The Great Moderation In Macroeconomics

by Mario Rizzo  

I have now read both Paul Krugman’s New York Times essay on the state of macroeconomics and John Cochrane’s reply. They are each, in very different ways, quite disappointing. The level of argument is poor, the prejudices are simplistic, and the tones are annoying.  

Beginning with tones: Krugman is too dismissive of all macroeconomics since John Maynard Keynes. Cochrane responds by saying, in effect, that it is impossible that mainstream macro (read Chicago and probably “New Keynesians,” as well) could have been fundamentally mistaken over the past forty years or so. We don’t need to “rehabilitate an 80-years old book” (Keynes’s General Theory).  

The prejudices: Krugman thinks that if you lessen the reliance of macro on assumptions of rationality and efficient markets you find your way to Keynes. In a related fashion, he believes that formalism in macro theorizing is the root of the problem. Cochrane, on the other hand, thinks that traditional Keynesian approaches are too informal and that more, not less, mathematical formalism is needed. He believes that it is too easy to wave the banner of “irrationalities,” “animal spirits,” and so on.  

Isn’t there something else? I hope so.  

I am reminded of the economist Roger Garrison, quite a few years ago, characterizing Hayekian macroeconomics as the “middle ground.” At the time I pooh-poohed this. I argued that one could always situate something as a “middle” by suitably choosing the extremes. This is quite true. But what I missed was the argumentative context. In the context of today’s macroeconomics alternatives, the Austrian approach is very naturally the middle ground.   

The traditional Keynesian view is that if equilibrium obtains it will be a very bad one: depression. But ordinarily the uncertainty of the real world makes the economy prone to all sorts of bubbles, liquidity traps, aggregate demand failures. In other words, it is as if the economy is always on the precipice of some great disaster. Keynes advocated the permanent “socialization of investment” as insurance against this tendency toward disequilibrium leading to horrible equilibria.  

The Freshwater view, as I see it, is that we are (almost) always in a state of equilibrium. The only thing that can knock us out is inherently unpredictable shocks, usually of a supply or technological variety. Expectations are usually well-behaved and presumptively “rational” at least in the sense that we do not have to worry about big disturbances arising from this subjective (or “demand”) side of the picture.  

The Austrian perspective is more balanced. Austrians have been saying that the current recession was precipitated by excessively low interest rate policy followed by the Fed. They say that the structure of production was distorted in at least two ways. First, investment relatively far from the consumption stage was stimulated as was consumption spending – both at the expense of the middle (a different middle here) and of the replacement/maintenance of capital. (Traditional Austrian view.) Second, low interest rates stimulated greater risk-taking on the part of economic agents. (“New Austrian” view a la Tyler Cowen.) This was not an exogenous change in risk preferences but endogenous, that is, caused by low interest rates, not irrational spirits.  

So here you have a real, underlying distortion caused by poor monetary policy. We can call this a disequilibrium, if you like. The recession must involve a readjustment to the undistorted productive structure. This is not to say that the recession is simply resource re-allocation and therefore unambiguously “good.”  

It is not good because, after all, the original distortion was not good. But we can go even further.  

Once a recession starts certain secondary, but not necessarily unimportant, phenomena may be set in motion – chiefly the threat of cumulative price decline in almost all markets (aka “deflation”), systemic failures in the credit institutions caused by imperfect expectations of what is likely to happen, and general discoordination of plans. Keynes’s macroeconomics seems to be only about these secondary phenomena. Cochrane is right: Keynesians don’t know and don’t care what the fundamental causes of the recession are. 

The “bubble” – to the extent there was one – was strictly speaking a dependent phenomenon. It was dependent on the enabling policies of the Fed during the expansion. I do not believe it would have happened in a different interest-rate environment.  

Thus the Austrian view really is a middle ground. There are real underlying distortions – not simply animal spirits gone wild. They must be dealt with. But there are also secondary, subjective and expectational consequences induced by the original poor monetary policy. It is not so much that markets are inefficient and that actors can be irrational. Rather, in the process of market correction markets will seem inefficient but they are “trying” to correct errors. Actors may be prone to “irrational excesses” because the level of radical uncertainty has been increased, some of this induced by unpredictable government policies and some by the exigencies of readjustment. But the real misallocation problem underlies this.  

I hope this is not too balanced, too moderate, too middle-grounded. Generally, I dislike these things, but bad economics to one side and to the other makes a moderate of me. Woe is me.