According to Brad DeLong, professor of economics at the University of California at Berkeley, if we are to get a full understanding of the financial crisis and recession of the past two years, we need to take a historical perspective. In the following article from The Economic Times of India, he argues that modern macroeconomists need to learn from history if their assumptions and models are to be relevant and predictive.
The anti-history boys The Economic Times (India) (1/10/09)
A fuller version of the above article, along with comments from readers, can be found on Brad deLong’s blog site, a Semi-Daily Journal of an Economist at:
Economic History and Modern Macro: What Happened? (30/9/09)
Questions
- According to Narayana Kocherlakota, most macroeconomic models “rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)…”. How could these models explain business cycles? Would you classify them as ‘real business cycle theories’: i.e. as ‘supply-side’ explanations?
- How does Brad deLong explain recessions?
- Why does a change in the velocity of circulation of money contribute to a crash?
- What are the strengths and limitation of using economic history to understand the current crisis?
On the eve of the September 5/6 G20 meeting of Finance Ministers in London, the OECD published an interim forecast of the macroeconomic and financial performance of the G7 economies. According to the OECD, “Recovery from the global recession is likely to arrive earlier than had been expected a few months ago but the pace of activity will remain weak well into next year.” So is it time to start reversing the various fiscal and monetary stimuli adopted around the world? Or should governments and central banks continue to stimulate aggregate demand in order to maintain the fragile recovery? The following news releases, speeches and articles look at answers given to these questions by various countries and international institutions.
Recovery arriving quicker than expected but activity will remain weak, says OECD OECD News release (3/9/09)
What is the economic outlook for OECD countries? An interim assessment OECD Economic Outlook, Interim Assessment (3/9/09)
IMF Managing Director Dominique Strauss-Kahn sees Renewed Stability but remains cautious about Global Economic Recovery, notes need for Continued Policy Actions IMF press release (4/9/09)
Beyond the Crisis: Sustainable Growth and a Stable International Monetary System Speech by Dominique Strauss-Kahn, Managing Director of the International Monetary Fund (4/9/09)
Brown urges further G20 spending (video) Gordon Brown on BBC News (5/9/09)
America’s Timothy Geithner says it’s ‘too early’ to withdraw economic stimulus Telegraph (3/9/09)
Finance chiefs warn against early end to state support for eurozone economies Guardian (3/9/09)
Keep spending – Darling warns G20 against complacency Independent (3/9/09)
Brown’s agenda deserves a hearing Financial Times (1/9/09)
Tories join Germany and France in call for exit strategy from G20 bailout Times Online (3/9/09)
UK recession: Why are we lagging our neighbours? Telegraph (3/9/09)
Reflections after the conference:
After the shock, challenges remain BBC News (7/9/09)
The G20 has saved us, but it’s failing to rein in those who caused the crisis Observer (6/9/09)
The world is as one on not endangering recovery Times Online (t/9/09)
Questions
- Why is the pace of recovery in the G7 countries likely to be modest for some time?
- Why have unemployment rates risen much more rapidly in some countries than in others (see page 19 of the OECD report)?
- Referring to the OECD report, how would you summarise changes in the global financial situation over the past few months?
- Assess the arguments put forward by France and Germany for reining in their expansionary fiscal and monetary policies.
- Why is the UK economy, according to the OECD, likely to be the last of the G7 countries to pull out of recession?
Both business and consumer confidence are affected by the state of the economy. A recession, or even a slowdown in the economy, will make people worried for their jobs and future incomes and hence cut back on spending and either save more or reduce their debts. Similarly firms are likely to cut back on investment if they are pessimistic about the future. But both consumer demand and investment are components of aggregate demand. A cut in aggregate demand will drive the economy further into recession and cause even greater pessimism. In other words, there is a feedback loop. Recession causes pessimism and hence a fall in aggregate demand, which, in turn, worsens the recession.
A similar process of feedback occurs in times of optimism. If the economy recovers, or is thought to be about to do so, the resulting optimism will cause people and firms to spend more. This rise in aggregate demand will help the process of recovery (see Accelerating the recession and Animal Spirits).
The following article by Robert Shiller, co-author of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, looks at the swing from pessimism to optimism over the past few months.
An Echo Chamber of Boom and Bust: Robert Schiller New York Times (29/8/09)
Efficient Market Hypothesis: True “Villain” of the Financial Crisis? The Market Oracle (26/8/09)
Monthly confidence indicators for the EU can be found at:
Business and Consumer Surveys: Time Series European Commission Directorate-General for Economic and Financial Affairs. (Each of the ‘en’ cells links to a zipped Excel file.)
Questions
- Explain why “confidence has rebounded so quickly in so many places” in recent weeks.
- Is Robert Shiller’s explanation of feedback loops consistent with the accelerator theory?
- In what circumstances do business and consumer psychology result in destabilising speculation and what causes turning points in the process? Why may such turning points be difficult to predict?
- Examine the monthly Economic Sentiment Indicator (ESI) for the UK from the ‘Business and Consumer Surveys: Time Series’ link above. You will need to refer to the final column in the Excel ESI Monthly worksheet (Column GV). Chart the movements in this indicator over the past three years. Also chart the quarterly growth in UK GDP over the same time period. You can find data from Economic and Labour Market Review (ONS), Data tables, Table 1.01, Column YBEZ. Is ESI a leading or a lagging indicator of GDP?
- What implications does Shiller’s analysis have for the management of the economy?
- Why may stock market movements not be a ‘random walk’?
Whilst some economists predicted the banking crisis of 2007/8 and the subsequent global recession, many did not. Was this a failure of macroeconomics, or at least of certain macroeconomic schools of thought, such as New Classical economics? Or was it a failure to apply the subject with sufficient wisdom? Should the subject be radically rethought, or can it simply be amended to take into account aspects of behavioural economics and a better understanding of systemic risk?
The four linked articles below from The Economist look at the debate and at the whole state of macroeconomics. The other articles pick up some of the issues.
Will the ‘crisis in macroeconomics’ lead to a stronger subject, more able to explain economies in crisis and not just when they are working well? Will a new consensus emerge or will economists remain divided, not only about the correct analysis of how economies work at a macro level, but also about how to tackle crises such as the present recession?
What went wrong with economics The Economist (16/7/09)
The other-worldly philosophers The Economist (16/7/09)
Efficiency and beyond The Economist (16/7/09)
In defence of the dismal science The Economist (6/8/09)
How to rebuild a shamed subject Financial Times (5/8/09)
What is the point of economists? Financial Times – Arena (28/7/09)
Macroeconomic Models Wall Street Pit (23/7/09)
Macroeconomics: Economics is in crisis – it is time for a profound revamp Business Day (27/7/09)
Questions
- Distinguish between ‘freshwater’, ‘saltwater’ and ‘brackish’ macroeconomics.
- Explain why economists differ over the efficacy of fiscal policy in times of recession. To what extent does the debate hinge on the size of the multiplier?
- Why is the potential for macroeconomics higher now than prior to the recession?
- What is meant by the ‘efficient market hypothesis’? How did inefficiencies in financial markets contribute to the banking crisis and recession?
- Should economists predict the future, or should they confine themselves to explaining the present and past?
The current recession has seen the re-emergence of many of the intellectual battles fought amongst economists between the two worlds wars and again from the 1960s to the 1980s. The current debate has hinged around the appropriate policy response to the current recession. Is the solution a Keynesian one of stimulating aggregate demand; or is it a new classical one of keeping public spending under control to make room for private spending and to allow the market to function to best effect? And what about banking reform? What are the arguments here? The following articles by Lord Skidelsky examine the debate.
Robert Skidelsky, Economists clash on shifting sands Financial Times (9/6/09)
Robert Skidelsky, Economic reform needs a dose of reality Guardian (27/7/09)
See also the following video:
Robert Skidelsky, The financial challenge of our times Guardian (2/3/09)
Questions
- Explain the ways in which economics is (a) similar to and (b) different from the natural sciences.
- For what reasons would new classical economists criticise the fiscal stimulus packages pursued by many countries in the past few months?
- Under what circumstances would a fiscal stimulus crowd out private spending? Do these circumstances apply (a) today; (b) over the next two years?
- Why may crowding out in practice depend on issues of confidence?
- What ‘Keynesian lessons’ have been learned from the banking crisis and recession?