Category: Economics: Ch 16

With an election approaching, there is much debate about recovery and cuts and about the relationships between the two. Will rapid cuts stimulate confidence in the UK by business and bankers and thereby stimulate investment and recovery, or will they drive the economy back into recession? The debate is not just between politicians vying for your vote; economists too are debating the issue. Many are taking to letter writing.

In the February 2010 news blog, A clash of ideas – what to do about the deficit, we considered three letters written by economists (linked to again below). There has now been a fourth – and doubtless not the last. This latest letter, in the wake of the Budget and the debates about the speed of the cuts, takes a Keynesian line and looks at the sustainability of the recovery – including social and environmental sustainability. It is signed by 34 people, mainly economists.

Letter: Better routes to economic recovery Guardian (27/3/10)
Letter: UK economy cries out for credible rescue plan Sunday Times, 20 economists (14/2/10)
Letter: First priority must be to restore robust growth Financial Times, Lord Skidelsky and others (18/2/10)
Letter: Sharp shock now would be dangerous Financial Times, Lord Layard and others (18/2/10)

Questions

  1. Summarise the arguments for making rapid cuts in the deficit.
  2. Summarise the arguments for making gradual cuts in the deficit in line with the recovery in private-sector demand.
  3. Under what conditions would the current high deficit crowd out private expenditure?
  4. What do you understand by a ‘Green New Deal’? How realistic is such a New Deal and would there be any downsides?
  5. Is the disagreement between the economists the result of (a) different analysis, (b) different objectives or (c) different interpretation of forecasts of the robustness of the recovery and how markets are likely to respond to alternative policies? Or is it a combination of two of them or all three? Explain your answer.
  6. Why is the effect of the recession on the supply-side of the economy crucial in determining the sustainability of a demand-led recovery?

Should economists have foreseen the credit crunch? A few were warning of an overheated world economy with excessive credit and risk taking. Most economists prior to 2007/8, however, were predicting a continuation of steady economic growth. Inflation targeting, fiscal rules and increasingly flexible markets were the ingredients of this continuing prosperity. And then the crash happened!

So why did so few people see the downturn coming? Were the models used by economists fundamentally flawed, or was it simply a question of poor assumptions or poor data? Do we need a new way of modelling the economy, or is it simply a question of updating theories from the past? Should, for example, models become much more Keynesian? Should we abandon the new classical approach of assuming that markets are essentially good at pricing in risk and that herd behaviour will not be seriously destabilising?

The following podcast looks at these issues. “Aditya Chakrabortty’s joined in the studio by the Guardian’s economics editor Larry Elliott, as well as Roger Bootle, the managing director of Capital Economics, and political economist and John Maynard Keynes biographer Robert Skidelsky. Also in the podcast, we hear from Nobel prize-winning economist, Elinor Ostrom, Freakonomics author Steven Levitt, and UN advisor and developmental economist Daniel Gay.”

The Business: A crisis of economics Guardian podcast (25/11/09)

See also the following news items from the Sloman Economics news site:
Keynes is dead; long live Keynes (3/10/09)
Learning from history (3/10/09)
Macroeconomics – Crisis or what? (6/8/09)
The changing battle grounds of economics (27/7/09)
Repeat of the Great Depression – or learning the lessons from the past? (23/6/09)
Animal spirits (30/4/09)
Keynes – do we need him more than ever? (26/10/08)

Questions

  1. Why did most economists fail to predict the credit crunch and subsequent recession? Was it a problem with the models that were used or the data that was put into these models, or both?
  2. What was the Washington consensus? To what extent did this consensus contribute to the current recession?
  3. What is meant by systemic risk? How does this influence the usefulness of ‘micro’ financial models?
  4. What particular market failures were responsible for the credit crunch?
  5. What is meant by ‘rational behaviour’? Is it reasonable to assume that people are rational?
  6. Is macroeconomics too theoretical or too mathematical (or both)? If you think it is, how can macroeconomics be reformed to improve its explanatory and predictive power?
  7. Does a ‘really good economist’ need to have a good grounding in a range of social sciences and in economic history?

This podcast is from the Library of Economics and Liberty’s EconTalk site. In it, Scott Sumner of Bentley University discusses with host Russ Roberts the role of monetary policy in the USA since 2007 and whether or not it was as expansionary as many people think.

In fact, Sumner argues that monetary policy was tight in late 2008 and that this precipitated the recession. He argues that the standard indicators of the tightness or ease of monetary policy, namely the rate of interest and the growth in the money supply, were misleading.

Sumner on Monetary Policy EconTalk podcast (9/11/09)

Questions

  1. Why is it important to look at the velocity of circulation of money when deciding the effect of interest rate changes or changes in the monetary base? Can the Fed’s failure to take velocity sufficiently into account be seen as a cause of the recession?
  2. Is there evidence of a liquidity trap operating in the USA in late 2008?
  3. How could the Fed have pursued a more expansionary policy, given that interest rates were eventually cut to virtually zero and the monetary base was expanded substantially?
  4. Why does Sumner argue that monetary policy should focus on influencing the growth in aggregate demand?
  5. How useful is the quantity equation, MV = PT (or MV = PY) in understanding the role and effectiveness of monetary policy?
  6. What is the Keynesian approach to monetary policy in a recession? How does this differ from the monetarist approach? Are both approaches focusing on the demand side and thus quite different from supply-side analysis of recession?
  7. Why is the consumer prices index (CPI) a poor indicator of a nominal shock to the economy? Should the central bank focus on nominal GDP, rather than CPI, as an indicator of the state of the economy and as a guide to the stance of monetary policy?
  8. What are the strengths and weaknesses of using a Taylor rule as a guide to monetary policy? Would nominal GDP futures be a better target for monetary policy?

The following two clips look at John Maynard Keynes’s contribution to macroeconomics and whether his theories have been proved to be correct by the events of the past two years.

“What would John Maynard Keynes make of the financial crisis and the credit crunch?” In the first clip, “Author Peter Clarke, former professor of modern British history at Cambridge University, and the former Conservative chancellor Lord Lamont consider whether Keynes’s ideas were twisted by modern politicians to support their desires to run big spending deficits.”

What would Keynes make of the crisis? BBC Today Programme (25/9/09)
Is Keynes influencing today’s politics? (video) BBC News (2/10/09)

Questions

  1. How is the recent crisis and recession similar to and different from the Great Depression of the inter-war period?
  2. Can recent fiscal policies adopted around the world be described as Keynesian?
  3. How would a government of a Keynesian persuasion attempt to manage the move from recession to economic growth and deal with the problem of mounting public-sector debt?

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

  1. 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?
  2. How does Brad deLong explain recessions?
  3. Why does a change in the velocity of circulation of money contribute to a crash?
  4. What are the strengths and limitation of using economic history to understand the current crisis?