The past 30 years of macroeconomics training at American and British universities were a “costly waste of time”.
Says an article in The Economist quoting Willem Buiter of the LSE. One would hope that Mr Buiter was either having a bit of a laugh or was slightly intoxicated when that was said, but somehow I’m doubtful. This article is perhaps a bit late – based on articles in the July 18th – 24th issue of The Economist, but in the grand scheme of things, a fortnight and a bit hasn’t changed anything. If at all, it’s given time for everything to sink in. Before proceeding, I strongly recommend you read all 3 cover articles in this issue. The 2 main articles forming the basis for discussion can be found online here: (read them!)
What went wrong with economics?
The other-worldly philosophers
Not only do these articles raise questions that you might well be asked in an interview or wish to pose yourself in your personal statement but they’re also relevant to the macroeconomics you’ll be learning, examining the way central banks make decisions and referring to concepts such as the Phillips curve and the variations between the Classical or Monetarist and Keynesian approaches. It’s also a great basis for undertaking further research. I’ll be the first to admit that macroeconomics isn’t my favouritest bit of economics, yet it’s still really interesting and (dare I say it) fun to delve deeper than the usual classroom stuff. I’ll first cover the basics of what the articles said and then raise some points for discussion.
Let’s first look at what is said in the article to have gone wrong and been at the root of the crisis. Perhaps some of this is above the level of understanding of an pre-undergrad student (me included), but that shouldn’t stop you!
- Too much emphasis on price control (i.e. inflation-targetting) than other factors.
- Incorrect assumptions built into models: e.g. “House prices have been rising for the last 20 years so they will always rise in the future” and the provision of mortgages on such assumptions.
There are some other issues raised too such as the belief that markets were largely self-regulating and so on, but let’s keep things simple (this is economics after all!) 😛
The first point is an interesting one – one that I’ll struggle to discuss concisely! But for those doing the Target 2.0 competition, it’s likely that it will be something you look at closely. At the Bank of England’s Monetary Policy Committee (MPC), inflation control has always taken centre stage (how many times did CPI go outside the 1-3% boundary between 1998 when the MPC was formed until just before the credit crunch began?) but it’s also the Bank’s responsibility to maintain financial stability and that’s where things turned sour with the liquidity crisis, something explained in detail here. This is precisely one of the main criticisms leveled at educational institutes graduates weren’t too well placed to deal with such a crisis and were caught off-guard as liquidity conditions changed and they found that their assets were not sellable causing the build-up of toxic assets within organistations leading to complications in interbank lending and so undermining financial stability. As for the second point, the link above explains that too but a simple search for the terms ‘sub prime’ will achieve the same result.
Theory hunting – why this is so relevant to your A-Levels… or IB.. or even Leaving Cert?
Sticking with the same (first) article, there’s reference to an “uneasy truce between the intellectual heirs of Keynes…and purists”. This is something you will already have studied or will do so in the near future. The basic explanation is that the Keynesian way of thought is that the economy can produce at below Yfe (Output at full employment) and an increase in AD will only cause an increase in price levels if there is no output gap (hence the L-shaped LRAS curve) whereas Classicists/Monetarists believe that any increase in AD is bound to cause an increase in price levels giving a totally vertical LRAS curve. Anwyay, that’s enough theory for now – it’s explained with diagrams at economicshelp.org.
What interests me more can is the so called synthesis between the two groups – how in recent years there was some sort of fragile consensus between them which has now broken down and caused everyone to retreat right down to the core ideas held by the group they belong to. Now this is probably not going to be in your studies but it is pretty relevant meaning it’s a chance to shine and show off how cool you are… So what is this synthesis? A bit of googling and I’d found a possible answer:
“During the 1990s, the debate between new classical and new Keynesian economists led to the emergence of a new synthesis among macroeconomists about the best way to explain short-run economic fluctuations and the role of monetary and fiscal policies. The new synthesis attempts to merge the strengths of the competing approaches that preceded it.
In many ways, this new synthesis forms the intellectual foundation for the analysis of monetary policy at the Federal Reserve and other central banks around the world.” Source
So, from classical economists, it takes the tools that help provide an insight into how households and firms make decisions and from Keynesian’s it takes theories such as ‘sticky wages’.
It’s supposedly the breakdown of this resulting from recent events that are causing debate over how the crisis should now be tackled and causing focus to once again fall back on fiscal policy (which was previously disregarded as a tool to manage fluctuations in AD) as well as other tools (not interest rates) of monetary policy, namely money supply with the ever-increasing figures of quantitative easing being employed by many countries around the world.
The underlying argument here is that the models used by many financial institutions, central banks included, didn’t account for changing conditions in finance (I’m not entirely sure about this, but I’m presuming it refers to liquidity) and as the current crisis was caused by an upset in the financial world, those working on tomorrow’s models have already started factoring this in so that the same mistake is not repeated. The conclusion reached is that while the models of tomorrow are unlikely to have the same flaws that caused the recent mess, there’s still a “broader change in mindset” needed leading to greater co-operation between macroeconomists and financial professors.
Moving onto the second article – starting with the ‘hunt for theory’ again, another distinction between Keynesian and Classical methodologies is drawn in regard to the behaviour of households:
Classical – Earnings are either spent – or saved. What is saved is then invested in capital projects. Money isn’t hoarded and consequently nothing lies idle.
Keynesian – Savers could well hoard their wealth in a liquid form (cash under the pillow) rather than in capital projects — the liquidity preference.
Keynes argued that it is this liquidity preference that eventually determines interest rates. So if the liquidity preference was high, the natural response would be to cut interest rates, making it more attractive to spend and less so to save.
There’s also a reference to the Phillip’s Curve which appeared to break down during a period of stagflation although alternative theories are now offerred (perhaps something worth looking further into).
Ok, so that’s enough about the articles themselves. Now for the fun bit, a bit of discussion on the following…
Given that Keynes himself said “When the facts change, I change my mind,” does Willem Buiter’s statement claiming that the last 30 years of macroeconomics training were a “costly waste of time” hold at least some merit?
Leave your views in the comments section below and we’ll try and get a bit of a debate going!
Disclaimer: Even though I often pretend to be, I'm not a real economist or anything like that, this post is purely based on my experience of the kind of things that would have helped me when I was applying to university and should hopefully help you too!