Friedman and Schwartz were wrongIn the postwar period, among the sources of distress that would appear in the good times of the later 1940s and the 1950s was the revival of faith in the magic of monetary policy. In 1951 the Treasury Accord, a conspiracy, in our opinion, set up the Federal Reserve as the fourth branch of government.
It’s one of Ben Bernanke’s most memorable quotes: at a conference honoring Milton Friedman on his 90th birthday,Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.He was referring to the Friedman-Schwartz argument that the Fed could have prevented the Great Depression if only it has been more aggressive in countering the fall in the money supply. This argument later mutated into the claim that the Fed caused the Depression, but its original version still packed a strong punch. Basically, it implied that no fundamental reforms of the economy were necessary; all it takes to avoid depressions is for central banks to do their job. But can we say that recent events appear to disprove that claim? (So did Japan’s experience in the 1990s, but that lesson failed to sink in.) What we have now is a Fed that is determined not to “do it again.” It has been very aggressive about monetary expansion. Here’s one measure of that aggressiveness, banks’ excess reserves: And yet the world economy is still falling off a cliff. Preventing depressions, it turns out, is a lot harder than we were taught.
Galbraith's trenchant summary of the postwar use of monetary policy is worth repeating.
Monetary policy would again be used as a weapon against inflation and recession. Not to be relied upon in the serious exigency of war, it would again have a role in the less pressing problems of peace. No course of public action would be so successful in surviving disappointment about its efficacy and even its forthright failure.Krugman and Brad DeLong are concerned with the Chicago School's witless advocacy of the crowding out theory, which postulates that even in the worst of times, if government spends, it merely substitutes for private spending.If, for example, government contracts for the building of a road, and the private contractors hire a bunch of folks to build it, and these people buy food, cars and houses, and nobody else is competing for their labor, or investing in anything, it is still a wash. No increase in economic activity will be seen.
It is not oversimplifying the position, except to omit that the Chicago School imagines somebody will be investing. They see the ghosts of earth movers cast up by their simple models.
Let's enter the discussion by way of Mark Thoma and Willem Buiter
"The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics" Willem Buiter (via Economist's View by Mark Thoma)How stupid is this? The efficient market hypothesis is unraveled several times over just in the two or three decades since it won its promoters the Nobel Prize. The absurd contention that all economic actors have perspicacity beyond measure and all come to the same conclusions, which are right.
Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.;
Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes; rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability.; So the economics profession was caught unprepared when the crisis struck.
Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered.; They did not allow such questions to be asked. ...
[M]arkets are inherently and hopelessly incomplete.; Live with it and start from that fact. ... Perhaps we shall get somewhere this time.
The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. ...
The Auctioneer at the end of time
In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained.; This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.
As Buiter says
Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. education ... But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, and Joseph Stiglitz ...
In financial markets, and in asset markets, real and financial, in general, today’s asset price depends on the view market participants take of the likely future behaviour of asset prices.
But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right. ... The friendly auctioneer at the end of time,
No wonder modern macroeconomics is in such bad shape. ...; Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.
Linearize and trivialize
If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear
Macroeconomists are brave, but not that brave; So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.; This was achieved by completely stripping the model of its non-linearities and by ... mappings into well-behaved additive stochastic disturbances.
Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc.; will appreciate what is lost: Threshold effects, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.
The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models ... was a major step backwards.; I trust it has been relegated to the dustbin of history by now in those central banks that matter.