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Major Currents
in Contemporary Economics
Ryszard Rapacki (editor)
Piotr Maszczyk
Mariusz Próchniak
Małgorzata Znoykowicz-Wierzbicka
The textbook is co-financed by the European Union from the European Social Fund.
Major Currents
in Contemporary Economics
Ryszard Rapacki (editor)
Piotr Maszczyk
Mariusz Próchniak
Małgorzata Znoykowicz-Wierzbicka
Major Currents
in Contemporary Economics
Warsaw 2012
This textbook was prepared for the purposes of International Doctoral
Programme in Management and Economics organized within the Collegium
of World Economy at Warsaw School of Economics.
The textbook is co-financed by the European Union from the European Social Fund.
This textbook is distributed free of charge.
Contents
PART ONE – INTRODUCTION
Chapter 1. The state of contemporary macroeconomic debate
– an overview of key issues and concepts (Ryszard Rapacki) . . . . . . . . . . . . . . 7
1. Setting the stage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2. Main areas of disagreement and evaluation criteria . . . . . . . . . . . . . . . 10
3. Methodological framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4. Major schools in modern macroeconomics . . . . . . . . . . . . . . . . . . . . . . 15
PART TWO – MAINSTREAM MACROECONOMICS
Chapter 2. The monetarist school (Mariusz Próchniak) . . . . . . . . . . . . . . . . . 21
1. The quantity theory of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2. The expectations-augmented Phillips curve . . . . . . . . . . . . . . . . . . . . . . 23
3. Balance of payments theory and exchange rate determinants . . . . . . . 30
4. The orthodox monetarism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Chapter 3. The new classical school (Mariusz Próchniak) . . . . . . . . . . . . . . . 37
1. The structure of new classical models . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2. Equilibrium business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3. The policy implications of new classical approach . . . . . . . . . . . . . . . . 42
4. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Chapter 4. The real business cycle school (Mariusz Próchniak) . . . . . . . . . . . 51
1. Business cycle theories in historical perspective. . . . . . . . . . . . . . . . . . . 52
2. Cycles versus random walks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
3. Real business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4. Real business cycle theory and stylized facts . . . . . . . . . . . . . . . . . . . . . 61
5. The policy implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
6. Selected criticism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
7. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
5
Contents
Chapter 5. The new Keynesian school (Małgorzata Znoykowicz-Wierzbicka) . . . 67
1. New Keynesian economics – core propositions and features . . . . . . . . . 67
2. Nominal and real rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
3. Hysteresis and unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4. New Keynesian economics and stylized facts . . . . . . . . . . . . . . . . . . . . 75
5. Policy implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
6. Assessment of new Keynesian economics . . . . . . . . . . . . . . . . . . . . . . . 77
Chapter 6. New developments in growth theory (Mariusz Próchniak) . . . . . . 79
1. The neoclassical growth theory: the Solow model
and the Ramsey model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
2. Endogenous models of economic growth (Romer, Lucas) . . . . . . . . . . . 83
3. Neoclassical revival: the Mankiw-Romer-Weil
(augmented Solow) model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
4. Growth empirics: growth determinants, convergence, growth
accounting (TFP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
5. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
PART THREE – HETERODOX ECONOMICS
Chapter 7. The economics of transition (Ryszard Rapacki). . . . . . . . . . . . . . 101
1. Understanding transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
2. Applicability of standard economic theories . . . . . . . . . . . . . . . . . . . . 104
3. What has economics learned from transition? . . . . . . . . . . . . . . . . . . 107
4. Summary and conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Chapter 8. Do we have to change capitalism – the alterglobalist view
(Piotr Maszczyk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
1. Materialism versus moral commitment . . . . . . . . . . . . . . . . . . . . . . . . 116
2. Economics and lack of moral responsibility . . . . . . . . . . . . . . . . . . . . 117
3. GDP fetishism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
4. Sustainable development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
5. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Chapter 9. New challenges facing the economic science – did economists
really get it so wrong? (Piotr Maszczyk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
1. Global economic crisis – diverging explanations and questions
of efficient markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
2. Global economic crisis – fiscal stimulus and the questions of remedies . . . . 141
3. The future of macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
CHAPTER ONE
Ryszard Rapacki
The state of contemporary
macroeconomic debate – an overview
of key issues and concepts
1. Setting the stage
Between the mid-1930s and the early 1970s, there was a generally accepted
broad consensus among economists that centered on the orthodox Keynesian
model.1 Since the mid-1970s, the prevailing consensus in macroeconomics has
fallen apart and a number of competing schools of thought have emerged. They
comprised in particular the monetarist school, the new classical school and the
real business cycle theory. Their development, combined with the revival of the
Keynesian tradition from the mid-1980s on, gave birth to the present status
of the economic science or what became to be dubbed – the ‘mainstream’
(orthodox) macroeconomics.
Simultaneously, the 1980s and the following decades witnessed the fast
development of ‘heterodox’ economics. This broad category includes – inter alia
– such currents as the new institutional economics, behavioral and experimental
economics, evolutionary economics, economic sociology, and the alterglobalist
view. They further extended the frontiers of economic analysis seeking to
capitalize on possible synergies between the ‘orthodox’ economics and other
social science disciplines, as a result of sticking to a broader research perspective
and applying a more interdisciplinary approach.
1
Exception being the Soviet Union and – after the Second World War – the other centrally-planned
economies where the dominant socialist ideology was deeply rooted in the Marxist political economy.
7
The state of contemporary macroeconomic debate – an overview of key issues and concepts
Seen from a longer historical perspective, however, these tendencies can
hardly be perceived as a surprise. The co-existence of competing schools in
economics is not a recent phenomenon whatsoever – it suffices to compare the
state of the discipline e.g. in the 19th century and the ‘cohabitation’ of a number
of economic currents offering different views on the way the economy operates
or should operate (to name a few, the classical school, the utopian socialist view,
Marxian political economy, the neoclassical economics, etc.).
The disagreements among economists are inherent to the very nature of the
object being studied, which is the economic activity of individuals and societies
or the way the economy operates. Normative judgments apart (which by
definition are subjective and prone to be controversial), for a number of reasons
there is a considerable space for diverging opinions even in the field of positive
economics, i.e. on how the economy actually works.2
The first and most general reason is due to the fact that – unlike in most
physical sciences – the very object of economic research that is the market
economy seems to resemble a moving target as it undergoes a constant
transformation. The forms of market exchange and economic cooperation as
well as the key interrelationships, transmission mechanisms and feedbacks in
the economy have been evolving over time, which puts a question mark over the
robustness of many economic generalizations and makes the economic theories
vulnerable to possible falsification with the new empirical evidence.
Second, the same holds true for the behavioral patterns and social norms
guiding the decisions and choices made by economic agents. As they have
been changing too, the results of past research and the pertinent conclusions
are not always consistent with the economic reality prevailing today. For
example, even if we had a good estimate of the empirical magnitudes in
the demand for money function for the period of 1950–70, would it be
relevant after 2000, with credit cards and Internet shopping? (Begg, Fischer,
Dornbusch 2008).
Third, again in a sharp contrast with many disciplines within the physical
sciences, economists can seldom undertake controlled laboratory experiments.
As a result, to be able to make judgments on how the economy works, they have
to rely on available historical data – such as the official statistics or empirical
evidence generated through own research.
Fourth, even the empirical research in economics does not always offer
unequivocal answers and the most the economists can do in many instances is
to arrive at tentative conclusions (Dornbusch, Fischer, Startz 2001). This may be
due, among other causes, to the fact that the time series of data is too short
to prove a given case (for instance, the full economic effects of the floating
exchange rates introduced after 1973).
2
For an interesting discussion on the frontiers between positive and normative economics and
the possible ways of their reconciliation, see Czarny 2010.
8
1. Setting the stage
Finally, an important part of today’s behavior of economic agents – both firms
and households – tends to be heavily influenced by their expectations of future
events (Dornbusch, Fischer, Startz 2001). Although economists are capable of
measuring quite precisely the actual outcomes of the current decisions of firms
and households (e.g. the level of spending) they have no equivalent measures
of current expectations (e.g. of future personal incomes and corporate profits)
nor the full understanding of the way expectations are formed. This leaves
a substantial room for diverging interpretations of the role of expectations as
a determinant of today’s economic decisions. As a derivative, while looking at
the same data different economic schools may view them differently.
All the forgoing reasons combined offer a plausible explanation why
economists may disagree even in their positive judgments. Notwithstanding the
fact that many conclusions stemming from empirical studies are quite persuasive
and widely accepted in the ‘mainstream’ economics essential controversies
remain. What is important, the latter involve not just mere quibbles about points
of detail but concern the most fundamental issues in key problem areas of
economic research (such as e.g. factors of long-run growth, causes of short-term economic fluctuations, inflation and unemployment, and possible tradeoffs)
that shape the very view of the world and determine policy prescriptions offered
by different economic schools to the policy makers.
Against this background, it is worth emphasizing however that the co-existence
of different schools of thought in the contemporary economics does not only
imply competition or rivalry – it may also entail complementarities and stronger
incentives to learn from each other thus providing a fertile ground for the
development of the entire economic discipline. A similar view can be found in the
works of Snowdon, Vane, Wynarczyk (2002, p. 2) who claim that the co-existence
of alternative explanations in economics is a sign of strength rather than weakness
since it permits gains from intellectual trade and improved understanding. In fact,
it was John Stuart Mill who first recognized, more than a century ago, that all parties
involved gain from the comparative interplay of ideas (Mill 1982, p. 105).3
With this in mind, below we embark on the main task of the present chapter,
which is to show the state of the contemporary economic debate and to briefly
introduce the major currents or schools of economic thought. We will focus
here only on those schools that represent the ‘mainstream’ macroeconomics
while leaving for the later parts of this textbook, a more in-depth characteristics
of the selected currents in ‘heterodox’ economics. In order to pursue our
objective, we will first (Section 2) sketch the main areas of controversies in
3
Stanley Fischer and Olivier Blanchard seem to represent an even more extreme view – they
maintain that on the surface macroeconomics appears to be divided among competing schools but
actually, this represents largely the public relations gimmick and reflects the strong incentives that
exist in academia to differentiate products. This assertion implicitly implies that if you dig deeper
much more similarities can be found. See Snowdon, Vane, Wynarczyk 2002, Interview with Stanley
Fischer, p. 34 and Blanchard, Fischer 1998.
9
The state of contemporary macroeconomic debate – an overview of key issues and concepts
‘mainstream’ macroeconomics and outline the set of evaluation criteria that
will organize our discussion and enable a comparative analysis – both in this
chapter and throughout the whole textbook – of the coexisting economic
schools. Next (Section 3), we will also briefly refer to selected methodological
frameworks with a view to providing a useful benchmark for assessing the
schools concerned.
2. Main areas of disagreement and evaluation criteria
It may be convenient to organize our thinking about the co-existing schools
in contemporary macroeconomics around three concepts or a triad of key terms
that appear to best characterize the prevailing general view on the way a market
economy works: equilibrium – shock – adjustment (to a new equilibrium). If we
add to this list two more concepts, i.e. the time dimension of economic activity
and the propagation mechanism we are ready to embark on the discussion of
the main areas of disagreement among economists.
For most (if not all) economists the ideal state of economic affairs entails
market or macroeconomic equilibrium. The notion of equilibrium may be
interpreted in terms of a benchmark or – by analogy – a one-meter standard of
Sèvres. Similarly, only few economists would dispute the view that – out of four
main markets in the economy, i.e. those for goods, money, labour and foreign
exchange – these are the financial markets, which display the fastest pace of
adjustment while the slowest to clear is the labour market.
What really feeds the ground for controversies in macroeconomic debates is
the speed of adjustment (time required to clear) of each and every of the four
markets, and the way the propagation mechanism works. For the sake of the
present discussion, we will define the propagation mechanism as a mechanism
through which a shock (or a disturbance) is spread throughout the economy
(Dornbusch, Fischer, Startz 2001).
Seen from the perspective just outlined the main disagreements in
macroeconomics concentrate in five key areas. While briefly presenting the most
salient features and the essence of pertinent controversies we will by the same
token provide a set of criteria for the subsequent comparative analysis of the
main currents in contemporary ‘mainstream’ macroeconomics. The five areas in
question include the following:
• market clearing,
• hysteresis,
• formation of expectations,
• short run vs. long run, and (as a derivative)
• demand-side vs. supply-side.
10
2. Main areas of disagreement and evaluation criteria
Market clearing
According to the standard definition, a market clears when the quantity supplied
by sellers equals the quantity demanded by purchasers. The question of whether all
markets clear and if so – how quickly, ranks among the most heatedly debated issues
in the contemporary macroeconomics. At the one extreme, the classical analysis
assumes that all markets clear – the economy is then at potential output and full
employment. Both the expansionary monetary and expansionary fiscal policies are
then helpless as the only effect they can produce is to raise the price level and
accelerate inflation but not to increase output. At the other extreme, the Keynesian
economics assumes that markets, and in particular the labour market, do not clear.
This is mainly due to the sluggish adjustment of wages and other nominal variables.
Under such circumstances a fall in aggregate demand for goods and in the derived
demand for labour reduce output and employment. The expansionary fiscal and
monetary policies are then effective and increase the actual output.
As of today, the economic profession continues to be divided in addressing
the question of market clearing. On the one hand, with the revival of the new
Keynesian economics after 1980 and the development of microeconomic
foundations supporting the assumption of wage stickiness and other nominal
rigidities the prevailing belief that markets automatically clear has been
undermined. On the other hand however, the emergence of the real business
cycle school and its attempt to explain even the short run fluctuations with
market clearing models shed a new light on the determinants of potential
output and equilibrium unemployment and empowered the advocates of the
market clearing approach with new intellectual weapons.
Hysteresis
Economists are also divided into two broad camps in their views regarding
the status of hysteresis as part of the propagation mechanism or the number
of possible long-run equilibria in the economy. Hysteresis occurs when the
adjustment path an economy follows in the short run, reacting to a shock,
determines the position of its long-run equilibrium.
According to the first view, the economy always returns to its original
equilibrium position after the adjustment process is completed. Hence, hysteresis
does not exist or is irrelevant – the short-run evolution of the economy does not
affect its long-run behavior including its unique equilibrium position.
In contrast, the second view claims that the short-run performance of the
economy does affect its behavior in the long run. This implies that there are
multiple possible equilibria in the long run and hysteresis is important as part of
the explanation on how the economy works.
11
The state of contemporary macroeconomic debate – an overview of key issues and concepts
Formation of expectations
The third area of disagreement in macroeconomics concerns the role of
expectations as determinants of current decisions and the way expectations are
formed. Most economists subscribe to the view that beliefs about the future
affect current decisions. However, some controversies remain over the nature of
expectations formation. In this respect, three distinct approaches can be singled
out.
1. Some economists assume that expectations are given or exogenous.
Although they are accounted for as a possible explanatory variable in their
studies, they are not explained in a pertinent economic model.
2. The second approach makes expectations endogenous or being determined
within a given economic model. The proponents of this view rely on a simple
rule of thumb, which consists in assuming that expectations are extrapolative
(or adaptive). This is equivalent to say that – while forecasting future events
or behavior of an economic variable – people tend to simply extrapolate the
trends experienced in the recent past.
3. The third, most numerous, group of economists builds their models based on
the assumption of rational expectations. Similar to the second approach,
expectations here are endogenized. In contrast to the latter, however, the
rational expectations hypothesis claims that – while forecasting the future
– economic agents make good use of all information available today and
are not systematically wrong in their predictions. Even if sometimes they
overshoot or undershoot in their forecasts, the errors get noticed, which
brings about an amendment to the information basis and revision of the
expectations formation until predictions are on average correct (Dornbusch,
Fischer, Startz 2001).
Short run vs. long run (demand-side vs. supply-side)
The relative importance attached to the short run and the long run by
different schools in macroeconomics, as a time frame of their analyses, may
in part reflect their diverging value judgments about the tradeoffs involved in
assessing benefits and costs of different government policies.
On the other hand, the different views on the relative significance of the short
vs. the long run may be to some extent seen as a function of disagreements
prevailing in the three areas just discussed. If we are convinced that it takes
little time for markets to clear, it follows that there is no much room for the
demand management policy in the short run and the supply-side policy becomes
important as a tool for raising potential output and equilibrium employment
in the long run. Conversely, if we believe in the possibility of high levels of
Keynesian unemployment in the short run, we may be tempted to judge that
12
3. Methodological framework
the short-run benefits of restoring the full employment more than offset the risk
of reducing potential output in the long run. Similarly, the more one’s horizon
is short-run, the more plausible it becomes to treat expectations as exogenous
or to neglect the role of hysteresis as part of the propagation mechanism (Begg,
Fischer, Dornbusch 2008).
Apart from outlining the context for a comparative analysis or describing
the main areas of disagreement between alternative economic schools, any
assessment of a particular theory must also include its capability of explaining
the ‘stylized facts’ that characterize macroeconomic phenomena (Greenwald,
Stiglitz 1988). According to Snowdon et al., the ‘stylized facts’ may be defined
as the broad regularities, which have been identified in the statistical property
of economic time series (Snowdon, Vane, Wynarczyk 2001, p. 29).
The greatest deal of controversy in macroeconomics appears to concern
the causes of fluctuations in the level of economic activity. That is why in the
ensuing discussion (and throughout the whole textbook) we decided to use the
explanatory power of alternative economic schools with regard to major stylized
facts of the business cycle as a means of evaluating these theories.
The major ‘stylized facts’ as summarized by Abel and Bernanke (1992), are
as follows:
1. Output movements tend to be correlated across all sectors of the economy.
2. Industrial production, consumption and investment are procyclical and
coincident. Government purchases also tend to follow the same trend.
3. Investment is much more volatile during the business cycle than consumption,
although spending on consumer durables is strongly procyclical.
4. Employment is procyclical while unemployment counter-cyclical.
5. The real wage and average labour productivity are procyclical although the
real wage is only slightly procyclical.
6. The money supply and share prices are procyclical and lead the cycle.
7. Inflation (and by the same token the price level) and nominal interest rates
are procyclical and lagging.
8. The real interest rate is acyclical (Snowdon, Vane, Wynarczyk 2001, pp. 30–31).
3. Methodological framework
With a view to further enhance our understanding of the differences and
similarities between the major currents in contemporary macroeconomics, in
this section we will briefly discuss some key methodological issues seeking to
provide a useful framework or a reference point for the ensuing comparative
assessments. In their methodological debates, deeply rooted in the philosophy
of science, economists have in particular drawn on ideas from the ‘growth of
knowledge’ theories in order to account for the historical evolution or current
status of their discipline (see Snowdon, Vane, Wynarczyk 2001).
13
The state of contemporary macroeconomic debate – an overview of key issues and concepts
The ‘growth of knowledge’ theories associated with Popper, Kuhn and Lakatos
have become popular among economists as models for the development of
their discipline and a useful methodological framework enabling an in-depth
comparative analysis and appraisal of different theories, research programs and
paradigms.
Popper (1959) pointed out to a logical asymmetry between verification and
falsification of the prevailing theories, with a strong bias towards the latter.
In his view, while it is not sufficient to prove theories by confirmation we can
disprove them by refutation. Seen from the perspective adopted in this textbook,
worth emphasizing is the fact that the growth of economic knowledge has not
followed the path predicted by Popper. There is no evidence of serious Popperian
falsificationism in economics – the new ideas tend to be accepted without the
complete rejection of the old ones (Snowdon, Vane, Wynarczyk 2001).
According to Kuhn (1970), the development of science exhibits a cyclical
pattern: the periods of continuity and progress are followed by the time
spells characterized by a serious anomaly or crisis, which may be conducive
to discontinuity or revolution leading to the emergence of a new scientific
paradigm. His view has been widely adopted and applied by economists to their
own discipline. Unlike Popper’s methodology, however, which emphasizes the
need of criticism and permanent revolution, Kuhn puts a stress on tenacity and
commitment to defend a paradigm from attacks (Snowdon, Vane, Wynarczyk
2001). In his view, revolutions are only occasional occurrences marked by intense
competition between paradigms. Yet, in economics the end of controversy
implies as a rule an acceptance of the new paradigm without destroying the
old one (Kuhn 1977). This may explain why the contemporary macroeconomics
can support at the same time a number of incompatible schools or research
traditions.
In turn Lakatos (1978) in his methodology shifts emphasis from a single theory
or hypothesis to scientific research programmes or a series (or succession) of
theories that are genetically linked together. A research programme is composed
of three main building blocks: the hard-core, positive heuristic and a protective
belt of auxiliary hypotheses.
The hard core of a research programme spells out a fundamental set of
statements about the world, consisting of deep and fertile hypotheses, which
are conventionally accepted as irrefutable (Snowdon, Vane, Wynarczyk 2001).
An example of hard-core propositions within macroeconomics is Keynes’s
replacement of classical and neoclassical belief in rational economic calculation
based on certainty equivalence with pervasive uncertainty (see Blaug 1980).
The positive heuristic of a research programme in turn describes the paths of
research to be pursued, i.e. it provides a future research strategy or agenda. For
instance, the basic positive heuristic of orthodox Keynesian economics boils down
to the endeavour aimed at explaining the volatility of output and employment by
14
4. Major schools in modern macroeconomics
analyzing fluctuations in the aggregate demand for output while that of orthodox
monetarism is to explain sustained variations in the rate of inflation by sustained prior
variations in the growth rate of money supply (Snowdon, Vane, Wynarczyk 2001).
Lakatos makes also a distinction between progressive and degenerative
research programmes the key evaluation criterion being the concept of a novel
fact. The latter entails the production of new empirical evidence that extends the
frontiers of our knowledge and understanding of the world. However, putting
an equality sign between the results of empirical research only (or novel facts)
and the scientific progress seems problematic as it neglects the contribution of
purely theoretical or conceptual advances to the stock of available knowledge.
Criticism aside, the Lakatosian methodology has gained a remarkable
popularity among economists one of the underlying reasons for that being its
stress put on competition between coexisting currents or research programmes
and its allowance of comebacks of previously degenerating currents.
Still another methodological perspective can be found in Laudan’s (1977)
approach. His problem-solving model acknowledges equal importance of
conceptual and empirical issues, with scientific progress measured both in terms
of increasing the stock of empirical evidence and the elimination of conceptual
difficulties (Snowdon, Vane, Wynarczyk 2001). In his view, the value of a theory
depends upon how many problems it solves relative to its competitors. Worth
stressing is also one more distinctive feature of his methodological framework:
in contrast to both Kuhn (paradigm) and Lakatos (research programme) Laudan
makes the research tradition rather than the individual theory, the primary
focus of interest (different research programmes can represent the same research
tradition).
Wrapping up the foregoing account of methodological debates in the last
three decades we are confident that some of the insights derived from this
debate will be helpful in organizing and supporting our thinking of the complex
developments in the contemporary macroeconomics. They are briefly outlined
in the next section and discussed in a much greater detail in the subsequent
chapters of this textbook.
4. Major schools in modern macroeconomics
Apart from the general reasons discussed in Section 1, one more important
determinant of a specific nature should be added to our list of factors that
can be hold responsible for the (re-)emergence of different schools of thought
in contemporary macroeconomics in a particular historical period, i.e. since
the early 1970s. This was the first oil shock of 1973 and its consequences that
highlighted the failure of the orthodox Keynesian economics to offer satisfactory
explanation of the changing world and resulted in the breakdown of the
Keynesian consensus. They also triggered a heated debate among economists
15
The state of contemporary macroeconomic debate – an overview of key issues and concepts
on how to best explain the new economic reality and to make the theory again
fitting the facts. The diversity of views in this regard has logically led to their
gradual evolution into more ‘institutionalized’ currents or schools.
Another possible angle of looking at the possible driving forces behind the
unfolding evolution of the contemporary ‘mainstream’ macroeconomics boils
down to contrasting two seemingly incompatible theories, i.e. the neoclassical
microeconomics (the Walrasian theory of general equilibrium) and the orthodox
Keynesian macroeconomics. During the ‘golden age’ of the Keynesian consensus,
the two sub-disciplines led separate lives even accounting for Paul Samuelson’s
atttempt at producing a neoclassical synthesis (Samuelson 1955). By 1973 the
sharp differences between these two strands of economics could not be ignored
(Snowdon, Vane, Wynarczyk 2001). According to Greenwald and Stiglitz (1987),
there were two broad options for their reconciliation. Either the macro theory
could be adapted to micro foundations or the micro theory adapted to fit the
macroeconomic framework. While the former approach gave birth to the new
classical school the latter evolved into the new Keynesian economics.
In the subsequent part of this section we will provide a concise picture of the
most prominent currents in the contemporary macroeconomic debate, following
a chronological order of their emergence and development. According to the
most widespread view, four such currents can be thought of as components
of the ‘mainstream’ macroeconomics today: the monetarist school, the new
classical school, the real business cycle theory and the new Keynesian economics.
We will briefly outline the most salient features of each of these schools below.
The monetarist school
The immediate cause of the monetarist counter-revolution in the early-1970s was the apparent failure of orthodox Keynesian economics to address
the growing problem of inflation (Snowdon, Vane, Wynarczyk 2001). However,
the origins of monetarism can be traced back to the late 1950s and the work of
Milton Friedman and his followers.
Monetarists believe that although the economy may temporarily depart from
its potential output level, as a result of shocks, full employment is restored within
few years and the economy returns to its unique, original long-run equilibrium.
As a result, the effectiveness of monetary policy as a tool of demand management
is limited – the main effect of monetary expansion is higher prices and inflation.
The latter critically depends on the growth rate of nominal money supply.
The new classical school
The development of the new classical school was inspired by pioneering
works of Robert Lucas (1972, 1973) in the early-1970s. The analysis here is
16
4. Major schools in modern macroeconomics
classical since it assumes wage and price flexibility, which ensures the return
of the economy to its unique long-run equilibrium position at full employment
and potential output. One of the possible implications of this assumption is that
hysteresis is unimportant. At the same time, the analysis is new, as it believes
that the whole adjustment process to a shock (or market clearing), including
(rational) expectations, wages and prices is almost instant (Blanchard 2009). The
monetary and fiscal policy can at best affect the composition of full-employment
aggregate demand but not its level.
The real business cycle theory
The origins of this new current in macroeconomics can be traced in the
innovative work of Kydland and Prescott, published in 1982. As a matter of fact,
the approach dubbed the real business cycle theory belongs essentially to the
same family as the new classical economics – both believe in a very fast market
clearing and rational expectations.
However, the former is both more extreme and more general than the latter.
It is more extreme because it neglects deviations from the potential output
even in the short run. Instead, it assumes that all fluctuations in the level of
output are fluctuations of the potential output alone. Simultaneously, the real
business cycle theory is more general compared to a new classical approach
as it concentrates its explanatory power on making explicit the microeconomic
foundations for the intertemporal decisions of economic agents – households,
firms and governments (Begg, Fischer, Dornbusch 2008).
The new Keynesian school
The new classical approach (including the real business cycle theory) has
been challenged by a group of prominent economists4 who – particularly since
the mid-1980s – have revitalized the Keynesian analytical tradition and formed
the new Keynesian school. Referring back to our earlier remarks in this section,
instead of adapting the macro theory to orthodox neoclassical market-clearing
micro foundations, the new Keynesians chose the opposite option, i.e. to adapt
the micro bases to their macro theory (Snowdon, Vane, Wynarczyk 2001).
The proponents of the new Keynesian approach highlight the role of nominal
rigidities, which make the wages and prices sticky and the whole adjustment
process sluggish (Hillier 1991). In their view, the latter can take many years.
Moreover, as a result of hysteresis, there might be multiple long-run equilibria
in the economy – once adjustment is completed a new eventual equilibrium
4
The group includes – inter alia – Nobel Prize laureates George Akerlof, Edmund Phelps, Joseph
Stiglitz and James Tobin and such reputed scholars as Ben Bernanke, Olivier Blanchard, Rudiger
Dornbusch, Stanley Fischer, Gregory Mankiw and David Romer.
17
The state of contemporary macroeconomic debate – an overview of key issues and concepts
position is likely to be different from the original one. In such a world, there is
a substantial scope for the demand management policies that are quite effective
in liquidating (or at least narrowing) the output gap and restoring long-run
equilibrium.
As a recap of our hitherto discussion, Table 1 below provides a stylized
summary of the main differences and similarities between the four alternative
views on the modus operandi of the contemporary market economy.
Table 1. A stylized summary of major currents in macroeconomics
Area
Monetarist
school
New classical
school
Real business
cycle theory
New
Keynesian
school
Market
clearing
Quite fast
Very fast
Instantaneous
Quite slow
Speed of
adjusting
expectations
Slower
Rapid
Very fast
Fast or slow
Relative
weight of
short run/long
run
Long run more
important
Little
difference
since
adjustment is
fast
No
difference as
adjustment is
instantaneous
Don’t forget
short run
Full
employment
Never far
away
Always close
Always
present
Not easy to
achieve and
may take time
Hysteresis
Irrelevant
Irrelevant
Non-existent
Might be
a problem
Demand
management
vs. supply-side
policy
Supply more
important;
avoid swings
in demand
Forget
demand;
supply side is
what matters
Only supply
side matters
Demand
matters too
Source: Adapted and extended from Begg, Fischer, Dornbusch 2008, p. 624.
Bibliography
Abel, A., B.S. Bernanke, 1992, Macroeconomics, New York, Addison Wesley.
Begg, D., S. Fischer, R. Dornbusch, 2008, Economics, 9th edition, Maidenhead,
McGraw-Hill.
Blanchard, O.J., 2009, Macroeconomics, 5th edition, Upper Saddle River, Pearson
Prentice Hall.
Blanchard, O.J., S. Fischer, 1998, Lectures on Macroeconomics, Cambridge, The
MIT Press.
Blaug, M., 1980, The Methodology of Economics or How Economists Explain,
Cambridge: Cambridge University Press.
18
4. Major schools in modern macroeconomics
Czarny, B., 2010, Pozytywizm a sądy wartościujące w ekonomii (Positivism and
Value Judgments in Economics), Warszawa, Oficyna Wydawnicza SGH.
Dornbusch, R., S. Fischer, R. Startz, 2001, Macroeconomics, 8th (International)
Edition, McGraw-Hill.
Greenwald, B.C., J.E. Stiglitz, 1988, Keynesian, New Keynesian and New Classical
Economics, Oxford Economic Papers, March.
Greenwald, B.C., J.E. Stiglitz, 1987, Examining Alternative Macroeconomic
Theories.
Hillier, B., 1991, The Macroeconomic Debate. Models of the Closed and Open
Economy, Oxford and Cambridge, Blackwell.
Kuhn, T.S., 1977, The Essential Tension, Chicago, University of Chicago Press.
Kuhn, T.S., 1970, The Structure of Scientific Revolutions, Chicago, University of
Chicago Press.
Kydland, F.E., E.C. Prescott, 1982, Time to Build and Aggregate Fluctuations,
Econometrica, November.
Lakatos, I., 1978, The Methodology of Scientific Research Programmes,
Cambridge, Cambridge University Press.
Laudan, L., 1977, Progress and its Problems, London, Routledge and Kegan
Paul.
Lucas, R.E. Jr., 1972, Expectations and the Neutrality of Money, Journal of
Economic Theory, April.
Lucas, R.R. Jr., 1973, Some International Evidence on Output-Inflation Tradeoffs,
American Economic Review, June.
Mill, J.S., 1982, On Liberty, Harmondsworth, Penguin English Library.
Popper, K.R., 1959, The Logic of Scientific Discovery, London, Hutchinson.
Popper, K.R., 1961, The Poverty of Historicism, London, Routledge and Kegan
Paul.
Samuelson, P.A., 1955, Economics, 3rd edition, New York, McGraw Hill.
Snowdon, B., H. Vane, 2002, An Encyclopedia of Macroeconomics, Cheltenham,
Edward Elgar.
Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics.
An Introduction to Competing Schools of Thought, Cheltenham, Edward
Elgar.
19
CHAPTER TWO
Mariusz Próchniak
The monetarist school
In this chapter we present the main characteristics of the monetarist school.
We start with a quantity theory of money (which was explored by monetarists
during the 1950s and the first half of the 1960s). Then we describe the monetarist
development of the Phillips curve (second half of the 1960s). At the end we
present the monetarist approach to the balance of payments and exchange rate
determination (the 1970s).
1. The quantity theory of money
Let us start with the traditional approach of the quantity theory of money.
This theory is based on the following equation:
MV = PY ,
(1)
where: M – nominal money supply, V – the velocity of money circulation
in the economy, P – the average price level in the economy, Y – real income,
output, GDP. It is assumed that the speed of money circulation (V), i.e. the
average frequency across all transactions with which a unit of money is spent,
is constant. The main implication of the quantity theory of money is as follows:
given a constant income (which takes place when output is at its potential level),
the increase in the nominal money supply leads to inflation. In other words, the
increase in the nominal money supply only raises the nominal income (PY), and
not the real income (Y). This theory is over 500 year old, and according to some
economists it even comes from Confucius. The monetarists defend it as they
argue that inflation is mostly caused by changes in nominal money supply.
The monetarist school is identified with Milton Friedman. He may be regarded
as the founder of this mainstream in economics. The monetarist school is based
21
The monetarist school
on the quantity theory of money. In 1956, Friedman re-established this theory,
treating it not as a theory of the general price level or monetary income, but as
a theory of the demand for money.
According to Friedman, the demand for money (like the demand for all other
assets) depends on four factors:
• income (which determines the maximum amount of money that people want
to have),
• rate of return on money in comparison with the rate of return on other
financial and real assets,
• expected rate of inflation,
• consumer preferences.
Thus, the demand function for real money balances can be written as follows:
MD
= f (Y , r , π e , µ ),
P
(2)
where: MD – nominal money demand, P – the average price level, Y –
permanent income, r –rate of return on financial assets, πe – expected inflation
rate, µ – consumer preferences. The left-hand side of this equation, i.e. the
nominal money demand to price ratio, is equal to the demand for real money
balances. Income, that appears on the right-hand side, is a measure of wealth
and it represents the budget constraint.
Equation (2) is a simplified version of the Friedman’s demand function for
money balances. This equation implies that the demand for money increases
with income, but decreases with both the rate of return on other financial assets
and the expected inflation rate.
Based on Equation (2), we can explain the ‘core’ of the monetary approach,
i.e. the way the increase in nominal money supply causes inflation.
If the rates of return on various financial assets are different, the structure
of individuals’ wealth is not optimal. Thus, utility-maximising consumers should
change their portfolio of assets until the rates of return are equal. This mechanism
is a key element in monetary approach as it directly shows how changes in
nominal money supply affect the real output and prices.
Suppose initially that the economy is in equilibrium. This means that the wealth
is divided between the real and financial assets in such a way that the marginal
rates of return on different types of assets are equal. Assuming further that the
central bank performs open market operations in order to increase the monetary
base. As a result, the nominal money supply increases. Since the marginal rate of
return on any asset decreases with an increase in its stock, monetary expansion
will decrease the marginal rate of return on money. As a result, utility-maximizing
individuals get rid of money and buy other assets (financial and real assets such
22
2. The expectations-augmented Phillips curve
as consumer goods). This leads to an increase in their prices; in other words – it
accelerates inflation. Everything will be stabilized at a point at which marginal
rates of return on different types of assets are equal. In this way Friedman
explained why the increase in nominal money supply causes inflation.
The monetary approach to the quantity theory of money can be summarized
as follows. First, the increase in nominal money supply is the main factor
stimulating inflation and nominal income growth. Second, given a stable money
demand, the instability in the real economy is mainly caused by the fluctuations
in money supply, triggered off by the central bank’s policy. Third, the money
supply should grow at a constant rate corresponding to the real GDP growth
rate, leading to long-term price stability.
2. The expectations-augmented Phillips curve
The second stage of the analysis of the monetarist school is to show how
the monetary expansion influences the real and nominal economic variables. The
most important papers in this field have been published by Friedman in 1968 and
Phelps in 1967. These authors extended the original analysis of the Phillips curve.
In textbook terms, the Phillips curve shows the relationship between unemployment and inflation. It is illustrated in Figure 1a. The relationship is negative,
which means that higher inflation is accompanied by lower unemployment, and
vice versa: lower inflation rate corresponds to higher unemployment.
This curve is named after the New Zealand economist Alban William Phillips.
In 1958, Phillips showed the existence of a statistical relationship between the
unemployment rate and the growth rate of nominal wages in the UK during
1861–1957. This relationship was negative and non-linear. The original Phillips
curve is illustrated in Figure 1b. When the unemployment rate was about 2.5%,
the growth rate of nominal wages was about 2%. Nominal wages tended to
stabilize at the unemployment rate of around 5.5%.
Figure 1. The Phillips curve
Inflation
rate
π
Growth rate
of money
wages
2%
Unemployment rate
U
(a)
2.5%
5.5%
Unemployment rate
U
(b)
23
The monetarist school
In mathematical terms, the Phillips curve can be written as follows:
.
W = f (U)
or
π = f (U ) ,
(3)
.
where W is the growth rate of money wages (dot over a variable means its
time derivative), π is the rate of inflation, and U is the unemployment rate.
The Phillips curve has been used by many Keynesians as an evidence that
there is a long-run stable relationship between inflation and unemployment.
The government may, therefore, pursue a combination of fiscal and monetary
policy to choose any point on the Phillips curve, depending on whether the
government prefers lower inflation or lower unemployment.
The above reasoning, however, turned out to be false. Since the end of the
1960s, past trends in the economy have reversed. In the 1970s, both the U.S.
and UK often recorded simultaneous increase in inflation and unemployment.
The non-existence of a stable long-run negative relationship between inflation
and unemployment was observed at the same time by Friedman and Phelps. In
their opinion, the original specification of the Phillips curve was misleading due
to the fact that the rate of increase in money wages does not depend on the
rate of inflation.
In 1968, Friedman suggested that the original Phillips curve, showing
the negative relationship between the growth rate of money, wages and
unemployment, was misspecified. Although nominal wages are established in
wage negotiations, both workers and firms are interested in real, rather than
nominal wages. Since wage negotiations take place at discrete time intervals,
the anticipated real wage depends on the expected rate of inflation during the
employment contract. Friedman argued that the Phillips curve should include
real wages, i.e. it should illustrate the relationship between the growth rate of
real wages and the unemployment rate.
Therefore, Friedman has expanded the analysis of the Phillips curve introducing
an additional variable: the expected rate of inflation. As a result, the growth rate
of money wages depended not only on the unemployment rate (that measures
the output gap) but also on the expected rate of inflation. Mathematically, this
can be written as follows:
.
W = f (U )
+ πe,
(4)
where πe is the expected inflation rate.
After introducing the expected rate of inflation, the analysis becomes more
complex. We do not have one unique Phillips curve. We obtain a family of Phillips
curves for different expected rates of inflation. In other words, we have infinitely
many Phillips curves showing a negative relationship between the growth rate
24
2. The expectations-augmented Phillips curve
of nominal wages and the unemployment rate, each of which corresponds to
a different expected rate of inflation. This is illustrated in Figure 2. For simplicity,
we assume that labour productivity growth is zero. Therefore, if nominal wages
are constant, price level is. constant as well implying a zero expected rate of
e
inflation. In other words: W = π = π , W = const., P = const.
Figure 2 shows five Phillips curves: PC0, PC1,…, PC4. The curve PC0 shows
a negative relationship between the growth rate of money wages and the
unemployment rate in the absence of inflationary expectations. This nonexpectations augmented Phillips curve intersects the horizontal axis at the
natural rate of unemployment (NARU or U*) or the non-accelerating inflation
rate of unemployment (NAIRU).5
Figure 2. The expectations-augmented Phillips curves
Growth rate of money wages
π4
π3
PC4
π2
PC3
π1
PC2
PC1
U*
NAIRU
Unemployment rate, U
PC0
The curves PC1,…, PC4 illustrate a negative relationship between the growth
rate of money wages and the unemployment rate for different expected rates
of inflation. Expected rate of inflation shifts the Phillips curve parallel upwards
by a distance equal to the expected rate of inflation. For example, the curve PC1
corresponds to the expected inflation rate π1, the curve PC2 corresponds to the
expected inflation rate π2, and the curve PC4 represents the expected inflation
rate π4.
5
The concepts of NARU and NAIRU stem from a slightly different economic reasoning, even
though they rather represent the same economic category. NARU is the unemployment level in the
labour market equilibrium. If the labour market is in equilibrium, the demand for labour equals
the supply of labour. There is no involuntary unemployment, and the output is at its potential level
(there is neither excess demand nor excess supply). Zero output gap means that there are neither
deflationary nor inflationary pressures. Hence, if the labour market is in equilibrium, there exists the
non-accelerating inflation rate of unemployment (NAIRU).
25
The monetarist school
We now combine the short-run and long-run analysis, showing the short-run
and long-run effects of the monetary expansion.
The effects of the increase in nominal money supply are illustrated in Figure 3.
In Figure 3, SRPC0 and SRPC1 represent the short-run Phillips curves (SRPC0
corresponds to a lack of inflationary expectations). LRPC is the long-run Phillips
curve (which will be explained in greater detail later in this section).
Figure 3. Short-run and long-run Phillips curves
π,
πe
F
G
e
π
SRPC1
e
π
E
U1
U*
NAIRU
U
SRPC0
At the initial equilibrium, the economy is at point E. The inflation rate
and the growth rate of nominal wages are both zero. Unemployment is at
its natural level (U*), and the output is at the potential level. There are no
inflationary expectations. In other words: W = const., P = const.; π = 0, πe = 0.
Now suppose that monetary authorities decide to pursue an expansionary
policy: central bank increases the nominal money supply in order to boost
the economy. As a result, the aggregate demand and output both increase:
output exceeds its potential level and unemployment decreases to U1. This
leads to an increase in both prices and nominal wages, but prices adjust faster
than wages. Since at the starting point the inflation rate was zero, workers
initially treat the increase in money wages as the increase in real wages and
supply more labour. In other words,
. workers exhibit money illusion. Although
nominal wages rise at a rate W1 , real wages decline. The economy moves
to the point F on the short-run Phillips curve SRPC0. In the next periods,
26
2. The expectations-augmented Phillips curve
however, workers will adjust their inflationary expectations to the actual
rate of inflation. They will recognize that real wages have fallen despite the
increase in nominal wages. Therefore, they will insist to raise their nominal
wages, which shifts the short-run Phillips curve parallel
upwards from SRPC0
.
to SRPC1. Nominal wages will raise at a rate of W1 plus the expected rate of
inflation. Since the growth rate of nominal wages exceeds the actual inflation
rate, real wages will raise. It implies that firms will fire workers yielding an
increase in unemployment. This adjustment process occurs until the economy
reaches a new long-run equilibrium point G. At point G, real wages are at the
initial level and the labour market is in equilibrium with the natural rate of
unemployment.
Based on this analysis we may conclude as follows: a negative relationship
between the growth rate of nominal wages and the unemployment rate does
not exist if workers – in wage negotiations – fully anticipate future inflation,
i.e. when the expected inflation rate equals the actual rate. This means that if
output is at the potential level and unemployment stands at the natural level,
the growth rate of nominal wages is equal to both the actual and the expected
inflation rate. Thus, money wages are constant only if there are no inflationary
expectations.
Hence, the long-run equilibrium may occur at point E, at point G, as well as at
any other point corresponding to the natural rate of unemployment (a particular
point depends on the expected rate of inflation). Connecting these points, we
get the long-run Phillips curve (LRPC). It always intersects the horizontal axis at
the natural rate of unemployment (U* or NAIRU). On the long-run Phillips curve,
the growth rate of nominal wages is exactly equal to the inflation rate (i.e. real
wages are constant), while the expected inflation rate is equal to the actual rate
of inflation (i.e. inflation is fully anticipated).
The analysis carried out by Friedman helped to combine the existence of the
neutrality of money in the long run with the fact that money influences the real
economy in the short run.
Adaptive expectations hypothesis
When we look at the above analysis in terms of expectations, it follows that
monetarists assume the existence of adaptive (in other words: error-learning
or extrapolative) inflationary expectations. Adaptive expectations are based on
the assumption that the future is an extension of the recent past. It means that
workers formulate their inflationary expectations extrapolating past inflation
rates. Therefore, if the government changes its monetary policy, the expected
inflation gradually adjusts to the actual inflation and output may vary around
the potential level in the short run.
27
The monetarist school
Policy implications of the expectations-augmented Phillips curve
The above analysis allows us to draw some recommendations for economic
policy.
1. The short-run effects of an expansionary monetary policy
According to monetarists, the vertical Phillips curve concerns the long run.
In the short run, the economy moves along the short-run Phillips curve implying
a trade off between inflation and unemployment. Monetary expansion could
therefore lead to a short-run increase in output over the potential level and a shortrun decrease in unemployment below the natural rate. This outcome occurs
because inflation is unexpected (monetarists assume the adaptive expectations
hypothesis). As soon as workers adjust their inflationary expectations and fully
anticipate the inflation rate (including it in wage negotiations), the short-run
Phillips curve will shift upwards and the unemployment rate will return to
the natural level. Monetarists believe that the economy returns to long-run
equilibrium with potential output and full employment during a relatively short
period of time (2–3 years).
2. The accelerationist hypothesis
The second policy implication of monetarism concerns the accelerationist
hypothesis. According to this hypothesis, if the government wants to keep output
permanently above its potential level, such a policy will result in accelerated
inflation. This is because the persistent excess of output can only be achieved by
a continuous monetary expansion.
3. The effects of anti-inflationary policy
Monetarists argue that inflation is a monetary phenomenon caused by an
increase in money supply. Thus, the reduction of inflation can be achieved by
a decline in the growth rate of money supply. In the short run the economy
may deviate from the potential output and full employment, implying that
anti-inflationary policy will result in a temporary increase in unemployment.
The more rapid is the reduction in inflation planned by the government, the
higher will be a temporary increase in unemployment and the greater costs of
anti-inflationary policy. Therefore, when pursuing anti-inflationary policy, the
government faces the following dilemma: it can reduce inflation rapidly at the
cost of high unemployment, or it can choose a gradual (long-run) deceleration
of inflation at the expense of only a small increase in the level of unemployment.
Both variants are illustrated in Figure 4.
Figure 4 shows the long-run and short-run Phillips curves. Initially, the
economy is in the long-run equilibrium given by point E, with the inflation
rate (π1) equal to the growth rate of money wages. Inflation is fully expected:
π 1 = π e.
28
2. The expectations-augmented Phillips curve
Let us consider the first policy option. If the government chooses a policy of
a rapid reduction in inflation, it sharply reduces the growth rate of money supply.
In the short run, the economy moves to the point G and unemployment rises to
U3. When workers adjust their inflationary expectations to the new growth rate
of money supply, the short-run Phillips curve will shift from SRPC1 to SRPC3. As
a result, the economy moves to a new long-run equilibrium given by point F,
where unemployment is at the natural level and inflation equals π3, that is less
than π1. In this policy option, a new inflation target is achieved quickly, but at
the cost of high unemployment.
Figure 4. The effects of anti-inflationary policy
π,
LRPC
π1
π2
π3
E
H
J
F
G
K
SRPC1
SRPC2
SRPC3
U*
NAIRU
U1 U2
U3
U
On the other hand, if the government chooses a policy of a gradual reduction
in inflation, the growth rate of money supply decreases initially only slightly. In
the short run, the economy moves to the point H and the unemployment rises
to U2. When workers adjust their inflationary expectations, the short-run Phillips
curve will shift downwards to SRPC2 and the economy tends to reach the point
J. Inflation rate falls to π2. However, the inflation target is π3, not π2. Thus, the
government pursues a policy of a further reduction in the growth rate of money
supply. A similar mechanism leads the economy through the point K to the
new long-run equilibrium point F. In this policy option, the process of reducing
inflation lasts longer than in the previous case, but it does not result in a large
increase of unemployment as before.
29
The monetarist school
3. Balance of payments theory and exchange rate
determinants
The third stage in the development of monetarism includes the theory of the
balance of payments and exchange rate determination. This phase dates back
to the 1970s. The most important papers have been written by Johnson in 1972
and Frenkel and Johnson in 1976 and 1978.
The system of fixed exchange rates
We begin the analysis with the presentation of the monetary approach to the
balance of payments under the system of fixed exchange rates. The monetarist
approach focuses primarily on the money market, at which the interdependence
between money demand and money supply is treated as the main factor
determining the balance of payments outcome. The monetary approach to
balance of payments is based on four major assumptions:
a) demand for money is a stable function of a specified number of variables,
b) in the long run, the economy is in equilibrium with the potential level of
output and the natural rate of unemployment,
c) in the long run, the central bank cannot sterilize or neutralize the impact of
the balance of payments deficit or surplus on the domestic money supply,
d) the prices of similar tradable goods are equal in all countries in the long
run.
Here, we present a simple model of balance of payments for a small open
economy (under the system of fixed exchange rates), developed by Johnson in
1972. The Johnson’s model is based on three major assumptions:
a) real income is constant at the potential output level and the natural rate of
unemployment,
b) the law of one price holds at the goods and financial markets,
c) domestic interest rates and domestic prices are pegged to global levels.
Demand for real money balances (MD/P) is a function of two variables: real
income (Y) and interest rate (r), according to the equation:
MD
= f (Y , r ).
P
(5)
The money supply (MS) equals domestic credit D (that is, the money created
by the country’s banking system) plus the money corresponding to changes in
foreign exchange reserves (R):
MS = D+R.
30
(6)
3. Balance of payments theory and exchange rate determinants
The money market is in equilibrium when the demand for money equals the
money supply:
MD =MS.
(7)
Substituting (7) into (6) we obtain:
MD = D+R
or
R=MD −D.
(8)
Let us consider the effects of an expansionary monetary policy, namely
the growth in domestic credit (D). We assume that initially the economy
is in equilibrium. Since the price level, real income and interest rate are all
exogenous, nominal money demand (MD) cannot increase after a domestic
credit growth (see Equation 5). Thus, the excess supply in the money market
(in relation to demand) implies that consumers will buy foreign goods and
services and foreign securities. This will lead to a deficit in the balance of
payments. Since we consider a system of fixed exchange rates, monetary
authorities intervene in the forex market. The central bank buys up national
currency in exchange for foreign currency, reducing international reserves
(R decreases). As we can see, an increase in one component of money supply
– domestic credit (D) – results in a decrease of another component of money
supply – foreign exchange reserves (R). International reserves decline until
the money market returns to equilibrium and the balance of payments deficit
disappears. In the new equilibrium point, the volume of money supply (MS) is
the same as initially. The increase in domestic credit has been fully offset by
a decrease in foreign reserves.
Summing up, under the system of fixed exchange rates any discrepancies
between money supply and money demand lead to imbalances in the balance of
payments (deficit or surplus). Then, the adjustment process starts, that is there is
a change in the volume of foreign reserves. As a result, the economy returns to
equilibrium where the demand for money equals the money supply and foreign
reserves are constant.
Now we will present the policy implications of the model.
First, the model implies that disequilibria in the balance of payments are
automatically adjusted (corrected). Any discretionary government policy is not
needed to improve the balance of payments outcome. If the demand for money
does not equal money supply, individuals are engaged in transactions with
foreign countries, trying to get rid of or acquire real money balances through
international markets for goods and securities. This leads to a deficit or surplus
in balance of payments. External imbalances imply the adjustment process in
terms of changes in international reserves. As a result, the economy returns to
money market equilibrium at the initial level of money supply.
31
The monetarist school
Second, the analysis confirms that for a small country with fixed exchange
rates the national money supply is an endogenous variable. If domestic credit
increases, the balance of payments deficit causes a fall in foreign reserves and
money supply decreases to the initial level. Similarly, if domestic credit declines,
the balance of payments surplus leads to an increase in foreign reserves and
the money supply increases to the initial level. The volume of money supply
always returns to the starting point. This analysis suggests that monetary policy
affects only the structure of money supply (i.e. its division between domestic
credit and international reserves), but not the volume of money supply itself. In
a small open economy, monetary policy in the long run does not influence any
variable except the size of foreign reserves. Therefore, expansionary monetary
policy does not affect neither inflation rate in a given country, nor the domestic
interest rates, nor the rate of economic growth.6
Third, the presented model implies that in a world with fixed exchange
rates inflation is seen as an international monetary phenomenon. The source of
inflation is the excess of global demand as compared with the level of output,
but the excessive demand must result from global, not domestic expansionary
monetary policy. The increase in world monetary expansion (resulting from an
expansionary monetary policy pursued by one big country or simultaneously
by many small countries) leads to an increase in global demand, causing world
inflation.7
The system of floating exchange rates
Now we describe the monetary approach to exchange rate determination.
The monetary approach to exchange rate determination is the model of the
monetary approach to the balance of payments, presented earlier, applied to
the floating exchange rates. This analysis was explored by Frenkel and Johnson
in 1978.
As in the case of fixed exchange rates, we will analyse the effects of
expansionary monetary policy. The economy is initially in equilibrium and
exchange rates are floating.
Under the floating exchange rate system, the balance of payments is
always zero. This follows from the fact that exchange rate adjusts to maintain
equilibrium in the forex market (it happens when demand for a given currency
equals its supply). In the system of floating exchange rates, there is neither
6
Slightly different is a case with a relatively large country (compared with the rest of the world).
Expansionary monetary policy of this country, however, may accelerate global inflation.
7
For example, according to monetarists, the acceleration of inflation in Western economies in
the 2nd half of the 1960s was caused by the U.S. monetary expansion to finance the expenditure
related to the Vietnam war (until 1971, Western countries maintained a system of fixed exchange
rates against the U.S. dollar, namely the Bretton Woods system, so the model presented here is correct to such an analysis).
32
4. The orthodox monetarism
surplus nor deficit in the balance of payments and international reserves are
constant. Referring to Equation (6), since R is constant, the source of monetary
expansion can only be the growth of domestic credit (D).
Suppose that monetary authorities raise domestic credit. To determine the
response of the demand for money caused by the increase in money supply, let
us refer to Equation (5). After multiplying both sides by P, this equation takes
the form:
M D = P ⋅ f (Y , r ) .
(9)
Assuming that output (Y) is constant at the potential level (with natural
unemployment) and the interest rate (r) is also constant (because it is pegged
with the world level), the growth in money demand (MD) may occur only due
to the increase in prices (P). Hence, monetary expansion, namely the growth
of money supply, leads to higher prices. Given higher prices, higher nominal
money demand equals the increased money supply and money market is in
equilibrium.
Let us present in detail the adjustment process that occurs at the forex
market. Excess money supply relative to demand leads to higher demand for
foreign goods and securities. At the forex market, the supply of domestic money
increases, leading to a depreciation of national currency under the system of
floating exchange rates. Depreciation of domestic currency results in higher
domestic prices leading to an increase in nominal demand for money. Demand
for money raises until it equals the increased money supply and the money
market equilibrium is restored.
As we can see, the growth of money supply causes a depreciation of the
nominal exchange rate. This model shows that the exchange rate between the
two currencies depends on the relative money supplies in these two countries.
For example, if there were only two countries and both of them increased
the money supply by the same amount, the real exchange rate between the
currencies of these two countries would not change.
To wrap up, in the system of floating exchange rates, the increase in domestic
credit leads to a nominal depreciation of domestic currency and to inflation.
4. The orthodox monetarism
The most important findings and implications of the orthodox monetarism
can be summarized as follows.
First, changes in the money supply are the most important factor responsible
for changes in money income and inflation.
Second, the economy is inherently stable. However, it can be disturbed by
irregular monetary growth. But the economy returns quite rapidly to long-run
33
The monetarist school
equilibrium that occurs at the potential output level and the natural rate of
unemployment.
Third, in the long run, there is no trade off between inflation and unemployment.
The long-run Phillips curve is vertical and intersects the horizontal axis at the
natural rate of unemployment (NARU or U*) or non-accelerating inflation rate
of unemployment (NAIRU).
Fourth, both inflation and the balance of payments are treated as monetary
phenomena.
Fifth, the monetarists are averse to an active stabilisation policy (both
monetary and fiscal). The monetary policy should be conducted carefully to
ensure long-run price stability.
5. Summary
1. Monetarism is identified with Milton Friedman. The monetarist school is based
on the quantity theory of money. The monetarist approach to the quantity
theory of money implies that: (a) the increase in nominal money supply is
the main factor stimulating inflation and nominal income growth; (b) given
a stable money demand, the instability in the real economy is mainly caused
by the fluctuations in money supply; (c) the money supply should grow at
a constant rate corresponding to the real GDP growth rate, leading to long-term price stability.
2. Friedman expanded the original analysis of the Phillips curve introducing an
additional variable: the expected rate of inflation. According to monetarists,
the traditional Phillips curve showing a negative relationship between inflation
and unemployment concerns the short run. The inflationary expectations
shift the short-run Phillips curve upwards by a distance equal to the expected
rate of inflation. In the long run, the economy behaves according to the long-run Phillips curve, which is vertical and intersects the horizontal axis at the
natural rate of unemployment (U* or NAIRU).
3. Therefore, monetary expansion could lead to a short-run increase in output
over the potential level and a short-run decrease in unemployment below the
natural rate. As soon as workers adjust their inflationary expectations and fully
anticipate the inflation rate, the short-run Phillips curve will shift upwards and
the unemployment rate will return to the natural level. Monetarists believe
that the economy returns to long-run equilibrium with potential output and
full employment during a relatively short period of time (2–3 years).
4. Monetarists argue that inflation is a monetary phenomenon caused by an
increase in money supply. Thus, the reduction of inflation can be achieved by
a decline in the growth rate of money supply. But, in the short run, the economy
may deviate from the potential output and full employment, implying that
anti-inflationary policy will result in a temporary increase in unemployment.
34
5. Summary
5. The monetarist approach to the balance of payments implies that for
a small country with fixed exchange rates the national money supply is an
endogenous variable. Therefore, expansionary monetary policy does not
affect neither inflation rate in a given country, nor the domestic interest
rates, nor the rate of economic growth. In such a world with fixed exchange
rates inflation is seen as an international monetary phenomenon. By contrast,
the monetarist approach to exchange rate determination states that in the
system of floating exchange rates the increase in domestic credit leads to
a nominal depreciation of domestic currency and to inflation.
Bibliography
Begg, D., S. Fischer, R. Dornbusch, 2005, Economics, London, McGraw-Hill.
Polish translation: Begg, D., S. Fischer, R. Dornbusch, 2007, Makroekonomia,
Warszawa, PWE.
Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics.
An Introduction to Competing Schools of Thought, Cheltenham-Northampton,
Edward Elgar.
Additional bibliography
Frenkel, J.A., H.G. Johnson, 1976, The Monetary Approach to the Balance of
Payments, London, Allen and Unwin.
Frenkel, J.A., H.G. Johnson, 1978, The Economics of Exchange Rates, Reading,
Mass., Addison-Wesley.
Friedman, M., 1956, The Quantity Theory of Money. A Restatement, in: Studies
in the Quantity Theory of Money (ed. M. Friedman), Chicago, University
of Chicago Press. Reprinted in: The Optimum Quantity of Money (ed.
M. Friedman), 2007.
Friedman, M., 1968, The Role of Monetary Policy, American Economic Review,
March.
Johnson, H.G., 1972, The Monetary Approach to Balance of Payments Theory,
in: Further Essays in Monetary Economics (ed. H.G. Johnson), London,
Macmillan.
Phelps, E.S., 1967, Phillips Curves, Expectations of Inflation and Optimal
Unemployment Over Time, Economica, August.
Phillips, A.W., 1958, The Relation Between Unemployment and the Rate of
Change of Money Wage Rates in the United Kingdom, 1861–1957, Economica,
November.
35
CHAPTER THREE
Mariusz Próchniak
The new classical school
The new classical school is the economic school of thought, whose origins date
back to the 1970s (although some elements, such as the rational expectations
hypothesis, have been introduced into economics in the early 1960s). The new
classical economics is obviously linked with the traditional classical school (e.g.
the Walrasian theory of general equilibrium), but its emergence results directly
from the development of monetarism, a new trend in the economic thought.
We can even say that the new classical school evolved out from the monetarism
in the 1970s. Indeed, certain views in both schools are the same (e.g. the fact
that an increase in the nominal money supply causes inflation).
Representatives of the new classical school include, inter alia, Robert Lucas,
Robert Barro, Edward Prescott, Thomas Sargent (U.S.), and Patrick Minford (UK).
1. The structure of new classical models
The new classical school is based on three assumptions:
• the rational expectations hypothesis,
• continuous market clearing,
• the aggregate supply hypothesis.
The last two ones may also be referred to as the natural rate hypothesis.
Before we discuss these assumptions in detail, let us explain the name of the
school: a new classical economics.
First, the analysis is carried out in a classical way because it is assumed that
wages and prices are flexible (perfectly elastic). This implies that an economy
returns to equilibrium at the potential level of output and the natural rate of
unemployment.
37
The new classical school
Second, the analysis is new because it explains exactly what is the speed
of the adjustment process. According to the new classical school, both prices
and wages adjust almost immediately (continuously). It means that an economy
fairly rapidly returns to the potential output level. The standard classical analysis
did not give a precise explanation of the period covered. According to the most
common interpretation, it was a time long enough to fully adjust wages and
prices, that is to achieve the potential output (full employment). New classical
economics says, both wages and prices adjust almost immediately (continuously).
In other words, the actual output almost always equals the potential output
and the observed unemployment rate equals the natural rate. Only unexpected
shocks may yield temporary deviations of output and employment from their
natural levels. In this situation, there is no hysteresis phenomenon.
According to the new classical school, government policy (both fiscal
and monetary) can only influence the structure of aggregate demand at full
employment level. The volume of aggregate demand is determined by the level
of potential output.
Now we will discuss in detail the three assumptions which constitute the core
of the new classical economics.
The rational expectations hypothesis
The rational expectations hypothesis can be derived from the work of John
Muth in 1961, although some economists suggest that the model of rational
expectations was presented by Tinbergen 30 years earlier. This hypothesis was
not quickly used by economists and it took almost 10 years before it began to
be widely taken into account in macroeconomic models by Lucas and other
supporters of the new classical school.
The hypothesis of rational expectations is used in the economic literature in
different forms. It is worth quoting the two versions: weak and strong.
On the one hand, a weak version of the rational expectations hypothesis
states that rational economic agents, when formulating expectations (forecasts)
about future values of variables, use in the best (most efficient) way the set of all
available information about the factors that – according to their opinion – affect
a given variable. In other words, expectations are formed rationally in line with
the behaviour of utility-maximizing individuals. For example, if agents believe that
inflation is equal to the growth rate of money supply, inflationary expectations
will be formulated by economic agents using all available information on the
planned scale of monetary expansion.
On the other hand, a strong version of the rational expectations hypothesis
(formulated by Muth) assumes that subjective expectations about future values
of economic variables made by individuals will coincide with objective (true)
mathematical conditional expectations of these variables. Using the example
38
1. The structure of new classical models
of the expected rate of inflation, the rational expectations hypothesis can be
written as follows:
π te = E (π t | Inft −1 ) .
(1)
In the above equation, πte is the expected rate of inflation between period
t and t + 1, while E(πt|Inft–1) is the expected inflation rate conditional on a set of
information available to economic agents in period t – 1.
It is worth noting that rational expectations hypothesis does not mean that
economic agents foresee the future correctly. Rational expectations do not imply
perfect economic forecasts. For example, expectations about future inflation are
based on a model which, according to individuals, is appropriate for this type of
analysis. However, individuals may make errors in forecasting because they do
not have access to the full set of information. But given rational expectations,
individuals’ forecasts will be correct in the average terms: there will not be any
systematic errors up or down. If such systematic errors occurred, individuals
would learn from their mistakes and would revise their forecasts to eliminate
this problem.
More formally, a strong version of the rational expectations hypothesis
implies:
π te = π t + ε t ,
(2)
where πte and πt are the expected and actual inflation rates between period
t and t + 1 respectively, εt is a random factor. A random factor has a zero mean
and it is not correlated with the set of information available during the time
of formulating expectations (otherwise, individuals would not take fully into
account all available information).
Summing up, the rational expectations hypothesis assumes that forecast
errors have the following characteristics:
a) they are random with a zero mean,
b) they do not depend on errors made in previous periods (there is no
systematic tendency to make errors biased upwards or downwards),
c) they have the lowest variance in comparison with any other forecasting
method.
Continuous market clearing
Another assumption of the new classical school is that markets clear
continuously in line with the Walrasian tradition. At any point of time, the
markets are clear, i.e. they are in equilibrium where demand equals supply. When
we apply this assumption to the whole economy, it turns out that the economy
39
The new classical school
is continuously in equilibrium (both in the short run and long run). Therefore,
the new classical models are treated as equilibrium models.
The fact that markets are always in equilibrium implies that prices are flexible
(perfectly elastic). Flexibility of prices allows the markets to clear continuously.
The assumption of continuous market clearing is much more controversial
than the rational expectations hypothesis. The controversies concern in particular
the labour market. The assumption adopted by the new classical economists
implies that anyone who wants to work can find a job at a wage rate that clears
the labour market. Thus, the new classical school treats unemployment as an
entirely voluntary phenomenon.
The aggregate supply hypothesis
The aggregate supply hypothesis – like the rational expectations hypothesis
– is described in the literature in several ways. Here we will present the two
approaches.
1. The intertemporal substitution model of labour and leisure
The first approach is based on the intertemporal model of labour-leisure
choice, derived from the paper written by Lucas and Rapping in 1969. In each
period, an individual decides to divide his time between work and leisure. The
choice depends on the actual level of real wages in relation to the expected
(normal) real wages. If the actual wage rate in the current period is higher than
expected, the individual will work more (and have less leisure) in the current
period, anticipating that in the future – when the real wage will be lower than
expected – he will work less and have more free time. This model is called the
intertemporal substitution model because it includes the trade off between the
current and future leisure. This model implies that changes in employment are
treated as a voluntary choice of workers who supply labour depending on their
expectations about real wages.
2. The Lucas ‘surprise’ supply function
The second new classical approach to the aggregate supply hypothesis refers
to the papers written by Lucas in 1972 and 1973. This approach shows how the
supply of firms depends on the actual and expected inflation rate. We assume
that firms know the prices only at those markets at which they trade, while the
prices in other markets (i.e. the general price level in the economy) is known by
the firms with a significant delay. Whenever firms face an increase in the price of
their output, they must decide whether this increase occurs only in their markets
(and may reflect the increase in consumer demand for their goods and services),
or whether this increase corresponds to an increase in the general price level
in the economy (which may result from the growth of nominal demand in all
markets). In the former case, the appropriate firms’ response is to increase the
40
2. Equilibrium business cycle theory
output, while the latter case does not involve any supply responses. In other
words, firms have to distinguish between absolute and relative price changes.
If we apply the above reasoning to both the supply of labour by workers and the
supply of goods by firms, we get the so called Lucas ‘surprise’ supply function:
Y − Y * = α (P − P e )
or
Y − Y * = α (π − π e ).
(3)
In the above equation, Y is the actual output, Y* is the level of potential
output, while P, Pe, π, πe denote respectively the actual or expected levels of
prices or inflation. Equation (3) implies that output is different from the potential
level when the actual price level or the actual rate of inflation does not equal
the expected value. For example, if the observed price level (or inflation) exceeds
the expected value, economic agents are ‘surprised’ by the price increase and
supply more labour and more output to the market. As a result, both output and
employment are greater than their potential or natural levels.
We shall return to this case later in the chapter when we analyse in detail
the implications of government policy. Graphical analysis presented there will
facilitate the understanding of this approach.
2. Equilibrium business cycle theory
We have just shown that the volume of aggregate supply depends on relative
prices (the difference between the expected price level and the general price
level in the economy). This hypothesis provides the basis for explaining the
fluctuations in output and employment by new classical economists. Important
papers in this field were written by Lucas in 1975 and 1977.
According to the new classical school, unanticipated shocks in aggregate
demand (resulting mainly from unanticipated changes in money supply) yield
errors in inflationary expectations. Although the new classical school assumes
the existence of rational expectations, errors are likely to be made as a result of
unanticipated changes. Such errors in inflationary expectations imply that both
output and employment may deviate from the long-run equilibrium level (i.e.
the potential or natural level). The direct cause is the fact that given imperfect
(incomplete) information, firms and workers treat changes in the general price
level as changes in relative prices and, as a result, supply to the market more or
less labour (in the case of workers) or goods and services (in the case of firms),
compared to the natural level.
We now explain the equilibrium business cycle theory based on the growth
in money supply. Initially, output and employment are at natural levels. Suppose
the central bank adopts an unanticipated expansionary monetary policy. As we
have shown, this leads to an increase in the overall price level in the economy.
41
The new classical school
But firms control continuously only the prices at the markets at which they
trade. Therefore, firms erroneously treat the increase in the general price level as
the increase in relative prices for their output and begin to supply more goods
and services. A similar illusion affects workers: they treat the increase in nominal
wages as the increase in real wages and supply more labour. As a result, output
and employment will temporarily exceed the natural level. As soon as firms
and workers recognize that there are no changes in relative prices, output and
employment will return to the potential (natural) level.
As we can see, the fluctuations in output and employment (around the natural
level) result from random shocks (caused mainly by unanticipated changes
in money supply), which leads to expectational errors. However, the rational
expectations hypothesis, which constitutes the basis of the new classical school,
assumes that such errors are random and they do not reveal any systematic
tendency to deviate up or down. As a result, output and employment will vary
randomly around the potential (natural) level.
It is worth noting that, in contrast to monetarism, the new classical school
does not assume the existence of information asymmetry between firms and
workers. Both of them treat the increase in the general price level as the increase
in relative prices and supply more goods (firms) or more labour (workers). On the
other hand, in the Friedman model analyzed in the previous chapter, fluctuations
of output and employment around the natural level resulted, inter alia, from the
fact that workers were fooled.
3. The policy implications of new classical approach
In this section, we will illustrate in detail the government policy implications
according to the new classical school. This issue was briefly discussed at the
beginning of the chapter. Here we extend the analysis and we show, inter alia,
its graphical representation. For this purpose, we use the AD-AS model with
inflationary expectations.
The expectations-augmented supply functions
Figure 1 shows the derivation of the expectations-augmented aggregate
supply curve. This curve is derived from the labour market.
Panel (a) of Figure 1 shows three labour demand functions that correspond to
three different price levels (P1 > P0 > P2) as well as the expectations-augmented
labour supply curve that is associated with the expected price level of P0. If the actual
price level is equal to P0 (and therefore equal to the expected level), the nominal
wage will be set at W0 to clear the market. In the labour market equilibrium, the
real wage will equal W* and employment will be at the natural level of L* (full
employment). This outcome will occur in the absence of any expectational errors
42
3. The policy implications of new classical approach
made by workers or firms. However, if the observed price level is P1 but workers
do not change inflationary expectations and expect the price level of P0, then firms
are eager to raise nominal wages and increase employment – labour demand
rises to DL(P1) – meanwhile workers will want to supply more labour because they
believe that real wages have increased. In this case, that is when workers expect
the price level of P0 and the actual price level is P1 and is well-known by firms, the
employment will be L1 (more than L*) and the nominal wage will be set at W1.
The money wage W1 is greater than W0, but the real wage W1/P1 is less than W*
(otherwise firms would not employ more than L* workers).
Figure 1
W
P
SL[ t-1E(Pt ) = P0 ]
W1
EAS[ t-1E(Pt ) = P0 ]
W0
P1
W2
DL(P1 )
P0
P2
DL(P0)
DL(P2)
L2
L*
L1
(a)
L
Y2
L2 → Y2
L* → Y*
L1 → Y1
Y*
Y1
Y
(b)
(a) The labour market and the expectations-augmented labour supply curve
(b) The expectations-augmented aggregate supply curve
Panel (b) of Figure 1 shows the expectations-augmented aggregate supply
curve associated with the expected price level of P0. This curve is derived from
the expectations-augmented labour supply function. Y* is the volume of
potential output. If the actual price level is P0, workers’ inflationary expectations
are formulated correctly and the labour market is in equilibrium with the natural
employment L*, which corresponds to the potential level of output Y*. However,
if the actual price level is different than P0 (still assuming the expected price level
to be P0), workers make expectational errors and employment will be more or
less than L*, which corresponds to the volume of output greater or less than Y*
(e.g. the employment L2 is associated with the output of Y2).
The above analysis is conducted in line with the new classical approach. When
43
The new classical school
deriving the expectations-augmented labour supply curve, we have assumed –
in line with the classical view – that labour market clears and money wages are
flexible. The fluctuations in employment around the natural level L* are the
result of expectational errors. Thus, we can say that the analysis is based on the
natural rate hypothesis with flexible nominal wages that clear the labour market
given workers’ price expectations.
Expectations-augmented aggregate supply curves can be derived for different
levels of expected prices. As a result, we get the family of such curves shifted in
parallel to each other. For each curve, the price level depicted on the vertical axis
and corresponding to potential output (Y*) must be equal to the expected price
level for which a given EAS curve was derived. In other words, if output is equal
to the potential level, the expected and observed prices are the same.
Figure 2. The equilibrium in the economy according to the new classical school
P
LAS
EAS[ t-1E(Pt ) = P4 ]
P4
P0
EAS[ t-1E(Pt ) = P0 ]
E
EAS[ t-1E(Pt ) = P3 ]
P3
AD
Y*
Y
In order to obtain a full picture of the AD-AS model, we have to derive the
long-run aggregate supply curve (LAS) and the aggregate demand curve (AD),
also known as the macroeconomic demand schedule (MDS). These functions are
derived in a standard way. As the expectations-augmented aggregate supply
curves concern the short run, they can be treated as the short-run aggregate
supply functions (SAS).
The full picture of the AD-AS model in line with the new classical approach is
shown in Figure 2. The equilibrium is at point E – at the intersection between AD,
EAS and LAS functions (in equilibrium, the price level plotted on the vertical axis
must be the same as the expected price level for which a given EAS curve was
derived). The equilibrium point at the potential output level results, inter alia,
from the fact that new classical economists assume the rational expectations
44
3. The policy implications of new classical approach
hypothesis. Rational expectations are formulated based on a good knowledge
of the parameters of the model describing the economy and complete
available information. In other words, rational economic agents formulate their
expectations knowing the position of the EAS and AD curves. In such a situation,
workers expect the prices to be P0. Thus, the point of intersection between the
LAS and AD functions lies on that EAS curve which is derived for the expected
price level of P0. According to the new classical school, the economy will be in
disequilibrium (output different than potential level) only due to expectational
errors arising from unknown random shocks. The rational expectations hypothesis
implies that differences between the expected and actual inflation rate are
random and no systematic downward or upward deviations occur. Hence, the
economy almost immediately returns to the potential level.
The effects of expansionary government policy
As we have already presented the behaviour of the economy according to
the assumptions of the new classical school, we can analyse the government
policy implications. We will consider the effects of expansionary policy in two
variants:
• policy is unanticipated,
• policy is anticipated.
We will conduct the analysis based on the monetary policy. The results,
however, will be the same for fiscal policy. The most important here is the fact
whether the policy is anticipated or unanticipated, and not whether the increase
in aggregate demand is caused by monetary or fiscal expansion.
Figure 3. The effects of anticipated and unanticipated expansionary policy
P
LAS
P2
P1
P0
EAS[ t-1E(Pt ) = P2 ]
G
F
Anticipated expansionary policy:
E → G
Unanticipated expansionary policy:
E → F → G
EAS[ t-1E(Pt ) = P0 ]
E
AD1
AD0
Y*
Y1
Y
45
The new classical school
Figure 3 illustrates the analysis. Initially, the economy is in equilibrium at point
E, where the curves AD0, LAS and EAS intersect (at point E, the EAS function must
correspond to the expected price level of P0). This is the long-run equilibrium.
Indeed, if workers estimate the aggregate demand to be at AD0 level, they expect
the price level of P0 and, on this basis, they formulate inflationary expectations
reflecting by the EAS[t–1E(Pt) = P0] curve. As the new classical school assumes
that expectations are rational and, moreover, if we assume that there are no
unexpected shocks, then the economy will be in long-run equilibrium given by
point E with potential output and natural unemployment.
1. Unanticipated expansionary monetary policy
Suppose that an unanticipated increase in aggregate demand takes place
due to an expansionary monetary policy (as we said earlier, this analysis will
also be proper when an unexpected increase in aggregate demand is caused by
fiscal expansion). The aggregate demand curve shifts rightwards to AD1. Firms
misinterpret the increase in the general price level in the economy as an increase
in their relative prices and consequently increase the volume of output. To attract
more workers, firms will raise money wages. Similarly workers, who expect the
price level of P0, treat the increase in money wages as an increase in real wages
and supply more labour. The economy moves from point E to F: output increases
from Y* to Y1 and the price level raises from P0 to P1.
Point F will not be a long-run equilibrium because it includes expectational
errors. In fact, real wages have fallen, not risen, while the relative prices have not
changed (there was only an increase in the general price level). Assuming rational
expectations, workers will recognize that the new demand curve is AD1. Given
the aggregate demand of AD1, a potential output is achieved when the prices
are P2. Workers will review their inflationary expectations: they will expect the
price level of P2. As a result, a short-term aggregate supply curve shifts upwards
to EAS[t–1E(Pt) = P2]. The economy achieves the new long-run equilibrium given
by point G. At point G, the volume of output and employment is the same as at
E (natural level), but the prices are higher.
2. Anticipated expansionary monetary policy
Suppose that an anticipated increase in aggregate demand takes place
due to expansionary monetary (or fiscal) policy. For example, the central bank
announces in advance the increase in nominal money supply.
Under such circumstances, workers expect the aggregate demand curve to be
in the AD1 position. Hence, they immediately revise their inflationary expectations
and expect the price level of P2. The move of the aggregate demand curve to
the right (upwards) will be offset by an immediate shift of the EAS curve to the
left (also upwards). The economy moves from point E directly to a new longrun equilibrium G. Even in the short run, there is no increase in output and
46
3. The policy implications of new classical approach
employment: output and employment are continuously at their natural levels.
To wrap up, the new classical school states that:
• anticipated growth in money supply leads only to an increase in prices and
does not affect the volume of output and employment even in the short
run (the shift from point E to G),
• unanticipated growth in money supply leads similarly to an increase in
prices, although in the short run it causes a temporary increase in output
and employment (the shift from point E to F to G).
As we can see, the demand-management policy cannot be – according to the
new classical school – a source of sustainable economic growth. This is also known
as the policy ineffectiveness proposition. The new classical policy ineffectiveness
proposition was first presented by Sargent and Wallace in 1975 and 1976.
It is worth noting that the anticipated growth in money supply (the shift
from E to G) is consistent with the orthodox monetarist approach in the long
run, while the unanticipated increase in money supply (the shift from E to F to
G) is compatible with the orthodox monetary approach in the short run.
The costs of anti-inflationary policy
The second important implication of the new classical approach focuses
on the costs (in terms of lost output and employment) of anti-inflationary
government policy. New classical economists – like monetarists – believe that
inflation is a monetary phenomenon and is caused by the excessive growth
of money supply. The representatives of various schools of economic thought
differ, however, in what are the costs of anti-inflationary policy.
New classical economists believe – as we have just shown – that anticipated
changes in fiscal or monetary policy do not affect the volume of output and
employment even in the short run: output is continuously at its potential level and
employment is at the natural level (the economy moves along the LAS curve upwards
or downwards depending on whether the policy is expansionary or restrictive).
Thus, if monetary authorities announce a tightening of monetary policy, rational
economic agents will revise their inflationary expectations downwards. Referring
to Figure 3, the economy moves from point G to E: the volume of output does not
change and the price level (inflation rate) decreases. This is because the shift of
the aggregate demand function from AD1 to AD0 due to tightening of monetary
policy is accompanied by a simultaneous shift of the EAS curve downwards,
resulting from an immediate revision of inflationary expectations. Summing up,
the new classical school states that government can reduce inflation without any
loss of output and employment. The sacrifice ratio is zero.8
8
The sacrifice ratio is the amount of output that an economy endures in order to reduce inflation.
47
The new classical school
Let us compare these conclusions with the monetarist school discussed in the
previous chapter and the Keynesian model presented later in the book.
On the one hand, monetarists argue that the tightening of monetary policy
leads to a fall in output and a rise in unemployment in the short run. The output
returns to the potential level only in the long run when workers adjust their
inflationary expectations to the new situation. The sacrifice ratio is greater than
zero, and its size depends mainly on the speed of adjustment in expectations
to monetary policy changes, that is on the credibility and reputation of the
monetary authorities.
On the other hand, in the Keynesian model, the sacrifice ratio is high. Due
to rigidity of prices and wages, a drop in aggregate demand causes a fall in
output and employment (according to Keynesians, it happens even if economic
agents have rational expectations). The increase in the sacrifice ratio is further
strengthened by the hysteresis effect, i.e. the situation when the reduction in
aggregate demand and a recession both lead to an increase in the natural rate
of unemployment.
Economic growth determinants
Another policy implication of the new classical approach focuses on economic
growth determinants. According to the new classical school, economic growth
determinants are the supply-side factors. This follows from the fact that output
is assumed to be at the potential level and the economy records only the
natural rate of unemployment. In such circumstances, changes in output and
employment reflect equilibrium supply decisions of workers and firms, given
their perception of relative prices.
According to the new classical economics, labour market is continuously
in equilibrium. Unemployment is entirely voluntary because the unemployed
people simply do not want to work given the existing real wage. In such
a situation, stimulating aggregate demand does not lead to growth in output
and employment. The only thing the government can do is to affect the supply-side of the economy. The government should conduct activities that improve
microeconomic incentives of workers and firms to supply more labour and to
produce more output. The examples of supply-side actions pursued by the
government to stimulate economic growth include, inter alia:
• to increase productivity of inputs to production and total factor productivity,
• to increase economic efficiency by e.g. faster privatization, structural reforms,
favourable changes in institutional environment,
• to cut taxes, especially marginal income tax rate, that increases incentives to
work,
• to raise labour market elasticity (in terms of wages and employment
conditions),
48
4. Summary
• to reduce the power of trade unions,
• to increase mobility of workers (both geographically and structurally).
The Lucas critique of the econometric modelling of government policy
effects
According to the new classical school, the econometric modelling of
government policy effects is useless. This is known as ‘the Lucas critique’
and was first presented by Lucas in 1976. He criticized the use of large-scale
econometric models to evaluate the effects of different government policies
because these models are based on past values of the parameters while they
may vary due to changes in economic policies. This follows from the fact that
economic agents can adjust their behaviour to the new environment. The Lucas
critique has important policy implications. As policy makers cannot estimate the
impact of new or revised government actions on the parameters of the model,
simulations based on the existing econometric models cannot be used to assess
the effects of different economic policies.
4. Summary
1. The new classical school is based on three assumptions: (a) the rational
expectations hypothesis, (b) continuous market clearing, (c) the aggregate
supply hypothesis. (The last two ones may also be referred to as the natural
rate hypothesis). Thus, output is assumed to be at the potential level and the
economy records only the natural rate of unemployment.
2. Anticipated growth in money supply leads only to an increase in prices
and does not affect the volume of output and employment even in the short
run. Unanticipated growth in money supply leads similarly to an increase in
prices, although in the short run it causes a temporary increase in output and
employment.
3. Inflation is a monetary phenomenon and is caused by the excessive growth
of money supply. Thus, government can reduce inflation without any loss of
output and employment. The sacrifice ratio is zero.
4. Business cycles result from random shocks (caused mainly by unanticipated
changes in money supply) that lead to expectational errors. The rational
expectations hypothesis says that such errors are random and they do not reveal
any systematic deviations up or down. Hence, both output and employment
vary randomly around the potential (natural) level.
5. Economic growth determinants are the supply-side factors.
49
The new classical school
Bibliography
Begg, D., S. Fischer, R. Dornbusch, 2005, Economics, London, McGraw-Hill.
Polish translation: Begg, D., S. Fischer, R. Dornbusch, 2007, Makroekonomia,
Warszawa, PWE.
Hillier, B., 1992, The Macroeconomic Debate. Models of the Closed and Open
Economy, Oxford, Blackwell Publishers.
Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics.
An Introduction to Competing Schools of Thought, Cheltenham-Northampton,
Edward Elgar.
Additional bibliography
Lucas, R.E., 1972, Expectations and the Neutrality of Money, Journal of Economic
Theory, April.
Lucas, R.E., 1973, Some International Evidence on Output-Inflation Tradeoffs,
American Economic Review, June.
Lucas, R.E., 1975, An Equilibrium Model of the Business Cycle, Journal of Political
Economy, December.
Lucas, R.E., 1976, Econometric Policy Evaluation: A Critique, in: The Phillips
Curve and Labor Markets (eds K. Brunner, A.H. Meltzer), Amsterdam, North
Holland, Carnegie-Rochester Series on Public Policy.
Lucas, R.E., 1977, Understanding Business Cycles, in: Stabilization of the Domestic
and International Economy (eds K. Brunner, A.H. Meltzer), Amsterdam–New
York, North Holland.
Lucas, R.E., L.A. Rapping, 1969, Real Wages, Employment and Inflation, Journal
of Political Economy, September/October.
Muth, J.F., 1961, Rational Expectations and the Theory of Price Movements,
Econometrica, July.
Sargent, T.J., N. Wallace, 1975, Rational Expectations, the Optimal Monetary
Instrument and the Optimal Money Supply Rule, Journal of Political Economy,
April.
Sargent, T.J., N. Wallace, 1976, Rational Expectations and the Theory of Economic
Policy, Journal of Monetary Economics, April.
50
CHAPTER FOUR
Mariusz Próchniak
The real business cycle school
We know from the previous chapter that during 1972–82 the dominant
new classical theory was the monetary surprise model developed by Lucas in
1972 and 1973. This model implies that unanticipated changes in nominal
money supply cause temporary deviations of output and employment from the
potential level. However, anticipated changes in money supply do not influence
the real economy, which is known as the Sargent-Wallace policy ineffectiveness
proposition. Despite strong influence of the Barro-Lucas-Sargent-Wallace
surprise monetary explanation of the business cycle, until 1982 these models
shared theoretical and empirical impasse.9
In such circumstances, some supporters of the new classical school began
looking for a modified concept of the business cycle, which would be free
from theoretical and empirical weaknesses. The outcome was a real business
cycle theory. It replaces the impulse mechanism of the previous models (i.e.
unanticipated growth of money supply) with the supply-side shocks in the form
of random technological changes.
Since the early 1980s, the main new classical explanation of the business cycle
began to focus on real rather than nominal shocks. This theory was named the
real business cycle school. Its origin dates back to 1982 when Kydland and Prescott
developed a non-monetary equilibrium model. This model, supplemented by Long
and Plosser in 1983, constitutes the basis of the real business cycle theory.
As the real business cycle theory is derived from the new classical school,
the ‘core’ remains the same. Both currents assume rational expectations and
continuous market clearing. Moreover, as it will be discussed later, the real
business cycle theory does not distinguish between the short run and the long
run. Hence, the conventional definition of hysteresis does not apply here.
9
A similar monetary approach to business cycle analysis belongs to monetarists.
51
The real business cycle school
Main supporters of or contributors to the real business cycle school include,
inter alia, Finn Kydland, Edward Prescott, John Long, Charles Plosser, Robert
Barro, Sergio Rebelo (U.S.).
1. Business cycle theories in historical perspective
Real business cycle theory assumes that there are large random changes in
the pace of technological progress. Such supply-side shocks in the production
function cause fluctuations of output and employment. This theory is largely
a response to earlier monetary business cycle models and shows an increased
interest in the supply side of the economy.
The idea that business cycles are caused by real, not nominal forces is certainly
not a new idea. The real business cycle model developed by Kydland and Prescott
in 1982 belongs to a broad family of models that played an important role in the
literature before Keynes’ General Theory.
For example, changes in the level of technology were important in Schumpeterian analysis of short-run instability and long-run dynamics of a capitalist
economy. In 1939, Schumpeter – like today’s supporters of real business cycle
theory – treated business cycles and economic growth as interrelated phenomena. This follows from the fact that the introduction of a new technology affects
long-run productivity growth as well as short-term fluctuations of output.
Following the publication of Keynes’ General Theory, business cycle models
were based on the multiplier-accelerator mechanism. These models also had
a real character, but included the demand-side perspective: business cycles
resulted from fluctuations in real aggregate demand, which were primarily
caused by unstable investment expenditures.
Multiplier-accelerator models ceased to play a dominant role in the economic
literature in the early 1960s. During the 1960s, macroeconomic analyses
abandoned to focus on business cycles and dealt primarily with an analysis of
methods and actions that may improve the macroeconomic performance. In the
1970s and 1980s, the interest in analysing cyclical fluctuations came back. The
real business cycle theory, developed in the 1980s, was a competition not only
for earlier Keynesian models (focusing on fluctuations in aggregate demand),
but also for monetarist models and the early new classical models (that highlight
the monetary approach to the business cycle).
The transition from a monetary to real approach of the business cycle has
been reinforced by two other factors. The first was the increase in oil prices in
the 1970s, which stressed the importance of the supply side of the economy.
Second, Nelson and Plosser in 1982 indicated that real shocks may play a much
more important role in explaining output fluctuations than monetary shocks.
According to these authors, empirical evidence shows that output follows a path
known as a random walk.
52
2. Cycles versus random walks
2. Cycles versus random walks
The traditional approach to business cycle and economic growth analysis
is the following: the economy exhibits a long-run trend of output, but real
GDP fluctuates around this trend. These fluctuations have, however, a shortrun nature and, in the long run, GDP returns to a trend path. The problem
facing economists is to separate the two components of output dynamics:
trend and cyclical fluctuations. In the traditional approach, short-run GDP
fluctuations around the trend result mainly from the volatility in aggregate
demand. All deviations of output from the trend are therefore treated as
temporary. Such a traditional approach is supported by Keynesians as well as
monetarists and new classical economists, although there are some differences
(sometimes very significant) between these schools. For example, according
to Keynesians, deviations of actual output from the trend may be severe and
take a relatively long time (so these economists support the government
stabilization policy), while monetarists and especially proponents of the new
classical school treat deviations as much smaller and shorter (so they are
against an active government intervention aimed at stimulating aggregate
demand).
Despite some differences, in all these schools the business cycle (or more
precisely – the time path for GDP) can be written as follows:
GDPt = gt + α ⋅ GDPt −1 + ε t ,
(1)
where gt is the average GDP growth rate (that is, a deterministic trend), εt
is a random factor (with a zero mean) representing random shocks, and α is
a parameter in the interval (0;1).
Given such a traditional approach to the business cycle, suppose that in
period t there is a positive shock, lasting one period. Referring to Equation (1),
it means that εt increases. This causes the deviation of output above the trend
line. As time passes, however, output will return to the trend. This is because the
parameter α ranges between 0 and 1. Thus, output in period t depends on the
output from the previous period, but to a lesser degree.
The traditional approach to the business cycle, where output exhibits short-run fluctuations around the trend line, is shown in Figure 1a. The figure
illustrates the effects of a single positive shock. For example, if in the period
t0 there is an unanticipated increase in money supply, the economy will return to
its potential level at the time of t1. This analysis is fully consistent with the new
classical school.
In 1982, Nelson and Plosser criticized the traditional approach to the business
cycle. They showed that monetary disturbances do not explain much of the
observed fluctuations in output. These authors argue that the primary source of
53
The real business cycle school
output fluctuations is stochastic variation due to real factors. Nelson and Plosser
came to this conclusion by examining the U.S. economy. They could not reject
the hypothesis that U.S. GNP followed a path of a random walk. Thus, they state
that the majority of changes in output is permanent, not temporary. After the
shock, the economy does not return to the previous trend path. We can say,
therefore, that GDP behaves in line with a random walk.
A random walk path with drift is described by the following equation:
GDPt = gt + GDPt −1 + ε t ,
(2)
where gt is a drift of output.
Figure 1. Business cycle: (a) the traditional approach, (b) a random walk
GDP
GDP
t0
t1
(a)
Time (t)
t0
Time (t)
(b)
The main difference between equations (1) and (2) is that in Equation (2) the
parameter on GDP from the previous period is equal to 1. This means that any
shocks in productivity are permanent. They bring the economy to a new path. In
other words, the increase in output lasts forever (the economy does not return
to the previous trend line).10
A random walk approach to the business cycle is illustrated in Figure 1b. As
we can see, after a positive shock at time t0 there is a permanent increase in the
level of output as compared with the earlier trend.
The results obtained by Nelson and Plosser have important implications. If
the shocks due to technological changes that lead to an increase in production
are random and frequent, then GDP, which follows a random walk, will behave
as it would reveal cyclical fluctuations. In this case, however, fluctuations in GDP
reflect fluctuations in the potential output; not deviations of the actual output
10
This follows with the assumption that there will not be any negative shocks which move down
the path at which the economy is currently situated.
54
3. Real business cycle theory
from the deterministic trend. In other words, that what seems to be fluctuations
around the trend is the volatility of the trend itself, as a result of various supply-side shocks that have permanent nature and put the economy on a new path
of economic growth.
Hence, although in traditional terms the analysis of economic growth was
separated from the business cycle analysis, Nelson and Plosser indicate that such
analyses cannot be treated separately. The forces that yield economic growth are
the same as those that cause cyclical fluctuations. Proponents of the real business
cycle theory integrated the growth theory with the theory of cyclical fluctuations.
Since permanent changes in the level of GDP cannot result from monetary
shocks (the neutrality proposition supported by new classical economists), the
main sources of output fluctuations are real shocks. Proponents of the real business
cycle theory point out that in well-developed market economies, supply-side shocks
arise primarily from technological changes. These include changes in productivity
caused by changes in labour and capital quality, new management strategies,
inventing new products, and introduction of new production techniques.
3. Real business cycle theory
The real business cycle theory is derived from the new classical school, so
most of the assumptions remain the same. However, in some cases there are
changes as compared with the new classical economics. Real business cycle
theory is based on the following assumptions:
• prices are flexible. It implies a continuous market clearing and a permanent
equilibrium,
• expectations are rational and there is no information asymmetry. Although
some problems with information may occur (e.g. whether a given productivity
shock is permanent or temporary), information on the general price level is
publicly available,
• consumers maximize utility and firms maximize profits given budget or
resource constraints,
• changes in employment reflect voluntary decisions of workers. Labour and
leisure are characterised by high intertemporal substitution,
• fluctuations in output and employment are due to random technological
changes,
• money is neutral, so that monetary policy does not affect real variables,
• the distinction between the short run and the long run in the analysis of
trend and cyclical fluctuations is abandoned.
As we can see, the differences between the real business cycle theory and
the new classical school concern mainly three aspects. First, the real business
cycle theory ignores the distinction between the short run and the long run,
55
The real business cycle school
integrating the theory of economic growth with the business cycle theory.
Second, in the real business cycle theory there is no incomplete information
on the general price level (while in the Lucas ‘surprise’ supply model described
in the previous chapter the lack of knowledge on the general price level
caused expectational errors made by both firms and workers). Third, the real
business cycle theory assumes that shocks result from technological changes,
and not – as in the new classical economics – from monetary sources.
Technological shocks
In line with the work of Frisch (1933), proponents of the real business cycle
theory distinguish between the two mechanisms associated with shocks:
• impulse mechanism,
• propagation mechanism.
Impulse mechanism is a shock that throws the economy off its previous
steady-state. Propagation mechanism includes the forces which cause that
abandoning of the steady-state is permanent and the economy moves towards
a new growth trajectory.
Real business cycle theorists argue that shocks are primarily caused by
technological changes. Technical progress according to the real business cycle
theory looks, however, slightly different than in the standard Solow model. In the
Solow model, which will be discussed later in the book, technological progress
is exogenous and occurs smoothly over time. In other words, the variable
measuring the level of technology is growing at a constant rate, implying that
output rises smoothly over time. By contrast, real business cycle theorists state
that changes in the level of technology fluctuate randomly, so that economy
behaves as if it showed business cycles.
Let us discuss the effects of a positive supply-side shock. We use the figure
depicting the production function and the labour market. The analysis follows
a point of view of the real business cycle theorists. This is the example of the
impulse mechanism.
The upper part of Figure 2 shows the production function for a given physical
capital stock (therefore, labour is plotted on the horizontal axis). The lower part
of Figure 2 illustrates the labour market with standard labour demand and
supply functions.
We assume that initially the level of technology is low, that is, the variable
A, representing the technology, is equal to A1. The production function is in the
position Y = A1·F(K,L). Employment equals L1, and the output (GDP) amounts
to Y1. Labour market is in equilibrium: given labour demand function of DL1
and labour supply function of SL, employment at the level of L1 corresponds to
equilibrium real wage of W1.
56
3. Real business cycle theory
Suppose now that a positive supply-side shock takes place caused by random
technical progress. The level of technology rises to A2. The production function
moves to a new position Y’ = A2·F(K,L). The shift of the production function
affects positively the marginal product of labour. As a result, firms want to
employ more workers and the demand for labour increases from DL1 to DL2. All
these changes lead to an increase in output (from Y1 to Y2), employment (from
L1 to L2), as well as an increase in real wages (from W1 to W2).
Figure 2. The effects of a positive technological shock
Output (Y)
Y’ = A2 . F(K, L)
Y2
Y = A1 . F(K, L)
Y1
L1
Labour (L)
L2
Real wage (W)
SL
W2
W1
DL2
DL1
L1
L2
Labour (L)
In explaining how the economy responds to shocks, it is worth noting that
real business cycle theorists argue that unemployment is entirely voluntary and
the labour market is continuously in equilibrium. Thus, changes in employment
reflect voluntary decisions of workers and firms. This phenomenon can be
explained based on the intertemporal substitution model of labour and leisure,
discussed in the previous chapter. According to this model, the volume of
57
The real business cycle school
employment may fluctuate because decisions so as to divide time between
labour and leisure depend on both the current and future real wages.
Referring to Figure 2, the amplitude of the fluctuations in employment
depends on the elasticity of labour supply with respect to real wages. When the
curve is relatively inelastic (that is, quite steep), large fluctuations in real wages
imply small changes in the level of employment. By contrast, if the labour supply
curve is relatively elastic (flat), then small changes in real wages imply large
changes in the level of employment. ‘Stylized facts’ of the business cycle seem
to confirm this second option – small changes in real wages correspond to big
changes in the volume of employment.
Intertemporal labour substitution hypothesis
Real business cycle theorists believe that a large share of employment
fluctuations due to changes in real wages can be explained by the
intertemporal model of labour and leisure. The intertemporal labour
substitution hypothesis states that people supply more labour to the market
and enjoy less leisure if real wages are temporarily high. By contrast, if real
wages are lower than their long-run normal level, the supply of labour
declines. This hypothesis was first presented by Lucas and Rapping in 1969.
It explains the propagation mechanism that follows the impulse mechanism
(technological shock).
Intertemporal labour substitution hypothesis works in the following way.
In each period, an individual allocates its time between labour and leisure.
Individuals use labour income to purchase goods and services. The consumer’s
utility function depends on two variables: consumption and leisure. When
choosing the optimal time allocation, an individual takes into account both the
current and future wage rate.
Let us assume that real wage increases above the normal level. This change
yields two effects: substitution and income effect. The substitution effect leads
to an increase in the time devoted to labour in the current period. The income
effect works in the opposite direction: since people are richer, they work less and
choose more leisure. The total effect depends on which effect dominates.
Real business cycle theorists distinguish between permanent and temporary
changes in real wages due to technological shocks. Intertemporal labour
substitution hypothesis yields two implications in this field.
First, if both the shock and the resulting change in real wages are temporary, the volume of employment reveals significant fluctuations. For example,
a temporary rise in real wages implies that individuals decide to increase
significantly the current labour supply and enjoy less leisure in the current
period. In the future, when people expect real wages to fall to the normal level,
labour supply will decline. By contrast, if both the technological shock and the
58
3. Real business cycle theory
change in real wages are permanent, the change in employment will not be
so large as in the case of a temporary shock. In the extreme situation, if the
income effect dominates, labour supply in the current period may even fall.
Second, some economists (e.g. Barro 1981, 1993) point out the impact of
real interest rate on the supply of labour. According to their view, an increase
in the real interest rate raises the supply of labour in the current period. This is
because the rise in real interest rate positively affects the value of income earned
today in relation to income earned tomorrow.
As we can see from the above model, labour supply depends on both the real
wage (in the two periods) and the real interest rate. The slope of the budget line,
which represents the intertemporal relative price, is equal to:
(1 + R )
W1
,
W2
(3)
where: R – real interest rate, W1 and W2 – real wages in the current and future
period respectively.
Equation (3) implies that any event causing the increase in the real interest
rate or a temporary increase in real wages in the current period as compared
with the future leads to a rise in the current supply of labour and to the growth
of employment.
The IS-LM and AD-AS model according to the real business cycle theory
The real business cycle theory assumes rational expectations, perfect
price flexibility, and full information on changes in money supply. In this
situation, money is completely neutral and nominal variables do not affect
real variables.
We will present the IS-LM model according to the real business cycle school.
It is illustrated in Figure 3. The IS curve has a standard negative slope. It shows
income and interest rate combinations yielding equilibrium at the goods market.
The IS curve can also be interpreted as the real aggregate demand (RAD). The
vertical line on the figure is the real aggregate supply function (RAS), which lies
at the potential output level. The volume of potential output is determined by
the production function. The position of the LM curve – assuming flexible prices
and the neutrality of money – has a residual character. The LM/P function (where
P is the price level) always intersects the IS curve at the potential output. This
results from immediate price adjustments so that changes in money supply do
not affect real variables.
In further analysis, we can thus ignore the LM function. The equilibrium will
be determined only by real forces represented by the RAD and RAS functions.
This is illustrated in Figure 4. The RAS curve is now upward sloping but still every
point on this curve corresponds to full employment. The positive slope follows
59
The real business cycle school
from the fact that, given higher real interest rate, individuals supply more labour
in the current period, which leads to an increase in output and employment (see
Equation 3).
Figure 3. The IS-LM model according to the real business cycle theory
Real interest
rate (R)
RAS
LM/P
R*
IS (RAD)
Output, GDP (Y)
Y*
Figure 4. The AS-AD model according to the real business cycle theory:
the effects of a positive technological shock
Real interest
rate (R)
RAS1
RAS2
E
Temporary technological shock:
E → F
Permanent technological shock:
E → G
G
R1
F
R2
RAD3
RAD2
RAD1
Y1
Y2
Y3
Output, GDP (Y)
Let us present the effects of a positive supply-side shock due to technical
progress. The analysis is based on the real business cycle aggregate demand
and supply model. This is illustrated in Figure 4. Technological progress shifts
the RAS curve rightwards from RAS1 to RAS2.11 At the same time, the RAD curve
shifts rightwards as well. The magnitude of the shift of the RAD depends on the
size of the wealth effect that stimulates consumer demand.
11
This is the same situation which is illustrated in Figure 2. There, technical progress shifted the
production function from Y to Y’.
60
4. Real business cycle theory and stylized facts
If technological shock is temporary, the wealth effect is small and consumer
demand increases only slightly. The RAD curve shifts from RAD1 to RAD2 and the
economy moves from point E to F. As a result, output increases from Y1 to Y2
and the real interest rate falls from R1 to R2.
By contrast, if technological shock is permanent, the strength of the wealth
effect is large and the RAD curve moves rightwards from RAD1 to RAD3 (the
change in consumer demand is of similar size as the increase in output due
to technological shock). In this situation, the economy moves from point E to
G. The result is the rise in output from Y1 to Y3 given the real interest rate
unchanged.
The real business cycle model presented here can be summarized in several
points:
• there is no distinction between short-run and long-run aggregate supply
functions (such a distinction played an important role in monetarist, new
Keynesian, and early new classical models),
• the model is completely real because both the nominal money supply and
price level do not affect the real economy,
• all points on the RAS curve correspond to full employment,
• output and employment fluctuations are caused by technological shocks
that shift the RAS curve. However, the model suggests that changes in real
aggregate demand may also yield output fluctuations.
4. Real business cycle theory and stylized facts
In the 1980s, rapidly growing interest in business cycles stimulated discussion
on how well the business cycle mechanism according to various schools
of economic thought fits the ‘stylized facts.’ We will focus here on cyclical
fluctuations of prices and real wages.
The real business cycle model assumes that fluctuations of prices are countercyclical. It is illustrated in Figure 5. The aggregate demand and supply curves
are depicted in the coordinate system where price level is plotted on the vertical
axis and GDP is plotted on the horizontal axis. The AD function has a standard
negative slope. The AS curve is vertical due to the fact that output is at the
potential level and prices are perfectly elastic.
Suppose initially that the aggregate supply curve is AS1, which corresponds
to the equilibrium price level of P1 and potential output of Y1. A positive
technological shock shifts the AS curve rightwards. The increase in output from
Y1 to Y2 is accompanied by a fall in prices from P1 to P2. Similarly, if there is
a negative supply-side shock, output declines from Y1 to Y3 and prices rise from
P1 to P3.
61
The real business cycle school
Figure 5. Counter-cyclical behaviour of prices in the real business cycle model
Prices (P)
AS3
P3
AS1
AS2
G
E
P1
F
P2
AD
Y3
Y1
Y2
Output, GDP (Y)
As we can see, in the real business cycle approach the direction of price
changes is opposite to the direction of output changes. Thus prices (and inflation)
are counter-cyclical. By contrast, Keynesian models, monetarist models, and
the monetary misperception new classical models assume that prices behave
rather procyclically. Given these theoretical discrepancies, what are the ‘stylized
facts?’
Mankiw (1989) indicated that, in the absence of supply-side shocks (such as
negative supply-side shocks caused by oil price hikes in the 1970s), prices behave
rather procyclically in the real world and this is a well documented fact. In 1981,
Lucas reached a similar conclusion. By contrast, some other authors suggest the
existence of counter-cyclical fluctuations of prices and inflation. For example,
Kydland and Prescott (1990) show that in the U.S. during 1954–89 prices
revealed a counter-cyclical pattern. A similar finding was obtained by Blackburn
and Ravn (1992) for the British economy. Counter-cyclical behaviour of prices
has also been confirmed by Backus and Kehoe (1992) and Smith (1992).
As regards real wages, the real business cycle theory states that they are
procyclical. In turn, Keynesian, monetarist, and some new classical models treat
real wages as counter-cyclical. What are the ‘stylized facts?’
For example, Gordon (1993) shows that – apart from the oil shocks in the
1970s – real wages do not show systematic movements, but empirical evidence
rather confirms (although only slightly) the counter-cyclical behaviour of real
wages. However, Kydland and Prescott (1990) argue in the opposite way: that
real wages are procyclical. At present, economists mostly agree that real wages
are slightly procyclical (see Fischer 1988). However, this view is embarrassing to
both the supporters of traditional monetary approach to the business cycle as
62
5. The policy implications
well as supporters of the real business cycle theory. If real wages were indeed
only slightly procyclical, the labour supply curve would have to be very elastic
(see Figure 2) and the large growth in employment would be accompanied by
a slight increase in real wages. Significant intertemporal substitution of leisure
is not, however, strong supported by empirical evidence.
5. The policy implications
Before 1980, economists agreed – in general – in the following areas:
1. Business cycles are temporary fluctuations of output around the trend. The
trend is an exogenous variable resulting from a smoothed technical progress.
2. Business cycles (instability of output) are undesirable because they reduce
economic welfare. That is why the government should take actions to stabilize
the rate of economic growth.
3. Monetary forces are a major cause of cyclical fluctuations.
These views were accepted by Keynesians, monetarists, and new classical
theorists. However, these schools differ in many respects, including what actions
should be taken to reduce the magnitude of output fluctuations. For example,
Keynesians support discretionary government policy while monetarists and
new classical economists are in favour of constant growth in money supply.
During the 1980s, the above way of thinking changed dramatically.
Supporters of the real business cycle integrated the business cycle theory with the
growth theory. They argued that observed short-run fluctuations in output and
employment are what the standard neoclassical theory predicts. According to
the real business cycle school, economic instability results from the behaviour of
agents making optimal decisions in response to changes in economic conditions.
Therefore, instability is not a bad outcome: it does not reduce economic welfare.
The economy is in a Pareto optimal equilibrium during expansionary and
contractionary periods. According to real business cycle theorists, government
should not reduce fluctuations in output and employment.
The main policy implication of the real business cycle school is as follows.
The government stabilization policy is counterproductive. Fluctuations in output
and employment are the optimal responses to changes in economic conditions
resulting from different rates of technological progress. Thus, if fluctuations are
Pareto optimal responses to shocks in the production function due to changes in
technology, monetary policy is not responsible for the economic instability and
it does not influence the real economy. Hence, money is super-neutral.
According to real business cycle theorists, the economy is continuously in
full employment equilibrium. Unemployment is always voluntary. Observed
fluctuations of output occur at full employment level. Therefore, there is no
63
The real business cycle school
room for government intervention aimed at achieving full employment, because
the economy is still in that state.
It is worth adding that, according to real business cycle school, a temporary
rise in government spending leads to an increase in output and employment.
This is because labour supply raises due to the increase in real interest rate
resulting from larger aggregate demand.
6. Selected criticism
The main criticism of real business cycle theory addresses the following
issues.
1. In the real business cycle model, unemployment is entirely voluntary,
although this needn’t be true in the real world (see, e.g., Great Depression
during the 1930s or the Global Economic and Financial Crisis in 2009).
2. Recessions are treated as periods of technological regress. However, it is
difficult to agree that the level of technology declines during recessions.
3. Technological shocks do not appear so often and they are not so large to
fully explain the fluctuations in output.
4. Observed employment fluctuations are too large to be fully explained by
intertemporal substitution of labour and leisure.
5. Demand-side policies may have long-run impact on the volume of
output. For example, technical progress may depend on the size of demand,
R&D expenditure, or learning-by-doing. Thus, changes on the supply side of the
economy depend on changes on the demand side.
6. Empirical evidence shows that monetary policy does affect the real
sphere of economy. For example, we could observe, based on historical data,
that monetary disinflation policy in the UK led to a recession or economic
slowdown.
7. The final criticism concerns representative agents. Real business cycle
models ignore the issues related to information asymmetry, exchange, and
coordination. These models aggregate actions of representative agents into the
behaviour of the whole society.
To learn more about the criticism of real business cycle theory, see e.g. Mankiw
(1989) and Phelps (1990).
7. Summary
1. The real business cycle theory is the economic school of thought that
is derived form the new classical macroeconomics and assumes rational
expectations and continuous market clearing.
64
7. Summary
2. The real business cycle school integrates the theory of business cycles with
the theory of economic growth. It does not distinguish between the short run
and long run.
3. Business cycles are caused by real forces, namely technological changes.
Money is super-neutral – it does not affect the real economy. Random
technological changes yield permanent effects on potential output. In other
words, GDP follows a random walk.
4. GDP fluctuations are treated as the fluctuations of potential output. During
expansionary and contractionary periods the economy is at full employment
level.
Bibliography
Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics.
An Introduction to Competing Schools of Thought, Cheltenham-Northampton,
Edward Elgar.
Additional bibliography
Backus, D.K., P.J. Kehoe, 1992, International Evidence on the Historical Properties
of Business Cycles, American Economic Review, September.
Barro, R.J., 1981, Output Effects of Government Purchases, Journal of Political
Economy, December.
Barro, R.J., 1993, Macroeconomics, 4th ed., New York, John Wiley.
Blackburn, K., M.O. Ravn, 1992, Business Cycles in the UK: Facts and Fictions,
Economica, November.
Fischer, S., 1988, Recent Developments in Macroeconomics, Economic Journal,
June.
Frisch, R., 1933, Propagation and Impulse Problems in Dynamic Economics, in:
Essays in Honour of Gustav Cassel, London, Allen and Unwin.
Gordon, R.J., 1993, Macroeconomics, 6th ed., New York, Harper Collins.
Kydland, F.E., E.C. Prescott, 1982, Time to Build and Aggregate Fluctuations,
Econometrica, November.
Kydland, F.E., E.C. Prescott, 1990, Business Cycles: Real Facts and the Monetary
Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring.
Long, J.B., C.I. Plosser, 1983, Real Business Cycles, Journal of Political Economy,
February.
Lucas, R.E., 1972, Expectations and the Neutrality of Money, Journal of Economic
Theory, April.
Lucas, R.E., 1973, Some International Evidence on Output-Inflation Tradeoffs,
American Economic Review, June.
Lucas, R.E., 1981, Studies in Business Cycle Theory, Oxford, Basil Blackwell.
Lucas, R.E., L.A. Rapping, 1969, Real Wages, Employment and Inflation, Journal
65
The real business cycle school
of Political Economy, September/October.
Mankiw, N.G., 1989, Real Business Cycles: A New Keynesian Perspective, Journal
of Economic Perspectives, Summer.
Nelson, C.R., C.I. Plosser, 1982, Trends and Random Walks in Macroeconomic
Time Series: Some Evidence and Implications, Journal of Monetary Economics,
September.
Phelps, E.S., 1990, Seven Schools of Macroeconomic Thought, Oxford, Oxford
University Press.
Schumpeter, J.A., 1939, Business Cycles, New York, McGraw-Hill.
Smith, R.T., 1992, The Cyclical Behaviour of Prices, Journal of Money, Credit and
Banking, November.
66
CHAPTER FIVE
Małgorzata Znoykowicz-Wierzbicka
The new Keynesian school
New Keynesian economics – core propositions and features
New Keynesian economics arose in the late 1970s and 1980s as a response
to the new classical revolution in macroeconomic thought, which called into
question many achievements of the old Keynesian school. The new Keynesian
approach was to remedy the shortcomings of the old Keynesian models, and in
particular – to supplement aggregate demand analysis with a coherent theory
of aggregate supply, encompassing explanation of price and wage rigidities
(Snowdon, Vane 2005, p. 361). According to N. Gregory Mankiw and David
Romer, there are two basic propositions of new Keynesian economics:
1. The violation of the classical dichotomy – changes in nominal variables
influence output and employment in the short run.
2. Market imperfections (such as imperfect competition or asymmetric
information) cause economic fluctuations (New Keynesian economics, p. 2).
Main supplementing propositions of the new Keynesian approach include:
• rejection of the assumption of continuous market clearing (in opposition
to the monetarist, new classical and real business cycle approaches) and
consequently – possible multiple equilibria in the economy with prices
different from the market clearing levels (where an equilibrium is defined as
a state where no agents have an incentive to change their behavior),12
12
According to R.J. Gordon, the absence of continuous market clearing is the essential feature
of Keynesian economics. As this author puts it, a Keynesian model is by definition a non market
clearing model, one in which prices fail to adjust rapidly enough to clear markets within some relatively short period of time. (…) in response to a decline in nominal demand, the aggregate price
level will decline less tan proportionately over a substantial time period, during which the actual
price level is above the equilibrium price level consistent with the maintenance of the initial equilibrium level of real output. The fact that the price level is too high means that the subequilibrium level
67
The new Keynesian school
• pursuit of coherent microeconomic explanation of slow adjustment of wages
•
•
•
and prices to changing economic conditions and, in conclusion, the opinion that
even small nominal price rigidities may generate considerable real effects,
approval of the microeconomic principles of rational behavior of utility and
profit maximizing economic agents and the rational expectations hypothesis
by a vast majority of proponents of this approach in macroeconomics,
recognition of both aggregate demand and supply shocks as factors
determining the actual stage of the economy,
recognition of active role of the government in the economy (the new
Keynesian economists agree that government intervention can potentially
improve the allocation of resources, although they are not unanimous with
respect to desirability of active government policy) (Tsoulfidis, pp. 363–364;
Snowdon, Vane 2005, p. 383).
In general, the achievements of the new Keynesian school are sometimes
summarized as attempts to build the microeconomic foundations of wage and
price stickiness (Gordon, p. 478). However, it should be noted that under the
heading of new Keynesianism a diversified group of authors and ideas is hidden,
offering a multiplicity of mutually complementing explanations of wage and
price rigidities and their macroeconomic consequences.13
2. Nominal and real rigidities
The explanations of rigidities in the economy are divided into two main groups,
focusing on nominal and real rigidities. Nominal rigidity occurs when the nominal
price or wage level fails to adjust to the new market clearing levels resulting from
the nominal demand disturbances, whereas a real rigidity is explained as the
stickiness of a wage relative to another wage, of a wage relative to a price or
of a price relative to another price (Gordon 1997, p. 505; Snowdon, Vane 2005,
p. 366). As N. Gregory Mankiw underlines, the distinction made by the new
Keynesians between nominal and real rigidities is very important: unlike nominal
rigidities, real rigidities do not result in non-neutrality of money. However, both
nominal and real rigidities cause unemployment and reinforce each other.14
of output actually produced is not chosen voluntarily by firms and workers, but rather is imposed
on them as a constraint. It is the decline in nominal demand together with the absence of full price
adjustment that causes the economic system itself to impose the constraint on each agent; nominal
demand is insufficient to generate adequate real sales at the actual price level. See Gordon 1997, p.
500 (originally Gordon’s article was published in the Journal of Economic Literature, no. 28/1990,
pp. 1115–71); Snowdon, Vane 2005, p. 383.
13
The proponents of the new Keynesian school include, inter alia, N. Gregory Mankiw, L. Summers,
O. Blanchard, S. Fischer, E. Phelps, J. Stiglitz, G. Akerlof, J. Yellen, D. Romer, Ben Bernanke, R. Hall,
J. Taylor. See Snowdon, Vane 2005, pp. 361–366.
14
See an interview with N. Gregory Mankiw reprinted in: Snowdon, Vane 1995.
68
2. Nominal and real rigidities
Nominal wage and price rigidities are a common assumption of both
traditional and new Keynesian economics. Nominal rigidities are the reason
why short-term aggregate demand fluctuations may have real effects – in this
sense, nominal rigidities explain the existence of business cycles. However, in
contradiction to the orthodox Keynesian models, the new Keynesian approaches
do not present fixed nominal prices and wages as an arbitrary assumption and
try to provide microeconomic explanation to price and wage rigidities.
The early new Keynesian attempts to explain nominal wage rigidities were
based on nominal wage inertia resulting from long-term contracts. Long-term
(explicit or implicit) wage contracts set wages on a certain level for an agreed
period, and thus, prevent disadvantages (and costs) resulting from frequent
changes of wages and prices.15 Since the nominal wages are temporarily sticky
(till the end of the period of the current wage contract in force), monetary
policy is not neutral in the short run, even if economic agents have rational
expectations. Monetary policy may influence the real wage level, and thus,
influence the level of output and employment in the short run, provided that
monetary authorities are able to change the money supply in between periodic
wage contract negotiations. Monetary policy remains neutral in the long
run, when the nominal wages are fully adjusted. It is also worth noting, that
according to E. Phelps, long-term wage contracts are advantageous for both
companies and employees: they allow to avoid the transaction costs of frequent
wage negotiations, decrease the risk and costs of failure of wage negotiations
(e.g. in the form of a strike action undertaken by workers attempting to
increase their bargaining power) and allow to avoid potential costs resulting
from reduction of an individual firm’s relative real wages (if a company’s
decision to decrease real wages in response to a negative demand shock was
not immediately followed by other companies, workers experiencing decrease
in relative wages would be encouraged to change their jobs) (Snowdon, Vane
2005, pp. 366–371).
The new Keynesian economists also offer an explanation for nominal price
rigidities. They explain short-run price adjustment by referring to microeconomic
foundations of the macroeconomic adjustment processes. The distinctive feature
of the new Keynesian school is the assumption of imperfect competition. Under
imperfect competition, firms are not price takers – they are active price makers.
Nevertheless, deciding on a change in pricing policy, profit maximizing companies
take into account costs caused by price adjustment itself (called the menu costs
– costs connected e.g. with preparation and dissemination of new price list
and catalogues or negotiating new sales or purchase contracts). Such costs
discourage companies from frequent price changes (especially when changes of
15
Frequent wage contracting is costly (eg. research on the wage structure outside the particular
company, forecasts of the key variables taken into account during wage negotiations) and time-consuming both for the workers as well as for the companies.
69
The new Keynesian school
factors determining the optimum price – such as the costs of production – are
only of inconsiderable magnitude).
According to the new Keynesians, the existence of the menu costs may result
in considerable aggregate nominal price rigidity. Although the menu costs tend
to be relatively small in individual cases, they are not inconsequential. In order
to minimize the menu costs (which may be higher than the expected benefits of
frequent price changes), companies prefer to adjust their prices intermittently
rather than on a continuous basis. Additionally, the proponents of the menu-costs hypothesis point out to the aggregate-demand externalities to price
adjustment: a price reduction by one firm benefits other firms in the economy
(individual price reduction by one company slightly reduces the average price
level and, as a result, raises the real monetary balances, which in turn causes
the raise in aggregate income and the demand for goods produced by all the
companies in the economy). The existence of the aggregate-demand externalities
to price adjustment implies that even relatively small menu-costs incurred by an
individual company may cause short-run price stickiness, and in result, generate
large costs for the whole economy (Mankiw 2003, p. 510; Snowdon, Vane 2005,
pp. 371–376).
Moreover, the new Keynesians point out to another possible explanation of
price (and in fact – wage) stickiness – the staggering and prices (and wages).
Even when individual companies change their prices and wages frequently, the
adjustment of wages and prices throughout the economy is not a simultaneous
process: the overall adjustment of prices and wages is gradual (staggered).
Under staggered price adjustment, a price increase by an individual company
rises that company’s relative price (in comparison with its competitors). In order
to avoid losing their consumers (resulting from relative price changes), individual
companies prefer modest to substantial price adjustment. Therefore, staggering
of prices explains the overall price stickiness. Moreover, the phenomenon of
staggering may also explain wage stickiness. A decrease in money supply reduces
aggregate demand and requires an equivalent fall in nominal wages to maintain
full employment. If all wages in the economy were to be reduced simultaneously,
all workers might accept the immediate reduction of wages (equivalent to the
initial fall in money supply). Because wage-setting is staggered, an individual
worker may not accept a substantial pay cut: this would result in a temporary
fall in her/his relative wage (in comparison with other workers). Therefore,
staggering of individual wages may explain the stickiness of the overall level of
nominal wages (its slow response to changing economic conditions) (Mankiw
2003, pp. 512–513).
Real rigidities may occur both in product market (real price rigidities) as well
as in the labor market (real wage rigidities).
Real price rigidity may be defined as a factor reducing the responsiveness of
70
2. Nominal and real rigidities
firms’ profit-maximizing prices to variations in aggregate output resulting from
variations in real aggregate demand.16 At a general level, real rigidities discourage
companies from taking actions limiting aggregate output fluctuations.
Price may be expressed as a mark-up on marginal cost (expressed as the
nominal wage divided by the marginal product of labor). The size of this mark-up varies inversely with the price elasticity of demand. Decline in marginal cost
may not lead to price reduction if the mark-up on marginal cost rises enough
to offset the decline in marginal costs. Provided that the price elasticity of
demand does not decline and the marginal product of labor does not rise with
a reduction in input of labor, the menu cost may discourage a company from
reducing its prices. Moreover, the mark-ups on marginal costs depend on the
level of economic activity: they fall during booms (as maintaining oligopolistic
collusion becomes more difficult) and rise in recessions (when collusion
increases). Therefore, countercyclical behavior of markups also acts as a real
rigidity. Real price rigidities may also be explained another way: the greater the
decline in the elasticity of demand at the existing price as output falls, the more
the marginal revenue curve facing a firm shifts to the left and the less incentive
there is for a firm to reduce its price (Snowdon, Vane 2005, pp. 379–380; Romer,
pp. 8–11).
The new Keynesian economists suggest several other sources of real price
rigidity:
a) thick market externalities – the costs of searching desired goods and
finding consumers are generally lower during economic boom (when
markets are ‘thick’ – the level of trading activity is high) and higher in periods
of low economic activity (when markets are ‘thin’). This leads to a strategic
complementary: one firm’s optimal level of activity depends on the activity
of other firms: marginal costs increase in recessions and decrease in booms,
resulting in real price rigidity,
b) customer markets – customer markets are defined as markets characterized
by low frequency of search relative to the frequency of purchase. Buyers
usually have imperfect information on the best offer available on the market:
the costs connected with continuous search for the best offer imply that
many consumers make repetitive purchases. Therefore, firms avoid frequent
changes of prices, which would encourage their consumers to search for
a new supplier. Moreover, an increase of prices by one company offering its
goods at a consumer market would obviously be noticed by its consumers,
whereas a price cut would have considerably smaller effects on the behavior
of other firms’ consumers. In turn, companies trying to retain their current
clients will contribute to price stickiness,
c) input-output table theory – the concept of the input-output table describes
the complexity of the supplier-producer relationships (a single company may be
16
See D. Romer, Real rigidities, in: The New Palgrave Dictionary of Economics 2008.
71
The new Keynesian school
linked with many other cooperating companies facing different demand and
supply shocks. Moreover, apart from the costs of materials supplied by other
firms, an individual company’s short-run marginal costs are also influenced
by the ability of the costs of labor to adjust to changing economic situation
(which may depend on the scale of wage rigidities). A single company does not
believe that the actions of all other economic agents (collaborating companies,
workers) will allow its marginal costs to mimic nominal demand changes with
minimal lags. Deciding on a price change, a firm must take into account its
own demand and costs, as well as the pricing behavior of all other cooperating
companies. Therefore, many companies decide to adjust their prices gradually,
in line with other companies on the market, which in turn results in price
staggering and aggregate output fluctuations (Gordon, p. 504),
d) capital market imperfections – the cost of capital incurred by the firm tends
to be countercyclical (during periods of high economic activity, companies
may finance their investment projects at a lower costs, using internal
financing, whereas in recessions, firms may have to rely on external – thus
more expensive – financing). Countercyclical behavior of the costs of capital
may increase the firm’s total costs in recession, and therefore – influence
price rigidity,
e) judging quality by price – under imperfect information, companies may use
their pricing policy as a quality signal. Negative demand shock may not result
in a price cut, if the company wants to signal preservation of high quality of
offered goods (Snowdon, Vane 2005, pp. 380–383).
As it has already been mentioned, real wage rigidity may be defined as
stickiness of a wage relative to another wage or of a wage relative to a price.
The distinctive feature of the new Keynesian approach to real wage rigidities is
the definition of market equilibrium: an equilibrium may be reached at a real
wage different from the market clearing real wage. Therefore, opposite to the
new classical models, involuntary unemployment may occur even in the longrun equilibrium (Snowdon, Vane 2005, p. 383).
The new Keynesian propositions explaining the phenomenon of real wage
rigidity may be divided into three general groups:
a) implicit contract theories – since workers and employers may have different
tolerances towards risk, labor contracts may not only determine the cost of
labor, but also have an insurance function. Companies, interested in securing
loyalty of their employees, enter into unwritten (implicit) understandings
with the workers: wages do not only represent payment for labor services
in the current period, but may be treated as a form of insurance against the
risk of workers’ income volatility. Employees may prefer lowering this risk to
accepting wages varying in accordance with changing economic condition,
although varying wages could be on average higher than the stable real
72
3. Hysteresis and unemployment
wages negotiated with the company in an implicit contract (New Keynesian
economics, p. 11; Snowdon, Vane 2005, p. 384),
b) efficiency wage theories – efficiency wage theories are based on the
assumption that the level of real wages may affect labor productivity.
Therefore, rationally acting companies may be motivated to pay real wages
exceeding the market clearing level. Firms identify interdependence between
worker’s productivity (and thus – costs of production and profits) and the
level of real wages (the higher the real wage, the greater the productivity).
A pay cut may not lead to a reduction, but in fact – an increase of the costs of
production (because of reduced productivity). Therefore, real wage rigidity
may be advantageous for a profit maximizing company. Four different types
of efficiency wages theories are identified: the adverse selection model
(companies offering higher real wages may attract the most productive
workers), the labor turnover model (high real wages reduce the risk of high
– and costly – labor turnover), the shirking model (under asymmetry of
information on the workers’ individual productivity and considerable costs of
constant monitoring of workers’ efforts, high real wages deter workers from
shirking and encourage them to increase their efforts) and the fairness model
(worker’s productivity may also depend on sociological and psychological
factors, such as the feeling of being fairly treated by the employer: workers’
productivity (efforts), turnover and absenteeism rates may be a function of
the employees’ morale) (Snowdon, Vane 2005, pp. 388–394),
c) insider-outsider theories – at the labor market, insiders (present workers)
influence decisions concerning real wages and the level of employment at
outsiders’ (the unemployed workers’) expense. The power of the insiders
to influence a company’s wage policy results from considerably high costs
of worker turnover (interviews, negotiations with prospective employees,
training of new workers). Due to such costs, companies do not consider
outsiders to be perfect substitutes for insiders. In order to avoid turnover
costs, companies may decide not to lower wages even in case of an excess
supply of labor. The insider-outsider theory of efficiency wages does not
assume any direct effect of real wages on workers’ productivity (Snowdon,
Vane 2005, pp. 394–396).
3. Hysteresis and unemployment
The market-clearing models of the labor market assume that in case of
an excess labor supply, decrease in wages should raise the quantity of labor
demanded and restore labor market equilibrium. Nevertheless, even within
the standard macroeconomic models, a distinction is made between the
equilibrium unemployment (constant in the short run and determined mostly
by real supply-side factors such as labor market institutions) and actual unem73
The new Keynesian school
ployment (which deviates from the equilibrium unemployment). According to
the proponents of the new Keynesian approach, because of the imperfections
in its functioning, the labor market may reach equilibrium even with some
involuntary unemployment.
As it has already been mentioned in case of the rational expectations
hypothesis, the new Keynesian school adopted some theoretical concepts
from other macroeconomic schools. For example, the idea of the natural rate
of unemployment and the expectations-augmented Philips curve were used to
construct the NAIRU (non-accelerating inflation rate of unemployment) concept.
The NAIRU is defined as the unemployment rate at which there is no immediate
inflationary pressure. NAIRU is frequently used to estimate the natural rate of
unemployment, although there are some differences between the two concepts.
Unlike the natural rate of unemployment concept, the NAIRU does not represent
the equilibrium level of unemployment: under imperfect competition at the
labor and product markets, NAIRU may be defined as rate of unemployment
resulting from the balance of power between workers and firms (balancing the
real wage expected by the workers with feasible the real wage determined by
the companies pursuant to their mark-ups and labor productivity). Despite of
these differences, the terms natural rate of unemployment and NAIRU are used
interchangeably (Snowdon, Vane 2005, p. 403).
The concept of the natural rate of unemployment was challenged in 1980s –
both actual and equilibrium (natural) rates of unemployment rose significantly in
many European economies, which implied influence of aggregate demand shocks
on both rates of unemployment. E. Phelps suggested possible explanation of this
fact: borrowing the term ‘hysteresis’ from physics, Phelps suggested that following
aggregate demand shocks, the natural rate of unemployment may be dependent
on the course of the adjustment processes. According to the hysteresis concept,
the natural rate of unemployment will increase if the actual rate of unemployment
in the previous period was higher than the previous period’s natural rate of
unemployment (Snowdon, Vane 2005, p. 405). Therefore, a negative aggregate
demand shock will cause, in the short run, an output fall and an increase of
actual unemployment rate. In the long run, the natural rate of unemployment will
not return to its initial level. Therefore, recessions may have protracted effects.
There are several explanations of the hysteresis effect, which may be classified
within two main groups: duration theories (based on the distinction between
short-term and long-term unemployment: i.a. because of depreciation of human
capital, the bargaining power of the long-term unemployed decreases; this group
exerts little pressure on wage setting) and insider-outsider theories (based on the
distinction between the insiders and the outsiders at the labor market: in spite of
involuntary unemployment, incumbent workers oppose wage cuts – as a result,
the unemployed are not offered jobs).17
17
74
Find a detailed analysis of the hysteresis concept in: Blanchard, Summers 1991, pp. 235–243.
4. New Keynesian economics and stylized facts
It is also worth mentioning that E. Phelps suggested another possible
explanation of the natural (equilibrium) rate of unemployment fluctuations.
Conclusions drawn from the dynamic intertemporal non-monetary equilibrium
model suggest that the natural rate of unemployment should be treated as an
endogenous variable, determined by both real aggregate demand shocks as
well as aggregate supply shocks – technology changes, social preferences or
values and institutions (Snowdon, Vane 2005, pp. 406–408).
4. New Keynesian economics and stylized facts
The new Keynesian economics offers explanation to several business cycle
stylized facts, such as:
• the procyclical behavior of the main aggregate demand determinants
(consumption, investment, government expenditure) as well as employment
and productivity,
• the procyclical character of money (which, as it was explained, is not neutral
in the short run),
• the procyclical behavior of inflation,
• the procyclical character of the real wage unlike (in models assuming the
sensitiveness of the efficiency wage to the rate of unemployment, real wages
may be procyclical),
• the phenomenon of unvoluntary unemployment (Snowdon, Vane 2005, pp.
408–409).
(As the new Keynesian explanation of the above-mentioned stylized facts
may be concluded form the previously discussed aspects of this school of
macroeconomic thought as well as derived from the traditional Keynesian
analysis, these aspects are not discussed further in detail).
5. Policy implications
As it has already been mentioned, recognition of active role of the government
in the economy is one of the core propositions of the new Keynesian approach.
Nevertheless, the non-neutrality of money in the short run – a view shared by
new Keynesians – does not imply their support for active use of monetary policy
only for short-run gains in output and employment.
In general, the new Keynesian school advocates policy intervention to offset
the macroeconomic effects of considerable macroeconomic shocks (especially in
case of unexpected shocks lowering both output and inflation) and recognizes
the stabilizing role of both monetary and fiscal policy. Nonetheless, the New
Keynesians are not unanimous with respect to the extent of discretionary
75
The new Keynesian school
economic policy. N. Gregory Mankiw points out that discretionary policies
are intrinsically inflationary. Being aware of discretionary monetary expansion
aimed at reducing unemployment, economic actors accordingly adjust their
inflation expectations. As a result, the short-run trade-off between inflation and
unemployment may be deteriorated, if not eliminated.18 There is wide consensus
among economists (not only new Keynesians, of course) that price stability is the
primary goal of monetary policy. There is no agreement, however, with respect
to the most appropriate monetary policy regime to achieve this goal. The new
Keynesians’ support for a rule-based, rather than discretionary, monetary policy
is based on the short-term non-neutrality of money, existence of substantial
welfare costs attributed to inflation (especially unexpected inflation) and the
need (and significance) of establishing credibility of monetary policy. Proponents
of the rule-based monetary policy suggest different variants of monetary policy
regimes. Four most popular solutions used in practice are: exchange rate
targeting, monetary targeting, explicit inflation targeting and implicit inflation
targeting (Snowdon, Vane 2005, pp. 411–419). As for the monetary policy tools,
new Keynesians advocate the use of the interest rate rather than monetary
aggregates targeting (Tsoulfidis, p. 379).
The case for fiscal policy rules is more vague. The assessment of fiscal policy
rules (such as the balanced budget rule) highly depends on circumstances: it
may not be possible to design a universally correct fiscal policy rule. Therefore,
some proponents of the new Keynesian economics (including J. Stiglitz)
generally oppose introducing fixed fiscal policy rules because of irregular and
unpredictable character of macroeconomic shocks (Snowdon, Vane 1995, p. 58).
In some extreme cases, a budgetary deficit may be justified and even desirable
in the short run, but in the long run, continuous deficits reduce national savings
and economic growth. Moreover, many new Keynesian economists (including
N. Gregory Mankiw) believe that monetary policy generally is a more useful tool
of aggregate demand stabilization.
To sum up, the most general principle that the majority of new Keynesians
would share with respect to the role of government in the economy is that in
periods of normal economic activity, economic policy should be conducted on
a flexible basis (enabling the government to react to unexpected disturbances).
Active government policy (being a trade mark of the old Keynesian school) is
recommended in periods of severe macroeconomic shocks and recessions.
Due to heterogeneity and multiplicity of ideas hidden behind the new
Keynesian label, numerous specific economic policy measures are advocated by
different authors (e.g. with respect to remedies to various identified reasons
of nominal and real price and wage rigidities) (Tsoulfidis, p. 379). For example,
taking into account the above discussed factors combining to real wage rigidity,
the new Keynesian approach suggests several institutional reforms of the labor
18
76
See Mankiw 1992, pp. 559–565.
6. Assessment of new Keynesian economics
market aimed at reducing unemployment, such as reforms limiting the power of
the insiders and increasing the attractiveness of the outsiders at the labor market
(softening job security legislation, reforms of industrial relations limiting the risk
of strikes, vocational training for unemployed, policies increasing geographical
mobility of labor, profit-sharing arrangements improving wage flexibility,
reforms of the unemployment compensation systems aimed at increasing job
search incentives) (Snowdon, Vane 2005, pp. 422–423).
6. Assessment of new Keynesian economics
Critics of the new Keynesian school concentrate on several main objections:
• concentration on theoretical aspects (explanation of the microfoundations
of macroeconomics) at the expense of empirical research (however, this
particular objection may be overruled by increasing popularity of the DSGE –
dynamic stochastic general equilibrium – models),
• existence of numerous unrelated theories within the school, hampering
construction of a testable new Keynesian model,
• the magnitude of influence of the relatively small menu costs on output and
employment,
• extensive emphasis on deriving rigidities from microeconomic foundations
of macroeconomics,
• acceptance (by many new Keynesians) of the rational expectations hypothesis,
• extensive use of the IS-LM model to analyze aggregate demand (Snowdon,
Vane 2005, pp. 430–431).
Notwithstanding the above critical arguments, many economists regard the
new Keynesian school as a valuable input to modern macroeconomics, and
especially – a creative elaboration of the old Keynesian ideas. What the new
Keynesian economists are especially proud of is – that at least in their opinion
– the new classical argument that the Keynesian assumption of nominal
rigidities lacked theoretical foundations has been refuted (New Keynesian
economics, p. 15). Nevertheless, not all economists are optimistic with respect
to comprehensiveness of wage and price rigidity theories proposed by the
new Keynesian school. As R.J. Gordon noted, a satisfactory theory of price
adjustment must explain phenomena revealed by empirical research, such as
the variability of price adjustment parameters across industries, across countries
and across historical intervals. In his opinion, much of new Keynesian theory did
not succeed in explaining these facts 20 years ago, when he wrote the article
on new Keynesian economics (Gordon, p. 479). It is still disputable whether this
objection may be overruled now.
It is also worth noting that the proponents of the new Keynesian approach
have extensively used analytical concepts elaborated by other schools – such as the
77
The new Keynesian school
monetarist idea of natural unemployment and expectations augmented Philips
curve (adjusted to the NAIRU concept), the rational expectations hypothesis or
the methodology of the DSGE (dynamic stochastic general equilibrium) models
used by the proponents of the real business cycle school.
Last but not least, the propositions of the new Keynesian school have recently
attracted attention in the global crisis period. Economic policies conducted by many
governments (and supported or coordinated by international organizations) may
find theoretical underpinnings in the arguments presented by the new Keynesians.
What is also important, the new Keynesian approach may also offer plausible
explanation of both the causes and course of the global financial crisis.19
Bibliography
Blanchard, O.J., L.H. Summers, 1991, Hysteresis in unemployment, published in:
New Keynesian Economics, vol. 2: Coordination failures and real rigidities, eds
N.G. Mankiw, D. Romer, Cambridge, Massachusetts, MIT University Press.
Gordon, R.J., 1997, What is new-Keynesian economics?, in: A Macroeconomics
reader, eds B. Snowdon, H.R. Vane, London, Routledge.
Mankiw, N.G., 2003, Macroeconomics, 5th edition, New York, Worth Publishers.
Mankiw, N.G., 1992, The reincarnation of Keynesian economics, European
Economic Review, no. 36.
New Keynesian economics, vol. 1: Competition and sticky prices, eds N.G.
Mankiw, D. Romer, 1991, Cambridge, Massachusetts, MIT University Press.
New Keynesian economics, vol. 2: Coordination failures and real rigidities, eds
N.G. Mankiw, D. Romer, 1991, Cambridge, Massachusetts, MIT University
Press.
The New Palgrave Dictionary of Economics, 2008, 2nd ed, eds S.N. Durlauf, L.E.
Blume, Palgrave Macmillan.
Romer, D., 1993, The new Keynesian synthesis, The Journal of Economic
Perspectives, vol. 7, issue 1 (winter).
Snowdon, B., H.R. Vane, 2005, Modern macroeconomics. Its origins, development
and current state, Cheltenham, Northampton, MA, Edward Elgar.
Snowdon, B., H.R. Vane, 1995, New-Keynesian economics today. The empire
strikes back, American Economist, no. 39 (spring).
Stiglitz, J.E., 2009, The current economic crisis and lessons for economic theory,
Eastern Economic Journal, no. 35.
Tsoulfidis, L., 2010, Competing schools of economic thought, Berlin Heidelberg,
Springer Verlag.
19
78
See Stiglitz 2009.
CHAPTER SIX
Mariusz Próchniak
New developments in growth theory
1. The neoclassical growth theory:
the Solow model and the Ramsey model
The first works related to economic growth date back to the eighteenth and
nineteenth centuries. During this period, Adam Smith, Thomas Malthus, David
Ricardo and many years later, Frank Ramsey, Allyn Young, Joseph Schumpeter
and Frank Knight provided many elements used in modern growth models
(Barro, Sala-i-Martin 1995, p. 9).
Here, we will not explore the old history and we will focus on contemporary
models of economic growth. The first economist to formalize the analysis of
economic growth was Robert Solow (1956). His model included the neoclassical
production function and initiated an era of neoclassical models of economic
growth. Neoclassical production function assumes constant returns to scale and
diminishing marginal product of capital. To this day, the Solow model constitutes
the basis for the contemporary theory of economic growth. But important works
in this field appeared earlier.
Harrod (1939) and Domar (1946) tried to combine the Keynesian analysis
with the elements of economic growth. According to the Harrod-Domar model,
the pace of economic growth is proportional to the investment rate (equal to
the savings rate) and inversely depending on the marginal capital intensity of
production. The growth rate of GDP is described by the following equation:
gy =
s
,
k
(1)
where: gy – real GDP growth rate, s – the investment rate (the savings rate),
k – the capital intensity of production (investment outlays per unit increase in
national income).
79
New developments in growth theory
In 1928, Frank Ramsey published the article on optimal level of savings among
nations. Currently, the Ramsey model is widely recognized as the neoclassical
approach. But the Ramsey model gained significant acceptance among economists
in the early 1960s, following the Solow model, so about 30 years after its
development. The neoclassical group also includes the Diamond model (1965).
Neoclassical models share one common disadvantage. They do not explain
well the long-run economic growth. According to neoclassical theories, long-run economic growth depends on technological progress, which is exogenous.
The desired property of the model would be to endogenize technical progress,
so that economic growth could be explained within the model. Moreover,
neoclassical models (in their basic forms) do not cope well with the explanation
of differences in income levels between countries. Differences in physical capital
stock are in fact too small to explain differences in income.
We present in detail the two basic neoclassical models: Solow model and
Ramsey model.
The Solow model
The Solow model, also called the Solow-Swan model, was developed by
Robert Solow (1956) and Trevor Swan (1956). We present here the Solow model
with labour-augmenting technological progress.
Let F be the production function. Inputs to production are: physical capital
K(t) and effective labour A(t)L(t), which is the product of the level of technology
A(t) and population (labour force) L(t):
F (K (t ), A (t ) L (t )).
(2)
The production function exhibits constant returns to both inputs (capital
and effective labour) and diminishing marginal product of capital. One of
the functions satisfying these assumptions is the Cobb-Douglas production
function:
F (K (t ), A (t ) L (t )) = K (t )  A (t ) L (t )
1−α
α
,
(3)
where 0 < α < 1. Technology and population both grow at constant
exogenous rates, equal to a and n respectively:
.
A (t)
= a and
A (t)
.
L (t)
=n.
L (t)
(4)
The increase in capital stock equals investment (savings) minus depreciation:
.
K (t) = sF (K(t), A(t) L(t)) – δK(t) ,
80
(5)
1. The neoclassical growth theory: the Solow model and the Ramsey model
where s is the exogenous savings rate and δ is the capital depreciation rate.
The dynamics of the economy is analysed in terms of capital and output per
unit of effective labour, denoted by k(t) and f(k(t)) respectively:20
k≡
K
AL
f (k ) ≡
and
(6)
F (K , AL ) 

 K AL 
,
= F 
 = F (k ,1) = f (k ) .
AL
 AL AL 


To find the equation describing the dynamics of the economy, we differentiate
the definition of k (Equation 6) with respect to time and then we use formulas
(4), (5) and (6). As a result, we obtain:
.
k = sf (k) – (n + a +δ)k .
(7)
The above equation is the basic formula describing the dynamics of the
economy in the Solow model. The increase in capital per unit of effective labour
equals actual investment sf(k) minus replacement investment (n + a + δ)k.
Given that (i) marginal product of capital is positive and diminishing (f’(k) > 0
and f”(k) < 0), (ii) zero inputs yield zero output (f(0) = 0), and (iii) the production
function satisfies Inada (1963) conditions (limk→∞f’(k) = 0; limk→0f’(k) = ∞), then
the dynamics of the economy and the steady-state can be found graphically.
This is illustrated in Figure 1.
Figure 1. The transition period and the steady-state in the Solow model
20
In the rest of the chapter, we omit the time index t in order to preserve the transparency of
the formulas.
81
New developments in growth theory
The long-run equilibrium (steady-state) occurs at the point of intersection
between sf(k) and (n + a + δ)k functions. At this point, output and capital per
unit of effective labour are constant over time – Equation (7) implies that if
sf(k) = (n + a + δ)k, then dk/dt = 0.
Hence, what is the growth rate of total GDP (Y = F(K,AL)) and GDP per
capita (Y/L) in the steady-state? In order to answer this question, we have to
differentiate Y ≡ f(k)AL and Y/L ≡ f(k)A with respect to time (see Equation 6).
This yields:
.
.
. .
Y f (k) A L
=
+ +
Y f (k) A L
.
and
.
.
Y / L f (k) A
=
+ .
Y / L f (k) A
(8)
In the steady-state, output per unit of effective labour is constant (df/dt/f = 0),
while technology and population both grow at constant rates equal to a and
n respectively. Thus, we have obtained two important implications of the Solow
model. In the steady-state (long-run equilibrium):
• the growth rate of GDP equals technological progress plus population growth,
• the growth rate of per capita GDP equals technological progress.
These findings confirm also the weaknesses of neoclassical theories, discussed
earlier, namely, that economic growth depends on exogenous variables, formed
outside the model.
The steady-state in the Solow model is stable. This means that regardless of the
initial capital stock (except for k(0) = 0), the economy always tends towards the
steady-state and, eventually, approaches it. If k(0) < k*, then sf(k) > (n + a + δ)
k (see Figure 1), k will grow over time and eventually reaches k*. During the
transition period, the growth rate of total and per capita GDP is higher than in
the steady-state because capital and output per unit of effective labour both
increase (df/dt/f > 0 in Equation 8).
The above property of the Solow model, indicating a faster pace of economic
growth during the transition period, has very important implications. Namely,
the Solow model confirms the existence of conditional β-type convergence.
Convergence (β-type) means that less developed countries (with lower GDP
per capita) tend to grow faster than more developed ones. The catching-up
process confirmed by the Solow model is conditional because it only occurs if
the economies tend to reach the same steady-state.
According to the Solow model, the steady-state may be dynamically
inefficient. In other words, the long-run equilibrium needn’t be Pareto optimal.
This results from the nature of the savings rate which is exogenously given. Too
high savings rate leads to excessive capital accumulation in the economy and
produces dynamic inefficiency.
82
2. Endogenous models of economic growth (Romer, Lucas)
Finally, let us present the impact of an increase in the savings rate on the
dynamics of the economy. According to the Solow model, the exogenous
savings rate does not affect the pace of economic growth in the steady-state, but it influences the equilibrium level of income (higher savings
rate means a higher position of sf(k) function and consequently a higher
level of k*). The impact of a change in the savings rate on GDP growth is
only temporary – higher savings rate accelerates economic growth during
the transition period (when the economy is on the way towards the new
steady-state).
The Ramsey model
The Ramsey model is named after Frank Ramsey, a British economist, who in
1928 published an article on the optimal level of savings. The Ramsey approach
was extended by David Cass (1965) and Tjalling Koopmans (1965) and, therefore,
bears the name of the Ramsey-Cass-Koopmans model.
The main difference between the Ramsey model and the Solow model
concerns the savings rate. The savings rate, which in the Solow theory was
exogenous, in the Ramsey approach is endogenously given and results from
optimal decisions made by utility-maximizing individuals.
Due to complexity of mathematical calculations, we do not analyze in detail
the dynamics of the model. We present only the main conclusions.21
In the steady-state, physical capital, consumption, and output per unit of
effective labour are all constant. This means that GDP growth rate equals the
sum of technological progress and population growth (the variables exogenously
given) while the growth rate of per capita GDP equals technological progress.
Thus, the Ramsey model gives the same answer as the Solow model to the
question about the determinants of long-run economic growth.
The Ramsey model – in contrast to the Solow model – is Pareto optimal.
Endogenous savings prevent excessive accumulation of physical capital in the
economy. Hence, dynamic inefficiency does not appear here.
The Ramsey model – like the Solow model – confirms the existence of
conditional β convergence.
2. Endogenous models of economic growth (Romer, Lucas)
In the early 1970s – along with the oil crisis that changed dramatically the
current trends of economic development of many Western countries – the growth
theory left the main area of interest among economists. The breakthrough came
21
For a detailed analysis of various models of economic growth, see e.g. Barro, Sala-i-Martin
2003; Romer 2006.
83
New developments in growth theory
only in 1986 with the article by Paul Romer, initiating an era of endogenous
growth models.22
Endogenous models – as the name suggests – explain the economic growth
in an endogenous manner, i.e. within the model. This feature contrasts with
neoclassical growth theory where long-run growth depended on exogenous
technological progress, introduced into the model along with other assumptions.
Achieving endogenous growth is possible due to not including the neoclassical
production function which assumes diminishing returns to accumulable inputs
and constant returns to scale. Endogenous models assume that there are at
least constant returns to accumulable inputs.
The mechanism of endogenous growth can be explained by introducing into
the Solow model the following production function:
Y (t ) = AK (t ) .
(9)
The above function exhibits constant returns to capital, the only accumulable
factor of production. Given the income identity Y = C + I = C + dK/dt and the
equality of investment and savings I = sY (where s is the exogenous savings
rate), the economic growth rate in such a model is given as follows:
.
Y
= sA .
Y
(10)
The above equation shows that endogenous growth is achievable without
exogenous technical progress. Equation (10) implies that the economy is
continuously growing at a rate of sA. It also indicates that the increase in the
savings rate is sufficient to accelerate permanently the long-run rate of economic
growth. Since the production function is of the form Y = AK, this simple growth
approach is known as ‘the AK model.’
Endogenous growth occurs – in general – by eliminating the assumption of
diminishing returns to accumulable inputs. In particular models, however, the
introduction of constant returns takes various forms.
The Romer learning-by-doing model is a one-sector model, in which long-run growth is achieved due to increasing returns to accumulable factors at the
whole economy level. In the Rebelo23 and Lucas models, endogenous growth is
possible due to the existence of two sectors, each of which exhibiting constant
returns. Models with an expanding variety of products24 and models with an
improving quality of products25 are known as R&D models. In these models,
22
The first works containing elements of contemporary endogenous models were published,
however, much earlier – already in the 1960s (see e.g. Arrow 1962; Kaldor, Mirrlees 1962; Uzawa
1964, 1965; Shell 1966; Sheshinski 1967).
23
Rebelo 1991.
24
Romer 1990.
25
Aghion, Howitt 1992; Grossman, Helpman 1991.
84
2. Endogenous models of economic growth (Romer, Lucas)
long-run economic growth is obtained by endogenizing technical progress,
which is the output of the R&D sector.
Here, we will briefly discuss two basic models of endogenous growth:
the Romer learning-by-doing model and the Lucas two-sector model. Due to
extensive calculations, we present only the main assumptions and implications
of these models.
The Romer learning-by-doing model
The Romer model differs from the neoclassical models in that it does not
assume diminishing returns to accumulable inputs. On the contrary, knowledge,
which is the only accumulable factor of production, exhibits increasing returns
at the social (whole economy) level. The rationale for adopting this assumption
is that knowledge, being created through investment of individual firms, can
spread freely throughout the economy and thus it can be used by all firms without
incurring additional costs. Such a mechanism of knowledge diffusion is called
learning-by-doing which means learning (i.e. acquisition of knowledge) through
practice. The concept of learning-by-doing and the assumption of increasing
returns both refer to the work of Arrow (1962). Due to increasing returns, the
Romer model reveals an accelerating and permanent economic growth without
introducing exogenous variables.
The assumptions that lead to endogenous growth are the following. Let fi be
the production function of an individual firm:
fi (ai , ki , A ) ,
(11)
where ai is the level of knowledge of an individual firm, ki represents
other factors of production (capital, labour, etc.), and A is the general level
of knowledge in the economy (the sum of knowledge possessed by N firms:
A = Σi=1Nai). To simplify the analysis, we assume that other inputs are constant
(ki = const.), which means that knowledge is the only accumulable factor of
production. Since all firms are identical, we have: fi(ai,ki,A) = f(a,k,A) and A = Na.
The production function exhibits increasing returns with respect to all inputs (a,
k, A) and constant returns with respect to a and k:
f (λ a, λ k , λ A ) > λ f (a, k , A )
and
f (λ a, λ k , A ) = λ f (a, k , A ) . (12)
Since all other factors of production except knowledge are constant
(k = const.), production functions can be written as:
• at the individual firm’s level: f (a, k , A ) = f (a, A ) ,
(13)
85
New developments in growth theory
• at the social (whole economy) level: f (a, k , A ) = f (a, k , Na ) = F (a ) . (14)
Differences in the production function lead to differences in the marginal
product of knowledge. We assume that the marginal product of knowledge at
the social level is increasing while from the firm’s point of view it is decreasing
or constant:
d 2 f (a, A )
da 2
≤0
and
d 2 F (a )
da 2
> 0.
(15)
The dynamics of the economy in the Romer learning-by-doing model differs
from the dynamics of the economy in the neoclassical theory especially because
there is no steady-state in the Romer model. At the optimal trajectory, a perfectly
competitive economy reveals a permanent and accelerating economic growth.
The pace of knowledge accumulation is increasing and asymptotically approaches
its upper growth limit. Therefore, the growth rates of GDP and consumption
increase as well.
The Romer model does not confirm the existence of convergence between
countries. Moreover, it suggests rather divergence trends. According to
the Romer approach, the rate of economic growth increases with income
meaning that more developed countries grow faster than less developed ones.
Although GDP growth rates tend asymptotically towards the same upper
limit, poor countries will grow more slowly because at any given point they
have less knowledge. Thus, differences in income levels between countries are
permanently increasing.
Perfectly competitive economy in the Romer model is not Pareto optimal.
This is because investments in knowledge made by a single firm lead to the
increase of the overall level of knowledge which is a common input. But a single
company in its investment decisions does not take into account these positive
externalities. Marginal product of knowledge from the point of view of a single
firm is less than the marginal product of knowledge at the social level. This
means that a perfectly competitive economy accumulates too little knowledge
and reveals lower growth than a centrally planned economy.
The latter conclusion is a bit shocking at first glance. It results from the fact
that the Romer model includes positive externalities. The concept of learningby-doing suggests that there is a need for government intervention to ensure
a level of knowledge accumulation being optimal from the whole economy’s
perspective. Without government involvement, individual firms will take into
account only private costs and benefits. As a result, in a perfectly competitive
economy both the level of knowledge and the pace of economic growth will be
lower than in an economy with government intervention.
86
3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model
The Lucas model
The Lucas model (1988) is a two-sector model of economic growth that
includes – in addition to physical capital – also human capital. The concept of
the economy consisting of two sectors refers to the work of Uzawa (1964, 1965).
Therefore, the Lucas model is also called the Uzawa-Lucas model. Endogenous
growth is achieved due to the existence of two sectors that both exhibit constant
returns.
The Lucas model explains very well the differences in income levels between
countries. The economies, which at a starting point are capital scarce, achieve
long-run equilibrium with low level of capital. The economies which are initially
richer tend to steady-state characterized by higher capital level. However, the
growth rate of GDP is the same in each steady-state. Thus, differences in income
levels between countries will not disappear: the poor countries remain poor
while the rich countries are still rich.
The Lucas model, therefore, does not explain the phenomenon of convergence
– in terms of both the comparison of various steady-states and the comparison
of transition periods for the economies tending to reach the same steady-state.
In the first case, it appears that in the long-run equilibrium the rate of economic
growth does not depend on the level of capital and output. This means that
countries grow at the same rate regardless of income level reached. In the
second case, when we consider the transition period for economies striving
for the same steady-state, it turns out that less developed countries may grow
faster or slower than more developed ones. It depends on whether the low level
of development results from the lack of physical capital (poorer countries would
grow faster) or the lack of human capital (then poorer countries would record
slower growth).
3. Neoclassical revival:
the Mankiw-Romer-Weil (augmented Solow) model
We present now the augmented Solow model developed by Mankiw,
Romer, and Weil in 1992 (see also Romer 2006). Although the augmented
Solow model is a continuation of the neoclassical growth theory and is not
an endogenous approach, it is treated as the new growth theory mainly for
two reasons. First, it was developed in the 1990s, so during the era of a new
growth theory. Second, the inclusion of human capital makes this model
similar to other endogenous formulas. The Mankiw-Romer-Weil (MRW) model
shows, inter alia, that the neoclassical growth theory explains correctly the
differences in income levels between countries and the phenomenon of
conditional convergence.
87
New developments in growth theory
The main difference between the basic and augmented Solow model is that
the MRW model includes human capital. Human capital (H) is the third input,
in addition to physical capital (K) and effective labour (AL). The production
function has the form:
Y = K α H β ( AL )
1−α − β
,
(16)
where α > 0, β > 0, α + β < 1. As we can see, the production function still
shares all the neoclassical features, namely the diminishing marginal product of
each input, constant returns to scale, and Inada conditions. In the MRW model,
output may be devoted to consumption, accumulation of physical capital, or
accumulation of human capital.
The level of technology and the labour force both grow at constant exogenous
rates, equal to a and n respectively (see Equation 4). Both types of capital
depreciate at the same rate δ. Let sK be the income share spent on physical
capital accumulation (that is, the savings rate), and sH – the income share spent
on human capital accumulation. Thus, the time paths for physical capital and
human capital are:
.
K=sKY – δK ,
(17)
.
H=sHY – δH .
(18)
The dynamics of the model is analysed for capital and output per unit of
effective labour, denoted as k, h, and y:
K
k≡
;
AL
H
h≡
;
AL
K α H β ( AL )
Y
y≡
=
AL
AL
1−α − β
= k α hβ .
(19)
In order to find equations describing the dynamics of the economy, we
differentiate the definitions of k and h with respect to time. The result is:
.
k = sKy – (n + a + δ)k = sK kαhβ – (n+a+δ)k ,
(20)
h = sHy – (n + a + δ)h = sH kαhβ – (n+a+δ)h .
(21)
.
The above equations describe the dynamics of the economy in the MRW
model. They are analogous to Equation (7) in the basic Solow model. The increase
of human and physical capital per unit of effective labour is equal to the actual
investment in a given type of capital net of replacement investment.
In the steady-state, the capital per unit of effective labour is constant. Thus,
setting (20) and (21) to zero, we get the stock of physical and human capital in
88
3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model
the long-run equilibrium:
1
 s1K− β sHβ 1−α − β
k* = 
,

 n + a +δ 
(22)
1
 sαK s1H−α 1−α − β
h* = 
.

 n + a +δ 
(23)
Figure 2 illustrates the steady-state and the transition period in the MRW
model.
The dynamics of the augmented Solow model is considered in a two-dimensional space (k, h). The curves dk/dt = 0 and dh/dt = 0 in Figure 2 are
determined by setting equations (20) and (21) to zero. These curves have the
following functional forms:
1
.
• the curve k&= 0 :
β
 sK
1−α 1−α
k =
h
,

 n + a +δ 
(24)
1
.
• the curve h = 0 :
 n + a + δ  α 1−αβ
k =
 h .
 sH

(25)
Since β < 1 – α and 1 – β > α, the curve dk/dt = 0 is concave, while the curve
dh/dt = 0 – convex. The steady-state is at the point of intersection between dk/
dt = 0 and dh/dt = 0 functions (point E). As in the basic Solow model, the long-run equilibrium is stable. From any starting point (e.g. A, B, C, or D), depending
on the initial stock of physical and human capital, the economy is moving
towards the steady-state according to equations (20) and (21).
Figure 2. The transition peroid and the steady-state in the augmented
Solow model
k
B
.
h= 0 C
.
k= 0
k*
D
A
h*
h
89
New developments in growth theory
In the steady-state, physical capital, human capital, consumption, and output
per unit of effective labour are all constant. This means that GDP growth rate
equals the sum of technological progress and population growth (the variables
exogenously given) while the growth rate of per capita GDP equals technological
progress. Thus, the augmented Solow model gives the same answer as the
basic Solow model and other neoclassical theories to a question about the
determinants of long-run economic growth.
In the MRW model, the investment rates in physical and human capital are
exogenously given. Maximization of per capita consumption requires that these
rates were equal to the factors’ shares in income. But in reality, the investment
rates will be lower as compared with the consumption-maximizing level, because
individuals value the current consumption more than the future consumption
and therefore they do not choose high investment rates. This means that the
MRW model reveals dynamic inefficiency.
The Mankiw-Romer-Weil model, like other neoclassical approaches, confirms
the existence of conditional convergence.
4. Growth empirics: growth determinants, convergence,
growth accounting (TFP)
Growth determinants
In most of the empirical studies, economic growth determinants can be
found using correlation or regression analysis. Correlation coefficient shows
the relationship between the GDP growth rate and a variable tested as an
economic growth determinant. In the regression equation, it is possible to test
simultaneously many variables that are potential economic growth determinants.
Regression equations in growth empirics usually take the following form:
ggdpt = α 0 + α1 x1t + α 2 x2t + K + α n xnt + β1initialgdpt + β 2 dummyt + ε t . (26)
The explained variable (ggdpt) is the GDP growth rate. The explanatory
variables denoted as x1t, x2t, …, xnt are the variables that are tested as economic
growth determinants. The set of these factors should be chosen by the author
of a given study. The regression equation may include the GDP per capita from
the previous period (initialgdpt) to control the influence of initial conditions;
and/or dummy variables (dummyt) to assess the impact of a single shock on
economic growth. εt is the random factor. Regression equations are estimated
using various econometric techniques, e.g. ordinary least squares (OLS).
Here, we present four models of economic growth derived from the author’s earlier research (Próchniak 2010a).26 The results are presented in Ta26
90
For another study of economic growth determinants in CEE-10 countries see: Rapacki, Próchniak 2010.
4. Growth empirics: growth determinants, convergence, growth accounting (TFP)
ble 1. The models are estimated for the 10 Central and Eastern European
countries (CEE-10). All the variables are taken as the 3-year or 2-year subperiod averages.
Table 1. Empirical models of economic growth for the CEE-10 countries,
1993–2009
Variable
Coefficient
t-statistics p-value
MODEL 1
Gross capital formation (% of GDP)
General government balance (% of GDP)
Lending interest rate (%)
Private sector share in GDP (%)
GDP per capita at PPP (constant 2005 US$) from
the previous period
Dummy (= 1 for the 2008–2009 period; = 0
otherwise)
Constant
R2 adjusted = 0.5881
n = 54 R2 = 0.6347
0.1572
0.2427
-0.0569
0.0696
1.81
2.05
-3.16
1.65
0.076
0.046
0.003
0.105
-0.0002
-2.02
0.049
-7.1788
-5.21
0.000
-0.1681
-0.05
0.962
F = 13.61 (p-value for F = 0.000)
MODEL 2
Gross capital formation (% of GDP)
Market capitalization of listed companies (% of GDP)
General government balance (% of GDP)
CPI inflation (%)
GDP per capita at PPP (constant 2005 US$) from
the previous period
Dummy (= 1 for the 2008–2009 period; = 0
otherwise)
Constant
R2 adjusted = 0.5777
n = 55
R2 = 0.6246
0.1985
0.0620
0.2688
-0.0241
2.47
1.63
2.28
-3.66
0.017
0.111
0.027
0.001
-0.0002
-1.89
0.064
-4.6624
-3.92
0.000
2.0208
0.93
0.355
F = 13.31 (p-value for F = 0.000)
MODEL 3
Gross capital formation (% of GDP)
General government balance (% of GDP)
CPI inflation (%)
Private sector share in GDP (%)
GDP per capita at PPP (constant 2005 US$) from
the previous period
Dummy (= 1 for the 2008–2009 period; = 0
otherwise)
Constant
R2 adjusted = 0.5547
n = 56
R2 = 0.6033
0.1510
0.2732
-0.0234
0.0971
1.78
2.26
-3.37
2.40
0.082
0.029
0.001
0.020
-0.0002
-1.56
0.126
-5.5737
-4.64
0.000
-3.0093
-1.03
0.308
F = 12.42 (p-value for F = 0.000)
91
New developments in growth theory
Variable
Coefficient
t-statistics p-value
MODEL 4
Gross capital formation (% of GDP)
General government balance (% of GDP)
Services, value added (% of GDP)
CPI inflation (%)
GDP per capita at PPP (constant 2005 US$) from
the previous period
Dummy (= 1 for the 2008–2009 period; = 0
otherwise)
Constant
R2 adjusted = 0.4895
n = 54
R2 = 0.5473
0.2125
0.1972
0.0973
-0.0220
2.59
1.56
1.50
-2.86
0.013
0.124
0.140
0.006
-0.0001
-1.34
0.186
-4.1980
-3.24
0.002
-4.2728
-0.98
0.333
F = 9.47 (p-value for F = 0.000)
Estimation method: OLS. Explained variable: the growth rate of total real GDP.
All the calculations are based on subperiod averages: 1993–95, 1996–98, 1999–2001, 2002–04,
2005–07, 2008–09.
The models include six explanatory variables: four variables that are tested
as economic growth determinants as well as GDP per capita from the previous
period and a dummy variable to control the impact of global economic crisis.
Among the four factors of economic growth, each equation contains gross
capital formation and general government balance. The other two variables
depend on the model: model 1 includes lending interest rate and private
sector share in GDP, model 2 – market capitalization of listed companies and
CPI inflation, model 3 – CPI inflation and private sector share in GDP, and
model 4 – value added in services and CPI inflation. All these four models
exhibit excellent statistical properties: explanatory variables (save a constant
term) have all the expected sign and are significant with p-value less than
0.15 (only in one case p-value equals 0.19). R-square coefficients are very
high ranging from 55% in model 4 to 63% in model 1. For example, R2 of
63% in model 1 means that the differences in the investment rate, budget
balance, lending rate, private sector share in GDP, and initial income level
(controlled for the impact of crisis) explain about 2/3 of total differentiation
of the 3-year GDP growth rates in the CEE countries. If we substitute inflation
rate for lending rate holding all other variables unchanged, we switch to
model 3 which explains 60% of the variance in economic growth rates. This
is still a very good result. In all these four models, the coefficient on initial
income is negative and significant implying that our analysis confirms the
existence of conditional β convergence among the new EU member countries:
the negative relationship between initial GDP per capita level and subsequent
GDP growth rate does occur when the other factors influencing the rate of
economic growth are held constant.
92
4. Growth empirics: growth determinants, convergence, growth accounting (TFP)
Convergence
In empirical analyses, two most popular concepts of income-level convergence usually are tested: absolute β-convergence and σ-convergence. Absolute
β-convergence exists when less developed economies (with lower GDP per capita)
grow faster than more developed economies (with higher GDP per capita).
σ-convergence appears when income differentiation between economies decreases over time.
To verify the absolute β-convergence hypothesis, we estimate the following
regression equation:
1 yT
ln
= α 0 + α1 ln y0 .
T y0
(27)
The explained variable is the average annual growth rate of real GDP per
capita between period T and 0, while the explanatory variable is the log of
the GDP per capita level in the initial period. If parameter α1 is negative and
statistically significant, β-convergence exists.
In order to verify the σ-convergence hypothesis, we estimate the trend line of
dispersion in income levels between countries:
sd (ln yt ) = α 0 + α1t .
(28)
The explained variable usually is the standard deviation of log GDP per capita
levels between the economies, while the explanatory variable is the time variable.
If parameter α1 is negative and statistically significant, σ-convergence exists.
As an example of the empirical study, we present here the results of testing βand σ-convergence between the CEE-10 countries and the 15 old EU member states
(EU-15). These findings are presented in the latest Poland’s competitiveness report
published by the Warsaw School of Economics (Matkowski, Próchniak 2010).
Figure 3. GDP per capita growth rate over the period 1993–2009 and the
initial GDP per capital level
Annual growth rate of real GDP per
capita, 1993-2009
0,05
EST
LAT
POL
SLK
IRE
LIT
0,04
SLV
EU10
ROM
0,03
CZE
HUN
GRE
0,00
8,65
SPA
EU10 (average) & EU15 (average)
EU10
EU15
Trend line: EU10 and EU15
Trend line: EU10 (average) & EU15 (average)
8,85
LUX
2
R = 0.5485
SWE
0,02
0,01
g y = -0.0164y 0 + 0.1850
FIN
BGR
9,05
9,25
POR
UK
EU15
BEL
NET
AUS
DEN
FRA
GER
ITA
g y = -0.0226y 0 + 0.2424;
9,45
9,65
9,85
10,05
Log of real 1993 GDP per capita
10,25
2
R =1
10,45
10,65
10,85
93
New developments in growth theory
Figure 4. Standard deviation of GDP per capita, 1993–2009
Standard deviation of log of real GDP .
per capita
0,60
0,56
sd(y ) = -0.0100t + 0.6031
2
R = 0.8693
0,52
0,48
0,44
0,40
25 countries
2 regions
0,36
Trend line: country differentiation
Trend line: regional differentiation
sd(y ) = -0.0118t + 0.5441
2
R = 0.9251
0,32
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
The results are shown in Figure 3 and 4. The empirical analysis confirms the
existence of β- and σ-convergence between the CEE-10 countries and the EU-15.
The convergence has been evidenced for 25 individual countries as well as two
regions (the average for the 15 old EU members and the average for the 10 new
EU entrants).
Growth accounting (TFP)
Total factor productivity (TFP) is analyzed using the growth accounting
framework. Growth accounting is based on the decomposition of economic
growth initiated by Solow (1957). The starting point for this analysis is the macroeconomic production function of the following general form: Y = F(A, Z1,…, Zn), where
Y – output (GDP), A – level of technology, Z1,…, Zn – measurable factor inputs.
Two or three measurable factors are usually used in the empirical research: labour, physical capital, and sometimes human capital. Most of the analyses include two such factors: labour (L) and physical capital (K). Thus, the production
function takes the form: Y = F(A, L, K).
In order to break down the rate of economic growth, we differentiate the
production function:
.
94
(29)
4. Growth empirics: growth determinants, convergence, growth accounting (TFP)
The above equation shows that the GDP growth rate is the weighted average
of the growth rates of three factors: technology, labour, and physical capital.
The weights are the factor shares in income, calculated as the marginal factor
product (at the social level) multiplied by the quantity of the respective input
and divided by the level of output.
We assume the Hicks-neutral technological progress: F(A, L, K) = A⋅f(L, K).
For such a production function, the technological share in income, i.e. the
expression (∂F/∂A)A/Y in Equation (29), is simply 1.
In order to calculate the TFP growth rate empirically, we have to make further
assumptions concerning marginal factor products. It is impossible to estimate
the marginal product at the social level. Thus, we assume that all markets are
perfectly competitive and that there are no externalities. Given these assumptions,
the marginal social product of capital ∂F/∂K equals the price of capital r, and the
marginal social product of labour ∂F/∂L equals wage rate w. Let sK be the capital
share in income (rK/Y), and sL – the labour share in income (wL/Y).
Assume further that total income is obtained from labour and capital, i.e.
Y = wL + rK. This yields: sK + sL = 1.
Given all the above assumptions, Equation (29) can be expressed as:
.
.
.
.
Y& A&
K&
L&
= + sK + (1 − sK ) .
Y A
K
L
(30)
The above equation is the basic equation in standard growth accounting.
From this equation, we can calculate the TFP growth rate as the difference
between the GDP growth rate and the weighted average growth rate of labour
and physical capital:
.
.
.
.
& YY&  K
&
A
L&
K
A
TFP growth rate ≡ = −  sK + (1 − sK )  .
A Y  K
L
(31)
As an example of the empirical study, we present here the results of growth
accounting for Poland. These findings are presented in the latest Poland’s
competitiveness report published by the Warsaw School of Economics (Próchniak
2010b).27
27
The results of growth accounting for 27 transition countries are discussed in: Rapacki, Próchniak 2006.
95
96
contr. (% points)
contr. (%)
1.9
38.0
2.1
3.8
4.3
1.0
5.0
43.0
32.4
23.5
44.2
100.0
1.0
contr. (%)
growth (%)
2.2
1.6
3.0
6.8
19.0
growth (%)
contr. (% points)
4.4
3.2
3.0
6.8
2007
5.0
contr. (%)
2006
100.0
contr. (% points)
1.6
25.8
1.1
18.4
3.5
55.8
6.2
contr. (%)
growth (%)
3.2
2.3
3.5
6.2
2005
100.0
contr. (% points)
1.1
31.2
1.1
30.5
1.3
38.3
3.5
2004
100.0
contr. (%)
growth (%)
2.2
2.2
1.3
1.2
2.0
3.7
5.3
3.5
-15.7
26.8
88.9
100.0
contr. (% points)
-0.6
1.0
3.4
3.8
0.6
contr. (%)
growth (%)
-1.2
2.0
3.4
3.8
11.3
contr. (% points)
-107.1
103.4
103.7
100.0
1.0
contr. (%)
growth (%)
-1.5
1.4
1.5
1.4
18.7
growth (%)
contr. (% points)
-3.0
2.9
1.5
1.4
2003
3.7
contr. (%)
3.5
2002
70.0
contr. (% points)
-1.1
-99.1
2.2
195.5
0.0
1.1
100.0
2001
5.3
contr. (%)
growth (%)
-2.2
4.3
0.0
1.1
2000
100.0
contr. (% points)
-0.8
-19.1
2.3
55.3
2.7
63.8
growth (%)
4.2
2.7
4.2
100.0
L
-1.6
K
4.6
TFP
GDP
New developments in growth theory
Table 2. Labour (L), physical capital (K), and TFP contribution to economic
growth in Poland, 2000–2008
2008
contr. = contribution.
The results are shown in Table 2. In 2000–08, Poland recorded an average TFP
growth rate of 2.2% while the average TFP contribution to economic growth
equaled 54.1%. Our results indicate that the increase in total factor productivity
played a significant role in Poland’s economic growth.
5. Summary
1. The models of economic growth can be divided into two groups: neoclassical
and endogenous models. The first ones are characterized by a neoclassical
5. Summary
production function which exhibits diminishing returns to accumulable inputs
and constant returns to scale. The endogenous models assume at least constant
returns to accumulable inputs. The most important neoclassical approaches
include the Solow, Ramsey, and Diamond models. The basic endogenous theories
are the Romer learning-by-doing model, the Lucas model, and models with an
expanding variety or an improving quality of products. The new growth theory
also includes the Mankiw-Romer-Weil (augmented Solow) model.
2. Neoclassical growth theory does not explain well the determinants of long-run economic growth. According to these models, long-run economic growth
depends on technological progress which is exogenously given.
3. The conditional β-convergence is confirmed by all neoclassical models.
Endogenous growth models, however, do not confirm the existence of
convergence. Some of them even indicate that economic growth increases with
income suggesting rather divergence trends.
Bibliography
Barro, R., X. Sala-i-Martin, 2003, Economic Growth, Cambridge–London, The
MIT Press.
Mankiw, N.G., D. Romer, D.N. Weil, 1992, A Contribution to the Empirics of
Economic Growth, Quarterly Journal of Economics, 107, pp. 407–437.
Romer, D., 2006, Advanced Macroeconomics, New York, McGraw-Hill. Polish
translation: Romer, D., 2000, Makroekonomia dla zaawansowanych,
Warszawa, Wydawnictwo Naukowe PWN.
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Arrow, K., 1962, The Economic Implications of Learning by Doing, Review of
Economic Studies, 29, pp. 155–173.
Barro, R., X. Sala-i-Martin, 1995, Economic Growth, New York–St. Louis–San
Francisco, McGraw-Hill.
Cass, D., 1965, Optimum Growth in an Aggregative Model of Capital
Accumulation, Review of Economic Studies, 32, pp. 233–240.
Diamond, P.A., 1965, National Debt in a Neoclassical Growth Model, American
Economic Review, 55, pp. 1126–1150.
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Econometrica, 14, pp. 137–147.
Grossman, G.M., E. Helpman, 1991, Quality Ladders in the Theory of Growth,
Review of Economic Studies, 58, pp. 43–61.
Harrod, R., 1939, An Essay in Dynamic Theory, Economic Journal, 49, pp. 14–33.
97
New developments in growth theory
Inada, K.-I., 1963, On a Two-Sector Model of Economic Growth: Comments and
a Generalization, Review of Economic Studies, 30, pp. 119–127.
Kaldor, N., J.A. Mirrlees, 1962, A New Model of Economic Growth, Review of
Economic Studies, 29, pp. 174–192.
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Matkowski, Z., M. Próchniak, 2010, Real Convergence or Divergence in GDP
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Economics, pp. 42–56.
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Próchniak, M., 2010b, Total Factor Productivity, in: Poland. Competitiveness
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w krajach postsocjalistycznych w latach 1990–2003 (The Characteristics
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gospodarczy i realną konwergencję krajów Europy Środkowo-Wschodniej
(The Impact of EU Enlargement on Economic Growth and Real Convergence
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98
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99
CHAPTER SEVEN
Ryszard Rapacki
The economics of transition
1. Understanding transition
According to the widely accepted view, societies can be organized along the
lines of two diametrically distinct institutional models, that is the market versus
the central planning model in the economy, and the political democracy versus
dictatorship model in the society in general.28 Whereas most ‘Western’ countries
implemented the basic principles of the market-democracy system, the ‘Eastern’
countries applied the central plan-dictatorship model in a relatively pure form
(Heiduk, Rapacki 2009).29
The turn of the 1980s and 1990s witnessed a dramatic change in this well-structured picture. With Poland in the late-1989 as a trail-blazer, the vast
majority of ‘Eastern’ countries decided to start transforming their economic and
political systems and to enter the road from the central plan to the market and
from dictatorship towards political democracy. The group of transition countries
(as they soon began to be named) comprised 28 members in East-Central
and South-Eastern Europe and in Central Asia that regained their full political
sovereignty or emerged as new independent state entities after the breakdown
of the Soviet Union or the split of the former federal states (Yugoslavia and
Czechoslovakia).30
28
Whether the market and democracy models on the one hand and the central plan and
dictatorship models on the other are necessarily complementary remains a controversial issue.
29
The institutional system in some ‘Eastern’ countries in Asia (such as in particular China) does
not fully fit this simple distinction as it exhibits a number of hybrid features. It is often dubbed
a ‘developmental state model’ where political power is cemented over decades, and networks
between politics, administration and business overlap or even overrule market mechanisms.
30
It has to be stressed, however, that – while talking about transition from plan to market –
many scholars, politicians and representatives of international organizations alike – used to further
extend the coverage of this category and include some countries of Eastern and South-Eastern Asia,
101
The economics of transition
For the purpose of the present text we will confine the notion of systemic
transformation to its narrower, economic dimension alone and define it as a long-term process that changes an economic system into an opposite one. Here, we will
focus on a particular direction of this process, i.e. a shift from a centrally-planned
economy to a market-driven one. In order to be successful, systemic transformation
requires the implementation of the whole package of comprehensive and in-depth
reforms – institutional, legislative, regulatory, organizational, etc. – that change
the very nature of the economic system involved.
The second key term that needs to be defined for the sake of the ensuing
discussion is transition. The latter is closely interrelated with the notion of systemic
transformation and means the road or the direction to be followed (including the
target to be arrived) once a country decides to depart from the economic system
based on central planning. Hence, transition economies are the former socialist
countries, which are on the road from central plan to the market. It is also worth
emphasizing that, based on our definition and the very etymology of the word
‘transition,’ it may be inferred that the present status of transition countries is only
temporary – as soon as they succeed in building a fully-fledged market economy
they will not any longer be considered ‘transitory.’
The length and outcomes of the transformation process critically depend on
the initial conditions as well as on the timing and sequencing of systemic reforms.
The former are shaped by a country’s past political, economic, socio-cultural
and demographic trajectories (including the centrally-planned or command
economy legacy31)32 as well as by its geographical location. The timing and
sequencing are a derivative of the choice of transformation strategy (or reform
path) and the commitment to reform of political decision-makers. In the most
general terms, the choice of the reform path can be made essentially between
the two extreme approaches: that of a shock therapy or a ‘big bang’ and that of
a gradual change. The former concentrates the bulk of fundamental reforms at
the beginning of transition. Because of the expected short time span involved,
it might be difficult to unequivocally disentangle the sequencing of reform
measures. The outcome seems to be highly uncertain due to possible cumulative
effects, constructive or destructive, of various policies that are introduced at the
same time. On the other hand, the gradualist approach requires a long-term
timing and sequencing strategy with well-defined and well-managed transition
phases. Sudden stops are possible. Under such an environment some problems
with measuring the results of reforms may arise. Causal links might be reduced,
disturbed or even reverted.
which initiated market reforms on a limited scale well before 1989 (for China, for example, the
starting year was 1978). This sub-group comprises in particular China, Mongolia and Vietnam.
31
For an extensive discussion of this problem, see e.g. Rapacki, Linz 1992.
32
As a general finding, it may be claimed that in this respect systemic transformation of former
socialist countries towards the market system appears to follow a more universal pattern in the
development of institutions, i.e. the path dependency.
102
1989
1989
1989
1989
1989
1989
1989
1991
1991
1978
Poland
Hungary
Czech
Rep.
Slovakia
Slovenia
Romania
Bulgaria
Russia
Ukraine
China
Not relevant
Not relevant
1990
1994
1991
1995
1995
1994
1991
(big bang)
1965
(gradual)
1990
(big bang)
1991
(big bang)
1992
(big bang)
1994
(big bang)
1984
(dual)
1995
1968
(gradual)
1991
(big bang)
1990
1990
(big bang)
1980
1992
1995
1994
1993
1990
1993
1993
1988
1992
Liberalization Stabilization Tax reform
Source: Adapted from Roland 2000.
Political
reform
Country
1978
1992
1992
1993
1991
1965
1991
1991
1982
1990
Entry
Table 1. Stylized facts about the speed and sequencing of transition
1995
(gradual)
1994
(gradual)
1993
(mass)
1994
(gradual)
1991
(gradual)
1993
(gradual)
1992
(gradual)
1992
(mass)
1990
(gradual)
1990
(gradual)
1995
(gradual)
1995
(gradual)
1992
(gradual)
1991
1993
(gradual)
1989
(gradual)
1993
(gradual)
1993
(gradual)
1992
1993
(gradual)
-
-
1993
1994
1995
1989
1993
1993
1992
1992
Enterprise Bankruptcy
Privatization restructuring
reform
-
1995
1992
1997
-
1993
1991
1991
1991
1993
Banking
reform
1. Understanding transition
103
The economics of transition
Between these two extreme approaches, there is also a third option available.
Depending on the political decision-makers’ assessment of the initial conditions,
their attitudes towards risk and their internal homogeneity and strength, mixed
approaches are a feasible alternative (Heiduk, Rapacki 2009).
As an illustration, Table 1 provides a summary of key stylized facts on the
speed and sequencing of transition in ten selected transition economies.
These facts combined can simultaneously indicate the kind of a reform path
or transition strategy adopted in particular countries. In addition to nine East-Central European countries singled out earlier in the text, the table also includes
China, i.e. a country that embarked on a ‘dual-track’ reform strategy. The latter
can serve as a useful reference point, representing the third feasible approach
to systemic transformation.
2. Applicability of standard economic theories
Given its scale, complexity and the nature of problems to be tackled, it goes
without saying that the process of systemic transformation or transition from
socialist central planning to market allocation of goods and resources has been
historically unprecedented. What is of particular significance for our discussion,
while embarking on systemic transformation the countries involved not only
lacked a relevant empirical reference point, in terms of actual experience of other
countries; at the same time they could not rely on a well-formulated underlying
theoretical framework to cope with multiple social, economic and political
challenges inherent to the process of transition (Rapacki, Linz 1992).
On the one hand, for obvious reasons the economic ideology that dominated
the public debate and teaching curricula in socialist countries until 1989, disguised
under the brand of ‘economic theory’ (i.e. the duo of ‘political economy of
socialism’ and its twin sister – ‘the political economy of capitalism’), could not
offer any useful hint or guidance on how to switch from socialism to capitalism.
Much the same holds true – though for different reasons – for two other insights
provided by the economic theory – the current called ‘sovietology’33 and – to a
lesser extent – comparative economic systems.34 While the former focused on
explaining the ‘modus operandi’ of the centrally-planned economy, seen from
the Western perspective, the latter embarked on a comparative analysis of two
competing economic systems. Admittedly, they shared two common features –
they both displayed the symptoms of being backward-looking and – in a way –
33
The most prominent representatives of this current included such reputed scholars as – inter
alia – George Blazyca, Morris Bornstein, Phil Hanson, Michael Kaser, David Kemme, Paul Marer, Alec
Nove, and Mario Nuti.
34
Yet, some elements and conclusions of this branch of economics have been later implemented
as useful guidelines for transition strategies within a broader framework of the Washington Consensus. See Section 3.2 of this text.
104
2. Applicability of standard economic theories
static. This is equivalent to say that the research programs conducted by the two
currents were apparently based on an implicit assumption of a ‘systemic status-quo.’ Even if they both were capable of describing and interpreting changes
(reforms) occurring within each of the two systems, they had little to say on
the transition from one system to another and in particular – from socialism to
capitalism.
On the other hand, the intellectual offer provided by the orthodox economic
theories has not proved particularly well-suited to respond to the challenges
posed by systemic transformation (at least at its early stages) either. The key
reason behind a limited applicability of the theoretical frameworks embedded
in ‘mainstream’ macroeconomics was the fact that they originally emerged
and evolved with the overriding objective to explain the operation of a mature
market economy relying on a well-developed institutional infrastructure. As
a consequence, their explanatory power with regard to transition economies,
which – especially at the initial phase of their transformation – displayed strong
syndromes of a ‘systemic vacuum’35 turned out to be significantly constrained.
This general shortcoming has been additionally strengthened in case of three
major schools within the ‘mainstream’ macroeconomics – i.e. the real business
cycle theory, the new classical school and the monetarist school – due to the set
of specific assumptions embedded in the ‘hard core’ and the ‘protective belt’ of
their research approach and regarding the way the market economy operates.36
The assumptions in question, which have apparently been incompatible with the
‘modus operandi’ of the emerging transition economies, include in particular
a deterministic belief in full predictability of the outcomes of economic agents’
acts and decisions as well as in the rational nature of choices they make (hard
core). Similarly, the assumption of perfectly competitive markets as a dominant
mechanism of resource allocation and a belief in their automatic or semi-automatic
clearing in a transition economy (protective belt) seem overly optimistic.
Having faced this inconsistency the economic profession split in the prevailing
views on the most appropriate research approach to systemic transformation.
One group of economists believed that the unique nature of transition from
plan to market called for a ‘Grand Theory,’ specific for this particular historical
process (see e.g. Lavigne 1999). According to the opposite view, as the process
of transition is by definition temporary, it has not required a specific theory,
the more so the closer were the former socialist countries to the end-point
on their road towards a fully-fledged market economy. Seen from this angle,
the argument went, it would suffice to capitalize on the available economic
theories or their blends, especially those ‘off-mainstream,’ perhaps with some
35
This is to say that while the central planning was already dismantled in these countries, the market
mechanism has not yet been put on place. See e.g. Blazyca, Rapacki 1991; Nuti 1993 and 1996.
36
See Lakatos 1978; for a more detailed discussion of the methodological framework involved
you can refer back to Chapter 1 of this textbook.
105
The economics of transition
adjustments, amendments or extensions. With the benefit of hindsight, we
know today that this was the second view that gained the most support and
popularity among economists.
As a result, in order to fully understand the nature of systemic transformation
and to provide workable policy prescriptions, various analytical frameworks,
including in particular ‘heterodox’ economic theories, have been used (Lavigne
1999). The first approach relied on the public choice theory, which applies
the tools of economics to non-market decision-making, with a special emphasis
on political decisions (see e.g. Murrell 1991). The proponents of this approach
believed that the process of systemic transformation is very much determined
by political factors.
The second theoretical framework that was frequently called upon while
studying the process of transition was the theory of the firm. Here, the focus
shifted from the political stage to the microeconomic level or to enterprise as
the core element of the transformation process. Within this approach, a special
emphasis was laid upon such themes as property rights, transaction costs,
industrial organization theory, incentives theory, principal-agent framework,
decision-making in organizations in a context of bounded rationality, strategic
behaviour and information asymmetry (see e.g. Frydman, Rapaczynski 1994;
Frydman et al. 1993; Wijnbergen 1993).
The third most prominent current in the economic literature dealing with
systemic transformation has been rooted in the new institutional economics
(or NIE). Compared to both the public choice theory and the theory of the firm,
the latter has taken a much more comprehensive perspective on the key drivers
of and interrelationships inherent to transition. One of the most representative
approaches within this current was based on the evolutionary economics. It
looked at the process of systemic transformation from a broad, historical angle
and interpreted it as one more, specific path conducive to capitalism within
a more universal phenomenon, i.e. the historical evolution of the market economy-political democracy system. The evolutionary view on the nature and course
of transition from socialism to capitalism has been most extensively elaborated
in the works of Peter Murrell and Yijiang Wang (1992, 1993 and 1995). The
problem with the evolutionary view, however, is that it does not provide clear
insights into what is going to happen next, once the market infrastructure is
established (Lavigne 1999).37
37
It is worth emphasizing that since the very outset of systemic transformation there has not
been a clear vision among the politicians and scholars of what exactly kind of capitalism ought to
be built in particular transition countries. This assertion may sound striking given the varieties of
capitalism existing just in the Western world (the Anglo-Saxon model, the Continental model, the
Nordic model, and the Mediterranean or South European model, to name just the major ones)
and surprisingly vast room allowed in many areas in the European Union for applying particular
institutional arrangements in individual member countries. For details, see e.g. Hanson 2006 and
2007.
106
3. What has economics learned from transition?
In the light of our earlier reservations regarding a limited applicability of
the ‘mainstream’ macroeconomics in addressing the challenges inherent to the
initial stages of systemic transformation, in may come as a surprise that this
was notwithstanding the orthodox economics that ranked among the most
influential (if not a number one) currents dealing with transition in the beginning
of the 1990s. The blend of orthodox microeconomic and macroeconomic theory,
that since 1989 has come to be dubbed a Washington Consensus view,38 got
a strong support from international donor organizations and the most prominent
representatives of the academic community, as an intellectual basis for standard
reform packages advocated to transition countries. The great popularity of the
Washington consensus, however, may not be that surprising if we look at the
reasons behind its rise from the perspective of vested interests involved rather
than just its intellectual content and merit.
3. What has economics learned from transition?
3.1. General lessons
The hitherto transition experience, especially of those former socialist
countries that managed to successfully transform their centrally planned
economic systems into market-driven ones authorizes a number of useful lessons
of a general nature. The following such lessons deserve special attention (see
Rapacki, Heiduk 2009).
1. Shock therapy vs. gradualism. In a number of former socialist countries,
and in particular in Poland, deep macroeconomic imbalances at the start of the
process of systemic transformation39 called for a radical approach. As a general
lesson, the choice and design of transformation strategy should take into
account the initial conditions of the country involved including the command
economy legacy.
2. Sequencing of the reforms. The pace and sequence of implementing
particular components of the reform package depend again on initial conditions.
If a deep macroeconomic disequilibrium is pervasive, a radical stabilization
policy should be given priority, while the bulk of institutional reforms may be
undertaken once basic equilibrium in the economy is restored. On the other hand
however, some basic institutional changes even at the early stage of transition
38
The term Washington Consensus was initially coined in 1989 by John Wiliamson to describe
a set of ten economic policy prescriptions that in his view should constitute the ‘standard’ reform
package promoted by Washington-headquartered international financial institutions, such as the
IMF and the World Bank, for developing countries affected by economic crises. The package rested
on three pillars or catch-words: stabilization, liberalization and privatization. Subsequently, the term
has come to be used in a different and broader sense, as a synonym for market fundamentalism and
neoliberal policies in general. For more details, see Rodrik 2006.
39
See e.g. Blazyca, Rapacki 1991.
107
The economics of transition
are crucial for the success of systemic transformation, as complexity is required
to create the ‘critical mass’ of the reforms and to make them irreversible.
Although the institutional changes may take a more evolutionary course, they
should be implemented in their full complexity to ensure a positive synergy and
the necessary complementarities.
3. As the experience of systemic transformation clearly demonstrates, at the
early stages of institutional reforms a threat of ‘systemic vacuum’ may appear:
the central planning system has been already dismantled, but the market
mechanism has not yet become fully operational.
4. Relevance of historical traditions.40 With a view to making the transition
more effective and to enhance its successful completion, it is advisable that
the design of the transformation strategy and the accompanying economic
policies be compatible with the national ‘identity’ or the prevailing pattern of
personal characteristics of a country’s inhabitants. As a matter of illustration,
the pertinent patterns established during systemic transformation in Poland can
provide some useful lessons. Worth highlighting in this context is the significance
of – historically determined – individual initiative and entrepreneurial flair as
key drivers of Polish privatization in particular and systemic transformation in
general after 1989.
5. The role of behavioral factors. Among the most critical (yet often
underestimated or neglected) determinants of the transition process, the
behavioral patterns inherited from the command economy are of particular
importance. They encompass, inter alia, social perceptions, labour relations,
egalitarian attitudes, a distorted work ethos, pervasive risk-averse behaviour,
vested interests and widespread rent-seeking activities. As we have shown in
other studies,41 being deeply rooted in the outgoing system the behavioral
patterns in question tend to exhibit a strong persistence and inertia, thus
impeding a smooth systemic transformation and inflating its costs.
6. The importance of the ‘external anchor.’ Given the recent experience of
ten Central and Eastern European transition economies (Bulgaria, the Czech
Republic, Estonia, Hungary, Latvia, Lithuania, Romania, Slovakia and Slovenia),
it can be inferred that the existence of an ‘external anchor’ or the prospect of
EU membership can significantly accelerate the process of institutional reforms
in the candidate countries. As shown, inter alia, in annual EBRD assessments,42
countries invited to join the European Union initiated their reforms earlier,
implemented them much more effectively and with greater commitment, and
today are much more advanced in the reform process than the remaining former
communist countries. Moreover, the use of this ‘anchor’ can lead to different
40
In his famous book, El laberinto de la soledad, the Mexican Nobel prize-winner Octavio Paz
went to an extreme, arguing that the contemporary Mexican identity was deeply rooted in the
remote past, dating back to pre-Columbian times. See Paz 1959.
41
Rapacki, Linz 1992.
42
See e.g. EBRD 2008.
108
3. What has economics learned from transition?
reform paths not only within the group of transition economies, but also in
a much broader sample of countries. According to an IMF study, the quality of
institutions in the new EU member states is currently higher on average than
in other countries in the world at a comparable level of development. On the
other hand, in the remaining transition economies, particularly CIS countries,
the development of the institutional market infrastructure is slightly lower than
in other countries with a similar level of GDP per capita.43
7. The experience of systemic transformation has shown that – even in the
most successful transition countries – apart of desired or anticipated results, side
effects or negative surprises may occur too. Instead of growth and prosperity,
reform programs implemented in many countries tended to deliver rent seeking,
stealing, corruption and economic decline. Simultaneously, in about all transition
economies the process of systemic transformation was associated with growing
income and wealth disparities.
8. The exchange rate regime and macroeconomic performance. Finally, as the
experience of CEE transition economies indicates, a significant role as explanatory
variable of the macroeconomic performance during systemic transformation
has been played by the exchange rate regime adopted in a given country. The
empirical evidence has shown that the transition economies with fixed exchange
rate regimes (including those with currency board arrangements) or ‘fixers’
tended to display high rates of economic growth coupled with a relatively
large scale of macroeconomic imbalances (in particular, excessive inflation and
current account deficits). The opposite was true for those transition economies
with floating exchange rate regimes (‘floaters’) – while economic growth there
has been on average slower compared to ‘fixers,’ the scale of macroeconomic
disequilibrium has been smaller (Rapacki, Heiduk 2009).
3.2. Diverging interpretations of transition
While undertaking research programs on systemic transformation and
making the pertinent policy recommendations economists tended to subscribe
to either of two broad interpretations or visions of this process: the Washington
Consensus view or the institutionalist-evolutionary perspective (Roland
2000). The former used to be also labeled – somewhat over simplistically – the
big-bang or shock therapy view, and the latter the gradualist or incrementalist
view. In this section, we aim to briefly summarize the differences between these
two main visions of transition, both in terms of their theoretical underpinnings
and practical implications.
The Washington Consensus view on transition dominated the economic
thinking in the beginning of systemic transformation. It strongly influenced
the policy recommendations from international financial organizations (like
43
See IMF 2002, p. 102.
109
The economics of transition
the IMF and the World Bank) and was supported by top economists from the
leading Western universities (to mention only Jeffrey Sachs and Stanley Fischer).
Intellectually, it is embedded in a blend of: (1) standard neoclassical price theory,
(2) standard macroeconomics and international experience with stabilization
programs, and (3) core elements of the theory of comparative economic systems
(Roland 2000).
The institutionalist-evolutionary perspective was a minority view at the
outset of systemic transformation; however, it has gained an increasing support
(particularly in academic circles) over time, as a function of the cumulative
transition experience. Intellectually, it is rooted in (1) new institutional economics
and its methodology shaped in particular by the development of non-cooperative
game theory, (2) evolutionary economics, and (3) a philosophical skepticism,
influenced by Hayek and Popper, with a strong emphasis on our relative ignorance
of the dynamics of economic and social systems including their transformation,
a stress on the uncertainty associated with societal engineering, and a strong
aversion toward a Jacobin or Bolshevik-style one-shot, radical institutional
transformation (Roland 2000).
Table 2 provides a simplified summary of the most salient features of these
two opposing visions of transition. The table content has been organized
under three broad headings, i.e. (i) the political economy of reforms and their
strategies, (ii) allocative changes, and (iii) governance changes.
Table 2. A simplified summary of two different visions of systemic transformation
Institutionalist-evolutionary
perspective
1. The political economy of reforms and reform strategies
Insistence on sure efficiency
Insistence on aggregate
Attitude toward
gains; faith in social
uncertainty; skepticism toward
uncertainty
engineering
societal engineering
Political economy
Use of window of opportunity Ensuring continuous and
emphasis
to create irreversibility
growing support for reforms
Dependent on sequencing; can
View of partial
Creating rents that block
either create momentum or stall
reforms
further reform progress
reform process
Very important but
Of absolute importance.
comprehensiveness of initial
Necessity to jump-start
reforms not necessary provided
View of reform
the market economy by
initial reforms can create
complementarities
simultaneous introduction of
momentum for further reforms.
all key reforms
Transitional institutions can
develop and evolve gradually
Middle class and new private
Main support group
Owners of privatized SOEs
for reforms
sector
Washington consensus
110
3. What has economics learned from transition?
Creation of institutional
underpinnings of markets
Focus of reforms
to encourage strong
entrepreneurial entry
Comprehensive: legal
and financial change, law
Attitude toward
Emphasis on adoption of laws enforcement, reform of
institutional change
government, development of
self-enforcing social norms
Using existing institutions to
Creation of tabula rasa
Attitude toward
prevent economic disruption
conditions by breaking existing
and social unrest while
initial conditions
communist state structure
developing new institutions
Liberalization, stabilization,
privatization
2. Allocative changes
Main view of
markets and
liberalization
Main attitude
toward inefficient
SOEs
Main view of
government
Importance of institutional
underpinnings needed to
enhance market growth:
Markets will develop
minimum legal and contracting
spontaneously provided
environment, law enforcement,
government does not
political stability, building of
intervene; supply and demand
business networks and longas focus of analysis
term partnerships; contracting
agents and their institutional
environment as unit of analysis
Containment and politically
feasible downsizing. Rely on
Aggressive closing down
evolutionary development of
private sector to shrink state
sector
Weakening it as much
Role of government in law
as possible to prevent
enforcement and in securing
intervention in markets
property rights
3. Governance changes
Focus of
privatization
Fast transfer of ownership
in private hands via mass
privatization to break
government power and jumpstart market economy. Faith
in market to ensure efficient
resale
Main emphasis of
Shrinking the size of
government reform government
Hardening budget
constraint
Exogenous policy choice that
depends on political will
Emphasis on organic
development of private sector.
Emphasis on sales to outsiders
to achieve efficient transfer of
ownership from the start
Reform in the organization of
government so as to align as
much as possible the interests
of government bureaucrats with
the development of markets
Endogenous outcome of
institutional changes
Source: Roland 2000.
111
The economics of transition
3.3. Transition research and economics
As a result of research on transition, economics has learned a great deal of
useful lessons. Many findings in transition literature may well be generalized
and applied in institutional setups other than the specific context of systemic
transformation alone.
The main impact of research on systemic transformation of former centrally-planned economies into market-driven ones on the development of economic
science in general consists in reinforcing the institutionalist perspective in
economics. As a derivative, the focus of economic research has shifted from
markets and price theory to contracting and the institutional environment (legal,
social and political) of effective contract enforcement (Roland 2000).
The key determinants of this trend included – on the one hand – the side
effects or negative surprises associated with the implementation of reform
strategies based on the Washington consensus (deep and prolonged output
fall, government collapse, failures of mass privatization schemes) and on the
other hand – positive experience of Chinese transition. In general, it turned out
that the pillars of the Washington consensus, i.e. stabilization, liberalization and
privatization policies, if not supported by adequate institutions, may not ensure
successful outcomes.
It is also worth emphasizing that transition studies have not only reinforced the
existing perspective of the new institutional economics, but have simultaneously
stimulated the exploration of new and more complex areas such as e.g. the
dynamics of institutional change in the evolutionary perspective (Roland 2000).
Moreover, much of the results in the transition research extend well beyond
this particular area and have much broader and more universal implications.
For example, the conclusions regarding the political economy of systemic
transformation apply to other contexts such as the European integration
or reforms in Latin America where problems of speed, sequencing and
complementarities of reforms, and momentum effects play a vital role.
Similarly, while dual-track liberalization is originally an institution inherent to
transition in China, its principles apply to other kinds of reform in other countries
such as e.g. labour market reform and pension reform.
The analysis of liberalization and the output fall may also apply to all situations
of unexpected liberalization – for instance the liberalization of capital markets in
emerging economies. The same holds true for different institutional setups and
their effect on solving coordination problems related to law enforcement.
The economics of the soft budget constraint inherent to systemic
transformation may also have much more general applications, that range from
problems of bank bailouts (including the recent sub-prime financial crisis in the
U.S.) to understanding the East Asian crisis of the end-1990s. The analysis of
institutional mechanisms that harden the budget constraint also goes beyond
112
4. Summary and conclusions
the experience of transition to include such issues as the role of fiscal federalism,
decentralization of banking and banking reform and prudential regulation
(Roland 2000).
4. Summary and conclusions
As a wrap up of our discussion in this chapter, the following points are worth
making.
1. Systemic transformation is a long-term process that changes a centrally-planned economy into a market-driven one. In turn, transition means the
road or the direction to be followed once a country decides to depart from the
economic system based on central planning. In the most general terms, the
choice of the reform path is between two extreme approaches: a shock therapy
and a gradual change. Mixed strategies or a dual-track approach is the third
feasible option.
2. At the time of embarking on systemic transformation the countries
involved could not rely on a well-formulated underlying theoretical framework.
As a result, various analytical frameworks, including in particular ‘heterodox’
economic theories and – despite its limited applicability – some blends of the
‘mainstream’ economics, have been used.
3. While undertaking research programs on systemic transformation and
making policy recommendations, economists tended to subscribe to one of
the two broad visions of this process: the Washington Consensus view or the
institutionalist-evolutionary perspective.
4. The main impact of research on transition on economic science in general
has been to reinforce the institutionalist (or NIE) perspective in economics.
5. Moreover, economics has learned a great deal of useful lessons from transition.
Many findings in transition research can be generalized and applied in a wide
range of institutional contexts other than that of systemic transformation.
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Paz, O., 1959, El laberinto de la soledad, Mexico, D.F., Fondo de Cultura Económica.
Rapacki, R., S.J. Linz, 1992, Privatization in Transition Economies: Case Study of
Poland, Econometrics and Economic Theory Papers, no. 9011, Department of
Economics, Michigan State University, East Lansing.
Rapacki, R., G. Heiduk, 2009, The Road from Plan to Market: Lessons from
the Experience of Poland, paper presented at the international conference
on Korea and East Asia: Transformation of Socialist Systems, University of
Vienna, 13–14 February.
Rodrik, D., 2006, Goodbye Washington Consensus, Hello Washington Confusion?,
Journal of Economic Literature, vol. XLIV, December, pp. 969–983.
Roland, G., 2000, Transition and Economics. Politics, Markets and Firms,
Cambridge, The MIT Press.
Wijnberger, S. van, 1993, Enterprise Reform in Eastern Europe, Economics of
Transition, vol. 1, no. 1, January, pp. 21–59.
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CHAPTER EIGHT
Piotr Maszczyk
Do we have to change capitalism
– the alterglobalist view
To sum up the alteglobalists point of view on the modern economy and
economics (this chapter is dedicated to the presentation of such perspective
using the opinions of most prominent economists who sympathize with this
movement, e.g. Stiglitz, De Soto, Serra, Sen, Fitoussi and many others) it is good
to start with their most important thesis, which they have presented since the
beginning of the current crisis. Their way of thinking is mostly like that: the
global economy is passing the near-death experience, which is exposing not
only flaws in the prevailing economic model but also flaws in developing and
developed world society. Then all of us (which in their way of thinking is equal
to civilization or mankind) should take this moment as one of reckoning and
reflection, of thinking about what kind of society we would like to have and
ask our political and economic leaders but ourselves as well, are we creating an
economy that is helping us achieve those aspirations?
From the alteglobalists perspective, human civilization has gone (and what is
far more important is still going) far down an alternative path-creating a society
in which materialism dominates moral commitment, in which the rapid growth
that we have achieved is not sustainable environmentally and socially, in which
we do not act together as a community to address our common needs, partly
because rugged individualism and market fundamentalism have eroded any
sense of community and have led to rampant exploitation of unwary and
unprotected individuals and to an increasing social divide. Too many people had
taken advantage of others. A sense of trust had been broken. There has been
huge and widespread erosion of trust – and not just in the financial institutions
(Stiglitz 2010). By now (end of 2010) economic system was saved, but at the
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cost that is still hard to believe (this cost is currently creating next wave of
problems as a public indebtedness) and which would be paid by lots of next
generations. But, and that’s what is positive in alterglobalists way of thinking, it
is not too late to change this situation.
1. Materialism versus moral commitment
If there is any lesson (in a broader sense) from the current crisis, it is like that:
there is a need for collective action – there is a role for government, as the most
prominent representatives of the alterglobalists movement have repeatedly
emphasized. Politicians and all of the economical agents allowed markets to
blindly and freely shape the economy, and in doing so they also shaped us and
our society. And from the alterglobalists perspective the way that they have
been shaping us is not what the society wanted and what it wants for future.
Standard economic theory assumes that individuals are born with fully formed
preferences. Many people came to believe in the theory that salary (or more
broadly income) reflected social contributions and they concluded that those
who received such high income must have been making the most important
social contributions. And many people came to value what the market was
valuing. The high pay of let’s say bankers indicated that banking was important.
How the market has altered the way we think is illustrated by attitudes towards
an incentive pay. After the Second World War and till the 1980s there used to
be a social contract about the reasonable division of the gains that arise from
acting together within the economy. Within American corporations the salary of
the executive people used to be forty times of the average worker, a seemingly
large number, larger than in Europe and Japan. But then something happened
in the 1980s when Margaret Thatcher and Ronald Reagan came into power.
Alterglobalists, as the critics of current situations stress that any sense of fairness
in compensation was replaced by how much the executives could appropriate
for themselves. This change in attitude to fairness and sense of equity has sent
strong messages to which the youth respond and in doing so the whole society
has been shaped. When the government tax the returns to speculation at much
lower rates than the income of those who work hard for an income, not only
encourages more young people to go into speculation, but it says, in effect, that
as a society we value speculation more highly.
Much has been written about the foolishness of the risks that the financial
sector undertook, the devastation that the financial institutions have brought to
the economy, and the fiscal deficits that have resulted; too little has been written
about the underlying ‘moral deficit’ that has been exposed – a deficit that may
be larger and even harder to correct. The unrelenting pursuit of profits and the
elevation of the pursuit of self-interest may not have created the prosperity that
was hoped, but they did help create the moral deficit.
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There was perhaps a fine line between creative accounting and deceptive
accounting – a fine line that the financial sector in the U.S. (but also in many
European countries) has crossed time and time again, including a few short
years ago, in the WorldCom and Enron scandals. It is not always possible to
distinguish between incompetence and deception, but it is not likely that a firm
claiming to have a net worth of more than a hundred billion dollars would
suddenly find itself in negative territory without knowing that its accounting was
deceptive. It is not believable that the mortgage originators and the investment
bankers didn’t know that the products they were creating, purchasing, and
repackaging were toxic and poisonous (and in Polish case, for example, that
forward transactions sold to the enterprises were connected to the very low
risk or even they were risk free). The investment bankers would like people to
believe that they were deceived by those who sold the mortgages to them. But
they were not. They encouraged the mortgage originators to go into the risky
subprime market because it was only through the ample supply of mortgages
and the transformation of the risky assets into new products that they earned
the fees and generated the returns that, through leverage, made them look
like financial wizards. If they were deceived, it was because they didn’t want to
know. It is possible that a few didn’t know what they were doing, but they are
also guilty then, of a different crime, that of misrepresentation, claiming that
they knew about risk when clearly they did not (Stiglitz 2010).
Exaggerating the virtues of one’s wares or claiming greater competency than
the evidence warrants is something people might have expected from many
businesses, though the extent was almost surely outsized, just as were the
egos and the pay. Financial institutions discovered that there was money at the
bottom of the pyramid and did everything they could within the law (and many
went beyond the law) to move it toward the top. But instead of asking why the
regulators didn’t stop this, societies should have asked what happened to the
moral compunctions of those engaged in these practices, pointed alterglobalists.
2. Economics and lack of moral responsibility
Economics, maybe unintentionally, provided sustenance to this lack of moral
responsibility. A naive reading of Adam Smith might have suggested that he had
relieved market participants from having to think about issues of morality. After
all, if the pursuit of self-interest leads, as if by an invisible hand, to societal well-being, all that one has to do – all that one should do – is be sure to follow one’s
self-interest. And those in the financial sector seemingly did that. But clearly, the
pursuit of self-interest (greed) – did not lead to societal well-being, either in this
episode or in the earlier scandals involving WorldCom and Enron.
The theory of market failure helps to explain why things went so wrong;
how it was that the bankers, in the pursuit of their private interests, led to such
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disastrous social consequences; and why the pursuit of self-interest by the bankers
did not lead to societal well-being, or even the well-being of their shareholders.
When there are market failures, such as externalities, the consequences (the
marginal benefits and costs) of an action are not fully reflected in prices (received
or paid). The failure of one bank has potentially disastrous effects on others; the
failure of the banking system, or even the potential failure, has already had huge
effects on the economy, on taxpayers, workers, businesses, homeowners. The
foreclosure of one mortgage decreases market values of neighboring homes,
increasing the probability of their going to foreclosure.
The irony of the way the model of individualism (especially American style)
worked in practice was that people took credit for successes but showed little
sense of accountability or responsibility for the failures or the costs imposed on
others (they love to internalize profits and same time externalize costs). When
there were recorded profits (it is still questionable if there were real profits or
only created by book accounting), the bankers took credit claiming that it was
due to their efforts; when there were real losses they were the result of forces
beyond their control.
These attitudes were reflected in executive compensation schemes, which, in
spite of the emphasis on incentives, often had little overall connection between
pay and performance: incentive pay is high when performance is good, but
when performance is weak, the deficiency is made up by other forms of pay, with
another name, like ‘retention pay.’ Those in the industry like to say something
like that: we have to pay the worker highly even though performance has been
poor, because others might grab him away. One might have expected the banks
to want to get rid of those whose performance is poor. But profits are poor not
because of inadequate performance but because of events beyond anyone’s
control, sound common explanations. But the same thing was true when profits
were high. This is one of many examples of cognitive dissonance, of the ability
of those in the financial market to make a reasonably good argument on one
side but fail to see the full implications (Stiglitz 2010).
Much of the talk about accountability seems just a matter of words: in
Japanese society a CEO who was responsible for destroying his firm, forcing
thousands of workers to be laid off, might commit suicide. In the United States
and countries, which have more or less followed this model of capitalism, they
are fighting over the size of their bonuses. In today’s financial markets, almost
everyone claims innocence. They were all just doing their jobs. And so they were.
But their jobs often entailed exploiting others or living off the results of such
exploitation. Individualism did not match with individual responsibility. In the
long run, society cannot function well if people do not take responsibility for
the consequences of their actions. I was just doing my job cannot be a defense
neither in politics nor in economics, sounds the strong argument of alterglobalists
movement.
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Externalities and other market failures are not the exception but the rule in
modern economies both in developing and developed countries. If that is the
case, it has profound implications. There is meaning to individual and corporate
responsibility. Firms need to do more than just maximize their market value. And
individuals within corporations need to think more about what they do and the
impacts on others. They cannot get by, by saying that they are ‘just’ maximizing
their incomes.
The model of rugged individualism combined with market fundamentalism
has altered not just how individuals think of themselves and their preferences
but how they relate to each other. In a world of rugged individualism, there is
little need for community and no need for trust (in immortal words of Margaret
Thatcher – there is such thing like society, there are individuals and families).
Government is a hindrance; it is the problem, not the solution. But if externalities
and market failures are pervasive, there is a need for collective action, and
voluntary arrangements will typically not suffice (simply because there is no
‘enforcement,’ no way to make sure that people behave as they should and
usually there is lack of ‘silent heroes’ – people who take the risk and act in a way
everybody knows is needed, but nobody wants to take risk and pay costs). But
worse, rugged individualism combined with rampant materialism has led to an
undermining of trust. Even in a market economy, trust is the grease that makes
society function. Society can sometimes get by without trust – through resort to
legal enforcement, say, of contracts – but it is a very second-best alternative. In
the current crisis, bankers lost our trust, and lost trust in each other. Economic
historians have emphasized the role that trust played in the development of
trade and banking. The reason why certain communities developed as global
merchants and financiers was that the members of the community trusted each
other. The big lesson of this crisis is that despite all the changes in the last few
centuries our complex financial sector was (and is) still highly dependent on
trust. When trust broke down, world financial system froze (Stiglitz 2010).
Alterglobalists stress that the financial crisis has brought home, and
accelerated, the erosion of trust. The societies of developed countries economies
have taken trust for granted, and the result is that it has been weakened. Going
forward, if people do not make fundamental changes, they will not be able to
rely on trust again. If so, this will fundamentally alter how individuals within
these societies treat each other, it will impede such relationships with each other,
and it will change how people think about each other. The sense of community
will be further eroded, and even the efficiency of economy will be impaired.
Securitization, and how it was abused, epitomized this process of how
markets can weaken personal relationships and community. The ‘friendly’
relationship within a stable community between the banker and the borrower,
in which the banker knew the person who was borrowing money (so if the
borrower genuinely had a problem, the banker knew when and how to
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restructure the loan), may have been partly a myth. But, still, there was also
some truth in it; it was a relationship that was based partly on trust. With
securitization, trust has no role; the lender and the borrower have no personal
relationship. Everything is anonymous, and all the relevant information on the
characteristics of the mortgage (or any other banking product – like let say
investment funds units or credit cards) is summarized in statistical data. With
those whose lives are being destroyed described as merely data, the only issues
in restructuring are what is legal – what is the mortgage servicer allowed to do
– and what will maximize the expected return to the owners of the securities.
Not only has trust been destroyed between the borrower and lender but it also
does not exist among the various other parties: for example, the holder of the
securities does not trust the service provider to act in his interests. Given the
lack of trust, many contracts restrict the scope for restructuring. Enmeshed in
legal tangles, both lenders and borrowers suffer. Only the lawyers win (Stiglitz
2010). Securitization will not go away. It is part of the reality of a modern
economy. But implicitly, through the bailouts, governments have subsidized
securitization. It should at least create a level playing field – and we may want
to discourage it.
3. GDP fetishism
Striving to revive the world economy while simultaneously responding to the
global climate crisis has raised an important issue: are statistics giving us the right
‘signals’ about what to do? In our performance-oriented world, measurement
issues have taken on increased importance: at the end of the day our indicators
and methods of aggregating affect what we do.
The alterglobalist point of view is clear; if we have poor measures, what
we strive to do (say, increase GDP) may actually contribute to a worsening of
living standards. We may also be confronted with false choices, seeing trade-offs between output and environmental protection that – from their perspective
– do not exist. By contrast, a better measure of economic performance might
show that steps taken to improve the environment are good for the economy.
There is an increasing discussion among the economists (fueled mainly by the
alterglobalist point of view) concerns whether GDP provides a good measure of
living standards. In many cases, GDP statistics seem to suggest that the economy
is doing far better than most citizens’ own perceptions. Moreover, the focus on
GDP creates conflicts. Political leaders are told to maximize it, but citizens also
demand that attention be paid to enhancing security, reducing air, water, and
noise pollution, all of which might lower GDP growth.
The fact that GDP may be a poor measure of well-being, or even of market
activity, has, of course, long been recognized. But changes in society and the
economy may have heightened the problems, at the same time that advances
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in economics and statistical techniques may have provided opportunities to
improve our metrics.
Joseph Stigliz, Nobel Prize winner and one of the prominent representatives
of the alterglobalist point of view, named a few commentaries of failures that
can be met in the process of measuring the GDP (Report by the Commission…
2009). For example, while GDP is supposed to measure the value of output of
goods and services, in one key sector (government) there is typically no way
of doing this, so often measurement of the output has been simply done by
the inputs. If government spends more – even if inefficiently – output goes up.
In the last 60 years, the share of government output in GDP has increased to
40–52% in the United States, France, United Kingdom, and Germany. So, what
was a relatively minor problem has now become a major one.
Likewise, quality improvements (better cars rather than just more cars),
account for much of the increase in GDP nowadays. But assessing quality
improvements is difficult. Health care exemplifies this problem. Much of
medicine is publicly provided, and much of the advances are in quality. The
same problems in making comparisons over time apply to comparisons across
countries. The U.S. spends more on health care than any other country (both
per capita and as a percentage of income), but gets poorer outcomes. Part of
the difference between GDP per capita in the United States and some European
countries may thus be a result of the way we measure things.
Another marked change in most societies is an increase in inequality. This
means that there is increasing disparity between average (mean) income and
the median income (that of the ‘typical’ person, whose income lies in the middle
of the distribution of all incomes). If a few bankers get much richer, average
income can go up, even if most individuals’ incomes are declining. So GDP per
capita statistics may not reflect what is happening to most citizens.
This realization casts a new light not only on our measures of performance,
but also on the inferences that are made. Before the crisis, when U.S. growth
(using standard GDP measures) seemed so much stronger than that of Europe,
many Europeans argued that Europe should adopt U.S.-style capitalism. Of
course, anyone who wanted to could have seen American households’ growing
indebtedness, which would have gone a long way toward correcting the false
impression of success given by the GDP statistic.
Recent methodological advances made possible to assess better what
contributes to citizens’ sense of well-being, and to gather the data needed to
make such assessments on a regular basis. These studies, for instance, verify
and quantify what should be obvious: the loss of a job has a greater impact
than can be accounted for just by the loss of income. They also demonstrate the
importance of social connectedness (Report by the Commission… 2009).
Any good measure of how well the economy is doing must also take account
of sustainability. Just as a firm needs to measure the depreciation of its capital,
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so, too, our national accounts need to reflect the depletion of natural resources
and the degradation of our environment.
Additionally, there often seems to be a marked distance between standard
measures of important socioeconomic variables like economic growth, inflation,
unemployment, etc. and widespread perceptions. The standard measures may
suggest, for instance, that there is less inflation or more growth than individuals
perceive to be the case, and the gap is so large and so universal that it cannot
be explained by reference to money illusion or to human psychology,44 with
a clear impact on the way in which public discourse about the conditions of the
economy and necessary policies takes place.
There may be several explanations for the gap between the statistical
measurement of socio-economic phenomena and citizen perception of the same
phenomena (Report by the Commission… 2009):
• the statistical concepts may be correct, but the measurement process may be
imperfect,
• when there are large changes in inequality (more generally a change in
income distribution) gross domestic product (GDP) or any other aggregate
computed per capita may not provide an accurate assessment of the situation
in which most people find themselves,
• the commonly used statistics may not be capturing some phenomena, which
have an increasing impact on the well-being of citizens (e.g. traffic jams may
increase GDP as a result of the increased use of gasoline, but obviously not
the quality of life),
• the way in which statistical figures are reported or used may provide a distorted
view of the trends of economic phenomena (e.g. much emphasis is usually
put on GDP although net national product or real household income may be
more relevant).
In February 2008, Nicholas Sarkozy, unsatisfied with the present state of
statistical information about the economy and the society, asked Joseph Stiglitz
(President of the Commission), Amartya Sen (Advisor) and Jean Paul Fitoussi
(Coordinator) to create a Commission, subsequently called The Commission
on the Measurement of Economic Performance and Social Progress (CMEPSP).
The Commission’s aim has been to identify the limits of GDP as an indicator
of economic performance and social progress, including the problems with
its measurement; to consider what additional information might be required
for the production of more relevant indicators of social progress; to assess the
feasibility of alternative measurement tools, and to discuss how to present the
statistical information in an appropriate way. On September 14, 2009 (eighteen
44
In some countries this gap has undermined confidence in official statistics (for example, in
France and in the United Kingdom only one third of citizens trust official figures, and these countries
are not exceptions).
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3. GDP fetishism
months later), the Commission issued its long-awaited report. What are the
main messages and recommendations?
The report distinguishes between an assessment of current well-being and
an assessment of sustainability, whether this can last over time. The current
well-being has to do with both economic resources, such as income, and with
non-economic aspects of peoples’ life (what they do and what they can do,
how they feel, and the natural environment they live in). Whether these levels of
well-being can be sustained over time depends on whether stocks of capital that
matter for our lives (natural, physical, human, social) are passed on to future
generations. The main conclusions of the report are like that:
• there is a need to adapt the system of measurement of economic activity
to better reflect the structural changes, which have characterized the
evolution of modern economies. In effect, the growing share of services and
the production of increasingly complex products make the measurement of
output and economic performance more difficult than in the past. There are
now many products whose quality is complex, multi-dimensional and subject
to rapid change. In some countries and some sectors, increasing ‘output’ is
more a matter of an increase in the quality of goods produced and consumed
than in the quantity. Capturing quality change is a tremendous challenge,
yet this is vital to measuring real income and real consumption, some of the
key determinants of people’s material well-being. Under-estimating quality
improvements is equivalent to over-estimating the rate of inflation, and
therefore to under-estimating real income. The opposite is true when quality
improvements are overstated,
• the measurement system has to shift emphasis from measuring economic
production to measuring people’s well-being. And measures of well-being
should be put in a context of sustainability. Changing emphasis does not
mean dismissing GDP and production measures. They emerged from
concerns about market production and employment; they continue to
provide answers to many important questions such as monitoring economic
activity. But emphasizing well-being is important because there appears to
be an increasing gap between the information contained in aggregate GDP
data and what counts for common people’s well-being,
• emphasis should be put on the household perspective. While it is informative
to track the performance of economies as a whole, trends in citizens’
material living standards are better followed through measures of household
income and consumption. The household perspective entails taking account
of payments between sectors, such as taxes going to government, social
benefits coming from government, and interest payments on household
loans going to financial corporations. Properly defined, household income
and consumption should also reflect in-kind services provided by government,
such as subsidized health care and educational services,
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• aggregates on income and consumption should be considered jointly with
wealth. Income and consumption are crucial for assessing living standards,
but in the end they can only be gauged in conjunction with information on
wealth. A household that spends its wealth on consumption goods increases
its current well-being but at the expense of its future well-being,
• more prominence should be given to the distribution of income, consumption
and wealth. Average income, consumption and wealth are meaningful
statistics, but they do not tell the whole story about living standards. Thus,
average measures of income, consumption and wealth should be accompanied
by indicators that reflect their distribution. Median consumption (income,
wealth) provides a better measure of what is happening to the ‘typical’
individual or household than average consumption (income or wealth). But
for many purposes, it is also important to know what is happening at the
bottom of the income/wealth distribution (captured in poverty statistics), or
at the top,
• the measurement system has to include non-market activities and leisure.
Many of the services people received from other family members in the past
are now purchased on the market. This shift translates into a rise in income
as measured in the national accounts and may give a false impression of
a change in living standards, while it merely reflects a shift from non-market
to market provision of services. There is a need of inclusion of information
on how people spend their time that is comparable both over the years and
across countries,
• the environmental aspects of sustainability deserve a separate follow-up
based on a well-chosen set of physical indicators. In particular there is a need
for a clear indicator of our proximity to dangerous levels of environmental
damage (e.g. climate change or the depletion of fishing stocks.). There is
a need for a clear indicator of increases in atmospheric concentrations of
greenhouse gases associated with proximity to dangerous levels of climate
change (or levels of emissions that might reasonably be expected to lead
to such concentrations in the future. Climate change (due to increases in
atmospheric concentrations of greenhouse gases) is also special in that it
constitutes a truly global issue that cannot be measured with regard to
national boundaries. Physical indicators of this kind can only be identified
with the help of the scientific community.
4. Sustainable development
If there is a consensus today (not only among the economists from the
alterglobalists movement but also mainstream people) about what strategies
are most likely to promote the sustainable development of the poorest countries
in the world (taking into account not only the long-run perspective but also
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environmental problems), it is this: there is no consensus except that the
Washington Consensus (WC) did not provide the answer. Its recipes were neither
necessary nor sufficient for successful growth, though each of its policies made
sense for particular countries at particular times (Stigliz 2008). Whatever its
original content and intent, the term WC in the minds of most people around
the world (keen in economics and politics but so-called ordinary people as
well), has come to refer to development strategies that focus on privatization,
liberalization, and macro stability (meaning, mostly, price stability). To such
people the WC represents a set of policies predicated upon a strong faith –
stronger than warranted either by economic theory or historical experience
– in unfettered markets and aimed at reducing, or even minimizing, the role
of government. This development strategy stands in marked contrast to the
successful strategies pursued in East Asia where the development state took an
active role (Stigliz 2008). Of course how the term WC is understood depends
on the point of view. John Williamson in his works has arraigned the statement
that WC was more than disciplined macroeconomic policy, the use of markets
and trade liberalization. But according to Stiglitz (see e.g. Stiglitz 1998) WC
has always meant both more and less than Williamson suggested. Williamson
does not include in his list of WC’s elements capital market liberalization, which
has come to be one of the pillars of the WC as it has come to be applied. His
point is reducing public deficits, one of the keys to macro stability. But macro
stability itself under the WC as applied focused too narrowly on price stability
(Williamson 2004).
The biggest failure of the WC – as the alterglobalists claim – was in
understanding economic structures within developing countries, in focusing
on too narrow a set of objectives, and on too limited a set of instruments.
For instance, markets by themselves do not produce efficient outcomes when
information is imperfect and markets are incomplete (true in all countries, but
especially in developing countries) or when technology is changing as a result
of R&D expenditures or learning, or more generally, when there is learning, for
instance, about markets.
The intellectual foundations of the WC had been badly eroded even before
its doctrines became widely accepted. The fundamental theorems of welfare
economics provided the rigorous interpretation of Adam Smith’s invisible hand,
the conditions under which and the sense in which markets lead to efficient
outcomes. Under these theorems, it turned out, markets were efficient only
if capital markets were impossibly perfect – at least in the sense that there is
no missing risk or intertemporal markets. There could be no externalities (no
problems of air or water pollution), no public goods, no issues of learning,
and no advances in technology that were the result either of learning or
expenditures on R&D. Greenwald and Stiglitz (1986) went further and showed
that there also could not be any imperfections of information, changes in
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the information structure, or asymmetries of information. These problems are
serious in any economy, but are at the heart of development theory. There
are important externalities in these dynamic processes, which give rise to an
important role for government. The successful East Asian countries recognized
this role; the WC policies did not. In short, there is no theoretical underpinning
to believe that in early stages of development markets by themselves will lead
to efficient outcomes (especially in countries in early stages of development)
(Stiglitz 2008).45
Historical experience provided little support to the belief that markets by
themselves would lead to rapid development. While there is an active debate
about the particular role of each of the industrial policies undertaken by each
of the East Asian countries, there is a clear link between the policies and the
successes (Wade 2003). The township and village enterprises in China (publicly
owned at the local level) were central to China’s success in the 1980s and
early 1990s. The individual responsibility system, which was far short of full
privatization of land (which market fundamentalists claimed was necessary), was
responsible for the enormous increase in agriculture productivity. And it is hard
to conceive that Korea or Taiwan would have become the industrial players of
today without having undertaken active industrial policies. All of the countries in
East Asia had high savings rates, and it is at least plausible that the government
policies designed to stimulate savings actually did what they were intended to
do. While firms in the rest of the world complain about a shortage of capital, the
governments of East Asia provided capital to those firms that were proving their
mettle by exporting, especially in technology sectors where there were likely
spillovers to the rest of the economy (Greenwald, Stiglitz 2006).
If the success of East Asia suggests the desirability of a larger role for
government in successful development than was traditionally emphasized in
the WC policies, the failures in Sub-Saharan Africa and Latin America have
reinforced the doubts about the WC strategies (Stiglitz 2002a). The growth in
Latin America during the 1990s, the decade of reform, was just half of what
it was in the 1960s and 1970s, the decades marked by the ‘failed’ policies of
import substitution. Surely, there were problems with the import substitution
strategy and it would have had to evolve, as it did in East Asia, into a strategy
based more on exports. It was the debt crisis, however, and not the shortcomings
of the development strategy that brought an end to the period of high growth.
Success under reform was even more short lived (less than a decade), and the
end of that success (beginning in 1997) was directly related to the failures of
the reform strategy. The openness of capital markets exposed the countries to
the volatility of international capital markets, which had adverse consequences
in the global financial crisis of 1997–98.
45
The problem of efficiency of the markets (capital market) would be presented more detailed in
the last part: New challenges facing the economic science – did economist really get it so wrong?
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4. Sustainable development
In Africa, the costs of a simple-minded belief in the magic of the market
were palpable and huge. For example, policy conditionalities imposed on the
region’s countries too often focused much too narrowly on liberalization of
agricultural prices without adequate attention to the prerequisites to make
such liberalization effective, for example, functioning markets for inputs and
outputs, credit availability, and infrastructure (especially roads). The insistence
on static comparative advantage foreclosed the kind of dynamic changes that
underlay the successes in East Asia (Stiglitz 2008). But there were a further set
of problems, illustrating the fallacy of composition, whereby increasing exports
of commodities by many countries with similar comparative advantages led to
a collapse in their prices.
The fact that countries that followed the WC policies grew more slowly than
those that did not should, by itself, have been enough to lead countries to
abandon these strategies. But the International Monetary Fund (IMF) urged
patience; developing countries were told that growth was just around the
corner. They were told that if they abandoned the WC policies, all the pain and
suffering that they have experienced would be for naught (Stiglitz 2002a).
It was the crises, especially in countries like Argentina that had receive an A+
grade from the IMF that finally resulted in global disillusion with the WC. But
even before this, there was growing awareness that several of the policies that
they had pushed seemed flawed: privatization marred by corruption for instance,
and which resulted in monopolies that led to higher prices for consumers. Of
course, when such problems occurred, the IMF would say, the problem was not
with privatization itself, but with the way it was implemented. But that response
was disingenuous: they had urged countries to privatize rapidly, as if to say that
even a flawed privatization – and the more rushed the privatization, the more
likely was that it would be flawed – was better than a postponed privatization.
Moreover, policies have to be designed to be implemented by ordinary mortals,
and when country after country faced similar problems in ‘implementation,’ it
became clear that the roots of the problem were deeper (Stiglitz 2008).
The political agenda was most evident in the WC reliance on market
fundamentalism – the belief that markets by themselves lead to economic
efficiency, that economic policies should focus on efficiency, and that distributional
concerns could and should be taken care of elsewhere in the political process.
The policies pursued by the international financial institutions that came to be
called WC policies or ‘neoliberalism’ entailed a much more circumscribed role
for the state than was embraced by most of the East Asian countries.
Of course, governments can make matters worse (government failures etc.).
No doubt the WC represented, in part, a reaction to failures of the state in
attempting to correct failures of the market. But the pendulum swung too far in
the other direction and for too long. The WC policies often assumed the worst
about the nature and capability of all governments, and, in its quest to find
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Do we have to change capitalism – the alterglobalist view
a ‘one-size-fits-all’ policy, gave up on trying to improve governments, arguing
that it was better simply to rely on markets by themselves. This resulted in
a strong bias against basing policy advice on an analysis of what interventions
are appropriate in what contexts, or building the institutions or capacity of
states to intervene effectively.
What is at issue then is not just the size of government, but its role – what
activities should it undertake – and the balance between government and the
market. It is pretty sure that there is a role for markets (no one questioned
that); the question is to what extent do the advocates of WC recognize that
there is a role for the state, beyond the minimal role of enforcing contracts and
property rights? No doubts, there are government failures, just as there are
market failures. But it believes that there are systematic ways to improve the
performance of the government, just as there are systematic ways to improve
markets. Governments and markets are seen as complementary, with government
actually often playing an important role in addressing market failures, helping
markets to work better.
The WC failed so systematically largely because of its failure to understand
development and developing countries; but its failure is also attributable to the
fact that the objectives of development reflected in the WC were too narrowly
defined: the objective of policy should not have been limited to an increase in
GDP – putting aside for the moment the measurement problems associated
with that measure – but should have included sustainable increases in standards
of living, as well as the promotion of democratic and equitable development
(Stiglitz 2008).
The issue of equity, in particular, often received short shrift. Is a society in
which the vast majority of its citizens are becoming worse off, while a few at the
top are doing so well that average incomes are rising, better off than a society in
which the vast majority are doing better, even if total GDP is growing more slowly?
While there may be disagreements – and those at the very top may well stress
that average income is the appropriate measure – the possibility that increases
in GDP may not benefit most individuals’ means that we cannot simply ignore
issues of distribution. Some economists argued that distribution concerns could
be ignored because they believed in trickle-down economics, that somehow
everybody would benefit in the way that a rising tide would lift all boats. But the
evidence against trickle-down economics is now overwhelming, at least in the
sense that an increase in average incomes is not sufficient to raise the incomes
of the poor for prolonged periods. Some economists argued that distribution
concerns could and should be ignored, because such concerns were outside the
province of economics. Economists should focus on efficiency and growth alone;
distribution was a matter for politics. The fundamental theorems of welfare
economics gave economists some comfort, for those results suggested that one
could separate out equity and efficiency concerns, and any desired distribution
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4. Sustainable development
of income could be achieved simply by a redistribution of initial endowments.
But advances in economic theory (especially those related to the economics of
information) showed that that was simply not true; lump sum redistributions
were not generally feasible, efficiency and equity were inextricably interlinked.
Ignoring distributional concerns meant that sometimes even improvements
in efficiency were compromised. For instance, land reform, which would have
reduced the scope for and inefficiencies associated with agency problems
in tenancy, would have simultaneously improved equity and efficiency.
Sharecropping, a prevalent form of land tenancy in developing countries has
resulted in an effective tax rate of 50%, and in some cases 66%, on some of the
poorest people. It is ironic that while the IMF and the advocates of the WC often
railed against the distortions arising from high tax rates, land reform, which
should have been even more important, was seemingly not high on the agenda.
While the international financial institutions talked a great deal about ‘getting
incentives right,’ they never addressed this incentive problem (Stiglitz 2008).
Even worse than the formulation of too narrow a set of objectives was the
fact that, too often, the IMF confused means with objectives (especially in case
of privatization and liberalization). Sometimes privatization makes sense. But it
matters how privatization is done; if done in the wrong way, growth can be reduced
and societal welfare lowered. The pursuit of rapid privatization in the post-socialist
countries contributed to the enormous increase in inequality, compromising the
legitimacy of private rights, at least those acquired in the privatization process,
and perhaps even of the market system. Low inflation was seen as an objective
in itself; excessively tight monetary policy led to the growth of barter, which
undermined market efficiency as equally as inflation. Capital market liberalization
did not lead to faster economic growth, but did lead to more instability.
As the failures of the WC became increasingly evident especially after the
crises, beginning with the Mexican crisis and follow by the East Asian crises,
the Russian crisis, and the Argentine crisis – it has evolved to what is sometimes
called the Washington Consensus Plus. The advocates of the WC successively
tried to modify the prescription. But even as it changed, the underlying problems,
based on a flawed understanding of market economics and a too narrow set of
objectives persisted (Stiglitz 2008).
When these policies failed to produce the satisfactionary results, the diagnosis
changed, and it was argued that these policies needed to be supplemented with
additional policies: the Washington Consensus Plus. What was added depended
on the criticism that was being leveled and on the nature of the failure that was
being recognized.
When growth failed to materialize, ‘second generation reforms,’ including
competition policies to accompany privatizations of natural monopolies, were
added. When problems of equity were noted, the Plus Consensus included
female education or improved safety nets.
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Do we have to change capitalism – the alterglobalist view
The example of Mexico showed that even if a country got its own fiscal
house in order and kept inflation in check, it could have a crisis. The problem,
supposedly, was a lack of domestic savings. But when East Asian countries (with
the highest rates of savings in the world) faced crisis a new explanation was
sought. Now, it was lack of transparency. Weak financial institutions were to
blame, but if such weak institutions were found in the United States and other
advanced industrial countries (which had banking crises in the late 1980s and
early 1990s), what hope did the developing countries have? By this point, the
advocates of WC (most of all IMF and U.S. Treasury) advice rang hollow: ex post,
they could always find something that was wrong, and add something to the
increasingly long laundry list of what countries should do (Stiglitz 2008).
When all of these versions of the Washington Consensus Plus also failed to
do the trick, a new layer of reforms was added: one had to go beyond projects
and policies to the reform of institutions, including public institutions, and
their governance. In some ways, this represented a more fundamental change
in perspectives, but in other ways it was a continuation of the same mindset.
Government had long been viewed as the problem and markets as the solution.
The questions should have been: what can be done to improve the efficiency
of both markets and the government? What is the right balance between the
market and government and how should that balance change over time, as
markets improve and the competencies of governments change? Rather than
asking these questions, the WC had ignored market failures, viewed government
as the problem, assumed that governments could not be reformed, and
proposed massive scale backs in government. Belatedly, it recognized the need
to improve government, and that many of the countries where development
was not proceeding suffered not from too much government but from too little.
But there remained a lack of balance. For instance, rather than asking if public
pension systems could be strengthened, the Washington Consensus continued
to focus its attention on privatization (Stiglitz 2008).
When deficiencies in private pension schemes were noted (e.g., their higher
administrative costs, problems of adverse selection, the failure to insulate old
age pensioners against risks of market volatility or inflation, and the difficulty
of preventing fraud), the problems were ignored or attempts were made to
address the market failures, but it was simply assumed that it would be easier to
make markets work than to make public institutions work.
Nor was the link between policies and institutions, or between institutions and
society, adequately recognized. The IMF told countries to have good institutions,
and examples of good institutions were exhibited, but there was little to say
about how to create such institutions. It was easy to instruct countries on good
economic policies: simply cut the budget deficit. But an injunction to have
honest institutions was much more complicated.
There were other important instances of policies interacting with institutions
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4. Sustainable development
in ways that were adverse to economic performance. High interest rate policies
in Russia (and the failure to create viable financial institutions to supply credit
to new and expanding enterprises) made asset stripping more attractive than
wealth creation; and weakened support for the creation of the kind of rule of
law that would have facilitated wealth creation (Hoff, Stiglitz 2004). Thus, even
as the WC began to expand the list of what was to be done, its perspectives
remained too narrow. Broader goals and still more instruments were required.
A more fundamental change in mindset was needed.
But the criticism now went further. One of the longstanding criticisms of the
WC and the IMF was not just the failure to understand economics; it was argued
that they failed to take into account adequately politics and political processes,
and how they are intertwined with economics. But governance entails political
processes, and while the attention newly focused on governance was welcome,
these limitations and the imperfections in the international institutions’ own
governance itself meant that the IMF and the WC had less to contribute on the
subject than one might have hoped. Even when what they said may have had
more than a grain of truth, the international economic institutions lacked the
credibility required for their messages to have the desired impact (Stiglitz 2002).
Above there are described several elements of an emerging consensus, or the
broadly shared view about the inadequacies of the WC and its excessive belief
in market fundamentalism. But there are a few more named by most prominent
representative of the alterglobalist movement Joseph Stiglitz (Stiglitz 2008):
• development of a successful sustainable development strategy will have to
involve societies in the countries in which it is going to be applied in an
important and meaningful way,
• ‘one-size-fits-all’ policies are doomed to fail. Policies that work in one country
may not work in other ones (compare for example the successful policy
adopted in East Asian economies and Latin America countries which at least
partly followed instructions of WC),
• there are some areas in which economic science has not yet provided
sufficient evidence, sufficiently strong theory, or empirical evidence, to result
in a broad consensus about what countries should do. There may be a broad
consensus against excessive protectionism (with a lot of creditability to the
meaning of this expression) that only serves the interests of distributional
coalitions, but there is no consensus that rapid liberalization, especially in
a country with high unemployment, will lead to faster economic growth. It
may only lead to higher unemployment,
• a successful development requires not the minimal role assigned to the state
by the WC, but a balanced role. The exact role may differ from country to
country,
• success is to be measured not just by an increase in GDP, but by a broader
set of measures, including those that assess environmental and social
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Do we have to change capitalism – the alterglobalist view
sustainability. Greater attention must be paid, too, to issues of distribution,
a development strategy that leads to increases in GDP with most citizens not
sharing in the fruits of that growth is not a success, and such a development
strategy will almost surely not be sustainable over the long run.
5. Conclusions
From the alterglobalist point of view the failures in our economic system and the
failures of our economic system reflect deeper problems in our society. It is certain
(for everybody keen on the field of economics and economic policy) that there
will be changes as a result of the crisis. There is no going back to the world before
the crisis. But the questions are how deep and fundamental will the changes be?
Will they even be in the right direction (at least from their point of view)? In some
areas, regulations will be improved almost surely (the excesses of leverage, less
confidence in market liberalization, greater role of the government etc.). But in
other areas there is remarkably little progress (banking system still makes possible
to internalize profits and externalize cost, derivatives that cost taxpayers so much
will continue almost unabated, and finance executives will continue to receive out
sized bonuses). In each of these areas, something cosmetic will be surely done,
but alterglobalists claim it will fall far short of what is needed.
In several critical areas, in the midst of the crisis, matters have already
become worse. There have been alterations to not only institutions encouraging
ever increased concentration in finance, but the very rules of capitalism.
Governments indirectly announced that for favored institutions there is to be
little or no market discipline. An ersatz capitalism is emerging with unclear rules
but with a predictable outcome: future crises; undue risk-taking at the public
expense, no matter what the promise of a new regulatory regime; and greater
inefficiency. In earlier crises, there was worry about moral hazard, the adverse
incentives provided by bailouts; but the magnitude of this crisis has given new
meaning to the concept.
The rules of the game have changed globally, too. The WC policies and the
underlying ideology of market fundamentalism are dead. In the past, there
might have been a debate over whether there was a level playing field between
developed and less developed countries; now there can be no debate. The poor
countries simply can’t back up their enterprises in the way the rich do, and this
alters the risks that they can undertake. They have seen the risks of globalization
badly managed. But the hopes for reforms in how globalization is managed still
seem on the distant horizon. To use the words of Joseph Stiglitz (Stiglitz 2010, pp.
296–297), Will we seize the opportunity to restore our sense of balance between
the market and the state, between individualism and the community, between
man and nature, between means and ends? We now have the opportunity to
create a new financial system that will do what human beings need a financial
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5. Conclusions
system to do; to create a new economic system that will create meaningful jobs,
decent work for all those who want it, one in which the divide between the haves
and have-nots is narrowing, rather than widening; and, most importantly of all,
to create a new society in which each individual is able to fulfill his aspirations
and live up to his potential, in which we have created citizens who live up to
shared ideals and values, in which we have created a community that treats our
planet with the respect that in the long run it will surely demand. These are the
opportunities. The real danger now is that we will not seize them.
Bibliography
De Soto, H., 2000, The Mystery of Capital, Why Capitalism Triumphs in the West
and fails Everywhere Else, New York, Basic Books.
Greenwald, B., J. Stiglitz, 1986, Externalities in Economics with Imperfect
Information and Incomplete Markets, The Quarterly Journal of Economics,
May.
Greenwald, B., J. Stiglitz, 2006, Helping Infant Economies Grow: Foundations
of Trade Policies for Developing Countries, American Economic Review: AEA
Papers and Proceedings, no. 96/2, May.
Hoff, K., J. Stiglitz, 2004, After the Big Bang? Obstacles to the Emergence of the
Rule of Law in Post-Communist Societies, American Economic Review, no.
94/3, June.
Prasad, E., K. Rogoff, S. Wei, A. Kose, 2003, Effects on Financial Globalization
on Developing Countries: Some Empirical Evidence, IMF Occasional Paper,
no. 220.
Report by the Commission on the Measurement of Economic Performance and
Social Progress, 2009, Paris, www.stiglitz-sen-fitoussi.fr.
Stiglitz, J., 1998, More Instruments and Broader Goals, in: The Rebel Within, ed.
H.J. Chang, London, Wimbledon Publishing Company.
Stiglitz, J., 2002, Globalization and its Discontents, 2002, Mew York, W.W.
Norton& Company.
Stiglitz, J., 2002(a), Reforming Reform: Towards a New Agenda for Latin America,
Santiago de Chile, Prebisch Lecture.
Stiglitz, J., N. Serra, 2008, The Washington Consensus Reconsidered. Towards
a New Global Governance, Oxford, Oxford University Press.
Stiglitz, J., 2010, Freefall. America, Free Markets and the Sinking of the World
Economy, New York, W.W. Norton&Company.
Wade, R., 2003, Governing the Market: Economic Theory and the Role of
Government in East Asia industrialization, Princeton, Princeton University
Press.
Williamson, J., 2004, A Short History of the Washington Consensus, paper
presented at Foundation CIDOB Conference From the Washington Consensus
towards a New Global Governance, Barcelona.
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CHAPTER NINE
Piotr Maszczyk46
New challenges facing the economic
science – did economists really get it
so wrong?
In the early years of the 21st century the situation in the field of macroeconomics seemed to be clear. The majority of economists (still there is always
a group, which just loves to create rumor) were congratulating themselves over
the success of their field. Those successes were both theoretical and practical.
On the theoretical side, they thought that they had resolved their internal
disputes. Olivier Blanchard declared that the state of macro is good. The battles
of yesteryear, he said, were over, and there had been a broad convergence of
vision. And in the real world, economists believed they had things under control:
the central problem of depression-prevention has been solved, declared Robert
Lucas in 2004. Ben Bernanke celebrated the Great Moderation in economic
performance over the previous two decades, which he attributed in part to
improved economic policy making.
These common believes were completely destroyed by Paul Krugman and his
article How Did Economists Get It So Wrong? The Nobel Prize winner presented
the opinions, which shocked the professional world. In his view only a few
economists saw current crisis coming, but this predictive failure was the least
of the field’s problems. More important was the profession’s blindness to the
possibility of catastrophic failures in the market economy. During the golden
years, financial economists came to believe that markets were inherently
46
This chapter is based on two articles published on websites: http://www.nytimes.com/2009/09/06/
magazine/06Economic-t.html?pagewanted=8&_r=1 and http://modeledbehavior.com/2009/09/11/
john-cochrane-responds-to-paul-krugman-full-text/
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New challenges facing the economic science – did economists really get it so wrong?
stable – indeed, that stocks and other assets were always priced just right.
There was nothing in the prevailing models suggesting the possibility of the
kind of collapse that happened. Meanwhile, macroeconomists were divided
in their views. But the main division was between those who insisted that
free-market economies never go astray (‘freshwater economists’ as they come
from the inland University – mainly Chicago) and those who believed that
economies may stray now and then but that any major deviations from the
path of prosperity could and would be corrected by the all-powerful institutions
like FED or government (‘saltwater economists,’ because this group mainly
comes from the U.S. coastal school). Neither side was prepared to cope with
an economy that went off the rails.
So, Krugman’s attack – as his opposite John H. Cochrane pointed out – had
two goals. First, he though financial markets are ‘inefficient,’ fundamentally
due to ‘irrational’ investors, and thus prey to excessive volatility which needs
government control. Second, he has advocated the huge ‘fiscal stimulus’
provided by multi-trillion dollar deficits.
Based on his article (and than the discussion started with the ‘response’
published by Cochrane) it is a very good opportunity to answer these
fundamental questions: what happened to the economics profession? And
where does it go from here? From Krugman’s perspective the economics
profession went astray because economists, as a group, mistook beauty, clad in
impressive-looking mathematics, for truth. The Vision of capitalism as a perfect
or nearly perfect system disappeared during the great Depression in the face of
mass unemployment, but economists fell back in love with the old, idealized
vision of an economy in which rational individuals interact in perfect markets,
this time gussied up with complicated equations. The central cause of the
profession’s failure was in Krugman’s eyes the desire for an all-encompassing,
intellectually elegant approach that also gave economists a chance to show
off their mathematical prowess. As a consequence, they turned a blind eye to
the limitations of human rationality that often lead to bubbles and busts; to
the problems of institutions that run amok; to the imperfections of markets –
especially financial markets – that can cause the economy’s operating system
to undergo sudden, unpredictable crashes; and to the dangers created when
regulators don’t believe in regulation.
From Krugman’s perspective it is certain that economists will have to learn
to live with messiness. That is, they will have to acknowledge the importance of
irrational and often unpredictable behavior, face up to the often idiosyncratic
imperfections of markets and accept that an elegant economic ‘theory of
everything’ is a long way off. In practical terms, this will translate into more
cautious policy advice – and a reduced willingness to dismantle economic
safeguards in the faith that markets will solve all problems.
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1. Global economic crisis – diverging explanations and questions of efficient markets
1. Global economic crisis – diverging explanations and
questions of efficient markets
The roots of crisis – as Krugman describes it in his article – can be founded
when the financial economists putted away Keynes’s disparaging vision of
financial markets as a ‘casino’ and accepted the ‘efficient market’ theory, which
asserted that financial markets always get asset prices right given the available
information. Meanwhile, many macroeconomists completely rejected Keynes’s
framework for understanding economic slumps. Some returned to the view of
Schumpeter and other apologists for the Great Depression, viewing recessions as
a good thing, part of the economy’s adjustment to change. And even those not
willing to go that far argued that any attempt to fight an economic slump would
do more harm than good. Even the New Keynesians believed in an active role
of the government, have undertaken the notion that investors and consumers
are rational and that markets generally get it right. Exceptions to these trends,
a few economists challenged the assumption of rational behavior, questioned
the belief that financial markets can be trusted were swimming against the tide,
unable to make much headway against a pervasive and, in retrospect, foolish
complacency.
In the early 1970s the discussion of investor irrationality, of bubbles, of
destructive speculation had virtually disappeared from academic discourse. The
field was dominated by the ‘efficient-market hypothesis,’ promulgated by Eugene
Fama of the University of Chicago, which claims that financial markets price
assets precisely at their intrinsic worth given all publicly available information.
And by the 1980s, finance economists, notably Michael Jensen of the Harvard
Business School, were arguing that because financial markets always get prices
right, the best thing corporate chieftains can do, not just for themselves but for
the sake of the economy, is to maximize their stock prices. Constantly repeated
stock crash (in the 1970s and 1980s), in which indexes plunged for no clear
reason, should have raised at least a few doubts about market rationality.
The theoretical model that finance economists developed by assuming that
every investor rationally balances risk against reward – the so-called Capital Asset
Pricing Model, or CAPM – is wonderfully elegant. CAPM tells how to choose the
right portfolio – even more important from the financial industry’s point of view,
it tells how to put a price on financial derivatives, claims on claims. The elegance
and apparent usefulness of the new theory led to a string of Nobel prizes for its
creators, and many of the theory’s adepts also received more mundane rewards.
Of course, finance theorists didn’t accept the efficient-market hypothesis merely
because it was elegant, convenient and lucrative. They also produced a great
deal of statistical evidence, which at first seemed strongly supportive. But this
evidence was of an oddly limited form. Finance economists rarely asked the
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New challenges facing the economic science – did economists really get it so wrong?
seemingly obvious (though not easily answered) question of whether asset
prices made sense given real-world fundamentals like earnings. Instead, they
asked only whether asset prices made sense given other asset prices. Finance
theorists continued to believe that their models were essentially right, and so
did many people making real-world decisions. Not least among these was Alan
Greenspan who was then the FED chairman and a long-time supporter of financial
deregulation whose rejection of calls to rein in subprime lending or address the
ever-inflating housing bubble rested in large part on the belief that modern
financial economics had everything under control. And, how meanly describing
Krugman, by October 2008 Greenspan was admitting that he was in a state of
shocked disbelief, because the whole intellectual edifice had collapsed.
In face of recession almost as big as the Great Depression last century the
economists faced the questions: what should policy makers do? Unfortunately,
macroeconomics, which should have been providing clear guidance about how
to address the slumping economy, was in its own state of disarray.
In the 1970s the Nobel Prize laureate Robert Lucas argued that recessions
were caused by temporary confusion: workers and companies had trouble
distinguishing overall changes in the level of prices because of inflation or
deflation from changes in their own particular business situation. And Lucas
warned that any attempt to fight the business cycle would be counterproductive:
activist policies, he argued, would just add to the confusion. By the 1980s,
however, even this severely limited acceptance of the idea that recessions are
bad things had been rejected by many economists. Instead, the new leaders of
the movement, especially Edward Prescott, argued that price fluctuations and
changes in demand actually had nothing to do with the business cycle. Rather, the
business cycle reflects fluctuations in the rate of technological progress, which are
amplified by the rational response of workers, who voluntarily work more when
the environment is favorable and less when it is unfavorable. Unemployment
is a deliberate decision by workers to take time off. From the Krugman’s point
of view this theory seems to be foolish – was the Great Depression really the
Great Vacation? But the basic premise of Prescott’s ‘real business cycle’ theory
was embedded in ingeniously constructed mathematical models, which were
mapped onto real data using sophisticated statistical techniques, and the
theory came to dominate the teaching of macroeconomics in many university
departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel
with Finn Kydland.
Even the self-described New Keynesian economists (almost all saltwater
using the Krugman’s etiquettes) weren’t immune to the charms of rational
individuals and perfect markets. Although they were willing to deviate from the
assumption of perfect markets or perfect rationality, or both, adding enough
imperfections to accommodate a more or less Keynesian view of recessions
(and of course in the saltwater view, active policy to fight recessions remained
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1. Global economic crisis – diverging explanations and questions of efficient markets
desirable), they tried to keep their deviations from neoclassical orthodoxy as
limited as possible. This meant that there was no room in the prevailing models
for such things as bubbles and banking-system collapse. The fact that such
things continued to happen in the real world – there was a terrible financial
and macroeconomic crisis in much of Asia in 1997–98 and a depression-level
slump in Argentina in 2002 – was not reflected in the mainstream of New
Keynesian thinking.
Moreover, there was another interesting point to think about. Even taking into
account the pragmatic way of doing their job by saltwater economist (or New
Keynesian) you might have thought that the differing worldviews of freshwater
and saltwater economists would have put them constantly at loggerheads over
economic policy. Somewhat surprisingly, however, between around 1985 and
2007 the disputes between freshwater and saltwater economists were mainly
about theory, not action. The reason, Krugman believes, is that New Keynesians,
unlike the original Keynesians, did not think fiscal policy – changes in government
spending or taxes – was needed to fight recessions. They believed that monetary
policy, administered by the technocrats at the FED, could provide whatever
remedies the economy needed. And as long as macroeconomic policy was left in
the hands of the Greenspan’s FED, without Keynesian-type stimulus programs,
freshwater economists found little to complain about. They probably did not
believe that monetary policy influenced economy but they did not believe it did
any harm, either.
In economics discussions concerning the grounds and reasons of the crisis
it is very often repeated punch line appears – nobody could have predicted.
From Krugman’s perspectives it is not the truth. People saying such things with
regard to disasters that could have been predicted, should have been predicted
and actually were predicted by a few economists who were scoffed at for their
pains. As an example Krugman points out the precipitous rise and fall of housing
prices. Some economists, notably Robert Shiller of Yale, did identify the bubble
and warned of painful consequences if it were to burst. Yet key policy makers
failed to see the obvious.
How so many economists and policymakers did miss the bubble? In Krugman’s
eyes it is the one and only clear explanation. A general belief that bubbles just
do not happen. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that the word ‘bubble’ drives me nuts, and went on
to explain why we can trust the housing market, housing markets are less liquid,
but people are very careful when they buy houses. It’s typically the biggest
investment they’re going to make, so they look around very carefully and they
compare prices. The bidding process is very detailed.
To sum up Krugman’s point of view on the global economic depression. It
was the belief in efficient financial markets which blinded many if not most
economists to the emergence of the biggest financial bubble in history. And
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efficient-market theory played a significant role in inflating that bubble in the
first place.
Freshwater economists refused to feel guilty. John Cochrane pointed in his
article (treated as a response to the Krugman’s attack) that the central empirical
prediction of the efficient markets hypothesis is precisely: nobody can tell where
markets are going – neither benevolent government bureaucrats, nor crafty
hedge-fund managers, nor academics. From his perspective this is probably the
best-tested proposition in all the social sciences.
Krugman writes as if the volatility of stock prices alone disproves market
efficiency and efficient marketers just ignored it al these years. There is nothing
about ‘efficiency’ that promises ‘stability,’ pointed Cochrane. ‘Stable’ growth
would in fact be a major violation of efficiency. Efficient markets did not need
to wait for the memory of 1929 (…) gradually receding, nor did freshwater
economists fail to read about the stock market crisis in 1987. Data from the
great depression has been included in practically all the tests.
It is true and very well documented that asset prices move more than
reasonable expectations of future cash flows. This might be because people are
prey to bursts of irrational optimism and pessimism. It might also be because
people’s willingness to take on risk varies over time, and is sharply lower in bad
economic times. As Gene Fama pointed out in 1972, these are observationally
equivalent explanations at the superficial level of staring at prices and writing
magazine articles. At last the central prediction of free-market economics, as
crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able
to fully explain market price movements. Nobody knows what fundamental or
hold to maturity value is. In this perspective the case for free markets never was
that markets are perfect. The case for free markets is that government control
of markets, especially asset markets, has always been much worse. Free markets
are the worst system ever devised – except for all of the others. If anyone could
tell what the price of tomatoes should be, let alone the price of Microsoft stock,
communism would have worked, finished his reasoning Cochrane.
In his perspective the current crisis has a pure financial nature; it was a classic
near-run on banks. The centerpiece of the crash was not the relatively free stock or
real estate markets; it was the highly regulated commercial banks. A generation
of economists has thought really hard about these kinds of events. Look up
Diamond, Rajan, Gorton, Kashyap, Stein, and so on. They have thought about
why there is so much short term debt, why banks run, how deposit insurance and
credit guarantees help, but how they give incentives for excessive risk taking.
Krugman did not have anything interesting to say about FED policy, criticized
Cochrane. It did a lot more in 2008 than set the funds rate to zero and then
waits for fiscal policy to do its work. Leaving aside the string of bailouts, the
FED started term lending to securities dealers. Then, rather than buy treasuries
in exchange for reserves, it essentially sold treasuries in exchange for private
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debt. Though the funds rate was near zero, the FED noticed huge commercial
paper and securitized debt spreads, and intervened in those markets. There is no
‘the’ interest rate anymore, the FED is managing them all. Recently the FED has
started buying massive quantities of mortgage-backed securities and long-term
treasury debt.
2. Global economic crisis – fiscal stimulus and the questions
of remedies
As Krugman states in his article, current recession ended the phase of a false
peace over the field of macroeconomics. An extended period during which
inflation subdued and recessions were relatively mild brought both saltwater
and freshwater economist to common believe that FED had economy under, and
even if not it is doing less harm as it possible. Suddenly the narrow, technocratic
policies both sides were willing to accept were no longer sufficient – and the
need for a broader policy response brought the old conflicts out into the open,
fiercer than ever.
During previous recessions FED responded by driving interest rates on
government debt down and thanks to that lead to an economic recovery (in
1990 it was the decrease from 9 to 3% and in 2001 it was from 6.5 to 1%). And
it was the same idea in 2008, FED was driving rates from 5.25% to zero. But it
was not enough to end current recession. And the FED can’t push rates below
zero, since at near-zero rates investors simply hoard cash rather than lending it
out. So by late 2008, with interest rates basically at what macroeconomists call
the ‘zero lower bound’ even as the recession continued to deepen, conventional
monetary policy had lost all traction.
It was the second time America has been up against the zero lower bound,
the previous occasion being the Great Depression. And it was precisely the
observation that there is a lower bound to interest rates that led Keynes to
advocate higher government spending: when monetary policy is ineffective
and the private sector can not be persuaded to spend more, the public sector
must take its place in supporting the economy. Fiscal stimulus is the Keynesian
answer to the kind of depression-type economic situation the whole world is
currently in.
Such Keynesian thinking underlies the Obama administration’s economic
policies, which opened the furious debate about the efficiency of fiscal policy
stimulus. It was the hard voice of freshwater economists like john H. Cochrane
from Chicago who was outraged at the idea that government spending could
mitigate the latest recession. He states that Keynesian economy in the version
presented by Krugman requires that people make plans to consume more,
invest more, and pay more taxes with the same income. It also presumes that
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the government is able to systematically fool people again and again and people
do not think about the future in making decisions today.
In economics, stimulus spending ran aground on Robert Barro’s Ricardian
equivalence theorem. This theorem says that debt-financed spending can not
have any effect because people, seeing the higher future taxes that must pay
off the debt, will simply save more. They will buy the new government debt and
leave all spending decisions unaltered. Is this theorem true? Cochrane states
that there is a logical connection from a set of ‘if’ to a set of ‘therefore.’
Economists have spent a generation tossing and turning the Ricardian
equivalence theorem, and assessing the likely effects of fiscal stimulus in its
light, generalizing the ‘ifs’ and figuring out the likely ‘therefores.’ The impact
of Ricardian equivalence is not that this simple abstract benchmark is literally
true. The impact is that in its wake, if you want to understand the effects of
government spending, you have to specify why it is false. Doing so does not lead
you anywhere near old-fashioned Keynesian economics. It leads you to consider
distorting taxes, estate taxes, how much people care about their children, how
many people would like to borrow more to finance today’s consumption and
so on. And when you find ‘market failures’ that might justify a multiplier, that
analysis quickly suggests direct fixes for the market failures, not their exploitation
along the lines Keynes suggested. Most New Keynesian analyses that add frictions
don’t produce big multipliers.
This is how real thinking about stimulus actually precedes, pointed Cochrane.
He neglected the Kruhman’s point that freshwater economists asserted that an
increase in government spending cannot, under any circumstances, increase
employment.
But the Cochrane formulation (imputed to Krugman) that people make plans
to consume more, invest more and pay more taxes with the same income only
at first glance looks so crazy. Because from the Keynesian point Cochrane is
totally misunderstanding how economy works (it is an interesting mark of how
deep the division between saltwater and freshwater economist runs if they do
not understand such primary points). If people consume less, companies sell
fewer goods and services, requiring them to lay off people, who in turn spend
even less. This is the famous ‘paradox of thrift.’ This is exactly what we are living
through right now. The total money supply does not change, but the economy
goes into recession because that money is not circulating. The opposite also
holds true. If people consume more, companies aiming to meet that demand
hire more workers who then have the income to spend on more products.
Indeed it is not just from a Keynesian point of view. Robert Lucas won his
Nobel Prize for investigating a class of situations – those with unanticipated
nominal money and price level shocks – in which people are in the aggregate
confused about what their real incomes are and so plan to spend more (or less)
than their incomes turn out to be. Milton Friedman’s monetary transmission
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3. The future of macroeconomics
mechanism rests on people, because their money holdings are elevated (or
depressed), trying to spend more (or less) than their incomes. In fact, that is
the root of Irving Fisher’s foundational explanation of the quantity theory of
money. Knut Wicksell’s definition of the natural interest rate is that at which
planned investment is just equal to savings – and so planned spending is equal
to income – and in his model business cycles are driven by fluctuations in the
market interest rate away from the natural rate that induce wedges between
planned spending and income.
Milton Friedman of course believed that FED policy rather than changes
in government spending should be used to stabilize the economy, but he
never asserted that an increase in government spending cannot, under any
circumstances, increase employment. In fact, rereading Friedman’s 1970
summary of his ideas, A Theoretical Framework for Monetary Analysis, what’s
striking is how Keynesian it seems.
The question of unemployment and the eventually willingness of people to work
is in the center of the debate about the possible consequences of fiscal stimulus.
Like Krugman stated in his article, the current generation of freshwater economists
use the arguments that the mass unemployment represents a voluntary reduction
in work effort and the recession are actually good for the economy. For example,
Casey Mulligan suggests that unemployment is so high because many workers
are choosing not to take jobs and workers are choosing to remain unemployed
because that improves their odds of receiving mortgage relief.
Krugman in his article named such ideas craziness and ask rhetorically if
anyone can seriously claim that American economy has lost 6.7 million jobs just
because fewer Americans want to work? But if you start from the assumption
that people are perfectly rational and markets are perfectly efficient, you have to
conclude that unemployment is voluntary and recessions are desirable.
3. The future of macroeconomics
The whole Krugman’s article presented the vision that economics got in
trouble because economists were seduced by the vision of a perfect, frictionless
market system. If the profession is to redeem itself, it will have to reconcile itself
to a less alluring vision – that of a market economy that has many virtues but
that is also shot through with flaws and frictions. But there is no necessity to
start from scratch. Even during the heyday of perfect-market economics, there
was a lot of work done on the ways in which the real economy deviated from
the theoretical ideal. What is probably going to happen now – in fact, it is
already happening – is that flaws-and-frictions economics will move from the
periphery of economic analysis to its center.
Krugman in his article pointed out the school of thought known as behavioral
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New challenges facing the economic science – did economists really get it so wrong?
-world investors bear little resemblance to the cool calculators of efficientmarket theory: they are all too subject to herd behavior, to bouts of irrational
exuberance and unwarranted panic. Second, even those who try to base their
decisions on cool calculation often find that they can not, that problems of trust,
credibility and limited collateral force them to run with the herd. Behavioral
finance, drawing on the broader movement known as behavioral economics,
tries to answer that question by relating the apparent irrationality of investors
to known biases in human cognition, like the tendency to care more about small
losses than small gains or the tendency to extrapolate too readily from small
samples (e.g., assuming that because home prices rose in the past few years,
they will keep on rising).
Krugman argued that until the crisis, efficient-market advocates like Eugene
Fama dismissed the evidence produced on behalf of behavioral finance as
a collection of curiosity items of no real importance. That’s a much harder position
to maintain now that the collapse of a vast bubble – a bubble correctly diagnosed
by behavioral economists like Robert Shiller who related it to past episodes of
irrational exuberance – has brought the world economy to its knees. Probably
the most influential paper in this vein was a 1997 publication by Shleifer and
Vishny, which amounted to a formalization of the old line that the market can
stay irrational longer than you can stay solvent. As they pointed out, arbitrageurs
– the people who are supposed to buy low and sell high – need capital to do their
jobs. And a severe plunge in asset prices, even if it makes no sense in terms of
fundamentals, tends to deplete that capital. As a result, the smart money is forced
out of the market, and prices may go into a downward spiral.
But, as freshwater economists as the advocates of the free market stress, the
behavioral view gives us a new and stronger argument against regulation and
control. Regulators are just as human and irrational as market participants. If
bankers are, in Krugman’s words, ‘idiots,’ then so must be the typical treasury
secretary, FED chairman, and regulatory staff. They act alone or in committees,
where behavioral biases are much better documented than in market settings.
They are still easily captured by industries, and face horrendously distorted
incentives.
In the field of macroeconomics Krugman stated that recent events have pretty
decisively refuted the idea that recessions are an optimal response to fluctuations
in the rate of technological progress; a more or less Keynesian view is the only
plausible game in town. Yet standard New Keynesian models left no room
for a crisis like the world’s economy is struggling with, because those models
generally accepted the efficient-market view of the financial sector (there were
some exceptions – e.g. Bernanke and Gertler work, or Kiyotaki and Moor model
examined the influence of real estates assets market on the real economy).
To sum up Krugman’s statements, firstly he thinks that economists have
to face up to the inconvenient reality that financial markets fall far short of
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perfection, that they are subject to extraordinary delusions and the madness
of crowds. Secondly, they have to admit that Keynesian economics remains
the best framework we have for making sense of recessions and depressions.
Thirdly, they will have to do their best to incorporate the realities of finance into
macroeconomics.
But Macroeconomists have done it years ago, argued Cochrane. Pretty much
all freshwater economists have been doing for 30 years is introducing flaws,
frictions and new behaviors, especially new models of attitudes to risk, and
comparing the resulting models, quantitatively, to data. The long literature on
financial crises and banking, which Krugman does not mention, has been doing
exactly this bidding for the same time. When economics incorporates flaws and
frictions, the result will not be to rehabilitate an old theory of ‘pure’ Keynes. The
New Keynesians did just what Krugman asked, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked
a lot more like monetarism or even something more radical than monetarism.
A science that moves forward almost never ends up back where it started.
And as the biggest surprise Cochrane treated Krugman’s attack on
mathematics in economics. Cause what is the alternative? Does Krugman really
think economists can make progress on his agenda for economic and financial
research – understanding frictions, imperfect markets, complex human behavior,
and institutional rigidities – by reverting to a literary style of exposition, and
abandoning the attempt to compare theories quantitatively against data? In
Cochrane perspective the problem is that economists do not have enough maths.
Math in economics serves to keep the logic straight, to make sure that the ‘then’
really does follow the ‘if,’ which so frequently does not if you just write prose.
The challenge is how hard it is to write down explicit artificial economies with
these ingredients, actually solve them, in order to see what makes them tick.
No matter if you agree with Krugman or Cochrane (or in broader sense
with freshwater or saltwater economists, or with apologists of free market or
Keynesians), it will be a long time, before the new, more realistic approaches to
finance and macroeconomics offer the same kind of clarity, completeness and
sheer beauty that characterizes the full neoclassical approach.
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