Monday, September 7, 2009

Is Macroeconomics Relevant?

Paul Krugman's New York Times Magazine article argues for the superiority of Keynesian rather than efficient-markets explanations of...what, exactly? Sometimes his dependent variable seems to be bubbles, other times recessions/depressions. But the topic is supposed to be the financial crisis of 2008. How does Keynesianism explain that?

As near as I can tell, here is Krugman's answer, in the fourth paragraph from the end of the article: "...prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole." Is that really what brought the world economy to its knees--the unemployment of construction workers in California, Nevada, and Florida?

There is no place in Krugman's scenario for banks; Krugman is describing what we have just endured as if it were a standard-issue recession, or depression (as understood by a Keynesian), but as a practical matter, this seems to require assuming that what we just suffered was *not* a "financial" crisis.

I am a mere political scientist. But to judge from most of the economists' research published in the (widely acclaimed!) issue of CRITICAL REVIEW that gave rise to this blog, Krugman's story is, at best, incomplete. If I'm not mistaken, every one of our contributors argues (or assumes?) that this was a banking crisis--albeit one triggered by the popping of the housing bubble. According to them, the sources of the housing bubble and of its deflation are important, but these factors did not directly cause an economic calamity of worldwide scope. Instead, the popped housing bubble caused a sharp drop in the perceived value of mortgage-backed securities held by banks, leading to a severe credit crunch--and *that* is what led to the recession.

So I wonder if Krugman has managed to escape the abstraction from reality that he criticizes as typical of economics. Perhaps part of the urge to abstraction is the tendency to assume that all recessions are alike, and so can be subsumed under one or another macro theory--in turn, perhaps, part of the economists' conviction that they are only "scientists" if they discover economic "laws."

By contrast, our contributors suggest (in my reading of them anyway) that even if a decline in aggregate demand was an end result, the cause of the crisis was a series of "micro" factors that contributed to the concentration of toxic housing debt in the banks. These factors, according to our authors, ranged from bank-capital regulations (see the papers by Viral Acharya and Matthew Richardson and by Juliusz Jablecki and Mateusz Machaj) to the rating of mortgage-backed securities as AA or AAA (Lawrence J. White) to financial deregulation (Daron Acemoglu, Amar Bhide, and Joseph Stiglitz). Even the federal and state housing policies discussed by Peter Wallison, and the monetary factors emphasized by Steven Gjerstad and Vernon Smith, Joseph Stiglitz, and John Taylor are seen by the authors as having had their effect at the micro level--by making mortgages more affordable to subprime borrowers.

Maybe macroeconomics is useful in explaining "normal business cycles" or the Great Depression, but was the Crisis of 2008 in one of these two categories?

Jeffrey Friedman
Editor, Critical Review