Fruitful Economics

Papers in honor of and by Jean-Paul Fitoussi

Eloi Laurent, Jacques Le Cacheux, J. Le Cacheux, Kenneth A. Loparo

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137451057
• Topic: Economics
• Subtopic: Environmental Economics
• Index: Economics

This volume is both a tribute to and study of the French economist Jean-Paul Fitoussi. Fitoussi's pluralistic scholarship has shaped modern macroeconomics, political economy, economics of inequality and, more recently, the economics of sustainability.

1

Reconstructing Macroeconomic Theory to Manage Economic Policy

Joseph E. Stiglitz

It is a great pleasure for me to participate in this event celebrating Jean-Paul Fitoussi’s contribution to economics and to public life. There are so many aspects of his work and of his collaborations over a long period of years on which I feel I should comment: His role, for instance, in the International Commission on the Measurement of Economic Performance and Social Progress, has provided a critical impetus to what is now a major global movement. The commission’s work was not just about measurement; it was about shaping our society, for what we measure affects what we do.¹ I should talk too about his contributions over a quarter century to the International Economic Association, where he served as Secretary General, and which he continues to advise. I could talk as well about his efforts to reshape the G20 agenda when France chaired that group,² or the work we did together in the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, in the aftermath of the global financial crisis.³

But I have been asked to talk about macroeconomics, where Fitoussi has been a persistent advocate of policies that maintain full employment and institutional reforms, which would make it more likely that such policies would be adopted. But, of course, if we are to adopt policies that ensure full employment, we must understand why the economy often – as now – operates far below its potential. It should be evident that the macroeconomic models that predominated before the crisis were inadequate. We have to reconstruct macroeconomic theory if we are to do a better job in managing economy policy – the subject of this session, and the subject of much of Fitoussi’s life’s work.

The subject itself reflects a distinctive aspect of his work: a deep commitment to economic science, to the notion that economic policy has to be rooted in an understanding of economic fundamentals; and a deep commitment to policy – to the notion that our knowledge, such as it is, cannot remain within the ivory tower, and must be used to the betterment of mankind. His belief in democracy and democratic institutions has meant that he has worked hard not only to advocate institutions, such as central banks, which are more democratically accountable, but to translate the abstract ideas of economic theorists into a language that is more widely understandable. If our democracy and our economy are to work, there must be more of those with the dedication that Jean-Paul Fitoussi has demonstrated.

Why macroeconomics needs to be reconstructed⁴

No one would, or at least should, say that macroeconomics has done well in recent years. The standard models not only didn’t predict the Great Recession, they also said it couldn’t happen – bubbles don’t exist in well-functioning economies of the kind assumed in the standard model. Not surprisingly, even after the bubble broke, the models didn’t predict the full consequences, and they haven’t provided good guidance to policymakers in responding to the crisis. A half decade after the bursting of the bubble, US unemployment is still high – with almost one out of eight Americans who would like a full-time job not being able to get one.⁵ The government is still financing almost all mortgages.

So, too, our standard models didn’t predict either the occurrence of or the follow-on from the euro crisis – neither its occurrence nor its evolution, including the high levels of unemployment that persist today, and a downturn that in some countries is comparable to that of the Great Depression.

The assertions about how well the economy was performing just before the crisis by those who relied on such models are a painful testament to how badly our models performed. As Robert Wade⁶ has written:

In April 2006 Anne Krueger, deputy managing director of the IMF, announced the IMF’s view that “the world economy has rarely been in better shape.”⁷ In May 2007, Jean-Philippe Cotis, the chief economist of the OECD, presented the OECD’s view that “the current economic situation is in many ways better than what we have experienced in years ... Our central forecast remains quite benign ... [we expect the OECD to show] strong job creation and falling unemployment.”⁸

These assertions of confidence in the economy were made after the housing bubble – which was the precipitating event that brought on the crisis – had already broken. Even after the bubble broke, Bernanke predicted that the crisis would be contained.⁹ Their record in seeing that there was a bubble, let alone predicting when it would burst, was perhaps even more dismal. When shortly before the bubble broke, Greenspan was asked whether there was a bubble, he replied that there was not – just “a little froth” on the economy.¹⁰

The test of science is prediction – and one should have some skepticism of a model that can’t predict the two biggest macroevents of the last 80 years. A model whose predictive ability is so weak, it can hardly be relied upon for policy guidance. With so many of the same policymakers in place after the crisis as before, relying on the same flawed models, it is no wonder that our recovery from the crisis has been so disappointing.¹¹

Those who were so optimistic about the economy even as it was about to implode were guided in their assertions by the prevalent models. Not only did such models deny the existence of bubbles – in spite of more than two centuries in which capitalism had been marked by volatility, much of it brought about by credit and asset bubbles – the models asserted that even if there were a bubble, globalization had enabled the effects of its breaking to be diversified away. They didn’t even contemplate that the effects could have been amplified in a process of contagion.

It is remarkable, given how poorly the models performed, how complacent some of the advocates of the model have been. Defenders of the model (such as Ben Bernanke) argue that the models actually worked quite well – for the purposes for which they were intended:

The standard models were designed for ... non-crisis periods, and they have proven quite useful in that context.¹²

Indeed, Bernanke argued that there was little wrong with the models themselves:

the recent financial crisis was more a failure of economic engineering and economic management than ... of economic science.¹³

Defenders of the model often go further, arguing that no model could deal with events that happen once in 80 years, accidents of nature that are intrinsically unpredictable. But this misses three essential points: (1) The economy wasn’t really performing well, in a fundamental sense, prior to the crisis; it was setting up the conditions – the excesses – that led to the crisis; (2) The crisis itself was not just the result of an “accident,” an exogenous event that struck the economy; rather the crisis was created, or at least enabled, by the economic policies that Bernanke and Greenspan pushed; And (3) the benefits of slightly better performance in prediction in times of “normal” economic activity are far outweighed by the failures in prediction in the context of deep downturns. If we are concerned with overall societal welfare, macroeconomics should be focused on these deep downturns. Between the US and Europe, the loss in output as a result of the current downturn amounts to well over five trillion dollars, an amount far in excess of the benefits from improved fine-tuning of the economy in normal times over decades.¹⁴

Embarrassingly, some of the defenders of the current models go even further. One, Ed Prescott, gloated that this is the “golden age of economics.”¹⁵

Back to the beginning¹⁶

The title of the session provides a nutshell summary of today’s predicament. Prior to Keynes, there was, among classical economists, the general belief that markets worked well, that they were stable and efficient. Indeed, so strongly were these beliefs held that in the midst of the Great Depression, a majority of American economists supported the notion that government should do nothing. Markets would self-correct. (These economists did not, of course, explain why matters had gone so disastrously.)

Keynes provided an answer – a theoretical model, or perhaps more accurately, a set of theoretical models, with clear policy implications, the central tenets of which were: (a) markets were not self-correcting, at least in the relevant time span – unemployment could persist; (b) in deep downturns, monetary policy was ineffective; and (c) fiscal policy – government spending – could stimulate the economy, by a multiple of the amount that was spent.

The model provided an explanation both for the disaster that was associated with US President Herbert Hoover’s economic policies and for the successes of the New Deal and the war-led recovery in the US. Keynes’s ideas were incorporated in 1946 US legislation that recognized the responsibility of the government to maintain the economy at full employment, and entrusted the Council of Economic Advisers with formulating macroeconomic policies that would ensure that this would be achieved. In the ensuing decades, there were several instances – most notably under President John F. Kennedy – where Keynesian ideas were tried and tested, and worked.

But Keynes was never liked by those who believed in unfettered markets – who wanted to minimize the role of government – and the counterattack that began in the 1960s had remarkable successes in the ensuing decades. Prosperity meant that the Great Depression quickly faded into ancient history, and the problem of the day was inflation, not unemployment. The economics profession changed, too, demanding greater standards of rigor. The schism between microeconomics, which focused on well-functioning markets (which always “cleared,” so that there was never any unemployment), and in which the central result was Smith’s invisible hand, and macroeconomics, which focused on dysfunctional markets, which could be characterized by high levels of unemployment, was unsettling.

Modern macroeconomics can be viewed as growing out of an attempt to reconcile traditional Keynesian macroeconomics with microeconomics.¹⁷ There were two ways to achieve such a reconciliation: try to adapt macroeconomics to the microeconomic model of the time, or try to glean from macroeconomics insights about what was wrong with the traditional microeconomic models and reform them accordingly. Much of the mainstream of economics took the former course – just at the time that standard microeconomics was itself under attack, from the proponents of theories of imperfect and asymmetric information, game theory, and behavioral economics.

Mainstream macroeconomics came to be dominated by two “churches” – I use the term advisedly, because both were dominated by strong beliefs, which could be little altered by evidence and experience, though the style of argument seemed to suggest that both based their faith on a close examination of the empirical record.

One school returned to the doctrines of the classical economists, holding that markets worked well, that policy intervention was unnecessary. Some took the (seemingly absurd) view that what was widely viewed as unemployment was actually just leisure. Their theories were designed to explain the wide fluctuations in the demand for leisure. When challenged with the observation that normally, when individuals are experiencing a period of extensive leisure, they feel happy, and yet there were ample indicators that in recessions, that was not the case, they responded: that was a matter for psychologists, not for economists.

They held two further, somewhat contradictory positions: government policy was likely to be ineffective, and, if and when it had effects, it was counterproductive.

In support of their models, they took a major step backward from the use of statistical inference. They constructed calibrated models, and using simulations, described the correlations between certain selected variables, comparing those correlations with observed correlations. In many cases, when one looked at the underlying behavior, for example, of savings or labor supply, it was in fact poorly described by the model. What had begun as an attempt to reconcile macro- and microbehavior seemed, in the end, to almost ignore what should have been the underlying microfoundations.

Pa...

Table of contents

• Cover
• Title
• Introduction: Fitoussis Fruitful Economics
• Prologue: The Measurement of the Economic World
• 1  Reconstructing Macroeconomic Theory to Manage Economic Policy
• 2  Undemocratic and Unequal: Fitoussis Critique of Europes Institutions
• 3  Thinking about Sustainability la Faon de Fitoussi
• Epilogue: The Leadership of Jean-Paul Fitoussi