14 Sep 2009

Mario Rizzo: "Clowns to the Left of Me, Jokers to the Right / Here I Am, Stuck in the Middle With Lu"

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Mario Rizzo decides once again that macroeconomics is too important to be left to the macroeconomists. He is disappointed with Paul Krugman and John Cochrane as they sum up the great intellectual divide.

If I may paraphrase: Krugman says that the “freshwater” economists (at places like Chicago) are idiots for failing to see that market economies are fragile things that are prone to systematic, irrational bubbles and busts, which can and should be prevented or at least moderated because their sources aren’t “fundamental” to the underlying “real” economy. Krugman thinks the freshwater economists are being ridiculous when they try to model recessions as being caused by a “real” random productivity shock, or even worse because workers decide they want to enjoy more leisure all of a sudden.

But then Cochrane comes back and says the “saltwater” economists (at places like Berkeley and MIT) are idiots for failing to see that there are serious, structural problems with the economy during a severe recession. You can’t just magically fix a real, underlying mismatch between resources and preferences by spending money. And why, demands Cochrane et al., would we expect a bunch of profit-seeking investors, guided by rapidly updating prices, to make systematic errors for years at a time? That doesn’t make any sense, does it?

Ah, Rizzo to the rescue:

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 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…

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.

Joy is you, Mario. Woe are Krugman and Cochrane.

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