Is the Economic Crisis a Crisis for Economics?

The search for better economic policy.
Nov. 13 1998 3:30 AM

Is the Economic Crisis a Crisis for Economics?

Or, where is macroeconomics when we need it?

I have often used this column to defend economics and economists against their critics. It sometimes seems as if no public intellectual, be he Irving Kristol or George Soros, feels his résumé is complete until he has published an article or book attacking economic theory--a project that does not, of course, require that its author make much effort to find out what that theory really says. Nonetheless, economists can stand a little informed criticism. Right now, it seems to me, the discipline is in some trouble. Specifically, the marriage between macroeconomics and microeconomics--an imperfect but workable union achieved half a century ago, which has allowed economists to combine moderately activist views about monetary policy with otherwise generally free market beliefs--is now being called into question by events.

This is not an abstract problem. It is one with urgent application to the current global economic crisis. Conventional microeconomic analysis depends on the presumed ability of governments to maintain more or less full employment. If they can't--and if economists can't find a way to resolve the world's newly intractable macroeconomic problems--all sorts of heresy become entirely reasonable. And in the end that will be disastrous not just for the economics profession but for the world economy.

Suppose, for example, that you are an advocate of free trade, but some Brazilian tells you that his country needs export subsidies and tariffs to protect its industry and save jobs. Well, if Brazil cannot devalue its currency for fear of speculators, cannot use fiscal or monetary policy to reflate its economy because to do so would cause capital flight, and the country must therefore endure a prolonged period of recession and deflation, you cannot in good conscience make the conventional arguments in favor of free trade. That is, you cannot tell him that protectionism only redistributes jobs, that it cannot create them, since the truth is that, under these circumstances, his proposal would increase output and employment.

Now I am not advocating protectionism for Brazil or, for that matter, for anywhere. Nor am I giving up on microeconomics in general or on the general presumption in favor of free markets in particular. I still believe that macroeconomic activism is possible: that Japan can reflate itself out of its slump, that countries such as Brazil can find ways to deal with the threat of speculative attack. Many people disagree with my ideas; that's fine, as long as they have an alternative to offer. But very few of my colleagues, as far as I can tell, are even making a serious effort to rise to the challenge.

To understand the nature of this challenge, you need to realize that although the name of John Maynard Keynes is anathema to many conservatives, it was in fact Keynesian economics that allowed capitalism as a system--as well as belief in the efficacy of free markets--to survive the Great Depression. After all, circa 1939 it was very hard for an observant person to see much future in the free market. I happen to own a copy of James Burnham's The Managerial Revolution, a now-forgotten 1941 book that was for a time hugely influential. It purported to see the rise of both communism and fascism as part of the inevitable replacement of capitalism by a more efficient "managerial" state. Burnham did not attack free market economies; he simply regarded them as doomed, and those who thought otherwise as naive:

The first, and perhaps crucial evidence for the view that capitalism is not going to continue much longer is the continuous presence within the capitalist nations of mass unemployment. ... Capitalism is no longer able to find uses for the available investment funds, which waste in idleness in the account books of the banks. ... [T]he capitalist organization of society has entered its final years.

Gloomy sentiments indeed, but at the time they seemed quite reasonable. As far as most people who thought about it could see, capitalist economies were indeed unable to make use of their savings and thus of their resources. Given that massive failure, the traditional case that free markets lead to microeconomic efficiency--to the proper allocation of resources among firms and of goods among consumers--seemed not so much wrong as irrelevant.

But Keynesian economics--by which I mean not so much the specifics of Keynes' ideas as the understanding that monetary and fiscal policy could be used to fight economic slumps--rescued both capitalism and microeconomics from oblivion. Thanks in large part to the new understanding of governments that increasing interest rates, raising taxes, and cutting spending in a recession is a bad idea, the first postwar generation was one of near-full employment in most Western countries. And with the assurance that savings would be invested and that there would be enough demand to make use of the economy's resources, economists could return in good conscience to the microeconomic question of how those resources would be used--and to the broad presumption that free markets, except in some specific cases, would get it right.

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T ake, for example, the debate about the effects of the North American Free Trade Agreement. Although most of the public debate over that agreement focused on alleged job losses or gains (Ross Perot's "great sucking sound" vs. the administration's claim that NAFTA would create hundreds of thousands of jobs), believed that the net effect on employment would be zero. This is basically because the overall number of jobs in the United States is determined by Fed Chairman Alan Greenspan, who is always trying to get the economy as close to full employment as he can without creating inflation. So for serious economists the real questions about NAFTA involved microeconomic issues such as efficiency and income distribution--and efficiency concerns, at any rate, offered a strong case in favor of free trade.

In short, the success of macroeconomic activism, in both theory and practice, has made it possible for free market microeconomics to survive--again both in theory and in practice.

True, during the 1970s and early 1980s macroeconomics suffered a crisis. The experience of stagflation--the combination of inflation and unemployment--badly damaged the prestige of economists in general and macroeconomics in particular, even though it was not that much of a theoretical surprise. Equally important was an internal crisis of self-confidence: "Rational expectations" theorists, led by Chicago's future Nobelist Robert Lucas, challenged the whole idea that governments could do anything to mitigate macroeconomic instability. In the end, however, rational expectations to Keynesian macroeconomics. So-called "new Keynesian" economists provided at least a theoretical fig leaf for more or less Keynesian ideas, and in practical terms the intellectual basis of modern U.S. monetary and fiscal policy is pretty much what was already in the textbooks 20 years ago.

Now, however, economists are in trouble again--trouble that is a sort of muted version of what happened in the 1930s. The world is not now in depression, nor is a full-scale replay of the 1930s likely. But substantial parts of the world economy are depressed--and for one reason or another apparently cannot or will not use macroeconomic policy to restore full employment. "Emerging market" nations, terrified of capital flight, dare not reflate their economies; on the contrary, we find the front-line economy of the moment, Brazil, compelled by fear of speculators to act in a precisely anti-Keynesian fashion: increasing interest rates, raising taxes, and cutting spending even as the economy slides into a nasty recession. Meanwhile, Japan--the world's second-largest economy and a country that by normal criteria ought to have no trouble increasing demand--finds itself stuck in exactly the trap Burnham described: "no longer able to find uses for the available investment funds, which waste in idleness in the account books of the banks."

So economists must be rushing to solve these problems, right? Well, not exactly. You see, the rational expectations challenge to Keynesian economics was half-successful: It did not build a workable new structure for macroeconomic theory and policy, but it did seriously damage the old structure. And the effect of that damage has been to discourage economists from even thinking about the traditional Keynesian issues. Most younger economists have simply avoided macroeconomics entirely, or--if they do work on macroeconomic issues--they choose "safe" topics such as long-run growth, avoiding the academic minefield of business cycle research. I can't blame them, but it leaves us with a dangerous lack of fresh thinking about how to handle recessions at a time when the usual remedies don't seem to be working.

I wish I had more of a sense that other economists understand what is at stake. The point is not that the world is going to collapse; that could happen, but it is not the clear and present danger. Rather, the point is that the theory and practice of more or less free market economics depend crucially on the availability of adequate solutions to the problem of macroeconomic instability--and for the first time in half a century, the availability of those solutions cannot be taken for granted.

If you didn't chase the links in the text, is a reminder of how some people react to the sort of pronouncements we economists are prone to make, and is a little more on why the "equilibrium macroeconomics" school of thought has recruited few pupils.

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