Friday, March 13, 2009

The perils of first year principles of economics and some possible lessons for our current mess

It's very timely that I've just been teaching my freshmen first year principles of economics students about aggregate demand and aggregate supply and the received textbook theory of business cycles, just as we're heading into (0r rather, already are) in a downturn, at a time when everyone is once again talking about John Maynard Keynes, invoking him in one way or another, to justifty the stimulus packages in the United States, Canada, and elsewhere. The basic textbook model argues that governments can step in when there's a drop in aggregate demand for goods and services, by filling the gap through government spending, a cut in taxes, or monetary easing. This, in theory, should get us back to, and maintain, full employment, and keep output at what economists call its "natural" or "potential" level (that is, where it would be, if the economy behaved as if it were in a long run situation in which all nominal wages and prices were flexible). All of this sounds fine. But the basic textbook model, at its first presentation, might make it appear that stabilizing the economy is a fairly easy matter, and thus puzzle my freshmen as to why it's taking so long to figure out just what to do in our current situation, and why there's so much disagreement, for instance, on whether the stimulus is too large, too small, just right, or just totally irrelevant.

The textbook AD/AS model, in its most stripped down form, suggests that stabilization policy is easy, indeed trivially so. All the government has to do is to keep track of the positions of the economy's AD and AS curves in the short run, and, when something goes out of whack, step in with the necessary corrective measures. A recession should last all of ten minutes, or maybe half a day, while the government does this. Very quickly, then, we warn our students that the model omits several important features of the real world, that make stabilizing the economy more difficult than might at first blush appear. To start off with, the textbook assumes that we all know the model, and the model is correct. In the real world, no one knows what model "truly" describes the economy (if one can take this sort of Platonic leap), and, even if we can guess at, we don't know the parameters that describe it. Everyone, including central banks, government ministries of finance, private sector banks, consultancies, and all the rest, has their own model, and the models don't necessarily coincide. As a second difficulty, and this is a big one, policy acts with a lag on the economy, both fiscal policy and monetary policy. Unfortunately, no one is exactly quite sure how long this lag is, and this again requires an educated guess (based on models) by policymakers. All of this creates the possibility, for instance, that by the time a stimulus package does kick in, a year or two down the road, it will be redundant, or, worse still, counterproductive, if the economy has already started to turn around. Government intervention, thus, can, despite the best of intentions, inadvertently make matters worse. You would think that this more nuanced picture would emerge when the relevant models are taught at higher levels. But, strangely, this isn't often the case. The current default model of choice for macroeconomists, known as the "SDGE" (that stands for stochastic dynamic general equilibrium, if you must know) model, in its various incarnations, also usually assumes that government policy can act instantaneously, or with a predictable lag, and that everyone shares the same information about the model. This makes government stabilization policy, if not trivially, then pretty easy, and leaves many of our students, armed with newly minted PhDs in economics, convinced of the truth of this proposition.

Now, I'm not meaning to reopen the big debate about the correct balance between the market and the state in our modern society. I tacked, or tried to, parts of that big debate in a previous entry. Nor do I want anyone to think that by questioning received Keynesian or neo-Keynesian doctrine I am thereby expressing some sort of knee jerk, libertarian antipathy to government involvement in the economy. No, the contours of the big debate have been mapped out by many, and most of us agree that any sensible society, one would that we care to live in, has to have some sort of balance between the market and the state, some level of government involvement in the economy, although the edges of each's appropriate sphere may be a bit fuzzy. One of those fuzzy edges, I'd like to suggest, is the debate between those who suggest that activist government policy (fiscal and/or monetary) can cure recessions, or, more generally, attenuate, if not eliminate, the vicissitudes of the business cycle, and those who are more than a bit sceptical of this possibility. If we purge the writings, musings, and pontifications of libertarian sages such as Mises, Hayek, and Friedman of their excessive ideological fervour, and nihilism about government's efficacy and role, that borders, at times, on the view tha the government doesn't have any important role in the economy (and we agree, or I hope we do, from my previous entry, that this is illogical and impossible), what remains is a healthy, and, in my judgement, essentially valid scepticism about the government's ability to fine tune imperfections in the market. Human beings are prone to failty and failure, and so, pari passu, are markets, and governments. This basic lesson of Hayek, Friedman, and the other libertarians, has been entirely swept away in the zeal to find a Keynesian fix for our current economic woes.

My freshmen often ask whether they think the stimulus package (in the US or Canada or for that matter) is too big or too small, and why there's such disagreement amongst economists about this point. I point out that economists who claim that a $1 trillion dollar fiscal stimulus is too small, eminest economists such as the Nobel laureate Paul Krugman, are on the "liberal" end of the political spectrum in the US, whereas those who claim it's too big, such as the Harvard historian Niall Fergusson, or the Canadian-born US Republican strategist David Frum, tend to be on the "conservative" end. In other words, the pundits' prognostications on the package align with their received ideology. I make no further inference, but leave it to my students to do so, if they wish. When I'm pressed, I say that I have no idea whether the stimulus is too large, or too small. All I can say is that $1 trillion is a lot of money, the current recession seems deep, so if we're going to try something it should be of sufficient magnitude. But, at the back of my mind, I have lingering doubts whether we're intervening because we think this is what will fix our economic travails, or whether it's simply politically impossible to do nothing. I'll leave that heretical thought with you, as I enjoy the setting sun on a glorious early spring evening here in Ottawa.


Doc said...

Two quick points. First "fine tune" is key -- even those who doubt that the government can fine tune the economy -- those on the right/ conservative/ classical end of the spectrum (e.g., Martin Feldstein) have accepted the basic concept of stimulus in this situation -- because this is not a fine tuning but instead open heart surgery. Their disagreements are on magntitude and distribution, but it is remarkable how for once there is agreement on the concept -- at least among economists. Those who you cite as, and for that matter who I have heard, arguing against the concept tend to be deep ideologues and perhaps not accicentally non economists.

Vivek H. Dehejia said...

Doc, you make excellent points. I, too, share the conviction that something needs to be done. Perhaps this doesn't come through clearly in my original post. Certainly the economy at present needs much more than fine tuning. We are in a crisis. I expressed a certain scepticism, borne out, alas, by economic history, whether things are going to quite work out as planned, because, despite economists' protestations to the contrary, and their increasingly sophisticated models, there really is so much we don't understand, even in 2009, about, for instance, the relevant lags in the effects of different types of fiscal and monetary policies. And just how do you operate monetary policy anyway when interest rates are almost zero? My colleague, Nick Rowe, has been writing extensively on the latter point, and it's very much worth checking out. His blog is at:

I would make another small point. Ideologues on both sides of the debate tend to overstate their case, and thereby reduce its credibility. I believe this is true for those on the left as well as the right. Perhaps they are engaged in a different, bigger debate -- about rethinking the boundaries between the market and the state -- as I suggested in an earlier post, and are using the stimulus as a proxy to fight that bigger battle.