Apologies, readers, for the long silence between posts! Shap has been threatening bodily violence, among other forms of retaliation, against me for some time (and rightfully too, though I would never admit it to him) for not updating when I should attempt to do so more diligently, especially during these exciting economic times.
Before the actual substance of this post begins, I feel compelled to share a couple of links that have been floating around the economic side of the blogosphere. These links and related discussions are, at this point, admittedly rather dated, but they make excellent reading for anyone interested in learning more about economics (and who isn't, really?). First, The Economist managed to provoke quite the discussion by featuring the state of economics as their cover story. Economics, of course, is a broad discipline, and the two fields whose reputation and credibly have been hit most hard by the global economic crisis are macroeconomics and financial economics. This blog has already covered the basics of the divergences within macro (whereas -- and I think I speak for both Shap and myself here -- we're less up to date on the nature of asset markets), though The Economist provides a fantastic overview of them as well. One of my favourite responses to The Economist's take on macro is this post by Berkeley professor Brad DeLong, whose blog I would highly recommend.
With that out of the way, I'd like to tackle another subject that has been floating around lately: what is the exact nature and size of the role that the U.S. Federal Reserve should play in monetary policy, financial regulation, and oversight of the American economy in general? Suffice to say, the Fed has attracted quite its share of public attention since it found itself at the centre of the effort to stabilise the financial system. It has already deployed monetary policy to its fullest logical extent by slashing short-term interest rates to practically zero, although there is research currently being done to see if it's possible to transcend the so-called zero-bound problem, and President Obama has proposed investing in the Fed greater powers of oversight regarding institutions deemed too big to fail.
Given existing public queasiness about the government's stabilisation efforts, the Fed has become an irresistible target. At the risk of grossly oversimplifying (often the case when speaking of politics), this can hold true for both those on the left, who fear that the Fed will favour Wall Street over Main Street, and the right, who believe that the Fed will produce greater economic distortions through the manipulation of monetary policy than if it simply let business cycles run their course. Representative Ron Paul, who more famously ran for president in 2008, has introduced H.R. 1207, a bill that would give Congress the right to inspect the various comings & goings of the Fed. It is slightly tempting to discuss Paul as a politician on the the partisan fringe -- after all, this is the man who has also sponsored a separate bill to outright abolish the Fed -- but the fact that 282 of his colleagues have signed on as co-sponsors of H.R. 1207 indicates that, on Capitol Hill, his sentiments are shared. Various high-profile media outlets (see: Forbes and Bloomberg) have also nursed this idea of an abolished or reined in Federal Reserve. Fed Chairman Ben Bernanke has clearly been feeling the heat, especially with the end of his term and the possibility of reappointment coming up in January, and held a town hall late last month (though we can only hope that he wasn't heckled à la poor Congressmen on August recess).
Threats to the independence of the Fed are not new -- after all, debates about the concept of a national bank date back to the founding of this country -- but the current complexity of the world of finance has given the Fed an unprecedented level of importance. It is here that defenders of common economic sense must make their stand: the ability of the Federal Reserve to determine monetary policy and to conduct all of the asset transactions required to do so must not be curtailed. Central bank independence is a key tenet of all modern and rational economic systems for good reason. Imagine, for instance, that Congress did indeed have the ability to influence interest rates. If we posit that the primary goal of elected politicians is to be re-elected and that presiding over good economic times is correlated with re-election -- both are fairly reasonable assumptions to make, I should think -- then it is only a step away to assume that Congressmen would set monetary policy to accomplish these ends. Perhaps it would involve lowering interest rates in order to boost growth, or perhaps it would involve raising interest rates if the public frets about inflation. In both cases, though, policy would be set with little regard for actual macroeconomic circumstances and fluctuate in accordance with poll numbers.
All of this would result in an extraordinary level of instability, but the scenario needn't that extreme for a similar outcome to emerge. If Congress has just enough leverage over the Fed so as to make the latter beholden to the former in some manner -- the audits proposed by Ron Paul's bill would be enough to accomplish this -- it could easily give the Fed grief for politically unpopular policies and limit its willingness to pursue them. Central bank independence would be compromised, and the introduction of the fickle mob into the equation would increase uncertainty about the direction of U.S. monetary policy. Uncertainty heightens risk, and, assuming that the majority of actors in the market are risk-averse, the presence of unmitigated risk means that the economy will be performing at a suboptimal level.
An interesting revisionist school of thought argues that the Fed actually isn't an independent institution, and, to an extent, there is some truth in this. The Forbes article that I linked to earlier in this post details the politics that surround such a powerful institution, and to deny that the Fed is apart from domestic and international political considerations altogether is ultimately naive. With that said, however, central bank independence is less about independence from political currents -- for better or worse, politics is the process by which, well, anything is accomplished in government institutions -- than independence of action. The Fed needs space to undertake policies that may not sit well with elected officials but are nonetheless economically necessary. If our legislators wish to affect the course of the economy, then they are welcome to play around with spending and taxation in their own sandbox of fiscal policy, but it would be folly to condemn the whole of our economic fate to such hands.
~ Min
Showing posts with label macroeconomics. Show all posts
Showing posts with label macroeconomics. Show all posts
Saturday, 8 August 2009
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
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
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