Thursday, September 02, 2010

The Living Dead: Thoughts on Macro and Depressions

Macro is not my field. One of the reasons it is not my field is that, so far as I can tell, it lacks a theoretical structure as solid or as well supported as price theory—popularly but misleadingly called "Micro." One result is that a course on the subject is a tour of either a cemetery or a construction site.

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.





22 Comments:

At 12:27 PM, September 02, 2010, Anonymous Anonymous said...

Macro is not my field. One of the reasons it is not my field is that, so far as I can tell, it lacks a theoretical structure as solid or as well supported as price theory—popularly but misleadingly called "Micro."

Neither Macro nor Micro offer a well supported theoretical structure for applying their results to real life situations.

I'm surprised to see you imply otherwise.

 
At 12:32 PM, September 02, 2010, Anonymous Anonymous said...

Macro is not my field. One of the reasons it is not my field is that, so far as I can tell, it lacks a theoretical structure as solid or as well supported as price theory—popularly but misleadingly called "Micro."

...

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.

I'll admit that I'm quite relieved to see that despite the fact that Macro is not your field, and that it lacks a theoretical structure, that doesn't stop you from using to support your idealogical positions.

 
At 12:39 PM, September 02, 2010, Anonymous David E. Shellenberger said...

Dr. Freidman, I enjoy your work.

I agree the government created and prolonged the Depression and is prolonging the current recession. One reason for both phenomena is that the government takes steps that favor itself and special interests, rather than those that would help the general economy.

In my view, the steps needed to achieve recovery included 1) cutting spending, taxes, and regulation, and 2) letting housing values fully decline and banks and other businesses widely fail. The government has done the opposite. The steps it has taken have allowed it to grow and have protected banks and other financial service firms, as well as public and private unions.

 
At 1:26 PM, September 02, 2010, Blogger Garg the Unzola said...

There are a few cases were cutting taxes, increased privatisation and less government control lead to positive results. Great Britain under Margaret Thatcher is one such an example, America under Ronald Reagan is another. However, Argentina seemed to have tried a similar approach and it failed dismally. Though the point that Dr Friedman is making is that uncertainty with regards to property rights inevitably leads to prudence on the side of private industry. I don't think this is a viewpoint motivated by ideology. We're seeing the same thing in South Africa with many farmers moving to other African countries where they are guaranteed property rights in light of the threats by government to nationalise/expropriate/steal their land and businesses. Seems to me that the only ideological motivations are to create a bloated government with stimulus, bialouts and breaking up businesses that are too big to fail. Except for General Motors, Freddie Mac and Fannie Mae, of course.

 
At 2:18 PM, September 02, 2010, Anonymous Anonymous said...

Price theory is a proper SUBset of microeconomic theory.

Classical demand & producer theory (incl. General Equilibrium) is well established and understood with little new research there. Sometimes 'price theory' is meant to be the applied side of micro.

Hierarchies of beliefs in games, axiomatic choice theory, behavioral is also micro but not price theory.

 
At 2:20 PM, September 02, 2010, Anonymous Anonymous said...

Asking what is the "cause" of a Great Depression is approaching the subject from a myopic perspective.

The cause is unimportant. The real issue is that the economy was in a fragile state (too much debt, not enough cash, asset price bubble, etc).

 
At 3:30 PM, September 02, 2010, Anonymous Anonymous said...

Price theory uses many simplifying assumptions which are not true in the real world:

- perfect competition
- transactions are frictionless

Price theory also depends on utility theory, which in turn depends on false assumptions like:

- people are rational
- utility is monotonic

Once you move from a small close system to a large open system, the oversimplified model that price theory uses breaks down.

Maybe it would help if you could point out *any* research which indicates that applying price theory models provides predictable and quantifiable results on scales larger than the classroom level.

 
At 10:06 PM, September 02, 2010, Anonymous Anonymous said...

Dear fellow anonymous -- you're spinning in circles, confusing yourself in the process of trying to sound smarter than Mr. Friedman. Here's some bad news for you: However hard you try, you'll never reach his level--even on a good day. Here's a suggestion for a better use of your time: Go start a business, create some wealth and jobs, then get back to us in about 20 years.

 
At 5:05 AM, September 03, 2010, Anonymous StrangeLoop said...

My only hesitation to alter macroeconomics to "disequilbrium theory" is that respectable theorists can still cast business fluctuations ("cycles") as equilibrium phenomena, and I tend to think that business fluctuations are what Friedman was implying.

 
At 6:35 AM, September 03, 2010, Blogger Mike Hammock said...

As far as I can tell, three of the assertions regarding Price Thoery made by one of the anonymous posters are false.

Specifically:
- perfect competition: Price theory is not just the study of one market structure. It also covers monopoly, and market structures between the two extremes.
- transactions are frictionless: Transactions costs are a standard topic in microeconomics/price theory, thanks to Coase.
- utility is monotonic: I think every intermediate micro course discusses bliss points. Local non-satiation is often assumed, but that's not a radical assumption.

Regarding rationality, economists know that people are not always perfectly rational. Experimental and behavioral economists have devoted significant effort to investigating the various ways in which people may be irrational. Nonetheless we usually assume rational self-interest because it seems to work so well in so many situations. It is a very useful and often correct simplifying assumption.

 
At 10:54 AM, September 03, 2010, Anonymous GregS said...

It is insufficient to point out that a simplifying assumption is incorrect. You have to explain how that incorrect assumption affects your conclusions. Newtonian physics is "wrong," but it will get a rocket to the moon and back.

The topic of human irrationality is fascinating and definitely worth looking into. But in my experience people are far to willing to jump from the premise "people are irrational" to the conclusion "people need to be controlled" or "the free market is a broken system." I can believe that we routinely deviate from rationality, but I find it very hard to believe that a set of instructions from a central bureaucracy can bias us in the right direction. We may not know our preferences very well, but certainly no one knows our own preferences better than ourselves.

I also think that many people don't know what they are talking about when they use the term "rational." It means you have a strict ordering of preferences; I'd hardly be disappointed in myself if I discovered that I prefer A to B, B to C, and C to A. I could conceivably enjoy the thrill of a lottery ticket and at the same time enjoy the comfort offered to me by home insurance, but a snarky economist might graph my risk-preference curve and label me irrational.
Rationality is not the Achilles Heel of price theory as so many people seem to believe.

 
At 11:35 AM, September 03, 2010, Anonymous Anonymous said...

It is insufficient to point out that a simplifying assumption is incorrect. You have to explain how that incorrect assumption affects your conclusions.

Indeed, which is why I asked for:

*any* research which indicates that applying price theory models provides predictable and quantifiable results on scales larger than the classroom level.

 
At 9:27 PM, September 03, 2010, OpenID hudebnik said...

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.

True, but I think in the current recession the uncertainty is less about the regulatory climate than about whether there will be customers to buy your product. Businesses aren't hiring because other businesses aren't hiring. Loosening and stabilizing regulations, or for that matter cutting taxes on businesses, won't solve the problem of a shortage of customers.

What would solve that problem? Well, giving lots of people money... but if you just hand them money once, they might just save it or pay off debts or something socially useless like that. They need to believe that they're going to keep getting money for a while. You could do that by having the government promise everybody a salary... but where would it come from? Or you could do it by the government hiring people: there's still a question of how to pay for it, but at least you're getting useful labor in exchange for handing out money.

Sure, it would be better to have the private sector hire them, but as mentioned above the private sector won't do that until it believes there are customers.

 
At 9:33 PM, September 03, 2010, OpenID hudebnik said...

Or, I guess, you could wait for wages to fall so low that businesses are willing to hire again... but if wages in general fall, so does purchasing power, so businesses will have even fewer customers so they still won't hire. And all this time people are suffering... people who vote. No incumbent political party, right or left, will risk that.

 
At 6:58 AM, September 04, 2010, Anonymous William H. Stoddard said...

I have always thought of "macro" as aggregative economics: the attempt to study magnitudes defined over entire economies, and relations among those magnitudes. It's kind of like classical thermodynamics before Maxwell showed that its macroscopic variables could be redefined as statistical summations of molecular-level mechanical variables.

The trouble is that macro as we now understand it was created as a field of inquiry mainly by Keynes, and specifically by Keynes's rejection of Say's law. Keynes tried to sell this as an innovation comparable to Einstein's innovations in physics (the title "General Theory" is a claim to the mantle of Einstein) . . . but it's more like the innovation of adding perpetual motion into Newtonian mechanics.

I'm a bit baffled by the idea of calling macro "disequilibrium economics." When I read the General Theory in 2008, I was struck by the derivation of the multiplier from the marginal propensity to consume, in which Keynes goes from income as the independent variable and investment as the dependent variable to having it the other way around, with the two being mathematical inverses. That is, Y determines I, and I turns around and (in Keynes's derivation) determines the same magnitude of Y. In a more general treatment, I could determine a different Y', which could determine a different I', which could determine Y", and so on. The only time you can treat the two as mutually determining each other is when you are in a static equilibrium. And, in fact, the Keynesians I've looked at seem to spend a lot of time on "statics" and to assume that the natural state of the market is at equilibrium, and that it is only ever gotten away from equilibrium by external shocks . . . and their policy largely relies on having the government administer those shocks. Since one of the most glaringly obvious traits of markets in the real world is that the are constantly in disequilibrium (rather like Schumpter's "creative destruction"), it's not very surprising to me that classical Keynesian doesn't work very well.

 
At 1:19 PM, September 04, 2010, Blogger Michael Strong said...

Robert Higgs' article "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War" develops the concept of "regime uncertainty" well,

http://www.independent.org/publications/tir/article.asp?a=430

We should all begin using the term "regime uncertainty" so that it becomes understood as an obvious description of these situations, so obvious the NYT can't ignore it.

 
At 11:03 PM, September 05, 2010, Anonymous Anonymous said...

In every field of science you have the framework of ideas of that field - which the science process can extend, refine or fully or partially replace. Keynesian analysis became a part of that framework of ideas for macro-economic field. Those academic economists who rejected the Keynesian analysis but were unable to refine, extend or replace it with the other framework... are not scientists. There were others, including M.Friedman, who were able to extend or partially refute and replace it in a meaningful way. The subject of macro-economics is well-defined, clear and non-trivial. So if I may - very, very humbly - suggest, it is the framework that integrates Keynesian (and refined - neo-Keynesian) and monetarist analysis that may be of interest. And not statements of those academic economists that fail to bring the new insights to the discussion.

 
At 10:02 AM, September 08, 2010, Anonymous Anonymous said...

Perfect example of price theory's failure in the real world:

http://economix.blogs.nytimes.com/2010/09/07/mortgage-rates-and-home-prices/

 
At 10:08 PM, September 09, 2010, Anonymous Andrew said...

Uncertainty creates an environment more ripe for investment. Investments which are certain have a small rate of return. I'm not interested in investing in some commodity, my brain is my advantage. The more uncertainty, the better for the smart investor/business person.

 
At 12:18 PM, September 13, 2010, Anonymous malavel said...

Monetary policy works well even in a liquidity trap. Level targeting is one example. So why not use that?

http://www.riksbank.se/templates/Page.aspx?id=30660

Here's a fascinating take on the trigger for the great depression.

http://oxlib.blogspot.com/2010/05/scott-sumner-its-complicated-great.html

Short version: central banks bought too much gold which caused deflation.

And one more Scott Sumner link for the cause of the long duration:

http://www.themoneyillusion.com/?p=4220

 
At 9:07 PM, September 20, 2010, Anonymous Andrew said...

To emphasize my previous point about how uncertainty is good and a normal state for business, here's an article from the Harvard Business Review:

"Embracing Uncertainty Rather than Whining About It"

http://blogs.hbr.org/fox/2010/08/embracing-uncertainty.html

 
At 11:05 PM, September 22, 2010, Blogger Troy Camplin said...

I would argue that the real situation is far-from-equilibrium, with "equilibrium" as at best a useful fiction (though the errors perpetuated by adherence to it may suggest it has in fact outlived that usefulness).

I talk about far-from-equilibrum states in relation to spontaneous orders, the economy as a process, networks, and macroeconomics.

 

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