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Unit 5. Lesson 1

Economists still lack a proper understanding of business cycles despite lessons that could have been learned from the financial crisis. Rival theories within the field remain unreconciled and the consensus view has been repeatedly wrong in its predictions. A new paradigm is still needed to improve understanding of downturns and financial risks.

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52 views

Unit 5. Lesson 1

Economists still lack a proper understanding of business cycles despite lessons that could have been learned from the financial crisis. Rival theories within the field remain unreconciled and the consensus view has been repeatedly wrong in its predictions. A new paradigm is still needed to improve understanding of downturns and financial risks.

Uploaded by

halam29051997
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Economists still lack a proper understanding of business cycles

The Economist
Apr 19th 2018

The aftermath of the 2007-08 financial crisis ought to have been a moment of triumph for
economics. Lessons learned from the 1930s prevented the collapse of global finance and
trade, and resulted in a downturn far shorter and less severe than (1)_____________. But
even as the policy remedies were helpful, the crisis exposed the economic profession’s
continued ignorance of the business cycle. That is bad news not just for the discipline, but
for everyone.

The aim of those studying the macroeconomy has always been to understand the
economy’s wobbles, and to work out when governments should intervene. That is not easy.
Downturns come often enough to be a serious irritant, but not often enough to give
economists sufficient data for rigorous statistical analysis. It is hard to distinguish between
short-run swings and structural economic changes resulting from demography or
technology. Most classical economists were sceptical of the idea that the macroeconomy
needed much (2)_____________at all.

By the early 20th century some thinkers were groping their way towards a better
understanding of money in the economy, and how its mismanagement could cause
problems. The Depression forced (3)______________ to concede ground. John Maynard
Keynes blamed recessions on a (4)______________ linked to changes in saving and
(5)_____________. Governments used both monetary and fiscal policy with gusto in the
years after the second world war to maintain full employment.

Yet the Keynesians’ (6)______________ never sat well with classically minded economists.
In 1963 Milton Friedman and Anna Schwartz published their “Monetary History of the
United States”, which resurrected the pre-Depression “monetarist” view that monetary
stability can mend all (7)______________. Other economists, including Edmund Phelps
and Robert Lucas, recognised that people learn to anticipate policy changes and adjust
their behaviour in response. They predicted that sustained stimulus would eventually
cause inflation to accelerate and were vindicated by runaway price growth in the 1970s.

In the years that followed, Keynesians regrouped, borrowed ideas from their critics and
built “New Keynesian” models (on which much modern forecasting is based). The
synthesis of Keynesian and neoclassical ideas informed a new approach to managing the
business cycle. The job was outsourced to central bankers, who promised to keep a lid on
inflation. Adopted around the world, this approach seemed to work. Downturns became
less frequent and less severe; inflation was low and stable; expansions became longer.

But all was not well. Many neoclassical economists rejected the “New Keynesian
consensus” and worked along separate lines. Some followed their models back to the
classical idea that fluctuations were natural and required no intervention. That
occasionally led to absurd conclusions, for instance that falling inflation in the early 1980s
had almost nothing to do with monetary policy. Although central banks largely ignored
this work, its leading theorists retained influence within the profession—winning Nobel
prizes, for example—and with conservative politicians.

The New Keynesians had their own troubles. To satisfy critics they built more
(8)______________, which aimed to show how decisions by (9)_____________, forward-
looking people could, in aggregate, cause downturns. The project was quixotic. People are
often (10)______________. Their behaviour in groups is not as predicted by models that
treat the economy as a mass of identical individuals. These models were complex enough
to be fitted to almost any story. They could replicate features of the economy, but that did
not amount to understanding why those features occurred.

The gap between many neoclassical economists and the New Keynesians running central
banks remained unbridgeable. As Paul Romer has pointed out in some scathing recent
papers, the rival camps were unable to settle their arguments by appealing to facts, or even
to debate politely. You might suppose that the existence of wildly different business-cycle
theories would make macroeconomists more humble, but no. Improbably, both groups
argued that, in the words of Professor Lucas, the “central problem of depression-
prevention has been solved”.

The return of depressing economics


Where consensus did prevail, it proved to be misguided. Economists of all ideological
stripes cheered on the financial deregulation of the 1980s and 1990s. The work of thinkers
like Hyman Minsky and Charles Kindleberger, whose writings on financial excess were
rediscovered after the financial crisis, gathered dust. In a speech in 2005 to central
bankers, Raghuram Rajan, an academic who later ran India’s central bank, warned of the
risks building within the financial system. He got a chilly reception.

There has been progress since the crisis. New research questions the old orthodoxy on
matters from the appropriate role of fiscal policy and the risks associated with large-scale
financial flows to the relationship between unemployment and inflation. But the
profession remains in a dangerous and unsustainable position. The macroeconomic
approach favoured by economists within central banks, regulatory agencies and finance
ministries has erred repeatedly in its prognostications over the past decade, predicting that
labour markets would heal quickly, for example, while underestimating the risks of
targeting a low rate of inflation. A compelling new paradigm seems a distant prospect. Nor
is it clear economists are capable of sorting out their disagreements. Macroeconomics must
get to grips with its epistemological woes if it hopes to maintain its influence and limit the
damage done by the next crisis. Because economists have learned one thing: there is
always another crisis.

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