Professor John Quiggin continues his examination of archaic economic models that have been ineffectual since the Global Financial Crisis.
IN THE IMMEDIATE aftermath of the Global Financial Crisis, I started work on a book looking at bad economic ideas that had been, as I thought, finally killed by the crisis. These ideas formed part of a package variously known as neoliberalism, economic rationalism and (my preferred term) market liberalism.
As the book progressed, however, I realised that these ideas were being reanimated in zombie form (a term I borrowed from Paul Krugman, winner of the economics Nobel award, as well as being a columnist for the New York Times). So, the title of my book was changed to ‘Zombie Economics: How Dead Ideas Still Walk Among Us’.
In previous instalments, I’ve looked at the Great Moderation (the idea that the economy of the early 2000s had reached a new and permanent state of stability) and the efficient market hypothesis (which stated that financial markets always make the best possible estimate of the value of any investment, public or private). The two were tied together by the idea that it was the massive size and sophistication of financial markets that produced the Great Moderation.
The other supposed source of the Great Moderation, closely related to the financialisation of the economy, was successful macroeconomic management by central banks like the Reserve Bank. The key idea was to set a target band of inflation rates (in Australia between two and three per cent) and use modest adjustments to interest rates — in Australia’s case, the “cash rate” at which the RBA lends to commercial banks in order to keep inflation within the target range.
The macroeconomic model underlying this approach went by the grandiose name of Dynamic Stochastic General Equilibrium (DSGE). “Dynamic” means over time, “stochastic” means under uncertainty and “general equilibrium” describes the balanced state towards which the economy supposedly tends in the absence of government mismanagement. The idea is that people (described in the model as “representative agents”) make lifetime plans for work, consumption and saving taking account of everything that can possibly happen, then interact in markets which determine equilibrium prices.
DSGE modellers don’t believe this hyper-rational model is actually correct, but they come close. The aim of the game is to make small tweaks to the model which allow it to match critical features of the economic data and derive suggestions for central bank policy as a result. This worked well enough during the calm years of the Great Moderation to build up an industry within the economics profession which drove most of its competitors, such as old fashioned Keynesians, out of business. But the model breaks whenever it encounters a real, unpredictable crisis.
The Global Financial Crisis should have killed off both DSGE modelling and inflation targeting. Contrary to the model, the economy regularly generates massive shocks that can’t be managed by tweaking interest rates. For a short time after the crisis, post-Keynesian models like those of Hyman Minsky came to the fore. But the DSGE school was too firmly entrenched to be dislodged. Doubtless, it will carry on despite the evidence of the current pandemic that uncertainty can’t be tamed by the well-defined probability distributions used in DSGE.
The case of inflation targeting is even worse. The policy has been in a state of zombified suspended animation ever since the GFC. Interest rates have been near zero, or even negative in some countries and inflation has been stubbornly below the target range (not a problem contemplated when the policy came in). The result is that conventional monetary policy is largely ineffectual.
The Reserve Bank recognised the difficulty some time ago and has been calling for governments to spend and invest more instead of obsessing about largely meaningless measures of budget surplus. After ignoring these pleas for years, the Morrison Government was commendably swift in its response to the pandemic, with temporary spending measures amounting to more than $200 billion.
But, as with the GFC, economic policymakers are still operating on the basis that the pandemic crisis is a once-off exception and we will soon be able to return to the illusory “normality” of the Great Moderation. But crises like this are the rule, not the exception. Unless governments and central banks commit themselves to achieving and maintaining full employment, the zombie ideas of market liberalism will continue to wreak havoc.
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