One thing that the current crisis has done is to expose just how much economists differ in their mental models of the macroeconomy. It seems as if we often talk right past each other, not really understanding the points the other side is trying to make. And I don’t think this is an inevitable part of academic discourse. In microeconomics, for instance, Chicago economists may differ from salt water economists about just how competitive most markets are, but at least they can debate the issue using a commonly understood language. Not so in macro.
Take the writings of Keynes, which have about as many possible interpretations as the Bible (and are about as consistent as the Bible as well.) Krugman has recently been ridiculing distinguished economists who don’t understand Keynes, or at least don’t understand Keynes the way he does. Tyler Cowen responded by noted that Keynes had spoken out against using fiscal policy to smooth out the business cycle. So perhaps even Krugman isn’t really a Keynesian. I wouldn’t deny that Krugman is sharp enough to spot the occasional lapse in logic by conservative economists, but I also think that all sides of the debate tend to underestimate just how much macroeconomic worldviews differ, and the extent to which we even lack even a common language to debate issues. Here are a few brief examples:
1. What does the term “monetary policy” mean? A Mundellian might visualize monetary policy in terms of the price of money (in terms of gold or foreign exchange.) Thus Mundell argued that the price of gold was set too low after WWI, and that that was a root cause of the subsequent deflation. Friedman might visualize monetary policy in terms of the quantity of money (M1, M2, etc.) and see the cause of the Depression as being the sharp fall in the monetary aggregates in the early 1930s. Most economists visualize monetary policy as the rental cost of money, the interest rate. For them, money is too tight if interest rates are set at a level too high to allow for full employment. So there are at least three very different indicators of policy. But even worse, it’s not clear how to interpret any individual indicator. Michael Woodford has argued (correctly in my view) is that what matters is not changes in the current setting of the policy indicator, but rather changes in the expected future path of that indicator. He also argued that what matters is not the level of interest rates, but rather how they compare to the (unobservable and always changing) Wicksellian equilibrium rate.
2. What is the Phillips Curve model? Friedman developed a “Natural Rate Model” where unexpected changes in inflation pushed unemployment above or below the natural rate (which was itself unobservable.) In his view, an expansionary monetary policy would raise M*V, or nominal spending. In the short run some of that increase would show up as increased output (due to sticky wages), and some as higher inflation. Today, however, most economists see the Phillips Curve model very differently. Expansionary monetary policy might lower interest rates, and if interest rates fall that might boost investment and real output, and if real output rises that might boost inflation. What Friedman saw as the direct effect of expansionary money, is instead a long run and very uncertain effect. Because I take Friedman’s view, I find I have trouble explaining to other economists why the current problem is simply to get an expansionary enough monetary policy to boost nominal spending. They see the problem more in real terms–will monetary stimulus lower interest rates and raise real investment spending? Inflation is an effect of growth, not of monetary expansion.
I often observe people switch from the Keynesian mental framework to the Friedman mental framework in a matter of seconds. In an earlier post on hyperinflation I mentioned that most people today do not believe that monetary expansion can boost AD. But when you give them a reductio ad absurdum example of running the printing presses and buying up everything in sight, they envision hyperinflation. To do so they switch to the monetarist excess cash balance model (assuming they are not a skilled macroeconomist who understands Krugman’s “expectations trap” model.) The transition is not smooth, it’s as if they are forced to speak a different language. One can can briefly observe the cognitive dissonance on their face when they make the transition.
Bennett McCallum identified no less than 10 different versions of the sticky wage/price model, each with different theoretical implications. And all that is within mainstream macro. If one moves into Austrian macro, post-Keynesianism, or even the writings of Keynes himself, the language changes much more radically. What do phrases like “savings exceeds investment” really mean?
Elite macroeconomists may have a common mathematical language with which they can communicate via DSGE models (a language I do not speak) but it is becoming increasing apparent that when thrown out in the open to face complex real world problems, they revert back to their instinctive worldview, which varies greatly from one economist to another. Some say monetary policy is obviously impotent today, others cannot imagine a more absurd idea under a fiat money regime. And no one knows whether familiar models like IS-LM are of any use in resolving that debate.