that what is going on in the real economy, particularly after a financial shock, is a reallocation of resources out of dying sectors and into emerging sectors.
And, equally important, that the taxing part of the fiscal-stimulus equation is a reallocation of resources out of emerging sectors into dying ones (with political clout).
Joe writes:

Arnold,

I find your posts to be even handed and well thogh out, pulling ideas from many sources to try and understand what is happening. Great Stuff!!!

Winton Bates writes:

I agree with Bill Woolsey. I am surprised by your claim that monetary policy does not work when interest rates are low. Perhaps you mean conventional interest rate policy rather than monetary policy.

The advantage of using monetary policy i.e. purchase of bonds by the central bank to increase the money supply is that it will be easier to unwind when inflation takes off.

Robert Bell writes:

Dr. Kling:

"However, the fiscal-stimulus theory fails to take into account the fact that what is going on in the real economy, particularly after a financial shock, is a reallocation of resources out of dying sectors and into emerging sectors."

Is this more or less the same as the "technological frictions" James Hamilton spoke about here:
http://www.econbrowser.com/archives/2009/02/the_paradox_of.html

and also referenced here
http://economistsview.typepad.com/economistsview/2009/03/equilibrium-and-meltdown.html

Pierre writes:

Insightful. I would only add the increasing importance of a global macroeconomic outlook. For example, Greenspan's efforts to cool the overheating of the housing boom was usurped by downward global pressure on long-term fixed assets.

We need to think bigger.

ionides writes:

"Changes in the market mix of short-term, low-risk assets can have little or no effect on interest rates for commercial loans, mortgage loans, and other interest rates that are important determinants of economic activity."

But does the Fed have to restrict it's transactions to short term bonds?

Lord writes:

I think you are basically correct but I wouldn't call recessions reallocations. Real reallocation substantially only occurs during growth and occurs all the time during growth. While mass extinctions happen, they are not at all necessary for evolution to occur. They may alter the path, but I don't think an asteroid impact would be an element of progress, only devastation.

Graeme Bird writes:

"What this thinking ignores is the impotence of monetary policy when inflation rates are low."

Monetary policy is never impotent. What you are talking about is banking subsidies. Not monetary policy. If you would lend me great mountains of cash at bargain basement rates I'd have to be pretty tired or silly not to become a multi-millionaire within about 20 years.

First thing I'd do is I'd refinance all outstanding debts and then I'd be bargain-hunting. But the principle is the same. The monetary policy you are talking about is just a racket. Thats not monetary policy its a gigantic rolling thunder of stealing and subsidy.

If monetary policy is defined instead as the use of two tools alone. And those two tools are:

1. new cash injection via debt retirement.

2. The incremental upward adjustment of the reserve asset ratio.

If the above is what we define as monetary policy then its NEVER ineffectual. Its always potent. Powerful stuff. Too strong. The medicine is too strong and deadly in the wrong hands.

Graeme Bird writes:

"I'm afraid the future of macroeconomics will continue to be a series of disastrous experiments until we come to understand macroeconomic behavior as emergent features of a complex system."

You are barking right up the wrong tree. This is not a difficult subject. If you can weed out all the hired nonsense-talk and taxeater perogatives its a very simple subject.

Bank cash pyramiding,like any ponzi scheme, leads to instability.

You don't need to drag in complexity theory to understand that scenario.

Pedro P Romero writes:

I agree with the core of what you say. But I think you are reducing the causes of the recent and also previous financial crises to psychological factors when you say:

"With too much confidence, the economy suffers from bubbles and excess credit creation, followed by crashes."

People always want to make money in the market. Even a prudent investor could be considered over-optimistic looking backwards. Policy mistakes, populist regulations, distorted financial indicators. That compounded their optimistic tendencies.

Regarding the re-allocation of jobs I agree that a more decentralized and agentized (microlevel) view should be more emphasized. What we are seeing right now is people being lay-off which means that their localized skills are depreciated. It will take some time to find a new job, and even another while to apply the old and new labor skills before to get as productive as before. None government can just re-allocate jobs and keep the previous productivity of the overall economy as before. Some sectors that might have been favored by the economic environment previously, are not anymore attractive. If those sectors hired a lot of specialized people, that will be reflected in higher unemployment. And it will last longer, the more those were highly specialized jobs. Other sectors probably would be getting more applications that usual, pressing down wages.

The future will include: an agent-based interactive approach to economics.

Vasile writes:

But does the Fed have to restrict its transactions to short term bonds?

Well, what we have here is the logic of interventionism at work. Next step:

But does the Fed have to restrict its transactions to short and long term bonds?

.. then, after many, many iterations

But does the Fed have to restrict its transactions to short and long term bonds, home mortgages, consumer credit ... and dropping money from the helicopters?

Pedro P Romero writes:

"Historically, what we have seen is that after each crisis episode, new forms of guarantees and regulation are introduced. Over time, these institutions seem to degrade and a new crisis occurs. Can that cycle be overcome?"

I wanted to add comments on the above paragraph. Financial innovations are created to circumvent regulation. But some of these innovations may produce what the sub-prime type of instruments did, namely a distortion of risk valuation. So it can be argued that a financial crisis is the unintended consequence of 'excessive or clumsy' regulation. Like price controls, generating big lines.
Another way to see this is learning. After a time in which new regulations where in place, investors learn how to reduce their cost or impact on capital gains. But learning should yield good results, not over-confidence and crises....

Troy Camplin writes:

Not all mass extinctions are caused by asteroids -- that's a rare event. I was thinking more along the lines of cambrian explosion. where there is a sudden increase in number and kinds of species after a period of relative stability. But then, the mass extinction example really isn't quite what I'm talking about. Gould proposes that an individual species stays that species over long periods of time, and mutations accumulate over that period, until a critical number of mutations accumulate, and (a) new species emerge(s). On the cellular level, the stable system moves closer and closer to chaos, until a catastrophic collapse is reached. The system either goes extinct, having collapsed into complete chaos, or it moves into a new, typically more complex level.

All economies are nonlinear, complex, self-organizing, dissipative systems. Simple is not an option. Simple, linear thinking is what makes recessions in these cycles worse. The attempt to make such a system simple and linear -- through welfare statism or socialism -- stretches the recession out through time and at best flattens growth. What we are witnessing right now is the actions of people who see the economy as simple ,linear, and as a zero-sum game. They are wrong on all accounts.

Macroeconomics is the attempt to understand the macrofeatures of the economy. To make an analogy, microeconomics is biochemistry, macroeconomics is cell biology. Or should be. Right now, macroeconomics is more like molecular biology in its attempt to understand the large institutions within the economy. To that extent, there is in fact almost no theory of macroeconomics proper. There needs to be a medioeconomics that deals with institutions, firms, etc. in the same way molecular biology deals with structural and informational macromolecules. Could you imagine the state biology would be in if there weren't a separation between molecular biology and cell biology? Yet, that is the state I see in economics, with macroeconomics being that sort of fusion. At best. At worst, it doesn't even admit to their being true macrofeatures. It would be like having a theory of biochemistry and molecular biology without a theory of the cell.

To not understand the need for systems theory in economics is like not understanding the need for it in biology. You can keep trying to apply Newtonian physics equations to cellular behavior, but you're not going to have the foggiest idea what's going on.

Kartik writes:

Offtopic :

Arnold,

Do you still believe the 21st century GDP growth projections that you discussed over here :

http://econlog.econlib.org/archives/2004/01/longterm_growth.html

Are you still expecting that level of growth in the 2020s, 30s, and 40s? If not, do you have new projections?

rhhardin writes:

We believed in the Taylor Rule, which said that the Fed can keep unemployment and inflation close to target values by raising the Federal Funds rate when employment and inflation stray too high and lowering the Fed Funds rate when they stray too low.

It seems backwards to me. The short term interest rate is an output of the economy, not an input from the Fed. The Fed raises or lowers its target, and then prints or extinguishes money until the economy produces the interest rate it has decided on.

It's a way of regulating how much more money is printed or extinguished, which is the point of the target. If leading indicators of inflation point upward, raise the target and then extinguish money until the economy produces the target interest rate.

The rate itself is unimportant, only that it's a little bigger or smaller than the previous target, in response to something noticed about inflation. The real action is the creating or extinguishing of money. The reaction of the economy is the short term interest rate, used as a monitor of the action.

The problem now is that nobody wants the money for anything, so the exercise becomes pointless in the first step. The economy does not react.

That confounds a little the two missions, by the way; or the mission creep from one to the other. The real mission is stabalize the financial system. The mission creep is stimulate the economy. The latter probably could be dropped, and perhaps should be.

Steve Roth writes:

Arnold: "the impotence of monetary policy when inflation rates are low"

I've been wondering since your last post on this: is the level of inflation the key criterion here affecting the efficacy of monetary policy?

Or is it real interest rates? That's what really determines the difference in "value" between cash and treasuries, no?

The most instantly effective monetary move we remember is Volcker's easing in the 80s, when, yes, inflation was high, but so were real interest rates.

Thoughts?

Scott Sumner writes:

Arnold, There are two points I would make in support of your analysis.

1. If central banks don't know how to operate in a zero interest rate environment, then monetary policy will, de facto, become impotent.

2. Bankward looking Taylor rules don't work in fast-moving financial crises.

But I also agree with Bill Woolsey that in the end the path of nominal GDP is determined by monetary policy, whether actively of passively. The question of whether nominal GDP will be 10 times higher or 50 times higher at mid century is completely up to the monetary authorities, "real factors" play almost no role. And changing expectations about the future path of nominal spending have an enormous impact on current spending (a lesson we are painfully learning right now.)

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