Some Straight Talk

Mainstream macroeconomics, failing to explain the Great Recession, received blunt criticism from stabilization policymakers. Three examples suffice. First, Narayana Kocherlakota, then President of the Federal Reserve Bank of Minneapolis: “I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with the fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not.” Second, Jean-Claude Trichet, then President of the European Central Bank: “When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policymaker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.” Third, and most tellingly, I can personally attest that during the 2008-09 instability the leadership of the Federal Reserve scornfully rejected guidance from the macro modeling that dominated graduate-school curriculums and cutting-edge research as useless.

If ill-served policymakers are not to be ignored, some straight talk among macroeconomists is needed. Here is my contribution. The modern consensus research program is a fundamentally flawed endeavor that must be reworked. Mainstream theorists are attempting to construct, within the micro-coherent market-centric DSGE model class, a stabilization-relevant model absent meaningful wage rigidity. It cannot be done. Micro-coherence is not the problem. It is instead the stubborn insistence, more than a hundred years after the Second Industrial Revolution and its requisite new corporate forms, that all significant exchange occurs in the marketplace. The futility of making the consensus approach stabilization-relevant was vividly illustrated by Great Recession and must not be ignored.

Critical characteristics of the Great Recession must be explained. First, and foremost, are the six million involuntary job losers, accounting for three-quarters of the increase in unemployment. Lost employment and income are central to the Great Recession’s welfare loss. We must stop ignoring that mainstream modeling cannot suppress wage recontracting and, therefore, cannot accommodate forced job separation. We also must stop deluding ourselves that modern search theory will ever be able to juice up voluntary frictional joblessness sufficiently to explain cyclical fluctuations.

Second, the overall cost of the 2008-09 instability was huge, measured in the trillions of dollars. In the consensus market-centric playbook, however, recessions must be mild, difficult to distinguish from efficient reallocations of resources in response to real shocks. Any explanation of what happened in the Great Recession as resulting from an efficient reallocation of resources (rather than broad market failure rooted in collapsing aggregate demand) is laughable. Taken seriously, it is deeply embarrassing.

Third, the financial crisis was propagated by a virulent nominal-demand contraction that induced same direction changes in employment, output, wage income, and profits. Almost all of the consequent welfare loss resulted from that propagation. The costs directly resulting from the financial-institution disruption itself were tiny in comparison. The proper stabilization policy in the crisis had to be single-minded, wholly focused on halting and reversing the collapse in total spending, a venerable Keynesian idea that cannot be accommodated by the consensus market-centric DSGE model class.

Fourth, the crash in asset markets, most notably for equities, both played an important role in 2008-09 macrodynamics and was not motivated by economic fundamentals. The efficient-market hypothesis rooted in coherent mainstream thinking provides no plausible explanation for sickening drop in prices.

Fifth, the Great Recession revealed the longstanding mainstream monetary consensus to be mostly wrong, harmful to effective stabilization policymaking. Borrowing from Blanchard (2013), the precrisis monetary consensus had the following components:

• Inflation targeting, on its own, provides a sound framework for monetary policy. This principle, widely adopted by central banks, turns out to an artifact of the nonintuitive limitation of rational exchange to the marketplace. In the arbitrarily truncated mainstream model, central banks have little need for a companion real-side objective. By contrast, the generalized-exchange model class rationally suppresses wage recontracting and thereby coherently generates recognizable instability, featuring involuntary job and income loss, from nominal demand shocks. A real-side objective that turns out to be more important than the inflation goal is microfounded.

• Departures of asset prices from fundamentals are hard to detect in real time, and the contractionary effects of sharp price drops cannot be much mitigated by monetary intervention. Asset prices should affect monetary policy only to the extent that they help predict goods-price inflation. The GEM Project demonstrates that uncertainty with respect to stabilization authorities’ real-side credibility induces rational investor inaction, framing the interplay of asset pricing and investor confidence as a positive feedback that centrally influences acute instability. (Chapter 6)

• The zero lower bound on nominal interest rates is a minor issue. It is rarely encountered, and its consequences are likely to be modest when it is. Moreover, policymakers have powerful tools (such as targeting long-term rates and temporarily raising their inflation target) that they can use if it becomes a major constraint. The GEM Project concurs with the conclusion that zero-bound rates are a minor issue, but for different reasons than the monetary consensus. Mainstream analysis of the zero bound is little more than an artifact of inadequate market-centric modeling. Zero interest rates are characteristic of non-stationary demand disturbances, which is featured in generalized-exchange thinking and shown to require determined interventions in total nominal spending. Policies must be big and fast. Temporarily increasing the inflation target or targeting longer-term interest rates is inherently inadequate to the task at hand, indicative of a dangerously poor grasp of the macrodynamics at work.

• Monetary policy and fiscal policy are linked in the long run through the government budget constraint, but in the medium term they should and can be kept largely separate. The GEM Project microfounds, especially in circumstances of extreme instability, the discretionary use of fiscal policy in conjunction with monetary policy to halt and reverse faltering total spending.

Blog Type: Wonkish Chicago, Illinois