Economics is in crisis: it is time for a profound revamp
By Paul De Grauwe
Published: July 21 2009
There can be little doubt. The science of macroeconomics is in deep trouble. The best and the brightest in the field fight over the most basic problems. Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp ofmacroeconomists claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment. Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation. Wrong, says the other camp. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits wouldintensify the deflationary forces in the economy and would lead to a new and more intense recession.
Or take monetary policy. One camp warns that the build-up of massive amounts of liquidity is the surest road to hyperinflation and advises central banks to prepare an “exit strategy”. Nonsense, the other camp retorts. The build-up of liquidity just reflects the fact that banks are hoarding fundsto improve their balance sheets. They sit on this pile of cash but do not use it to increase credit. Once the economy picks up, central banks can withdraw the liquidity as fast as they injected it. The risk of inflation is zero.
Both camps line up an impressive list of Nobel prize-winners to buttress their arguments. Economists have often disagreed in the past, but this time the tone isdifferent. The protagonists do not hesitate to accuse the other camp of ignorance or bad faith. I have never seen anything like this.
So what? Does it matter that economists disagree so much? It does. Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal which of the two camps you believe. If you believe the first one, you will fear futureinflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise. You will have made a reality of the fears of the first camp. But if you believe the story told by the second camp, you will happily buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery that the second camp predictswill follow from high budget deficits.
Most people are not sure which camp is right. They hesitate. One day, when green shoots are popping up here and there, they believe the story warning about inflation; the next day, when the shoots turn brownish, they believe the other story. Disagreements among economists take away the intellectual anchors around which market participants interpret eventsand forecast the future. Ultimately, all our forecasts use a particular economic model to interpret data and to forecast their future course. The existence of wildly different models takes away this intellectual anchor and this translates into more market volatility.
This conflict matters not only for market participants, but also for policymakers. The two camps of economists have wildlydifferent estimates of the effect of a 1 per cent permanent increase in government spending on real US GDP over the next four years. According to the first camp, the Ricardians, the multiplier is closer to zero than to one, ie 1 per cent extra spending generates much less than 1 per cent of extra GDP, producing little extra tax revenue. Thus budget deficits surge and become unsustainable.
Bycontrast, the second camp, the Keynesians, predict that the same 1 per cent of extra government spending multiplies into significantly more than 1 per cent of extra GDP each year until the end of 2012. This is the stuff of dreams for governments, because such multiplier effects are likely to generate additional tax income so that budget deficits decline.
With so much disagreement it is no surprise...
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