In this blog post, we walk through the evolution of the key ideas in historical order, and offer suggestions to interesting readings,
which will help you see the fuller picture. Many of them are on your reading list, but some are not.

The old paradigm

Nobody tells it better than The age of uncertainty by John Kenneth Galbraith.

The old paradigm is now in the dustbin of history. But in order to comprehend the revolution in macroeconomics, it is rather useful to start from there. One encounters these arguments from time to time, so it’s worth knowing about the furniture of that mind.

The revolution of modern macroeconomics

The starting point is a speech : The role of monetary policy by Milton Friedman, American Economic Review, 1968, which had enormous influence in arguing that the mainstream Keynesian paradigm was fatally flawed, and that it was not going to work as a guide to policy on a sustained basis. By the early 1970s, the empirical evidence was showing that Friedman was on the right track, which led to everything that followed. This speech is arguably the beginning of modern macroeconomics. At the same time, this was only an argument conducted in English, and not a model.

The next big milestone was the Lucas critique: Econometric policy evaluation: A critique by Robert Lucas, Carnegie-Rochester Conference Series on Public Policy, 1976. This devastated traditional macroeconomics. In addition, it’s a remarkably elegant idea.

Lucas, Sargent and others mapped out a work program in a series of non-technical pieces, which were enormously influential. They set a generation of economists going to build a class of models that were rooted in the intuition of Friedman, 1968, and were invulnerable to the Lucas critique. You should read: Understanding business cycles by Robert Lucas, Carnegie-Rochester
Conference Series on Public Policy, 1977; After Keynesian Macroeconomics by Lucas and Sargent, Federal Reserve Bank of Minneapolis Quarterly Review, 1978; Methods and problems in business cycle theory by Robert Lucas, Journal of Money, Credit and Banking, 1980.

As important as the Lucas Critique was Rules rather than discretion: The inconsistency of optimal plans by Kydland and
Prescott. An accessible set of materials on this work is found in their 2004 Nobel Prize page.

This work came to fruition in the early 1990s in the form of the NK-DSGE model with a policy rule. Important tools got developed in a
classical setting (the RBC model), and then Keynesian frictions were put in, to give the NK-DSGE model. It has many problems, but with this, the Lucas program did work out. Nice readings on the NK-DSGE model are The science of monetary policy: A new Keynesian perspective in the JEL by Clarida, Gali, Gertler (1999), and their Monetary policy rules and macroeconomic stability: Evidence and some theory in the QJE in 2000.

The new macroeconomics is nicely showcased in Technology, employment, and the business cycle: Do technology shocks explain aggregate fluctuations? by Jordi Gali in AER, 1999. This is a wonderful example of confronting empirics with theory, plus a fundamental (if highly controversial) contribution in the eternal quest for the sources of business fluctuations.

On the other side, there is a powerful critique of the micro-founded approach to macroeconomics: The scientific illusion of empirical macroeconomics by Larry Summers, Scandinavian Journal of Economics, 1992.

By the late 1990s, there was a lot of progress to report. There is a nice article: Thirty-Five Years of Model Building for Monetary Policy Evaluation: Breakthroughs, Dark Ages, and a Renaissance by John B. Taylor, Journal of Money, Credit and Banking, 2007. There is the best single book on monetary policy: Monetary Policy Strategy by Frederic S. Mishkin, 2007. And, there are two other nice articles: A stable international monetary system emerges: Inflation targeting is Bretton Woods, reversed by Andrew K. Rose, Journal of International Money and Finance, 2007, and How the World Achieved Consensus on Monetary Policy, by Marvin Goodfriend, Journal of Economic Perspectives, 2007.

The second stage

Once the basic plan was laid, important work emerged in connected fields. A critical issue that came to fore was the role of finance in macroeconomics. Agency costs, net worth, and business fluctuations by Bernanke and Gertler, AER 1989, is the most elegant illustration that financial structure matters for macroeconomics.

We close this off with a canonical reference about fiscal policy from a macro perspective. A good recent treatemnt is Activist fiscal policy to stabilise economic activity by Auerbach and Gale, from the 2009 Jackson Hole symposium.

Post-crisis revisionism?

On this, see Monetary policy and financial stability: Is inflation targeting passe? by Takatoshi Ito, July 2010.

What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.

In thinking about GDP growth, it’s always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate.  In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.

But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.

From this viewpoint, it’s useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.

The bulk of the drama that we’re now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.

Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.

As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We’re going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.

A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.

The article brings to mind a concept introduced in 1999 by Andrew Lawrence, called the “Skyscraper Index”. The index highlights a fairly strong correlation between new world record buildings and the onset of recession. While correlation isn’t causation, and tall buildings certainly don’t cause economic downturns, it is quite interesting and can help to shed some light on the workings of business cycles.

Business cycles can be more aptly described as banking or monetary cycles. They arise in conjunction with inflationary credit bubbles, the responsibility for which lies with the central banks and the fractional reserve banking system. The relative regularity of the bubbles is linked to the fact that the actions taken to mitigate the deflationary effects of an economic downturn, when the bubble bursts, actually plant the seeds for the next bubble.

The root of the matter is that central bankers use incentives to spur rapid economic growth. The interest rate is artificially reduced to below the market rates and the market is flooded with money. Fractional reserve banks greatly leverage the money supply, and it expands like an accordion. The banks use deposited money to make loans, and the leverage of fractional reserves transforms a billion dollars of new reserves into ten billion dollars of new money, created out of thin air.

When interest rates are artificially lowered, business ventures that might not make sense under normal conditions suddenly look profitable. The beginning of the bubble is actually the end of the previous bubble, so costs look favorable. The prior shakeout means that there are lots of resources available at cheap prices. Business really does look good, and entrepreneurs make rational decisions to start projects which look profitable. The money entering the system makes it appear that business is booming for everyone. High spirits and lots of cash stoke the fires for bigger and bigger projects. At times like this, record breaking skyscrapers start to materialize. The thesis of the Skyscraper Index is that when world record building projects get rolling, it is likely that the end of the bubble is near.

The problem is that real resources are limited in the short term. More money pouring into the system does not make any more steel, concrete or lumber available. It does not make more people available to do the work. As the market heats up, the limitation on real resources becomes apparent and costs of production are bid up far beyond expectations. It turns out that entrepreneurs have been fooled. Projects that once looked like big winners now become losers.

The downhill side of the bubble occurs when businesses and individuals can’t pay and the loans go bad. The accordion of fractional reserve banking starts to contract as the leverage is reversed. A billion dollars in bad loans will cause a contraction of 10 billion dollars, as money made from nothing disappears into the ether from whence it came.

As the bust progresses, the real productive resources are still there. Skyscraper owners may go bankrupt but deflation should make prices come down. Productive assets, or overpriced homes in the present case, should become more affordable and realistically priced. If that was allowed to happen, the efficient entrepreneurs would take over productive assets and prospective homeowners would finally be able to afford the homes that they were responsible enough to avoid when they were overpriced.

The reaction among politicians today is to flood the market with “stimulus” to prevent prices from falling and to prop up failed banks and businesses. Aside from the glaring moral hazard of supporting failing businesses and irresponsible homeowners at the expense of those who were responsible, the actions prevent the adjustment that is needed for the economy to become productive again. Skyscraper owners are bailed out, while Average Joe drowns.

Eventually, we may wake up to the reality that the present banking system is the problem. Real banking reform may make the bailout mentality obsolete. It is probably not a good idea to hold your breath waiting, though. Big banks and skyscraper owners with political clout have become addicted to bailouts.