ZOMBIE ECONOMICS

Zombie Economics:
by Professor JOHN Quiggin



Chapter 3: Dynamic stochastic general equilibrium

· British Liberal politician Sir William
Harcourt observed ‘we are all socialists now’. Harcourt was referring to a radicalland reform measure that had been denounced as ‘socialist’ when it was
introduced, but was generally accepted by the time he was speaking (a couple of
years later). Harcourt’s point was applicable to the whole trend of economic and
social policy, in Britain and elsewhere, from the 1867 Reform Bill that gave
millions of working class men the vote (women had to wait until after World War
I) to the crisis of the 1970s.
notable adaptations of Harcourt was that of Time
I) magazine in 1965,
· Nixon’s statement marked the end of the era of
Keynesian dominance. Nixon was citing Keynes’ aversion to the gold standard (a
‘barbarous relic’) as a justification for abandoning the pegging of the US dollar to
gold. The gold peg was a central feature of the Bretton Woods system of fixed
exchange rates that had underpinned Keynesian economic management since
World War II. The outcome of Nixon’s move was not a system of stable exchange
rates backed by a basket of commodities rather than gold, as Keynes had
proposed, but the complete breakdown of Bretton Woods and a shift to the
floating exchange rate system advocated by the greatest critic of Keynesian
economics, Milton Friedman.

· In the course of the 1970s, Friedman and his supporters, centered on the
University of Chicago, won a series of political and intellectual victories over the
Keynesians. Following the failure of attempts to stabilize the economy using
Keynesian fiscal policy, governments around the world switched to Friedman’s
preferred remedies based on controlling the growth of the money supply.

· Keynesian Robert Solow, who observed ‘Everything
reminds Milton of the money supply. Well, everything reminds me of sex, but I
keep it out of my papers.’ Money supply targeting did not work particularly well, and was later replaced by policies based on managing interest rates, but the resurgence of the Chicago School was not reversed. Their case against government intervention, both to stabilize the macroeconomy and to address market failures in particular industries, was widely accepted.

· The Keynesians conceded Friedman’s central points: that inflation is
driven by the money supply, and that macroeconomic policy can affect real
variables, like the levels of employment and unemployment, only in the short run.

· The main Keynesian response to the intellectual and policy defeats of the
1970s was to develop a ‘New Keynesian’ economics. The central idea was that,
given small deviations from the competitive market assumptions of the basic
neoclassical economics model, it would be possible to explain the recurrence of
booms and recessions and to justify the modest stabilization policies pursued by
central banks during the Great Moderation
Friedman was never truly a freshwater[i] economist. Most importantly, while he opposed active use of fiscal policy, he supported the use of monetary policy to maintain medium term economic stability. Friedman’s intellectual descendants of the freshwater school sought to push his arguments to their logical conclusion, arguing that macroeconomic policy could not be beneficial even in limited role he proposed. They tried to show that government intervention could only add uncertainty and instability to the economic system, and that, in the absence of such intervention, economic fluctuations like booms and slumps were actually good things, reflecting
economic adjustments to changes in technology and consumer tastes. This is called ‘Real Business Cycle Theory’.

· Despite their often heated debates, saltwater and freshwater economists
agreed on one fundamental point: that macroeconomic analysis must be based on
the a foundations of neoclassical microeconomics. Both schools took it for granted
that macroeconomic management should be implemented through the monetary
policies of central banks, that the only important instrument of monetary policy
was the setting of short-term interest rates, and that the central goal of
monetary policy should be the maintenance of low and stable inflation

· saltwater economists argued that stability could only be
achieved if central banks paid attention to output and employment as well as
inflation whereas freshwater school favored an exclusive focus on
price stability.

· The saltwater school could claim vindication for their view that the economy is not inherently stable. However, their models had little to say about the kind of crisis we have actually observed, driven by an interaction between macroeconomic imbalances and massive financial speculation.

· If we are to develop a macroeconomic theory that can help us to understand economics crises and improve policy responses, economics must take a different road from that it has followed since the 1970s

Says law said: Recessions are impossible since supply create its own demand.
The labour force looking for a job, and therefore adding to the supply of labor. According to the classical view of Say’s Law, this new worker plans to spend the wages he or she earns on goods and service produced by others, so that demand is increased by an exactly equal amount. Similarly, any decision to forgo consumption and save money implies a plan to invest. So, planned savings must equal planned investment and the sum of consumption and savings must always equal total income and therefore can’t be changed by policy. If prices are slow to adjust,
there might be excess supply in some markets, but implies that, if so, there must
be excess demand in some other market. It is this idea that is at the core of
general equilibrium theory.

· The very first developed ‘general equilibrium’ theory is by French economist, Leaon Walras (1870s). Walras in favor of socialism but his general theory of general equilibrium used by advocates for laize fair that even it subject to severe shocks, the economy would always return to full employment unless it was prevented by the wrong moves of the government or actions of the union making the wage higher than the market price. Arrow and Debreu are his disciples(1950s)
· The point of Keynes title is that the general equilibrium was not general enough. The fully general theory of employment must give account of the recession states where unemployment remains high without tendency to return to full employment.
· Simplest version of Keynesian economics, equilibrium can be consistent with sustained unemployment because, unlike in the classical account of Say, the demand associated with workers’ willingness to supply labour is not effective and does not actually influence the decisions of firms. So unsold goods and unemployed labour can co-exist. Such failures of co-ordination can develop in various ways, but in a modern economy, they arise through the operation of the monetary system.
· Keynes observed, savings initially take the form of money. If lots
of people want to save, and few want to invest, total demand in the economy will fall below the level required for full employment. Actual savings will equal
investment, as they must by the arithmetic of accounting, but people’s plans for
consumption and investment may not be realized.

· Paul Krugman’s description of a babysitting co-operative in Washington DC, where babysitting credits worked as a kind of money. When members of the group tried to build uptheir savings by babysitting more and going out less, the result was a collapse of demand. The problem was eventually addressed by the equivalent of monetary expansion, when the co-operative simply issued more credits to everyone, resulting in more demand for babysitting, and a restoration of the original equilibrium.



· the second part of Keynes’ analysis shows that the monetary mechanism by which equilibrium should be restored, may not work in the extreme recession conditions referred to as a ‘liquidity trap’. This concept is illustrated by the experience of Japan in the 1990s and by most of the developed world in the recent crisis. Even with interest rates reduced to zero, banks were unwilling to lend, and businesses unwilling to invest


· During periods of recession, Keynesian analysis suggested that
governments should increase spending and reduce taxes, so as to stimulate
demand (the first approach being seen as more reliable since the recipients of tax
cuts might just save the money). On the other hand, during booms, governments
should run budget surpluses, both to restrain excess demand and to balance the
deficits incurred during recessions. But the work of John Hicks and others
produced what came to be called the Keynesian–neoclassical synthesis. In Hicks’
synthesis, individual markets were analyzed using the traditional approach, now
christened ‘microeconomics’, while the determination of aggregate output and
employment was the domain of Keynesian macroeconomics.



· The Bretton Woods system was based on fixed exchange rates between
different currencies, ultimately anchored by the requirement that the US dollar
be exchangeable for gold at a price of $35 an ounce. The Bretton Woods
agreements also established key international economic institutions, most
importantly the International Monetary Fund, the World Bank and the
precursors of the World Trade Organization. By 1970, the Bretton Woods system was under serious pressure. Inflation
in the United States had rendered untenable the commitment to hold the price of
gold at $35 an ounce. Previous episodes of inflation had been brought under
control quite rapidly through Keynesian contractionary policies. Unfortunately,
these policies were becoming less effective as inflationary expectations became
embedded and as the social restraint generated by memories of the Depression
broke down.

· The 1970s and 1980s were decades of high unemployment and inflation.
The ugly term ‘stagflation’ (a portmanteau word derived from ‘stagnation’ and
‘inflation’) was coined to describe the appearance of these two economic evils
simultaneously, rather than as part of a cycle of inflationary boom and
deflationary bust


· In his famous and influential pamphlet, How to Pay for the War, Keynes
argued that inflation was the product of an excess of demand over supply The
appropriate policy response, he suggested, was for governments to increase taxes
and run budget surpluses, to bring demand into line with supply.

· Since wages account for the majority of production costs, rapid wage
inflation also implies rapid price inflation. The higher the rate of unemployment,
the lower the rate of wage growth. However, because workers generally resist
outright cuts in wages, the curve flattens out. As unemployment increased more that a certain point(5 to 10%) its deflationary pressure diminishes.


· Despite his reputation as an exponent of (literally) ‘hydraulic’
Keynesianism, Phillips did not endorse a mechanical interpretation of the curve.
He is said to have remarked that ‘if I had known what they would do with the
graph I would never have drawn it’. The leading American Keynesian economists
of the day, Paul Samuelson and Robert Solow, were less cautious, particularly in
their popular writing.

· Friedman and Phelps suggested that the beneficial effects of
inflation were the product of illusion on the part of workers and employers. And,
by implication, they suggested that their Keynesian colleagues were subject to a
more sophisticated form of the same illusion. Friedman argued that exploitation of the Phillips curve could not work for long, because expectations of inflation would eventually catch up with reality.




· One of the first and most extreme applications of the rational
expectations idea was put forward in 1974 by Robert Barro11. Barro’s adoption of
the rational expectations approach was all the more striking because his early
work, with Herschel Grossman on the macroeconomics of disequilibrium, was
widely seen as the most promising way forward for Keynesian macroeconomics. New Classical school key idea was to replace Friedman’s adaptive model of expectations with what they called ‘rational expectations’, which, in its strongest form, required all participants in an economy to have, in their minds, a complete and accurate model of that economy


· Barro’s big contribution, in an article published in 1974, was to focus on
theory rather than reality and suggest that what he called ‘Ricardian
equivalence’ actually holds in practice.
Econometric testing strongly rejected the “Ricardian equivalence’
hypothesis, that current borrowing by governments would be fully offset by
household saving. Some tests suggested that borrowing might result in moderate
increases household saving, but others showed the exact opposite.


· Economist John Muth saw a problem. In the cobweb model, farmers
expect a high price this season to be maintained next season, and so produce
high output. But this is a self-defeating prophecy, since the high output means
that the price next season will be low. Why, Muth, asked would farmers keep on
making such a simple, and costly, mistake?

· Economist John Muth saw a problem. In the cobweb model, farmers
expect a high price this season to be maintained next season, and so produce
high output. But this is a self-defeating prophecy, since the high output means
that the price next season will be low. Why, Muth, asked would farmers keep on
making such a simple, and costly, mistake? Fifty years later, the debate between advocates of bounded rationality and of rational expectations is at centre stage in macroeconomics. But, for more than a decade, neither of these ideas received much attention. Rational expectations was the first to come to the fore.

· The first attempt, Real Business Cycle theory emerged in the early 1980s
as a variant of New Classical economics. The Real Business Cycle literature
introduced two big innovations, one theoretical and one technical.



22

Five Zombie Economic Ideas That Refuse to Die
Two years after the financial crisis, the U.S. economy has steered clear of total disaster, with the Dow Jones industrial average currently near its pre-crash level. But the theories that caused it all are still out there, lurking in the shadows.
BY JOHN QUIGGIN OCTOBER 15, 2010
The global financial crisis that began with the collapse of the U.S. subprime mortgage market in 2007 ended by revealing that most of the financial enterprises that had dominated the global economy for decades were speculative ventures that were, if not insolvent, at least not creditworthy.
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Much the same can be said of many of the economic ideas that guided policymakers in the decades leading up to the crisis. Economists who based their analysis on these ideas contributed to the mistakes that caused the crisis, failed to predict it or even recognize it when it was happening, and had nothing useful to offer as a policy response. If one thing seemed certain, it was that the dominance of the financial sector, as well as of the ideas that gave it such a central role in the economy, was dead for good.
Three years later, however, the banks and insurance companies bailed out on such a massive scale by governments (and ultimately the citizens who must pay higher taxes for reduced services) have returned, in zombie form. The same reanimation process has taken place in the realm of ideas. Theories, factual claims, and policy proposals that seemed dead and buried in the wake of the crisis are now clawing their way through the soft earth, ready to wreak havoc once again.
Five of these zombie ideas seem worthy of particular attention and, if possible, final burial. Together they form a package that may be called "market liberalism," or, more pejoratively "neoliberalism." Market liberalism dominated public policy for more than three decades, from the 1970s to the global financial crisis. Even now, it dominates the thinking of the policymakers called on to respond to its failures. The five ideas are:
The Great Moderation: the idea that the period beginning in 1985 was one of unparalleled macroeconomic stability that could be expected to endure indefinitely.
Even when it was alive, this idea depended on some dubious statistical arguments and a willingness to ignore the crises that afflicted many developing economies in the 1990s. But the Great Moderation was too convenient to cavil at.
Of all the ideas I have tried to kill, this one seems most self-evidently refuted by the crisis. If double-digit unemployment rates and the deepest recession since the 1930s don't constitute an end to moderation, what does? Yet academic advocates of the Great Moderation hypothesis, such as Olivier Coibion and Yuriy Gorodnichenko, have stuck to their guns, calling the financial crisis a "transitory volatility blip."
More importantly, central banks and policymakers are planning a return to business as usual as soon as the crisis is past. Here, "business as usual" means the policy package of central bank independence, inflation targeting, and reliance on interest rate adjustments that have failed so spectacularly in the crisis. Speaking at a symposium for the 50th anniversary of the Reserve Bank of Australia this year, European Central Bank head Jean-Claude Trichet offered the following startlingly complacent analysis:
We are emerging from the uncharted waters navigated over the past few years. But as central bankers we are always faced with new episodes of turbulence in the economic and financial environment. While we grapple with how to deal with ever new challenges, we must not forget the fundamental tenets that we have learned over the past decades. Keeping inflation expectations anchored remains of paramount importance, under exceptional circumstances even more than in normal times. Our framework has been successful in this regard thus far.
The Efficient Markets Hypothesis: the idea that the prices generated by financial markets represent the best possible estimate of the value of any investment. (In the version most relevant to public policy, the efficient markets hypothesis states that it is impossible to outperform market valuations on the basis of any public information.)
Support for the efficient markets hypothesis has always relied more on its consistency with free market ideas in general than on clear empirical evidence.
The absurdities of the late 1990s dot-com bubble and bust ought to have killed the notion. But, given the financial sector's explosive growth and massive profitability in the early 2000s, the hypothesis was too convenient to give up.
Some advocates developed elaborate theories to show that the billion-dollar values placed on companies delivering dog food over the Internet were actually rational. Others simply treated the dot-com bubble as the exception that proves the rule.
Either way, the lesson was the same: Governments should leave financial markets to work their magic without interference. That lesson was followed with undiminished faith until it came to the edge of destroying the global economy in late 2008.
Even now, however, when the efficient financial markets hypothesis should be discredited once and for all, and when few are willing to advocate it publicly, it lives on in zombie form. This is most evident in the attention paid to ratings agencies and bond markets in discussion of the "sovereign debt crisis" in Europe, despite the fact that it was the failure of these very institutions, as well as the speculative bubble they helped generate, that created the crisis in the first place.
Dynamic Stochastic General Equilibrium (DSGE): the idea that macroeconomic analysis should not be concerned with observable realities like booms and slumps, but with the theoretical consequences of optimizing behavior by perfectly rational (or almost perfectly rational) consumers, firms, and workers.
DSGE macro arose out of the breakdown of the economic synthesis that informed public policy in the decades after World War II, which combined Keynesian macroeconomics with neoclassical microeconomics. In the wake of the stagflation of the 1970s, critics of John Maynard Keynes like University of Chicago economist Robert Lucas argued that macroeconomic analysis of employment and inflation could only work if it were based on the same microeconomic foundations used to analyze individual markets and the way these markets interacted to produce a general equilibrium.
The result was a thing of intellectual beauty, compared by the IMF's chief economist, Olivier Blanchard, to a haiku. By adding just the right twists to the model, it was possible to represent booms and recessions, at least on the modest scale that prevailed during the Great Moderation, and derive support for the monetary policy.
But when the crisis came, all this sophistication proved useless. It was not just that DSGE models failed to predict the crisis. They also contributed nothing to the discussion of policy responses, which has all been conducted with reference to simple Keynesian and classical models that can be described by the kinds of graphs found in introductory textbooks.
Economist Paul Krugman and others have written that the profession has mistaken beauty for truth. We need macroeconomic analysis that is more realistic, even if it is less rigorous. But the supertanker of an academic research agenda is hard to turn, and the DSGE approach has steamed on, unaffected by its failure in practice. Google Scholar lists 2,600 articles on DSGE macro published since 2009, and many more are on the way.
The Trickle-Down Hypothesis: the idea that policies that benefit the wealthy will ultimately help everybody.
Unlike some of the zombie ideas discussed here, trickle-down economics has long been with us. The term itself seems to have been coined by cowboy performer Will Rogers, who observed of U.S. President Herbert Hoover's 1928 tax cuts: "The money was all appropriated for the top in the hopes that it would trickle down to the needy. Mr. Hoover ... [didn't] know that money trickled up."
Trickle-down economics was conclusively refuted by the experience of the postwar economic golden age. During this "Great Compression," massive reductions in inequality brought about by strong unions and progressive taxes coexisted with full employment and sustained economic growth.
Whatever the evidence, an idea as convenient to the rich and powerful as trickle-down economics can't be kept down for long. As inequality grew in the 1980s, supply-siders and Chicago school economists promised that, sooner or later, everyone would benefit. This idea gained more support during the triumphalist years of the 1990s, when, for the only time since the breakdown of Keynesianism in the 1970s, the benefits of growth were widely spread, and when stock-market booms promised to make everyone rich.
The global financial crisis marks the end of an economic era and provides us with a position to survey how the benefits of economic growth have been shared since the 1970s. The answers are striking. Most of the benefits of U.S. economic growth went to those in the top percentile of the income distribution. By 2007, just one out of 100 Americans received nearly a quarter of all personal income, more than the bottom 50 percent of households put together.
The rising tide of wealth has conspicuously failed to lift all boats. Median household income has actually declined in the United States over the last decade and has been stagnant since the 1970s. Wages for males with a high school education have fallen substantially over the same period.
Whatever the facts, there will always be plenty of advocates for policies that favor the rich. Economics commentator Thomas Sowell provides a fine example, observing, "If mobility is defined as being free to move, then we can all have the same mobility, even if some end up moving faster than others and some of the others do not move at all."
Translating to the real world, if we observe one set of children born into a wealthy family, with parents willing and able to provide high-quality schooling and "legacy" admission to the Ivy League universities they attended, and another whose parents struggle to put food on the table, we should not be concerned that members of the first group almost invariably do better. After all, some people from very disadvantaged backgrounds achieve success, and there was no law preventing the rest from doing so.
Contrary to the cherished beliefs of most Americans, the United States has less social mobility than any other developed country. As Ron Haskins and Isabel Sawhill of the Brookings Institution have shown, 42 percent of American men with fathers in the bottom fifth of the income distribution remain there as compared to: Denmark, 25 percent; Sweden, 26 percent; Finland, 28 percent; Norway, 28 percent; and Britain, 30 percent. The American Dream is fast becoming a myth.
Privatization: the idea that nearly any function now undertaken by government could be done better by private firms.
The boundaries between the private and public sectors have always shifted back and forth, but the general tendency since the late 19th century has been for the state's role to expand, to correct the limitations and failures of market outcomes. Beginning with Prime Minister Margaret Thatcher's government in 1980s Britain, there was a concerted global attempt to reverse this process. The theoretical basis for privatization rested on the efficient markets hypothesis, according to which private markets would always yield better investment decisions and more efficient operations than public-sector planners.
The political imperative derived from the "fiscal crisis of the state" that arose when the growing commitments of the welfare state ran into the end of the sustained economic growth on which it was premised. The crisis manifested itself in the "tax revolts" of the 1970s and 1980s, epitomized by California's Proposition 13, the ultimate source of the state's current crisis.
Even in its heyday, privatization failed to deliver on its promises. Public enterprises were sold at prices that failed to recompense governments for the loss of their earnings. Rather than introducing a new era of competition, privatization commonly replaced public monopolies with private monopolies, which have sought all kinds of regulatory arbitrage to maximize their profits. Australia's Macquarie Bank, which specializes in such monopoly assets and is known as the "millionaires' factory," has shown particular skill in jacking up prices and charges in ways not anticipated by governments undertaking privatization.
Privatization failed even more spectacularly in the 21st century. A series of high-profile privatizations, including those of Air New Zealand and Railtrack in Britain, were reversed. Then, in the chaos of the global financial crisis, giants like General Motors and American International Group (AIG) sought the protection of government ownership.
Sensible proponents of the mixed economy have never argued that privatization should be opposed in all cases. As circumstances change, government involvement in some areas of the economy becomes more desirable, in others less so. But the idea that change should always be in the direction of greater private ownership deserves to be consigned to the graveyard of dead ideas.
Despite being spectacularly discredited by the global financial crisis, the ideas of market liberalism continue to guide the thinking of many, if not most, policymakers and commentators. In part, that is because these ideas are useful to rich and powerful interest groups. In part, it reflects the inherent tenacity of intellectual commitments.
Most importantly, though, the survival of these zombie ideas reflects the absence of a well-developed alternative. Economics must take new directions in the 21st century if we are to avoid a repetition of the recent crisis.
Most obviously, there needs to be a shift from rigor to relevance. The prevailing emphasis on mathematical and logical rigor has given economics an internal consistency that is missing in other social sciences. But there is little value in being consistently wrong.
Similarly, there needs to be a shift from efficiency to equity. Three decades in which market liberals have pushed policies based on ideas of efficiency and claims about the efficiency of financial markets have not produced much in the way of improved economic performance, but they have led to drastic increases in inequality, particularly in the English-speaking world. Economists need to return their attention to policies that will generate a more equitable distribution of income.
Finally, with the collapse of yet another economic "new era," it is time for the economics profession to display more humility and less hubris. More than two centuries after Adam Smith, economists have to admit the force of Socrates's observation that "The wisest man is he who knows that he knows nothing."
Every crisis is an opportunity. The global financial crisis gives the economics profession the chance to bury the zombie ideas that led the world into crisis and to produce a more realistic, humble, and above all socially useful body of thought


[i] Freshwater school refer to Keynesian school where most economists are from coastal region in the US and most anti-Keynesians are in lake regions.