The end of macro magic
The International Monetary Fund recently held a conference that should concern most people despite its arcane subject — "Rethinking Macro Policy II." Macroeconomics is the study of the entire economy, as opposed to the examination of individual markets ("microeconomics"). The question is how much "macro" policies can produce and protect prosperity. Before the 2008-09 financial crisis, there was great confidence that they could. Now, with 38 million unemployed in Europe and the United States — and recoveries that are feeble or nonexistent — macroeconomics is in disarray and disrepute.
Among economists, there is no consensus on policies. Is "austerity" (government spending cuts and tax increases) self-defeating or the unavoidable response to high budget deficits and debt? Can central banks such as the Federal Reserve or the European Central Bank engineer recovery by holding short-term interest rates near zero and by buying massive amounts of bonds (so-called "quantitative easing")? Or will these policies foster financial speculation, instability and inflation? The public is confused, because economists are divided.
Perhaps the anti-economist backlash has gone too far, as George Akerlof, a Nobel Prize-winning economist, argued. The world, he said, avoided a second Great Depression. "We economists have not done a good job explaining that our macro policies worked," he said. Those policies included: the Fed's support for panic-stricken financial markets; economic "stimulus" packages; the Troubled Assets Relief Program (TARP); the auto bailout; "stress tests" for banks; international cooperation to augment demand.
Fair point. Still, the subsequent record is disheartening. The economic models that didn't predict the crisis have also repeatedly overstated the recovery. The tendency is to blame errors on one-time events — say, in 2011, the Japanese tsunami, the Greek bailout and the divisive congressional debate over the debt ceiling. But the larger cause seems to be the models themselves, which reflect spending patterns and behavior by households and businesses since World War II.
"The events [stemming from] the financial crisis were outside the experience of the models and the people running the models," Nigel Gault said in an interview. (Gault, the former chief U.S. economist for the consulting firm IHS, was not at the conference.) The severity of the financial crisis and Great Recession changed behavior. Models based on the past don't do well in the present. Many models assumed that lower interest rates would spur more borrowing. But this wouldn't happen if lenders — reacting to steep losses — tightened credit standards and potential borrowers — already with large loans — were leery of assuming more debt. Which is what occurred.
"We really don't understand what's happening in advanced economies," Lorenzo Bini Smaghi, a former member of the ECB's executive board, told the conference. "Monetary policy [policies affecting interest rates and credit conditions] has not been as effective as we thought." Poor economic forecasts confirm this. In April 2012, the IMF predicted that the euro zone (the 17 countries using the euro) would expand by 0.9 percent in 2013; the latest IMF forecast, issued last week, has the euro zone shrinking by 0.3 percent in 2013. For the global economy, the growth forecast for 2013 dropped from 4.1 percent to 3.3 percent over the same period.
Since late 2007, the Fed has pumped more than $2 trillion into the U.S. economy by buying bonds. Economist Allan Meltzer asked: "Why is there such a weak response to such an enormous amount of stimulus, especially monetary stimulus?" The answer, he said, is that the obstacles to faster economic growth are not mainly monetary. Instead, they lie mostly with business decisions to invest and hire; these, he argued, are discouraged by the Obama administration's policies to raise taxes or, through Obamacare's mandate to buy health insurance for workers, to increase the cost of hiring.
There were said to be other "structural" barriers to recovery: the pressure on banks and households to reduce high debt; rigid European labor markets; the need to restore global competitiveness for countries with large trade deficits. But these adjustments and the accompanying policies are often slow-acting and politically controversial.
The irony is rich. With hindsight, excessive faith in macroeconomic policy stoked the financial crisis. Deft shifts in interest rates by central banks seemed to neutralize major economic threats (from the 1987 stock crash to the burst "tech bubble" of 2000). Prolonged prosperity promoted a false sense of security. People — bankers, households, regulators — tolerated more risk and more debt, believing they were insulated from deep slumps.
But now a cycle of overconfidence has given way to a cycle of under-confidence. The trust in macroeconomic magic has shattered. This saps optimism and promotes spending restraint. Scholarly disagreements multiply. Last week, a feud erupted over a paper on government debt by economists Kenneth Rogoff and Carmen Reinhart. The larger lesson is: We have moved into an era of less economic understanding and control.
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