By 1988, it was already obvious that equilibrium business cycle theory had failed. Shiller had already circulated his devastating demonstration that asset prices were much too volatile to be explained by fundamentals, and the 1987 market crash had provided an object lesson in panic. Also, by the way, the savings and loan mess was illustrating the problems with inadequate financial regulation.
And nothing happened. Real business cycle theory continued to prosper, developing an increasing stranglehold over the professional journals. Behavioral finance stayed on the margins. The equilibrium guys had learned nothing and forgotten nothing; and by the time 2008 came around, the ravages of time had left people who actually understood demand-side shocks much thinner on the ground than they had been 20 years earlier.
I think this analysis is largely right, although the savings and loan mess can better be described as the product of excessive financial regulation (interest rate caps, and various rules that kept the S&Ls from diversifying their portfolios) followed by lamebrained deregulation. I’d also put the battle between “equilibrium guys” and “people who actually understood demand-side shocks” (which Krugman hasreferred to elsewhere as freshwater vs. saltwater economics) in different terms: It’s really about longrunonomics vs. shortrunonomics.
Longrunonomics is what’s also referred to as neoclassical economics, the logical, elegant study of incentives, utility, and equilibrium that has formed the core of the discipline for 150 years. It’s not wrong. It’s not useless. But as it doesn’t envision the existence of crises or panics or “demand shocks,” it’s not much help when the economy is confronted by such plagues. It’s reached the point that it feels like cliché to quote John Maynard Keynes, but he did say it best, back in 1923, right after that famous sentence about us all being dead in the long run:
Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
And so Keynes devised a new, less elegant sort of economics for tempestuous times, and in the 1930s began gathering disciples by the boatload (especially in the U.S.). This shortrunonomics coexisted with longrunonomics according to a taxonomy devised by Norwegian Ragnar Frisch. There was macroeconomics to deal with big, economy-wide issues where shortrunonomic factors often seemed to dominate, and microeconomics for the smaller but more timeless questions.
Because it was so much more elegant and logical, though, microeconomics increasingly attracted the sharpest students. And when the prescriptions of the macroeconomists seemed to stop working in the 1970s, young microeconomists leapt into the breach and reasserted the primacy of longrunonomics over the big-picture as well as the small. To a certain extent they were right to do so: central banks can’t forever trade off higher inflation for lower unemployment; you can’t goose an economy forever with government deficits; high tax rates will seriously distort behavior and crimp growth over time. The long run wins out eventually.
But the short run still matters too. And Krugman is right that, from the 1970s through the 1990s, short-run issues got increasingly short shrift from economists. That began to change with the various financial scares and crises and depressions of the 1990s, but as most of those occurred overseas and didn’t seem to impact the U.S. economy, many economists in academia and in government in the U.S. and Europe blithely continued in their belief that only longrunonomics mattered. It’s no coincidence that Krugman, Nouriel Roubini and Barry Eichengreen, who have done a far better (albeit far from perfect) job of charting the course of the Great Recession than most, all actually spent time studying the overseas crises of the 1990s rather than just celebrating the boom times at home.
But shortrunonomics, while more useful in times like these than longrunonomics, remains something less than (or maybe more than) a science. Keynes biographer Robert Skidelsky, in his 2009 book Keynes: The Return of the Master, urged that students of macroeconomics be required to take courses outside the discipline — in history, in philosophy, in politics — because economics so clearly didn’t have all the answers to the questions they sought to answer. As a non-economist who knows more about history and politics than most economists, I can’t help but like that idea. It doesn’t offer much hope, though, for clear guidelines to macroeconomic decisionmaking.
This week’s tax deal in Washington was pure shortrunonomics — putting more cash in the hands of American consumers to get them to spend now while running up bigger government debts that will have to be paid for later. Given the current economic situation — high unemployment, low interest rates, no inflation — that seems like the most sensible approach. But eventually it won’t be. Eventually, longrunonomic factors will matter more. And I don’t know of any handy formula that will tell us when that moment has come.
Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.
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