Thursday, 21 May 2009

The Curious Case of Macroeconomics

It is no understatement to say that the ongoing global financial crisis has reshaped many views about everything from derivatives regulation to geopolitics. One area that has been particularly shaken is economics, and, as countries continue to grapple with the tricky matter of stimulating economic recovery, macroeconomics has received the bulk of the attention. Economics, broadly and colloquially defined, is the science/art of balancing unlimited wants with limited resources. Macroeconomics, then, examines this problem at the national or aggregate level and, in its most basic formulation, looks at how those resources should be allocated in order to promote growth.

There's just one problem: macroeconomics does not have an answer to this problem -- or, more accurately, it has multiple answers and cannot seem to decide among them, and, as macroeconomists around the world wring their hands over this recession, the rifts between various schools of thought has never seen more pronounced.

So it seems to me, having just wrapped up a course in intermediate macro. My previous studies in macro, first at the Advanced Placement level and then in my international finance course, centred around a more classical, Keynesian approach that took the basic supply and demand model and extrapolated it to the national level. Aggregate demand and aggregate supply curves were our instruments of choice in AP. Aggregate demand was composed of consumption, investment, government spending, and net exports, and, whenever one increased or decrease through monetary or fiscal expansion or contraction, respectively, aggregate demand would respond accordingly, and so forth. This was complemented by the Philips curve, which embodies the inverse relationship between unemployment and inflation and could also be used to trace the effect of monetary and fiscal policy. In my college-level international finance course, I was introduced to the IS-LM model, where the IS curve represents fiscal policy and the LM curve allows for changes in money supply, as influenced by monetary policy.

As I proceeded through my intermediate macro course, though, not a single mention of IS-LM or aggregate demand/supply was made, except, perhaps, when my professor paused to speak of Keynesian economics with a distinct note of contempt in his voice. Indeed, the way he taught macro, one could have easily been under the impression that Keynesian ideas about the economy did not exist at all. Instead, he spoke of consumers and the government having fixed consumption preferences and rational expectations. Under this banner, I was taught, for instance, that taxing a person's income in old age will have absolutely no effect on how that income will be spent over a lifetime because the person in question will always want to spend x percent of his income when young and 1 - x percent of his income when old. When my class arrived at the very timely subject of business cycles, we spent a significant amount of time discussing an article that argued that, even if government were able to smooth out perfectly business cycles, this would only bring a negligible average benefit per capita. Indeed, I remember quite clearly the author concluding the article with a warning: governments should be less concerned about deviations from expected growth trends and more so with promoting policies that could be even more distortionary. This was accompanied by a discussion of the "Great Moderation," which stipulates that business cycles have become less severe in recent decades.

As Paul Krugman notes, this divide within macro is nothing new. Proponents of the rationalist school regard the Keynesian school as, well, irrational and simplistic, and, as for what the Keynesians themselves think, I would not know, having never received instruction in macroeconmoic theory from one. One thing, however, is clear: the rationalist school, with its belief in the declining importance of business cycles -- and, by implication, the declining importance of government intervention in economic activity -- had been ascendant in recent years, giving intellectual underpinnings to that ever expanding bubble of prosperity, the popping of which has led to the first worldwide recession since World War II.

On occasion, my mother, interested in what exactly what her tuition money was buying, would ask me what my macro course had to say about the current recession and government responses to it. I found that I could give her no meaningful response: theories about rational behaviour and expectations of future income had nothing to say about financial regulation or government stimulus (except, perhaps, that the government should not act, a notion I considered as outdated as, say, medieval witch hunts). Meanwhile, in the real world, Congress was wrangling with the president over the exact size and scope of the American Recovery and Reinvestment Act, the president was urging other heads of state to pass their own stimulus packages, and the Treasury Department was prepared to spend billions of dollars of government money to purchase legacy assets, thereby increasing liquidity and spurring private investment. Despite the very contentious nature of these debates, however, there appeared to a strong consensus that a massive infusion of public money into the economy was exactly what was needed. (Perhaps instead of asserting that "we are all socialists now," Newsweek should have argued that we are all Keynesians now.) This stood in direct contraction to the material I spent a semester learning.

Here at the Economic Adventures of Min and Shap, we make no secret of our scepticism toward the field of macroeconomics. Speaking solely for myself, this scepticism in large part stems from the fact that the most modern work being done in macroeconomics has very little to say about the questions that macroeconomists are supposed to answer. To me, this indicates a discipline that has gone astray, and, for all of our sakes, may present economic turmoil force it to rediscover its purpose.

~ Min


  1. you guys are getting lazy! I'm waiting for the next post!

  2. Wow. I am sitting here going through countless IS-LM exercises in prep for my econ exam soon. I don't know whether to say you were spared or deprived.

  3. I think the "modern macro" perspective is not only that government should not act in response to something like the current recession, but also that what happens to individuals within the economy after the government does not respond is just fine.

  4. Economics, broadly and colloquially defined, is the science/art of balancing unlimited wants with limited resources.

    Perhaps the problem is then that Economics is thus irrelevent? Wants are icing on cake -- I wish I could have more icing on more cake, but there's only so much of it, and if I eat it all, I'll get fat anyway.

    What about the art/science of balancing somewhat limited needs with slightly more limited resources and distributing resources to those who need them? That science/art would be a lot more relevent.

  5. I found your website through a blog post by Brad DeLong...

    The fact that he found you guys and quoted you seems to me quite astounding. Good work. Your intermediate micro teacher sounds like quite a guy.