The Living Dead: Thoughts on Macro and Depressions
The cemetery is the orthodox Keynesian account according to which a depression is the result of insufficient demand due to the exhaustion of investment opportunities, monetary policy is useless because the economy is in a liquidity trap, and the proper solution is for the government to run a large deficit, converting the excess savings into government expenditure. That was the accepted wisdom fifty years ago. As best I could judge, as observer not participant, it fell out of favor among academic economists in the ensuing decades, due to both theoretical and empirical problems.
The construction site is the attempt to replace the old orthodoxy. Some of it gets labeled "monetarism," some "neo-keynesianism," some other things. None has been sufficiently successful to have achieved the status of a new orthodoxy.
That is one reason why the old orthodoxy maintained its popularity in popular culture, including that of politicians and journalists. A second is that it provides a justification for large scale deficit financing, something politicians, left and right, are fond of doing whenever they have a plausible excuse. The old orthodoxy reappeared a few years ago in full force, complete with its old claim to be what everyone who knows anything about the subject believes, and was used to justify deficit spending on a scale large even compared to the deficit spending of the previous administration.
Think of it as the rise of the living dead.
All of which leaves open the question of why things went wrong, in the Great Depression and the recent Great Recession, and what should be done to fix them. I do not have a confident answer to those questions, but there is one possible answer which I find at least plausible. It is an explanation not of why a depression or recession starts—that, in the two cases of interest, seems to depend on special circumstances—but on why it is so severe and lasts so long.
The Great Depression of the thirties and the current Great Recession have one feature in common that has not, I think, received sufficient attention—the government response to them. Hoover reacted to the 1929 stock market crash by sharply increasing federal expenditure; by 1932 it was fifty percent higher than in 1929 in nominal terms, twice as high in real terms, three times as high measured as a share of national income. FDR went on to enormously expand the role of government in the economy, creating our modern regulatory state. Obama followed a similar policy on a smaller scale, expanding government involvement (already very large) in the health care and financial industries, bailing out failing firms on a scale I think unparalleled in U.S. history, threatening additional large scale interventions to deal with global warming.
The result, in each case, was to greatly increase the uncertainty of the environment within which private actors were making their decisions. If you do not know what the future is going to be like, there is much to be said for postponing any decision that depends on the future, whether an investment in physical capital or human capital. It is risky to hire new employees if you do not know whether, a few years hence, it will be legal to fire them. It is risky to build a new factory, in any industry where energy is a major cost, if you do not know whether next year's legislation will sharply raise the cost of energy—better to wait to choose your design until you have a clearer idea of what your costs are going to be. It is risky to choose a profession, or change professions, when you do not know whether the growth field is going to be health care or bankruptcy law. Multiply such considerations many fold, and you may have an explanation of why the recovery from the initial shock, in both cases, was so slow.
Arguably, the U.S. economy is suffering from a disease in part iatrogenic. Which may explain why the doctor can't understand what went wrong.
Post Script on Labels. They sound clear enough—micro deals with small things, macro with large. But it isn't true. The world wheat market or the world oil market is properly understood with supply curves, demand curves, conventional analysis of choice over time, and similar "micro" tools. Hence, in my view, the proper labels are "price theory" and "disequilibrium theory." Understanding disequilibrium—loosely speaking, the sort of situation that price theory tells us can't exist but that sometimes does—is a hard problem.