Schools of Thought and a Crisis of Conscience Part I

This was a difficult post to write, because I’m really in the process of exploring my basic beliefs of how economics and economic agents interact and operate – you could say this is an examination of my faith. So what will follow is a series of posts on schools of economic thought, from orthodox to heterodox, and I’m going to see where it takes me.

For starters I’ve been listening to a series of audiobooks, partly in an effort to expand my horizons, and partly because as Sun Tzu said:

Hence the saying: If you know the enemy and know yourself, you need not fear the result of a hundred battles.

If you know yourself but not the enemy, for every victory gained you will also suffer a defeat.

If you know neither the enemy nor yourself, you will succumb in every battle.

In this case, I am trying to find answers to the question (about economics): What do I believe? And why is that belief better, or worse, than what others believe? There are a number of distinct schools of thought in economics, with more or less highly divided views on how economies are organised and function, and in what the role should be of various institutions such as government and money.

Reassessing Macroeconomics

William White, Chairman of the Economic and Development Review Committee of the Organization for Economic Cooperation and Development and ex-Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements from 1995 to 2008, writes on what’s wrong with Macro analysis today:

Modern Macroeconomics is on the Wrong Track

"What do the above considerations imply for the future of macroeconomics? The simplifying assumptions of the New Classical and New Keynesian models do not make them obvious candidates for near-term guidance on how best to conduct macroeconomic policies.

We are left then with the Keynesian framework, with all the likely fuzziness and uncertainties implicit in the principal functional forms being subject to “animal spirits.” At the least, this implies appropriate skepticism of the forecasts generated by the available empirical models. Recent experience of very large forecast errors—not least by the IMF, the Organization for Economic Cooperation and Development, and other official bodies—only accentuates a tendency under way in most forecasting shops for many years. Conscious of the potential shortcomings of individual models, many institutions have begun to maintain a variety of such models. Judgments about policy requirements are based on an overview of them all, plus whatever intuition experienced policymakers are prone to add. This blend of art and science may be the best we can ever hope for.

White nicely summarises the developments in empirical macro over the past fifty years (in layman’s terms!), and also covers the contributions that Austrian theory and Hyman Minsky's insights have toward explaining the events of the past two years. He should know - White was one of the very few to correctly predict both the crisis and its proximate causes. With very few exceptions, most academic economists and central bankers got only one or the other right.

He identifies a few areas for future research to get macro analysis back on track:

1. Blending Austrian theory into the structure of Keynesian models, by identifying factors contributing to macro-imbalances
2. Investigate firm and household propensity to consume and invest, independently from the financial system and the supply of credit
3. Who should have regulatory responsibility for monitoring financial imbalances and “pressures”?
4. Urgently conduct research into the micro-foundations of the financial system
5. Due emphasis on research into non-efficient market/non-rational expectations hypotheses as the driver for agent behaviour
6. The impact of government intervention and safety nets needs to be investigated more thoroughly.

This research agenda is being echoed by many prominent economists (Krugman for one), and many central banks and multilateral institutions are scrambling to add financial accelerators and/or positive feedback loops into existing models (essentially putting old wine into new bottles).

The idea of adding Austrian insights into the existing macro-framework is a good one, a long as its not taken too far. The problem I have with Austrian economics is less about their analysis of the business cycle, which I think has validity – booms and busts driven by excessive credit creation – but because they have almost nothing to say about how to manage a bust beyond prescribing an economic system (money independent from discretionary authority e.g. the gold standard) that is many times worse than the present one. It’s like someone yelling fire, then trying to help put it out by telling everyone they shouldn’t be playing with the stuff. Absolutely correct – and absolutely useless.

H/T David Beckworth

What Kind Of Economist Am I?

WY asks what school of economic thought I support. The answer in a nutshell is...whatever works.

Here's the story - strike that, here's my summary of the history of economic thought:

The classical school - Adam Smith, David Ricardo, Hume, Bentham, Marx, Marshall and many others - really set the foundations of economic thought. They gave rise to many competing ideologies which didn't necessarily agreed with each other. For instance libertarianism and the Austrian school take freedom as the sole guiding principle of economic organisation, while Marx suggests the diametric opposite. Both are considered on the lunatic fringe in modern economics.

The classical school eventually gave way to the neo-classical school, which attempted to describe economics within a mathematical framework. The Great Depression and the rise of the Keynesian revolution derailed this movement momentarily, but it revived and assimilated Keynesian thought under the neo-classical synthesis starting with John Hicks (the ever popular and still relevant IS-LM model).

The 1970s brought stagflation and the breakdown of heretofore established macro-relationships, bringing about a resurgence of classical ideas, with an emphasis on micro-foundations for macro analysis - the new classical school.

The 1960s-70s also coincided with the rise of monetarism, which combined some of the ideas of the Austrian school with the neo-classical synthesis. Also known as the Chicago School from its identification with Milton Friedman, monetarism reduced economic policy management to essentially one tool: "2% money supply growth" (see Goodhart's law to see why this failed).

The new keynesian school essentially takes a cue from the new classical school by applying micro-foundations to keynesian macro analysis. These two competing schools of thought comprise mainstream economics today.

Then there is the heterodox school. Well not really a school per se, but rather a loose term covering economists who don't fall under a convenient label. These include people like Joseph Schumpeter and JK Galbraith.

The reason why you see economists disagree in the current crisis on seemingly basic questions like the effectiveness of fiscal stimulus or its structure, or whether it will work at all, goes back to their basic ideologies:

1. New classicals believe in complete markets and rational agents, and that government is less efficient in allocating resources. As such fiscal stimulus is less likely to be effective, and if stimulus has to be done, tax cuts are preferred.

2. New keynesians believe that markets can fail and prices are sticky, in which case there is a strong case for government to step in. Inefficient allocation of resources is better than no use of resources at all.

3. Monetarists don't believe fiscal stimulus works. All we need is 2% money supply growth.

4. Austrians and libertarians don't believe in government. All we need to do is go back to the gold standard and abolish all the central banks.

5. Marxists believe capitalism is doomed to fail. All we need is...never mind.

Where do I stand in this milieu? I admit I began my career a monetarist, with some leanings toward libertarianism. Age and (hopefully) some wisdom now puts me somewhat left of centre - markets do fail, frequently in fact. I also have some sympathy for some of Galbraith's and Schumpeter's ideas, which while often in conflict, do a better job of describing the real world then either mainstream school. It's hard to accept the efficiency of price signals, when competitors are essentially oligopolistic.

Having said that, I think my approach to economics is purely pragmatic. Some ideas work at some times, but not at others. It is a mistake to take a one-size-fits-all approach, especially when contemplating a developing country with immature markets and institutions. Just as important, I lean on empirical evidence rather than relying purely on the dictates of theory.

Theory only provides a framework for thinking, and it pays to listen a little to all the schools of thoughts - even Marxists and Austrians occasionally have something worthwhile to say.