The tragedy of modern macroeconomics

The cross-post from Richard Holden begins as follows:

Economists did not predict the financial crisis of 2007, nor did we predict that advent of secular stagnation that has followed. Those events have shaken the economic and political world. Our theories need work. Maybe a lot of work.

Recessions are naturally occurring phenomena which always come as a surprise, but on the second half of his statement, let me take you back to what I published in Quadrant in February 2009 and which I had written the previous December.

Just as the causes of this downturn cannot be charted through a Keynesian demand-deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand, and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.

This has been exactly what has followed the stimulus and it should not be a surprise although among economists it is. And this is not “secular stagnation”. This is the full-on consequence of following a Keynesian approach to recovery. Just because economists no longer understand the crucial importance of value-adding activity doesn’t mean it has stopped being essential to recovery. It has only meant that modern economists have no idea what is going on.

The rest of Holden’s post tries to get at the point via a critique of modern monetary policy – of which there is no greater critic than I am – that Say’s Law makes straightforward. He crosses correctly over to the real side of the economy to show that you can pour out all the money you like, but if there is no real value-adding activity to support it, you cannot make a recovery happen.

The problem with modern monetary theory is that, in short, there is only a finite amount of real economic resources that can be extracted through seigniorage (the difference between the face value of physical money and its production costs). Or, to quote the late, great Zvi Griliches: “one can only get so much lemon juice out of a lemon.”

It is understanding the overlap between the monetary side of the economy and the real side that is without doubt among the major issues in getting many of these things right. This is covered in Chapters 16 and 17 of the second edition of my Free Market Economics, which I began to write at the end of 2008 to explain why a Keynesian stimulus can never work. It is Say’s Law – uniquely discussed in this book and found nowhere else in all of modern economic literature! – that explains how these things work. Every economist understood this before 1936. Now almost no one does. This is the tragedy of modern macroeconomic theory which only makes things worse every time it is applied.

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15 Responses to The tragedy of modern macroeconomics

  1. Catfeesh?

    They started out by calling it ‘pump priming’. What is it now?

  2. Tel

    This has been exactly what has followed the stimulus and it should not be a surprise although among economists it is. And this is not “secular stagnation”. This is the full-on consequence of following a Keynesian approach to recovery.

    This is one of the things I’ve tried to point out to Bob Murphy. You cannot have a large separation between real interest rates and real growth in the economy. That is to say, interest rates must in some way attach themselves to the ability of people to find projects that make a genuine return on investment.

    Anyhow, it fits the observable facts: if your government attempts to force real interest rates to zero (and if they find a way to be successful) then real growth must also be driven down to zero.

    I know about Ludwig von Mises and his pure time preference theory, and I’m not discounting that time preference is important… that is to say, important to the supply of investment. However real world productivity is also important in terms of the demand for investment. Both sides must be satisfied. What Keynesian stimulus does is two things: on the supply side it crowds out private investment because no one can beat ZIRP when it comes to time preference, and on the demand side it pretends that infinite supply of zero interest investment is available, and therefore that projects with physical productivity of zero are worth investing in. The consequence on the supply side is that people stop saving, and the consequence on the demand side is wasted resources and mal-investment. Both are destructive.

  3. .

    Tel – productivity or expected productivity is a latent variable for time preference. No problem at all then.

  4. RobK

    Steve,
    You convinced me to purchase a copy of your book, however the e-elgar link went into an eternal loop once I hit the add-to-basket button. This has real implications regarding supply and demand. Do you have a different link? It might be my phone although it does PayPal on eBay fine.

  5. mundi

    And there is zero chance of this situation changing anytime soon.

    Most macro-economists are employed directly or indirectly by government after getting their education in left wing institutions. Their entire existence is based around government spending being inherently a good investment, the more of it the the better, see GDP.

  6. Botswana O'Hooligan

    What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.

    There was a man, an ex bullocky who took me under his wing in the mid fifties, and his advice to this young apprentice was “you cannot spend your way out of debt, if you cannot afford it, don’t borrow to buy it!” I have stuck by those principles all my life, and guess what, it works! The problem now in retirement is that the income from investments, safe ones at that, aren’t a lot better than the stipend of a pensioner so one wonders ” why did we work so hard, why did we struggle to put five kids thro Uni, for in retirement we are no better off than a bludger.”

  7. testpattern

    Bill Mitchell today

    ‘The teenage labour market went backwards in dec with signs of further full time job losses. The teenage labour market remains in a poor state and requires urgent policy intervention.’

    http://bilbo.economicoutlook.net/blog/?p=35205

  8. Andrew M.

    Surely the missing ingredient is psychology.
    Macro is the aggregate of millions of individual psychological influences in supply and demand, not all minds hold the same values, not all minds are equally informed, not all minds are in equally influential positions in the supply chain, and the minds are attached to different size wallets.
    How you can simplify such complexity down to a quarterly prime lending rate and a GDP growth figure and still expect to predict what happens next is sheer audacity. This is the point where the Austrian notion of economics as a primarily qualitative exercise is just not up to snuff. You have two forces, one pushing GDP up, another pushing GDP down, does the resulting GDP go up or down? You need the numbers.
    Economists will continue to make rubbish predictions for at least as long as they don’t model the actors, and aren’t prepared to do any real work at all to get better quantitative answers.

    Of course the infamous Steve Keen is never reluctant to offer a superior curriculum for macro. He recommends inclusion of “multi-agent modeling” which I interpret broadly enough to mean the psychology of people living their lives.

  9. Ray

    The problem with modern macro is that, contrary to Say’s Law, we actually consume more than we produce. As a result, we run a chronic current account deficit, funded by net financial inflows which are required because of a significant domestic savings deficiency.

    Of course, a major factor in this is public sector dissaving emanating from politicians who are more than happy to spend other peoples’ money to feather their own careers. It is inevitable that politicians will be persuaded to follow the advice of economists recommending expansionary fiscal and monetary policies because these overlap with the self interest of the politician. Unfortunately, such policies will inevitably lead to disequilibria and a failure of markets to clear.

    However, recognizing that policies designed to stimulate aggregate demand are a mistake, should not lead to an acceptance of a reactionary ideological approach which places all emphasis on supply, in the process ignoring what more than a century of neoclassical economics has taught us.

    Markets clear when demand and supply are in equilibrium. When governments use monetary or fiscal policy to push up demand, markets will not clear efficiently because resources will be diverted from one sector of the economy to another, such as from the productive sector to hire more bureaucrats, or to pay people not to work through an increase in transfer payments. On the other hand, increasing output by pushing investment into specific sectors is equally as inefficient because it assumes a government is better at maximizing community welfare than the market.

    The answer is to accept that both demand and supply of equally important at determining equilibrium in markets. As a result, governments should work towards a neutral position in the economy, allowing the money supply to grow with inflation and the population and to ensure that budgets balance with tax rates which minimize distortions. Then again, this is never going to happen because no politician is going to push for marginal tax rates of 20%.

  10. Bruce of Newcastle

    to explain why a Keynesian stimulus can never work.

    Steve – I disagree with you slightly in this, although it may be a matter of terminology than actuality.

    I believe that Henry was correct with “go early, go hard and go households”. So the quick and dirty cash splash was perfect. It was everything afterwards which was wrong – and there’s where I then agree with you.

    The “go early, go hard and go households” cash splash was not macroeconomics it was stampede management. When there is a panic it can draw upon itself. There’s hysteresis in the economic cycle, so cutting the overshoot on the downside by stopping the stampede can get people out of panic mode and into a more considered thought space where they’re using their brains not sheer emotional terror.

    So what “go early, go hard and go households” did was say to the ordinary people “the authorities have this in hand”. The demand aspect wasn’t the important thing, it was the confidence effect in the short period after Lehman collapsed.

    The short term problem after Lehman is that people stopped spending money in sheer panic. So many small hand-to-mouth businesses failed, which then spiked unemployment. The cash splash gave enough confidence that consumers started to come out of their shells a bit. That saved a lot of businesses that might have gone under. That then is Says since destruction of supply through a massive loss of those businesses would be catastrophic to the recovery – which is the hysteresis problem. Saving the furniture through the panic phase meant that furniture was there and producing when the consumers did emerge.

    Then the Keynesian stimulus should have stopped – no pink batts, no BER. Those were a complete waste, exactly as futile as you say.

    This is where it may be a terminology thing. The cash splash was ostensibly Keynesian but actually was more like a market halt – it stopped the overreaction and let the dust settle a bit.

  11. Dr Fred Lenin

    If you are an egotistical ,up yourself ,career politician,you borrow lots of money in the peoples name ,you wasryte it on Ego projects which fail,and give lots of lt away . Soon the interest to be paid to lenders is huge ,you borrow more money to pay the interest and keep giving o]it to foreign governments . Its a sound theory ,the more you owe the more you borrow ,simple . When it gets too huge to bullshit your way out ,you resign to spend more time with your family and a third cousin who is gravely ill . You collect a massive super oay out ,and an indexed pension for life . You feel you deserve this.you were after all Pm for three whole years .you are in your early fifties and have a life expectancy of twenty or more years talk about the six million dollar man ! Thats my thesis Sinclair do I get the degree?

  12. .

    This is the point where the Austrian notion of economics as a primarily qualitative exercise is just not up to snuff.

    Wrong, sort of. This is where it is correct in as far as you cannot model millions of actors making discrete personal and autonomous choices. I would like the Austrian theory modelled – some have started work on it but it isn’t perhaps what you are asking for. Even if you practically did it, you would have a lot of omitted variables and need to model for that using logit etc models. How do you combine qualitative, time series, panel and quantitative models – along with CGE/IO – and ensure the models see good diagnostics, goodness of fit and high predictability and repeatability?

    You have two forces, one pushing GDP up, another pushing GDP down, does the resulting GDP go up or down? You need the numbers.

    Tell us where to get the numbers. Or you could just look at GDP and input output tables. IO models suffer from being static – CGE is dynamic IO.They all suffer from assumptions about fixed variables and socialist theoretical underpinnings – GDP assumes government spending on non transfers is always productive.

    I like the idea of modelling GDP as a special case of gross revenue.

    Economists will continue to make rubbish predictions for at least as long as they don’t model the actors, and aren’t prepared to do any real work at all to get better quantitative answers.

    Modelling something that complicated will suffer massive sensitivity issues and cost too much to model. As in infinitely expensive. Not just “expensive”.

    Kydland and Prescott’s equations more or less lead into Austrian theory, and their models are robust.

    A lot of economists are Keynesian – their predictions are terrible.

  13. .

    As a result, we run a chronic current account deficit, funded by net financial inflows which are required because of a significant domestic savings deficiency.

    However, practically irrelevant. We have a capital account surplus and that drives capital production.

  14. Paul Farmer

    I don’t know where to start with Andrew M ‘s contribution. Modelling is important but too often people rely on models at the expense of sound judgement and a credible theory that supports the modelling. Global warming is a classic example of modelling bidding at the expense of sound science and there are parallels in the economics world with some of the crazy macro models our treasuries rely on. Whilst you get a lot of people on here with an Austrian bent to their economics none of us are anti numbers . Any analysis needs to look at empirical evidence but it is a total fallacy to think to think a model can capture all the cause and effects, all the relevant variables. They very quickly teach you that omitted variable bias along with a host of other issues around interdependence between variables is one of the biggest reasons why modeling out an economy through regression analysis is always extremely difficult .

    For mine that is why the Austrian school makes a lot of sense as their search is for qualitative causes that are consistent with the facts, not a blind following of some fancy maths. The other issue with Keynesian economics – both fiscal and monetary is often the spending is clear , hence any model can easily show GDP going up from a boost in govt spending but the maladjustments caused and the waste and the crowding out is not so easily seen …………and no model is going to easily show this but its there nevertheless and shows up on much different time scales.

  15. Michael Cunningham aka Faustino aka Genghis Cunn

    I had a letter in The Australian prior to the first $950 cash-splash, noting that alleged counter-cyclical government had always and everywhere peaked well after the economy picked-up, leading to inflation, crowding out of the private sector etc, and that there was no recorded case of net benefits from such interventions. Sadly, this was ignored by Henry et al. Tony Makin was one of the few macroeconomists to make similar points, which were proven correct of course.

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