Monday, March 08, 2010

Women's Reservation Bill & Socio-Political Policy

A bill proposing 33% reservation for women in India's national parliament and state legislatures was tabled by the ruling Congress Party in the Rajya Sabha (upper house) today. Currently, it is in the process of being stalled in decidedly uncivil ways by those opposed to the bill, some elected representatives of dubious history. For today, I am cheering on the goons. Let me explain why.

My political philosophy is utilitarian. With the assumption of the zeroth law of all modern political philosophy - that political rights to all the governed will be equal - a version of preference utilitarianism comes closest to describing an ideal social objective. Give the people what they want, but don't privilege anyone's wants over anybody else's.

To a first approximation, people want to be rich and productive, to own territory, to be free and yet safe (from the territorial ambitions of others) and to not be very disadvantaged compared to others. 'Sovereignty' best describes the combination of liberty, safety and territory. 'Dignity' best describes the combination of relative and absolute aspects of the egalitarian ideal (nobody should die of starvation, nobody should be *very poor* compared to others). Prosperity, sovereignty, dignity - these are the sometimes conflicting objectives of an ideal social utility or welfare function.

An existing social order or legal status quo may be discriminatory. Women may be discouraged from ever thinking about a business or public career - some of them may be much better at the job than the present incumbents. Talented children of a disadvantaged background may never speak English as well as many urban nincompoops, curtailing their career options as well as national productivity. A legitimate farmer may have been dispossessed of his land to benefit an incapable land-owner two centuries ago by a foreign sovereign that is no longer recognized in the country. These are all impediments not just to the dignity of the people concerned (share of the pie), but also the prosperity of the entire society (size of the pie). Correction of a discriminatory social order can thus be a justified goal of policy for the purpose of both prosperity and dignity. The question is - what needs to be corrected and how best to do it?

Most discriminatory social orders manifest themselves as endowment failures. A policy that attempts to correct such an order while maximizing the combination of prosperity and dignity must aim at removing the relevant endowment failure, setting the equilibrium of the outcomes to be determined freely. Top-down reservations, of the kind embodied in the women's reservation bill, attempt to directly force outcomes - assuming that the endowment failures will then auto-correct. They end up maximizing neither prosperity nor dignity.

The most pervasive endowment failure is being born in poverty. Correcting for that - in the form of transfers and subsidies or economic status based reservations and affirmative action - is the highest RoI policy that one can have. This is a good case to support economic status based policy as opposed to caste based or gender based reservations, but it is not complete. Discriminatory social orders can often lead to significant endowment failures beyond poverty. A poor 'forward caste' student is much more likely to have indirect endowments - wealthy, well-educated, networked relatives or friends - than a poor 'backward caste' student. A poor boy will probably get to study in that good college away from home, a poor girl will be asked to drop out of school.

A case can thus still be made for reservations on the basis of gender or caste. Especially, if the reservation is in the law-making body of a representative democracy, where one can argue that the aim itself is 'representation' and not just efficient law-making. It's not a clinching argument, but it is one worth considering. And one must remember that the correct axis of representation is political aspiration, not any other part of your identity.

This argument thus does not really work for gender. Whatever is your preferred level of governance - the nation, the state, the local administration - geographical proximity is the best proxy we have for maximum shared political interests. Caste is rather strongly correlated with geography in India, but gender is obviously not. The constituencies that are reserved for SC/ST candidates are constituencies that have a significant majority of SC/ST population. That is clearly not the case with men and women. It has been proposed to select the reserved constituencies on a rotational basis, but that simply reduces the incentive to get re-elected (and hence to work in the constituency at all).

The fundamental problem with the endowment and representative aspects of the bill then is two-fold - gender is a good proxy neither for poverty nor for shared political aspirations. Moreover, the extremely top-down nature of the proposed reservations means that the new equilibrium will be a classic case of the somewhat disadvantaged crowding out the very disadvantaged. Most of the women who will get to compete on the reserved tickets will be those that are already politically well-off. Men and women will become more equal, but currently powerful women and currently powerless women will become even more inequal. A similar thing happened with caste based reservations. Top down forcing of outcomes does not level the playing field - it actually degrades the most disadvantaged even further.

And until now, we haven't even considered the fact that just as many women who are not given a shot at a career must be abler than many men who are, many men may be better representatives of the political aspirations (of both men and women) of a reserved constituency than all the women candidates. There is a loss to the dignity of these men, and there is a loss of national prosperity. What is more, just like with caste based reservations, the issue will later become part of the entrenched politically correct 'non-partisan' consensus in the country with no hope of being eased out.

The long term solution to the endowment failure of Indian women is surely a general fall in poverty and a more equal social outlook. That is however a long term outlook. Even in the short term, however, there are many better ways - even within the flawed ambit of quantity reservations - to implement a more equal polity and social order. One of the best ones is to reserve not constituencies but electoral tickets : empower women through a chance at political success, don't assure them of the result.

Reservation of seats in the national and state legislatures is a step that improves dignity of some people (currently powerful women) at the expense of many others (currently powerful men, currently powerless women). The effects on national prosperity are equally questionable. The bill must not pass and some uncivil representatives, abhorrent as they may be, are currently our best hope.

p.s: What confuses me, though, is what is the political benefit that Sonia Gandhi sees from such a move. Even if women were to prefer women over men as their representatives, why will women in a reserved constituency vote for a Congress woman over women from the competing parties? Does Sonia Gandhi really believe that such a policy has net positive social gains and is acting upon that? Is she obsessed with the legacy of her dead husband, who first introduced such a proposal in the parliament? Will Congress gain a significant number of votes by being remembered as the party that empowered women? I highly doubt that.

p.p.s: As I finish writing this, it seems that the goons have succeeded, at least for now. Bravo!

Friday, February 19, 2010

On Buiter and the Crisis

In August 2008, a month before Lehman collapsed, Willem Buiter presented what he light-heartedly called the "longest paper ever" at the Jackson Hole Symposium. The paper made waves around the world for primarily two things. The first was its length, a staggering 141 pages. The second, and more substantive was its criticism of the handling of the crisis (until then) by the three main central banks in developed nations (the Fed, ECB and BoE).

I finished reading the paper two days back. For me, the best and the most striking parts of the paper were not those that dealt with a judgement on how the central banks had been handling the crisis. They were the connections that he makes between macroeconomic (output, price, inflation) stability, financial stability and the central bank's role in binding the two.

Buiter begins with the premise that in any financial crisis, the job is two-fold. First, the immediate damage to the economy at large has to be minimized. Next, the probability of occurrence of future such crises has to be minimized and better tools to deal with them have to be developed. He then offers (or borrows form others and integrates) several great insights on the linkages between macroeconomic and financial stability.

1) The short term interest rate is a blunt and indirect measure suitable for macroeconomic stability but not for financial stability.

2) Reserve requirements (or Cash Reserve Ratios) are a quasi-fiscal tax on banks when they offer no interest. When they offer interest, they can be used as tools of financial stability.

3) Asset price booms and busts are always asymmetric. So is the leveraging and de-leveraging of the financial system. Booms and leverage ratios always build gradually, though they can reach monstrous proportions. Busts and de-leveraging are much more rapid.

4) Asset price bubbles are driven, by definition, by non-fundamental factors. The short term interest rate is a fundamental determinant of asset prices and is thus too insensitive to be used to prick such bubbles.

5) It is not just huge commercial banks that are 'too big to fail' . Any reasonably large or inter-connected institution that has considerable leverage and the majority of its assets as financial assets are 'too systemic to fail'.

6) Two different but inter-connected kinds of liquidity crises can lead to and feed from a system-wide solvency crisis. One is funding liquidity, which occurs on the liability side. Here, a financial institution is not able to borrow overnight or short term to meet certain regulatory or business requirements. The other is market liquidity, which occurs on the asset side. Here, a financial institution is not able to sell an asset on its books in the market to get cash as the market for that asset has frozen. Clearly, the two kinds of liquidity are inter-connected.

7) The central bank has two functions in such a situation: as a lender of last resort (LLR) to solve a funding liquidity crisis, and as a market-maker of last resort (MMLR) to solve a market liquidity crisis.

8) A special resolution regime with prompt corrective action (PCA) measures is required to ensure that fundamentally insolvent financial institutions are allowed to fail (as solvency is a private good) without damaging the rest of the financial system and the economy.

9) In the LLR function and MMLR functions, central banks should be willing to accept as collateral and/or purchase and hold on their books large varieties of assets that may not be good today but will be good of held to maturity. The discount/lending rates on such lending and purchases should be punitively high.

10) Such lending and purchases have to be buck-stopped by the treasury, ideally by an immediate exchange of risky assets with sovereign debt between the central bank and the treasury. This is to ensure that the central-bank is not abused as a quasi-fiscal institution and the risk is undertaken on the books of an institution answerable to the democratically elected legislature.

11) The secured overnight inter-bank lending market (call money market in India or the Federal funds market in the US) exists mainly due to bizarre central bank procedures and is rather redundant. To set a truly effective official policy rate, central banks must be willing to borrow and lend any amount at that rate. Because central banks have punitive rates or quantity caps on the overnight lending and borrowing that they do from banks, effective risk free rates often diverge from policy target rates. (A good example of this is the call rate in India, which has been hovering between 2% to 3% for the last few months even though the reverse repo rate is 3.25% and repo rate is 4.75%.)

12) Any financial system has inside assets (where the asset and the liability are both financial in nature) and outside assets (where the asset is in the real economy and the liability is financial). Home equity and stocks are outside assets while home mortgages and debt instruments are inside assets.

13) The modern financial system has many layers and a majority of its assets are inside assets. Even a rapid de-leveraging of such a system can be sustained if it can be ensured that the effects don't spill over into outside assets. More importantly, the counter-cyclical policy measures to flood the markets with liquidity in a crisis need to be tempered by the fact that a lot of de-leveraging may simply involve inside assets.

14) Monetary and credit aggregates are important tracking tools and obsession with the short term interest rate is counter-productive.

Apart from these, he makes some other key points as well.

1) Lack of transparency in the pricing of illiquid collateral creates moral hazard problems. When coupled with the in-built adverse selection in the way the Fed prices these collaterals - it accepts the pricing of a clearing bank that is typically that is typically a business associate of the broker-dealer in question - the US had created the mother of all moral hazard problems even before Lehman went under.

2) Due to its failure to differentiate between inside assets and outside assets, the Fed reacts far too strongly to weak asset prices. Or, it has been 'cognitively captured' by Wall Street.

3) There is a structural break in the relationship between core inflation (doesn't include energy and food prices) to predict future headline inflation (includes everything). This is due to increased consumption by India and China. As a result, Fed's monetary policy has been too loose and as the financier of the world and the dollar-country, the US has been exporting this inflation elsewhere.

4) The US and UK have current account deficits as well as low-interest bearing assets. What this means is that the US and the UK are living on borrowed consumption being financed at effectively negative nominal and real interest rates! This won't continue for a long time. A massive outbreak of inflation will follow in the middle run (2-3 years) unless there is a structural change in the ratio of consumption to savings.

5) With foreign assets and liabilities at 500% of GDP, the UK is almost like a giant hedge fund.

Buiter also shows remarkable foresight when he contends that the fed funds rate (which was 2% then) might hit the zero lower bound soon enough, and that the worst is not over. He also makes the interesting proposal of de-linking reserves from currency, arguing that bank reserves kept with the central bank can pay a positive as well as negative interest (storage costs and security costs of cash will ensure that banks will not mind paying a small interest to the central bank to keep reserves). This could then free up the policy option to actually have a negative nominal interest rate to counter deflationary pressures.

Where I fail to understand Buiter is if he supports or opposes counter-cyclical capital requirements for financial institutions (which go up in times of plenty and down in times of crisis). Early on in the paper, he recognizes leverage as the key villain and endorses the Goodhart-Persaud proposal of counter-cyclical capital and liquidity requirements and extends it to all large leveraged financial institutions from just commercial banks. He also argues that such requirements should be based on rapid leveraged balance sheet growth of the institution in question and that national regulators can and should go beyond Basel II in ensuring this. Not much later, however, he takes his oft-repeated stance of 'liquidity is a public good, solvency is a private good' and argues that any extra liquidity requirements during good times to provision for the bad times is a privately and socially inefficient waste of liquidity. He also makes the same case in this blog-post, where he trashes precisely the kind of move by the FSA that he seemed to be supporting early on in the Jackson Hole paper. If his point is that liquidity provisioning in bad times cannot solely be a private endeavour then I agree, but he seems to be making the case that liquidity provisioning in bad times should be completely a public endeavour undertaken by the central bank which can create new liquidity almost costlessly. It is hard to understand how such a view reconciles with a support for counter-cyclical capital and liquidity requirements.

Nevertheless, this is probably the only paper in which one economist manages to form a coherent whole of a wide variety of divergent thoughts on the crisis. Read it at your own leisure. It will continue to be relevant long after this crisis is gone.

Monday, February 15, 2010

Macro Cube - 5

By the last post, we were done with all vertices, edges faces and even a diagonal of the macro cube.

The interesting faces were

1. Social Democrat (SD) : SF - NK - DK - PK
2. Wicksellian / New Keynesian (WNK) : NK - NMC - MD - DK
3. Walrasian / Classical Liberal (WCL) : NC - NMC - MD - NA
4. Disequilibrium : NA - MD - DK - PK

I had said my own view of the macro-economy and understanding resonates and draws most heavily from the Disequilibrium and the WNK views. Let me explain why.

Based upon whatever little I have understood, there seems to be a case for :

1) Privileging money over other goods, but only just.
2) Privileging aggregate demand in the short run, but only just.
3) Privileging the banking and financial system as having special properties, but only just.
4) Privileging disequilibrium and non-optimization as the usual state of the economy, but only just.
5) Being wary of excessive leverage and short-term debt, but only just.
6) Healthy trust of the markets and skepticism of the government, without giving into the temptation of policy nihilism.

I find this set of principles best satisfied in the Disequilibrium and WNK versions of the economy. For a near- compulsive centrist and a non-believer in ideas in that try to re-invent the wheel (like me), this view presents two additional advantages. One, it is just the right distance of right from centre. Two, trying to incorporate it into the mainstream should not be too difficult - one needs to begin with the saltwater orthodoxy and infuse it with heavy dollops of disequilibrium and the financial system.

I believe that the economist who best represents such a school of thought is Willem Buiter. Buiter wrote a set of four essays (1, 2, 3, 4) in September last year that anyone interested in solutions to the crisis must read. Buiter's classifies his recommendations for fiscal stimulus into a broad framework of 'equitization of debt', a set of strategies that boosts aggregate demand while reducing leverage. Apart from Buiter, the ones that make most sense to me in the crisis and in general are - Raghuram Rajan, Barry Eichengreen, Kenneth Rogoff, Janet Yellen, Tyler Cowen and Rajiv Sethi.

Rajan was among the initial advocates of the brilliant solution of systematically important financial entities being partially financed by securities that convert automatically from debt to equity when there is substantial systemic risk. There's a fabulous interview here. Eichengreen's coverage of the crisis as well as his take on the gold standard as the proximate cause of the great depression are terrific. Rogoff has co-authored the book that is now almost universally considered the bible on financial crises and is the most reasonable among those that warn of sovereign defaults due to fiscal profligacy. Yellen was Buiter's favourite for the Fed Governor post and has a series of excellent thoughts/ speeches on the crisis. Tyler Cowen's macro is as eclectic and delightful as the rest of his thoughts and Rajiv Sethi is the most financially nuanced of those who try to model the economy as a non-linear dynamical system.

There are some common frameworks that unite and inform the macroeconomics of this seemingly disparate set. One is a keen understanding of banks and financial markets. The other is a habit of looking at international capital flows and political economy while analysing and recommending policies. The third, and most important, is a commitment to policy centrism and epistemic openness.

The cube has helped me place the confusing views of a large number of economists that I read in a somewhat more cogent framework. Scott Sumner, for example, is a monetary disequilibrium (MD) theorist who believes in rational expectations. I think it's rather impossible to be any kind of a disequilibrium theorist with a belief in ratex so I bump him up to Mo (Monetarist) from MD. Bryan Caplan's macro is a Disequilibrium/WCL mongrel that will resonate with that of Prof. J R Varma. If you're concerned how the Paul Krugman who recommended inflationary expectations as a way out of the Japtrap is now such an avowed fiscalist, you need only to realise that the macro of Krugman the MIT-trained theorist is WNK but that of Krugman the political polemicist is firmly SD - overall, he is simply a Keynesian (K).

And if you read and find both Krugman and Caplan persuasive, may I suggest the Disequilibrium - WNK space that I place myself into?

Saturday, January 23, 2010

Macro Cube - 4

At the end of all the heavy-duty categorising of the last three posts, this is what the modified Macro Cube looks like. It is now labelled at the vertices and edges with the theories that they represent. These are

NC: New Classical ; NCh: New Chicago

NMC: New Monetary Consensus

NW: Neo-Wicksellian ; NK: Neo-Keynesian

FK: Folk Keynesian ; SF: Socialist Fiscalism

SS: Supply Side ; A: Austrian ; NA: Neo-Austrian

OC/FB: Old Chicago, Free Bankers

MD: Monetary Disequilibrium Theory

Mo: Monetarist ; MK: Monetary Keynesian

DK: Disequilibrium Keynesian ; K: Keynesian

MPK: Minsky-like Post Keynesian ; PK: Post Keynesian ; FF: Functional Finance Theorists

RFD: Real & Financial Disequilibrium

Now there's only the faces and one rather interesting diagonal to go. The faces are easier : these are a collection of theories that a very broad view/consensus represents and not any one theory.

1) SF - NK - DK - PK : This face has Keynes written all over it, and the unifying factor is their fondness for fiscal solutions. This is a left-of-centre view that has a few things going for it. I will call it Social Democrat (SD) macro. The leading theorist would be Joseph Stiglitz and the leading practitioner, Gunnar Myrdal.

2) NK - DK - MD - NMC: These theories are a collection of Neoclassical and Keynesian views of the economy that assign a special role to money and prefer monetary solutions to crises, but are ok with fiscal ones too. I will call it Wicksellian/New-Keynesian (WNK) macro, for a variety of reasons.

Knut Wicksell was the first modern macro theorist, and he tried to assimilate a wide range of the prevailing macro thoughts of his era into a cohesive framework, while coming up with the ideas of a natural rate of interest (through which he integrated the real sector and the monetary sector) and even endogenous money creation. He was inspired by the Austrian and the Ricardian views of the economy, but yet ended up influencing both Keynes and Schumpeter. Endogenous money seems to place him close to the Post Keynesians, while a focus on the short term interest rate places him firmly in Neo-Classical category. His debate with Fisher seems to indicate a Keynesian view of the economy, while his fondness for Walras indicates a Classical view. I have no doubt that had he followed rather than predated Keynes and modern central banks, he would be trying to come up with a theory that is in equal parts equilibrium and disequilibrium, equal parts Neoclassical and Keynesian. Hence, Wicksell.

The New Keynesians - I have struggles to place them somewhere. Everyone post Samuelson who may focus on aggregate demand - from Joseph Stiglitz to Michael Woodford - are called New Keynesians. I believe that's not a helpful way of looking at things. I understand New Keynesian theory as one that tries to integrate the Neo-Classical view of the economy with the Keynesian view. The equilibrium and rational expectations based efforts resulted into the neo-Wicksellian framework. But there are others, who modify these efforts in many interesting ways. Ben Bernanke and Mark Gertler, with their financial accelerator and credit channel view of monetary policy. Robert Gordon, with his distinctions between markets that approximate Neoclassical auction markets and those that don't. And Edmund Phelps, the granddaddy of them all, with his adaptive expectations view of multi-period optimization by economic actors. Even Greg Mankiw, who in this excellent essay expresses dislike for the complete markets and rational expectations view of the world. Phelps, Gordon, Bernanke, Mankiw - these are the true New-Keynesian theorists. And they lie in the middle of that MD-NMC-NK-DK face of the cube.

So, I will call this the Wicksellian/New-Keynesian (WNK) macro theory. I am also convinced that a less sophisticated version of WNK is the macro of my favourite political philosopher John Stuart Mill, as evidenced by his stance in the Bullionist controversy.

3) NC - NMC - MD - NA: This is a bunch of people united by their distrust of fiscal policy and in general the government, though they may approve of judicious monetary policy. I will call this Walrasian/Classical Liberal (WCL) macro. This is more or less the 'Classical' view that Keynes disapproved of and that forms the most direct political opposition to a social democrat system. For the most sophisticated macro-model of this view - one that tries to incorporate asset prices into general equilibrium - we have to turn towards Fischer Black. This paper summarizes some of more important ideas of Black's magnum opus, which has been referred to approvingly recently by Tyler Cowen. Margaret Thatcher would be the leading politician whose government had a WCL approach to the economy.

4) NC - NA - PK - SF: This divergent group of theories is united by a distrust of expansionary monetary policy, a focus on production and supply rather than consumer demand, and not much else. I am going to call them Non-Monetary theorists and leave it at that.

5) NC - NMC - NK - SF: A group of theories with widely divergent politics but united by the model-simplification of equilibrium and optimization. Various versions of freshwater, saltwater and socialist thoughts keep indulging into such models but if we are to truly make sense of the world economy, equilibrium must go.

6) NA - MD - DK - PK: The best for the last. How does one unite Hayek and Keynes? Or listen to Bill Woolsey and Steve Keen at the same time? Or indeed, Schumpeter and Patinkin? Well you drop the assumption of equilibrium, open your mind to monetary aggregates, interest rates and credit risk at the same time, and try to incorporate balance sheets and the financial system into your version of the macro-economy. Incredibly difficult to formalize, but incredibly fruitful to conceive and follow. The disequilibrium dudes, of all hues, are the ones you turn to in a crisis in the modern financial economy.

And on this face, there is a very interesting diagonal: the one that leads us from Hayek (NA) to Minsky (DK). Along the diagonal, from Hayek(right) to Minsky(left of cente), you will successively find - Hayek, Arnold Kling (Recalculationist), Tyler Cowen (Austro-Keynesian), Willem Buiter (the golden mean), Axel Leijonhufvud (Keynesian) and then Minsky. Oh, and somewhere between Leijonhufvud and Minsky, I suspect, you will find Keynes himself.

Arnold has been arguing for some time that markets are self-correcting but they are slow adaptive systems, that monetary policy is useless in what is essentially a sectoral adjustment following over-investment into some sectors, and that inflation is round the corner. Tyler sympathises with Arnold's view but is less convinced about the ineffectiveness of monetary policy and generally less skeptical of government intervention.

Buiter is essentially a monetary theorist, but one who balances his fondness for monetary aggregates and interest rates with a keen understanding of the banking system, a deep respect for moral hazard problems and a healthy deference to the 'financial instability due to leverage' view of Minsky. To top it all, unlike most macro theorists, he never forgets to consider the international political economy when he makes a theoretical point or a policy recommendation. He also wrote the definitive essays on what I believe is the best way out of the current crisis, but more on that later.

Leijonhufvud proposes a 'corridor hypothesis' view of things in which the markets and the financial system self-correct if disturbances are small but can go out of range when exposed to large disturbances with no surety of coming back on their own. He was among the initial Keynesian theorists who expressed a dissatisfaction with the 'equilibrium' version of things. Not surprising then, that he has been appropriated both by Arnold Kling (of the real-disequilibrium story) and Nick Rowe (of the monetary disequilibrium story).

So that's it, the faces are all done. One could make a couple of further groups. If you combine Wicksellian/New-Keynesian macro with Social Democrat macro, you get Aggregate Demand (AD) macro. The single greatest insight of Keynes was to introduce and privilege demand in macro discussions, and Keynes is what SD and WNK macro have in common. AD macro abhors the gold standard and endorses the modern banking system with regulations. Unsurprisingly, if you combine Non-monetary and WCL macro, you get Aggregate Supply (AS) macro. AS macro is sympathetic towards either the gold standard, or full-reserve banking with no lender of last resort or deposit insurance, or free banking. Or all.

And finally, if you combine WCL and WNK macro, you get the old Classical view of the economy, which Keynes mis-characterized somewhat. Jean Baptiste Say did not believe in the Say's Law, David Ricardo disagreed with Ricardian equivalence and David Hume can be thought of as the first monetarist. The Classicals were skeptical of fiscal actions but not monetary, and had a more sophisticated (or paradoxically, more intuitive) understanding of disequilibrium than many modern mainstream macroeconomists.

I agree most with Disequilibrium and WNK macro, and in the next and final post of the series I will explain why.

Friday, January 22, 2010

Macro Cube - 3

In the last post, I covered 6 of the 12 edges of the macro cube. These were:

1) AB : Folk Keynesian (FK)
2) BC : Keynesian (K)
3) CD : Minsky-like Post-Keynesian (MPK)
4) DA : Functional Finance (FF)
5) BQ : Neo-Wicksellian (NW)
6) QR : Monetarist (Mo)

Let's cover the other 6 now.

7) CR : This is a set of theories that shares its preference for monetary solutions over fiscal ones in most cases with the neo-Wicksellian orthodoxy. However, some new dimensions are introduced. Some versions try to consider credit and the financial system; at any rate cash is an explicit feature of the economy. Money is thought to be especially privileged and could be exogenous or endogenous. Some versions of the theory have money as privileged as it is a medium of exchange/store of value (Nick Rowe, here and here). Others privilege it as it a medium of account (Bill Woolsey, here - though he is an MD theorist proper) or a numeraire. Some, like Brad De Long, worry about liquidity traps that may render monetary policy ineffective in extreme cases. Others, like Willem Buiter, worry that the tying up of a medium of exchange with a numeraire (or a 1 to 1 conversion between reserves and currency) unnecessarily curtails monetary policy options. At all times, the attempt is to merge Keynesian and Neoclassical views of money and the economy with heavy doses of disequilibrium. I will call these guys the 'Monetary Keynesians' (MK). The intellectual fountainheads of this theory are surely Irving Fisher (in the post-depression era) and Don Patinkin.

Now you may wonder how one can place an avowed monetarist like Nick Rowe in the same theory as an unabashed Keynesian like Don Patinkin. They are united, I believe, with their 'disequilibrium' and Keynesian approach to money. Remember, that the Keynes of 1930 was somewhat different from the Keynes of 1936. And of course, we have a spectrum - one third of the way from C to R is Patinkin, a further one-third away is Rowe. De Long is somewhere in between. This set of theories is very interesting and intellectually very attractive, though it may privilege money by just a tad too much.

8) RS: Alright, another interesting set of people and ideas. They treat the economy as if it is in disequilibrium, treat people as making sub-optimal choices and will yet not trust the government with fiscal stimulus, and only grudgingly with monetary actions. These have to be theorists who are skeptical of the government on not just utilitarian, but also moral grounds. Two distinct set of theories and theorists fit the bill almost perfectly - the Old Chicago (OC) school and the Free Bankers (FB). What I call Old Chicago is a set of people who had a unique and divergent take on the economy, but who were at the University of Chicago between the wars and formed one side of the intellectual opposition to Keynes - Frank Knight, Jacob Viner and Henry Simons. This forms the first wave of the Chicago-School, before the Friedman-Stigler era. They insisted on analytical rigour, yet regarded the future as inherently uncertain and volatile and defended capitalism on moral grounds.

The free bankers are a set of theorists who believe that private banks should have the right to have their own currencies and should operate with the minimal but hard constraint of full-reserve banking. Not only does this make money 'free' and 'sound', it also decentralizes monetary policy in a way that no central bank could hope to achieve. While some of the free bankers are general anarchists (Rothbard, David Friedman), the one I'm really looking at for the purpose of macro theory is George Selgin. He merged his understanding of Hayek and Leland Yeager to privilege money, but only just, and tried to show the tenuous links between 'free money' and 'sound money'. OC/FB theorists are sometimes likely to recommend a gold standard.

9) SP: Now, we have the Austrians (A). They understand that the economy may sometimes be in disequilibrium, but absolve such disequilibria of any great damages. They warn instead of greater future damages if credit bubbles are not allowed to die their natural death. Credit bubbles and the ensuing recessions are thought to arise from irrational investment decisions in the real sector and considered non-monetary, but may be stoked or aggravated by an irresponsible central bank. Deflations are not feared. Money is neutral for all practical purposes - though again, a central bank might create unnecessary illusions. This is a 'liquidationist' view of recessions - which prevents moral hazard problems but takes no account of the loss of social welfare and wealth, considering it a necessary readjustment. Governments and central banks don't have much of a role in such readjustments - though they can make it worse by unnecessarily stoking inflation through monetary and fiscal measures. Hence, neither are recommended. This is a quirky, consistent, far-right view that is unnecessarily fearful of government action and does not consider the demand-side at all. The Austrian theory of heterogeneous capital, sectoral re-adjustment and government skepticism has a ring of truth to it. But worrying about inflation in a crisis might just be akin to - as Robert Skidelsky put it - crying 'Fire' in Noah's flood, and adherence to the gold-standard is too deflationist.

Krugman blames them for much of the damage caused by the Hoover-Mellon administration in the Great Depression. Though that might be uncharitable, the Austrians are far too right for my liking, despite some interesting ideas. Rothbard and Bohm-Bawerk are the canonical Austrians. Hayek, I would place at vertex S, as a Neo-Austrian.

10) PQ : What lies between the New Classicals and the New Monetary Consensus? Why, the New Chicago (NCh) guys, of course. By this, I refer to Robert Lucas, Robert Barro, John Cochrane and everyone else who believes that markets almost always self-correct, fiscal policy is useless due to corruption and/or Ricardian equivalance and monetary policy may be used, but only judiciously. These are essentially the third generation of Chicago economists - the first being Knight et al, the second being Friedman-Coase-Stigler et al. As theorists who refuse to leave rational expectations and optimization, and would rather treat recessions as some "episodes" (Lucas) or "residuals" (Barro) they are far-right, far too theoretical and seemingly more concerned with precision than relevance. Though they are far too trusting of the efficiency of markets, some of their more sombre ideas have meat - as can be witnessed in this recent interview, for example.

11) AP: Between socialist fiscalism and the New Classicals - the most left-wing and the most right-wing of our theories here - there can't be any one cogent theory. So, I will use the 'spectrum' view of things one more time. As we move from left to right, on a path that eschews monetary policy and doesn't have a good disequilibrium theory of the economy, we will first meet some naive centrists who would think of deficit spending in crises but not of interest rate cuts. There aren't many academics who would hold this view, but enough laymen. They are fiscalists, but trust markets to do the job in normal times. They aren't very interesting.

But further down right, there's a set of theories that is very non-monetary and equilibrium-driven in its approach but favours fiscal policy, albeit not deficit spending. Yes, we are talking about the 'cut-taxes-please' Supply Siders (SS) - people like Jude Wanniski and Arthur Laffer. Krugman once called them snake-oil theorists, and I am tempted to agree. We should remember, though, that when times are good focusing on the productive capacity of the economy as opposed to simply consumer demand might be important. In a crisis, this theory has nothing to add.

12) SD: This is a rather broad spectrum too, with the Neo-Austrians on the right and the Post-Keynesians on the left. But there are many common themes that unite them. One is surely the idea of heterogeneous capital that makes monetary aggregates irrelevant and credit risk important. The other is a distrust of the financial sector, as well as of monetary policy's effectiveness in solving problems arising out of the financial or the real economy. The result - you often see these theorists worry about excessive credit, moral hazard, big banks and inflation expectations. For this crisis, whether they blame the government or the financial sector is more or less a question of political ideology rather than theory, for the theory is often the same. Apart from the Austrians and the Old Chicago school, this is also the set of people most likely to recommend the gold standard as a way to prevent the potential debauchment of the price level by central banks. If you begin from S and start moving to D, you might first encounter Joseph Schumpeter, then someone like V Anantha Nageswaran and further to the left, Simon Johnson and James Kwak of the Baseline Scenario blog. It's a very interesting set of theories, but one that I find most useful when I consider them along with the Monetary Keynesians.

I don't really know what to call them - Real & Financial Disequilibrium (RFD) theorists is the best I can come up with.

Phew, all edges done. The faces for the next post.

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.