Whither (-ed?, -ing?) macro economics

The governing paradigms of macroeconomic theory are in disarray.  Only in mainstream academia, and the Central Banking fraternity dominated by these dogmatists, has reality not forcefully intruded.  Unfortunately, government policy measures: spending, taxation, regulatory, and of course monetary, are in thrall to the Central Bankers.  Profound misunderstandings of economic realities dominate all financial decisions from capital spending to financial speculation to serious misallocation of education resources.  Over forty years, the gap between theory and reality has widened so far that rupture is inevitable. Trigger, timing, depth, duration and extent of the disruption are necessary subjects for speculation.

Macroeconomics at its height

Responding to the evident failure of Adam Smith’s invisible hand to make sense of the carnage of the great depression, Keynes revolutionized economic thinking with the publication of his General Theory of Employment, Interest and Money (1936). One of his radical notions was that national governments have an obligation to support aggregate demand and employment when the private economy is unwilling or unable to do so.

By 1970, confidence in the efficacy of macroeconomics was at its height.  Fiscal and monetary policy managers were confident in their ability to mitigate the Business cycle.  Freely operating markets permitted efficient price discovery, which directed optimal capital allocation.  Taxation policy was employed to permit appropriate sharing of the fruits of economic progress. Dr. Pangloss would have approved.

Central to the macroeconomic paradigm, the Phillips Curve described the clearly identifiable causal relationship running from employment (and growth) to inflation.  The policy objective was to run (no hubris here) the economy just strongly enough that prices did not erupt. All of this was possible in a world in which national boundaries enclosed economic activity, by and large isolating job and financial markets from external forces.

In 1971, this comfortable paradigmatic force field suffered its first major disturbance.  Unreasonably, some foreign governments requested that the US honour its commitment to exchange paper dollars into gold.  Reasonably, Nixon shuttered the gold window, releasing the inflation genii from its container.

Persistent disruptors in the force.

Repeatedly after 1971, world economies were battered by exogenous shocks.  [“Exogenous” is economist-speak for “that wasn’t in our model!”] Oil markets suffered the OPEC embargo of 1973 and the Iranian Revolution of 1979.  Over this six-year period, crude oil increased from around $3 per barrel to briefly over $100 in December 1979. In response, wage rates escalated sharply and financial contracts began to contain inflation-adjustment clauses.  Attempting to mitigate increasing interest rates, Central Bankers reluctantly but persistently provided liquidity to the banking system and thus validating inflation that averaged 6% for several years..

Until they didn’t!.  Chairman of the US Federal Reserve Paul Volcker, appointed in 1979 to regain control of the financial system, starved the banking system of liquidity forcing short term interest rates as high as 20% in June 1980.  Severe recession ensued, initiating the long process of declining interest rates and inflation.

Reverberations and oscillations triggered by these tectonic events were evident for many years.

Flailing about, and failing – a Flailure

Today, macroeconomic theory and all the endeavours that rely on it are in disarray.  The overarching symptom of flailure to achieve coherent theory consensus is that Central Bankers have totally upended the basic Phillips relationship that price inflation is the result of excessive growth.  Central Bankers are now dedicated to the proposition that inflation must be stimulated to achieve growth and employment. Their extreme focus on financial markets fails to provide any basis for capital spending or policy direction, serving only to fan the flames of financial market speculations.   In this policy vacuum, one-eyed Central Bankers are leading the blind.

After eight years of massive global monetary stimulation and anemic growth, is it unreasonable to demand a reexamination of the underlying proposition in the light of evidence, or at least caution in the prosecution of monetary experimentation?  Apparently so.

Is there a reconstituted macroeconomics in our future?

It may be that our system has become impossibly complex.  Economists have always relied on repeatable generalizations to formulate their theories.  It may be that elegant theories hubristically masked complexity. If there is to be revitalized and useful theory, it will have to account for several profound changes to the realities that confronted Keynes and his (neo-Keynesian) successors at the peak of their confidence.  

1. As a quantitative social science, economics relies on data – data estimated on the basis of national surveys, themselves constructed on the basis of certain theory-based assumptions.  What is to be understood of a Canadian assembled Honda made of parts sourced from multiple countries and sold in the US? National boundaries and therefore statistics mean progressively less.
2. The global labour force has rudely intruded into the developed economies – and will continue to do so.  This is the force that creates precarious employment and declining income for the middle class. Originally, low wage rates attracted plant and equipment capital to the offshore.  Increasingly, this effect has morphed into higher skilled sectors – call centres, accounting and legal services, software development – any activity in which technology has diminished distance.  National attempts to accelerate domestic jobs and wages are fighting an uphill battle.
3. The demographic growth rates of most developed economies have fallen close to zero, and not considering immigration, many nations actually have falling populations.  Is growth a sensible policy objective?
4. Driven by the massive explosion of liquidity since 1971, Capitalism has morphed into “Financialism”.   Always loosely defined, capitalism used to be about bringing together large projects to produce some economic goods and generally relying on equity and debt markets.  These companies hired workers, paid taxes and contributed to economic well being. Progressively, the central role played by this type of enterprise has been diminished in favour of financial activities.  Derivative transactions, speculation and financial employment now dwarf manufacturing. Macroeconomists have been unable to comprehend this global financial world.
5. National regulators are ineffective in the face of global arbitrage activities.  Witness the global banks skittering from London to Frankfurt and Belfast, big Pharma doing reverse takeovers to change domicile of their corporate offices for tax advantage, Apple borrowing unneeded funds to raise US costs while keeping profits in a relatively low-tax environment.
6. Even cherished concepts such as “inflation” are bordering on meaningless.  The Central Bankers’ attempts to stoke inflation has been spectacularly successful if measured by financial asset inflation.  Wage inflation, restrained by the global labour force, not so much. Industrial prices, since the Derivative Crisis of 2008, have experienced deflation.

Whither economic policies?  Agnosticism might be a good starting point.