Macro Cube -2

Ok, let's begin with a quick recap of the last post. I tried to categorize macro theories along three axes -

1. Does the theory use/believe in equilibrium and optimization? (E/O)

2. Does the theory recommend monetary stimulus in abnormal times? (M)

3. Does the theory recommend fiscal stimulus in abnormal times? (F)

Then, on the (E/O, M, F) co-ordinate space, I placed the 8 vertices of the resultant cube as follows

A (1,0,1) : Socialist Fiscalism (SF)

B (1,1,1) : Neo-Keynesian (NK1)

C (0,1,1) : Disequilibrium Keynesian(DK)

D (0,0,1) : Post-Keynesian (PK)

P (1,0,0) : New Classical (NC) Q (1,1,0) : Neoclassical/ New Monetary Consensus (NMC)

R (0,1,0) : Monetary Disequilibrium (MD) S(0,0,0) : Neo-Austrian (NA)

Let's begin with the edges of the cube now.

1) AB : Between the Neo-Keynesians and the socialist fiscalists, we have people who may or not recommend central bank action but definitely recommend fiscal initiatives to boost consumer spending and reduce unemployment, in good times and bad. This is a left-of-centre view that that Arnold Kling calls 'Folk Keynesian' and Paul Krugman once disparagingly called 'Vulgar Keynesian'. I will go with the Arnold Kling nomenclature (FK). It does not have much currency among academic scholars, though it is often the dominant popular view of the macro-economy. It strives for the right aims, but recommends the wrong policy actions and has confused theoretical underpinnings. Unfortunately, if you hold such a view in India, you would be considered 'centrist'.

2) BC : Recommend strong government action of monetary and fiscal kinds in crises, mild government action otherwise. Since I am running out of various prefixes, I am going to simply call it Keynesian (K). Jim Tobin and his brand of Keynesian teaching at Yale in the 70s is the best example of such a theory. Tobin was also the flag-bearer of the Keynesian defence against the Monetarist onslaught and made the first concerted efforts at integrating asset markets with macro-economic theory. More recently, Christy Romer & George Akerlof can be said to be of a true Keynesian persuasion. It is a comprehensive, coherent and attractive theory, but one that was surely called into question during the stagflation of the 70s (though the Keynsians would like to attribute that to the one-time but significant oil supply shock of the era) .

3) CD : Minsky inspired Post-Keynesian theorists. They try to integrate the financial instability hypothesis with the theory of endogenous money. I don't know what to call them but I can think of no better example than Steve Keen, who blogs at Debtwatch. Keen goes one step further than incorporating Minsky, Graziani and Moore into Keynes. He also tries to incorporate the debt-deflation hypothesis of Irving Fisher and Schumpeter's non-linear dynamical version of the economy. It is a difficult, perhaps fruitless research program but one that resonates with economic reality often enough to not be discarded. Keen is more left-wing than I think he should be, but there is no denying that his insights are ignored by the mainstream macro to its own disadvantage. This, actually, is about as left as I am willing to go.

4) DA : Functional Finance (FF) Theorists. This is the view that combines Chartalism (government deficits are necessary for the existence of a monetary economy) and strong fiscal dominance (Treasury >> Central Bank) with the notion of boosting consumer demand for employment and as a result asks for the government to do whatever it can fiscally to keep the economy up and running and happy. Abba Lerner is its foremost theorist and he summarized the view most succintly when he asserted that balanced budget constraints apply to individuals, not governments. More recently, one can find something similar espoused by Joseph Stiglitz when he recommended that the way out of the Asian crisis was more, not less, government spending. It is the policy proposition that resulted when a Machiavellian Republican president arm-twisted a reputed Keynesian/monetary theorist. It usually results in consumer profligacy, and has been strongly criticized in various ways by many scholars, including Ken Rogoff here (his open letter to Joe Stiglitz following the latter's book Globalization And Its Discontents).

5) BQ : This is the equilibrium theory that keeps an open mind to fiscal stimulus in bad times, but prefers monetary methods a lot more as it asserts that fiscal policy multipliers may be minimal due to a multitude of reasons. It is perhaps the dominant graduate school orthodoxy, and I will call these theorists neo-Wicksellian (NW) - as Nick Rowe does - for its obsession with the short-term interest rate. Inflation and output targeting is the goal, through rule-based or discretionary methods. The leading theorists are pretty much the who's who of modern monetary macroeconomics. One third of the way from B to Q, you will find Stan Fischer and Olivier Blanchard. A further one-third and you have John Taylor and Jordi Gali. ( I was a little off in saying that John Taylor was at vertex Q - Robert Hall is probably a better bet for that slot.) Somewhere in between, you will find Alan Greenspan's policies as the Fed chair. Though it is not an obnoxiously free-market-supporting theory as some like to characterize it, it has rightly taken a hit in this crisis for its predilection with equilibrium and the risk-free rate. Abstracting out of cash, credit risk and the financial system are model-simplifications that this theory needs to abandon.

6) QR : Finally, the Monetarist (Mo) view. Economy may be in equilibrium or disequilibrium, but central banks can always do enough to render fiscal policy unnecessary. The velocity of money (V) is either a constant, or increases in the money supply (M) and/or quantitative easing can always overcome a drop in the V so that the nominal GDP (M*V) can always be targeted and stabilized. Since discretionary policy may be subject to various errors and political pressures, a pre-announced targeted path of nominal expenditure or monetary aggregates is the best central bank policy. Money is exogenous, non-neutral in the short run but neutral in the long run. I probably shouldn't even bother to say it, but Milton Friedman is the canonical Monetarist. It is an attractive, theoretically sound view but one that was called into question in the Volcker recession. It's main problem is that it too abstracts away from credit risk (and hence does not pay enough attention to V).

Let me stop here and leave the other 6 edges and the 6 faces for the next couple of posts.