Thursday, January 21, 2010

The Macro Cube - 1

After a long time, back to macro. Even the most cursory of observers of the recent macroeconomic debates must have noticed that the field is far from settled. Some debates are academic, some political, some on theory and others on applications of that theory. How is one to make sense of all the theories and opinions flying past us? How does one decide, if one can't catalogue?

Allow me to present the completely new and original (and hopefully useful) Macro-Cube. This is also my first attempt at having anything remotely pictorial on this blog - hope it goes well.

Right, so let's get down to business. What is this cube? Very simplistically, it tries to catalogue theories (and the ideologies they entail) along three axes. These axes are each represented by a question.

1. Does the theory depend on/utilize equilibrium and optimization as major tools/concepts? (Equilibrium/Optimization)
2. Does the theory recommend monetary policy/stimulus in abnormal times? (M recommended)
3. Does the theory recommend fiscal policy/stimulus in abnormal times? (F recommended)

Why these three? Well, the first because of all methodological simplifications used by economists, equilibrium and optimization are the ones that seemingly introduce the greatest distortions from reality, and the ones that look most disposable in non-normal times. The second and the third are obvious - the macroeconomics of business cycles would have little relevance to the general society if it were not for the policy implications/ predictions that it makes. These policies usually stack up along the broad lines of fiscal or monetary initiatives, and the major macro theories also diverge along these lines.

Now, what do we do about these axes? Along each axis, a binary answer of 1 or 0 answers each of the above questions in a yes or no. This gives us a total of 8 polar points, or the 8 vertices of the cube. The resultant truth table is drawn in a manner that will be familiar to anyone conversant with boolean logic. For example, if your theory says that economic actors can be assumed to optimize and the economy is usually in equilibrium, and you strongly recommend both fiscal and monetary correctives anyway, you are a (1,1,1) or you lie on vertex B of the cube - and so on.

Clearly, various points within the cube, on each edge or face or even inside, represent points of view and theories that are somewhere in between the polar theories. What are the vertices and where do the more prominent theories fall?

A (1,0,1) : Theory that utilizes equilibrium and optimization, and recommends fiscal actions but not monetary. I understand it as a set of various theories that don't think a central bank or monetary policy is too important independently, recommend its subservience to the finance ministry or the treasury, want this treasury to run a bunch of fiscal initiatives in good times and bad, and think that the economy will be on track - if only the government is allowed to micromanage the macro-economy. From the description itself, this is a rather non-coherent theory - perhaps an unfair characterization on my part. Forgive this as a model simplification - I am less convinced of the existence of this vertex than any other. Let's call this vertex Socialist Fiscalism and move ahead after noting that sensible theorists and practitioners should have nothing to do with this rather naive view of the economy.

B (1,1,1) : Theory that utilizes equilibrium and optimization, and recommends both fiscal and monetary policy when times are non-normal. This should not be hard to guess. This is the classic Neo-Keynesianism of Solow, Samuelson and Modigliani and the IS-LM cross. It was the dominant paradigm for a long time and it is what introductory macro courses in most business schools still teach. One might wonder why the theory recommends strong government action though its methods of equilibrium and optimization entail self-correcting and complete markets. Well, the trick that the Neo-Keynesians used was to take sticky prices and wages from Keynes and use it to explain recessions and justify government action. As a result, this theory suffers from some incoherence due to a lack of micro-foundations but still has a lot of offer by way of policy recommendations in bad times.

C (0,1,1) : Alright, things get interesting here. Now we have a theory that discards equilibrium and optimization and hence recommends both monetary and fiscal initiatives depending on the conditions. I will call this 'Disequilibrium Keynesianism'. I can think of no better example of such a theory than Hyman Minsky's financial instability hypothesis, which Minsky proposed after extensive study of Keynes's General Theory and the financial system. It is the most 'left-wing' theory that I find myself in strong agreement with. In a financial crisis this theory looks very attractive but what one must keep in mind is - do we have reason to be so trustful of the government and so distrustful of markets on the average (or even in a crisis).

D (0,0,1) : Disequilibrium, monetary initiatives not useful in a recession, hence fiscal stimulus. This is classic Post-Keynesianism. Keynes's chief rationale for a fiscal stimulus was the liquidity trap argument. Post-Keynesians are wont to believe either that the economy is frequently in a liquidity trap or, more subtly, that money is endogenous and hence exogenous monetary actions by the central bank are useless. Or both. Paul Davidson, the Circuitists, and the Chartalists are good examples. On the left-right spectrum, these guys fall slightly left of Minsky and though they have several good and arguable ideas, they are more skeptical of the market economy than they should be.

P (1,0,0) : Equilibrium, self-correcting and optimizing markets, government policy either ineffective or actively damaging and hence not recommended. Right, we're talking about the New Classicals here. To me, this is a theory that prefers theoretical coherence over correspondence with reality. Money is thought to be neutral even in the short-run. Recessions are either sudden large vacations or real-sector phenomena that will correct soon enough or something equally implausible. Of course, most of the big names associated with New Classical macro are more moderate and nuanced in their thought but I think Thomas Sargent and Ed Prescott can still be placed firmly on vertex P. This is the most right-wing of our theories here, and the one most sanguine about markets - I don't find most of its views attractive.

Q (1,1,0) : The economy is mostly in equilibrium, economic actors optimize, monetary policy can be effective in the short run, but fiscal policy almost certainly isn't. This shouldn't be hard to guess either. This is the standard Neo-Classical view of the economy. This is the view of the first ever macro-model of the economy, of Irving Fisher before the Great Depression and before the debt-deflation hypothesis. This is also the theory of Taylor-rule based inflation targeting monetary policy that resulted from the uneasy truce between New Classicals and the New Keynesians. Following the good people of the Levy Institute, I will call it the New Monetary Consensus. Examples? None better than John Taylor and Michael Woodford. Closer to home - Ajay Shah. This is the standard macro-view backing mainstream capitalist thought, though a lot of its assumptions and conclusions are quite questionable. This is as right-wing as I get.

R (0,1,0) : The economy could be in disequilibrium, this disequilibrium is fundamentally monetary in nature and hence the solution is monetary, not fiscal. This is another interesting point of view and one that I would have been unexposed to had I not been following some blogs. These are the Monetary Disequilibrium theorists, and their fountainhead should surely be Leland Yeager. Yeager combined the fiscal suspicion of Hayek with the monetary theory of Keynes and created a new theory that is rather attractive and woefully under-explored by the mainstream. Money is thought to be completely exogenous, and the central bank can always help things by slashing interest rates, quantitative easing or by de-linking reserves and currency.

S (0,0,0) : Ladies and gentlemen, welcome the Neo-Austrians. I take the name from one of the various terms that Arnold Kling has used for his rather novel take on things. It says that the economy is frequently in disequilibrium, but that these disequilibria are the natural process of the evolution of the economy and government tinkering is either ineffective or damaging. Money is neither neutral, nor privileged - for what good does monetary policy do when the adjustment is hypothesized to be inter-sectoral and in real (not just monetary) terms? Fiscal policy can be subject to corruption, or can stoke and aggravate moral hazard or inflation problems. It is an interesting proposition, though I find it most useful when considered together with the Disequilibrium Keynesianism of vertex C.

So there you have it - descriptions of the 8 polar cases. I thought of such a cube for the first time about two months back but only now have been able to comprehensively place theories and theorists along the proper vertices, edges and faces of the cube. And if you found the vertices interesting (or are wondering just where the hell Friedman and the Monetarists went), wait for the next post which will be about these in-between theories.


The Arthurian said...

In the opening paragraph of his General Theory, Keynes distinguishes his theory from the Classical theory and says, "I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case...." He refers to that special case as "a limiting point."

When I read that, I picture a sine wave moving through time, with the "special case" fitting in at the cyclic peak. I picture a time-based, linear progression.

Your Rubik's cube -- Ritwik's Cube -- is anything but linear!

I have trouble combining your three-dimensional view with my one-dimensional understanding of Keynes' fourth-dimensional sequence of events. One cannot take Keynes out of your cube, certainly.

Maybe the "proper" geometric shape is tree-like, with lots of branches that end up going nowhere, and a main trunk that includes Keynes and his "classicals" ...But then one would have to re-envision your cube like Watson and Crick.

Certainly there is progress through time in economics. Beyond saying that all points on your cube are held concurrently, have you any idea how your cube would look as it evolves through history?

Anyway, I like what you have done here.

Ritwik said...

Thanks for the kind words! The cube is really only the state space - I have no time dimension, nor was I concerned with it. Economic theory may evolve along a curve that can take any value on the state space.