The tragedy of modern macroeconomics
The cross-post from Richard Holden begins as follows:
Economists did not predict the financial crisis of 2007, nor did we predict that advent of secular stagnation that has followed. Those events have shaken the economic and political world. Our theories need work. Maybe a lot of work.
Recessions are naturally occurring phenomena which always come as a surprise, but on the second half of his statement, let me take you back to what I published in Quadrant in February 2009 and which I had written the previous December.
Just as the causes of this downturn cannot be charted through a Keynesian demand-deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand, and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.
What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.
This has been exactly what has followed the stimulus and it should not be a surprise although among economists it is. And this is not “secular stagnation”. This is the full-on consequence of following a Keynesian approach to recovery. Just because economists no longer understand the crucial importance of value-adding activity doesn’t mean it has stopped being essential to recovery. It has only meant that modern economists have no idea what is going on.
The rest of Holden’s post tries to get at the point via a critique of modern monetary policy – of which there is no greater critic than I am – that Say’s Law makes straightforward. He crosses correctly over to the real side of the economy to show that you can pour out all the money you like, but if there is no real value-adding activity to support it, you cannot make a recovery happen.
The problem with modern monetary theory is that, in short, there is only a finite amount of real economic resources that can be extracted through seigniorage (the difference between the face value of physical money and its production costs). Or, to quote the late, great Zvi Griliches: “one can only get so much lemon juice out of a lemon.”
It is understanding the overlap between the monetary side of the economy and the real side that is without doubt among the major issues in getting many of these things right. This is covered in Chapters 16 and 17 of the second edition of my Free Market Economics, which I began to write at the end of 2008 to explain why a Keynesian stimulus can never work. It is Say’s Law – uniquely discussed in this book and found nowhere else in all of modern economic literature! – that explains how these things work. Every economist understood this before 1936. Now almost no one does. This is the tragedy of modern macroeconomic theory which only makes things worse every time it is applied.