ECON430-Topic #3: Where do we go from here?

There has been a lot of talk about how economic theory has failed us in our current crisis. With all the different schools of macroeconomics, it’s not really that much of a surprise that there wasn’t a lot of agreement how to tackle this crisis. It’s really even less surprising that people now think that someone in power would have listened if their theory was better able to predict what has occurred.

The different schools of macroeconomics have all come out in defense of their beliefs. Robert Lucas at the University of Chicago, has stood up in defense of the “freshwater” schools. Paul Krugman, who stands more on the interventionist side of Keynesian thought, recently wrote an article pointing out the flaws in the theories of other economic schools (This is a long article, but contains a lot of information). Brad DeLong also has pointed out the failure of some macroeconomic thought.

In an attempt to reform the current orthodoxy in macroeconomics, George Soros has created the Institute for New Economic Thinking. This new think-tank/foundation has a number of high quality scholars on board, such as Joseph Stiglitz and George Akerlof. The INET think-tank, is a straightforward attack on the idea that the free-market system cannot be improved.

Questions you might try to answer:

  • Which of these schools do you believe are correct? Or at least, on the right track?
  • Do you believe that macroeconomics is in a “dark time”? Or is this basically the way things have always been, and now non-economists are actually interested?
  • Comparisons of different monetary theories should show that there is a wide array of beliefs. Which fundamental errors have been made, if any? What primary assumptions about monetary theory have been the least likely to hold?

I would like your statements to be as subjective as possible, or in jargon terms, positive and not normative in nature. Also, remember, I want you to keep your descriptions short, basic, and related to classroom content. Read other students comments before posting, and please leave your name with your posting.

9 thoughts on “ECON430-Topic #3: Where do we go from here?”

  1. To say one economic school is correct and another is completely wrong is foolish because no school was able to predict the current credit crisis and no school has come out with any credible way out. With that said, the biggest point of dispute seems to be interventionist vs. non-interventionist policy or should the central bank use monetary policy? I think the current crisis has proven that some interventionist policies are needed. The bailouts of huge financial institutions such as AIG are an example of this because without the central bank’s intervention, their failure would have caused a domino effect collapse of the financial sector. However, an economy with too much regulation and intervention is also not healthy. In fact history has shown that too much regulation and intervention is ineffective—the collapse of the Soviet Union is the prime example. The two extremes have been eliminated, so the best approach most likely lies in the middle, an approach that knows when to step in and when to stay hands off. I think the school that is the closest right now (with the alteration of a few ideas) is the Austrian school. The most important idea the Austrians have is that human behavior is extremely difficult to model. They place a great deal of emphasis on the development of entrepreneurship, which they hold to be the most important factor to growth rather than the manipulation of monetary policy and fiscal stimulus. They rely on deductive methods to construct their models rather than experimental induction which the other schools employ. The only idea I would alter is there predominant hands off approach. Some shock to the economy must be dealt with, such as the one that recently occurred. If the central bank had waited too long to act, the economy would have sunk to much lower level. On a lighter note, I really don’t think we are in a “dark time” of macroeconomics. I think that certain assumptions that we have held as almost scientific law are crumbling, but that means that it will give way to newer superior models and theories that are one step closer to “perfecting” the science. by Alex Gans

  2. The recent credit crisis and depression of market cannot be predicted by schools of economics. It was the matter of realization of importance on risk management. Undervalue of credit risk, operational risk, and market volatility resulted this crisis. According to Nassim Taleb’s Black Swan, “almost all consequential events in history come from the unexpected.” The main idea is not to attempt to predict unpredictable events, but to build robustness to the negative ones. He contends that banks and trading firms are very vulnerable to hazardous Black Swan events and are exposed to losses beyond that predicted by their defective models. Their underestimation of volatility on risky assets contributed this mess. I do not think we are in a dark time. Our financial system needs to be modified with more regulations on certain fields. For example, in order to solve the operational risk, we need to have more transparent management system to solve the agency problem.

  3. The saltwater school of thought may not be totally correct but is on the right track. The freshwater school relies too heavily on the efficiency of markets. Denying the existence of asset bubbles and claiming all unemployment is voluntary is idiotic considering the current economy. Models provide a framework for understanding the economy but should not be taken as the gospel. They need to be reevaluated and updated once they can no longer explain current economic conditions. This is a dark time for macroeconomics and an upheaval of theory will follow. Assumptions of rational expectations, market efficiency and the inexistence of asset bubbles have left freshwater economists reaching for answers.

  4. I agree with Alex, I do not believe that there is a single school of thought that has all the answers to economic activity. I believe that the most efficient school of thought has not yet been created and should be a hybrid of all the other schools of thought. I think that interventionist policy is definitely necessary at times, with the bail outs of major financial institutions during the recent crisis as an example. If these major institutions had not been saved we would have experienced a total meltdown. However, discretionary intervention can sometimes cause negative effects. The fed can be tempted to monetize its debt and cause inflation and hurt growth. It can also be tempted to devalue its currency to increase exports. All of these discretionary policies cause externalities and have a lot of uncertainty. I believe that a monetary rule fixes this problem. If a monetary authority has guidelines and instructions on what to do in a given situation, it is less likely to make risky and inappropriate discretionary policy. Given, of course, our ability to create an efficient and functioning monetary rule. I think that the biggest factor for us in the near future is the adoption of a fully electronic monetary system. I do believe that physical currency or cash will soon be eliminated and everything will be done electronically. This is going to bring about a whole new box of issues, positive and negative ones. This might make monetary policy easier, as well as decrease the amount of money in the black market. It will probably decrease crime in some aspects, but I do believe that identity theft will be a big problem. I do not believe that macroeconomics is in a “dark time” I believe that our current situation was brought about as a consequence of specific actions, and that the right solution is just waiting to be found.

  5. I agree with Alex. The probability of the credit crisis happening, was six standard deviations away from the mean when it happened. No economic theory is going to be able to predict something six standard deviations away from the mean, otherwise its going to be wrong 99.99999% of the time. A lot of economic theory came out of the great depression, and I think that something very similar will happen here as well. I think the problem people have with the credit crisis is that since these theories didn't predict the credit crisis, how are these economic theories supposed to lead us out of the credit crisis it didn't predict. To intervene or not intervene? That is the question. Personally I think the financial system did need the bailouts, and will continue to need support in the near term, its still very fragile right now. On the other side I believe that over regulation hurts growth and competition in the long run.

  6. On the case of which school to believe i think all schools could be right to some extent as they all based on the theories and past effects,it is also hard to predict what one person can do in the changes of bussness cycles and other times.When look at classical theories it failed to lead to the conclusive explanation on what caused great depression of 1929 and how to come out of it.I dont believe that we are on the dark times yet if the right policies are put in place and we stay patient for the effect to take course because in all economies there are short term and longterm effects but all do take time to show effects.In federal intervention i think it is something which needs some attention because as the history as shown us on the great deppression of the 1929 was as the result of the assets market bubbles on which investors over invest with the hope of making ridicurous profits but the result was the downfall of the economy at the time.After sixty some years here we are again dealing with the same issue failed to see the bubble coming and take action before it burst why because we are the policy maker were scared to loose the foreign investors but now were are we in this new era of different schools of macro-economics will they get us out of this? maybe.looking at monetarist theories like Milton,Bernake all point out on some action by the federal reserve to act quickly trying to secure the great financial giants who are too big to fail so as to easy the impact of the overall economy suprisingly this did not happen on time as we saw the giants financial institutions like AIG collapse and so many others followed.I still have courage we are going to get out of this soon or later.

  7. After reading the articles it seems that the saltwater economists are moving forward while the freshwater economists are moving backward. As Krugman mentions and DeLong clarifies, freshwater economists have provided few explanations for the causes of the recessions that America has experienced over the past three decades (generally recessions resulting from bubble bursts). Specifically, some of the freshwater reasons include: lapses in the productivity of technology, and voluntary unemployment encouraged by the attempt to receive convenient government subsidies in refinancing mortgages. The underlying classical belief is that recessions are part of the business cycle and the most efficient way of handling them is letting the business cycle run its course. I disagree with this. I feel that we needed to bailout several financial institutions following the financial meltdown of 2007. The bailouts were necessary in order to keep the meltdown from spreading to many other sectors in the economy that were interconnected with the financial markets. In coming up with a solution, Krugman seems to hit the nail on the head. He recognizes the fact that bubbles and speculation exist, that activist policy is certainly more effective than no policy at all, and that financial inefficiencies have large impacts on our economy; (Keynes’s “casino” argument illustrated one negative externality of the financial sector). I do not think economics is in a dark age. As always the best macroeconomic lessons are learned through historical experiences. As Delong put it “theory is crystallized history”. We will probably not be able to predict the next recession that occurs, but we will certainly have at least two theories regarding how it was different than our current one.-Andrew DavidPaul Krugman, “How Did Economists Get It So Wrong”Brad Delong, “Economic History and Modern Macro: What Happened?”

  8. Currently there is not, and never was, and never will be an economic school that will be able to predict the future. Even the most brilliant minds, if all put into a room, would never be able to figure out what the rest of the non-brilliant population will do or react as a whole. Black Swans and the fact that this crisis was 6 standard deviations from the mean proves this. Isn't it possible that the mean could realistically be closer (increasing the likelihood of this event)? I envision economic schools and Mr. Soros' newly created INET to be a group of brilliant people wasting their talents, trying to predict the future. Ultimately, I believe that interventionist policy, whether in global politics or economics, is a sign of complete arrogance. It is as if you are declaring that you know the answers (the future) and will take the steps to tweak it as you see fit. Again, with absolute certainty, can anyone say that if no bailouts were given we would have a meltdown and people would go back to living in shacks with no food to eat? I believe things would have gotten worse, but I liken it to removing a band-aid quickly rather than peeling it off slowly. One thing you can say with 100% certainty, is that when trying to fix a problem in the economic cycle, another problem will surface as a result. Increasing money supply in short term will give rise to a short run increase in output, but can lead to high inflation in the long run. Intervening will have an effect on something in the future.Therefore I do believe we are in a dark-time. I feel that governments and central banks around the world have all come to the conclusion that they know what's best, and will intervene as much as necessary to get it.Matt Gerboth

  9. It’s hard to believe Lucus and the freshwater school of thought. I can understand Lucas’ point that no model could have predicted an in the value of financial assets. However his skeptical comments about the chance of a recession after Lehman’s collapse and the impact of the sub-prime mortgage crisis were off the mark to say the least. Given that it is very hard to buy what they are selling in terms of recovery and future outlook. Efficient-market theory also seems flawed in that they didn’t recognize a housing bubble as even possible. I think this will be a dark time for macroeconomics because no contemporary school of thought can say they saw this recession coming. People will be skeptical of the advice from advocates for the various schools. Perhaps they will follow Krugman’s and revert back to Keynesian ideas. But there will be some period of skepticism and distrust and that uncertainty will probably stall recover as the debate over proper action continues.

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