Macroeconomics After the Financial Crisis

Mogens Ove Madsen, Finn Olesen

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317300090
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

How should Europe cope with the negative and still unfolding economic consequences of the current economic crisis? And why does Europe seem to be more conservative than the USA in dealing with the crisis?

Since the outbreak of the current international economic crisis in 2008, the USA and many of the European countries have been tormented by high levels of unemployment and low levels of inflation, interest rates close to zero and fiscal policies of austerity. As such, the modern economic mainstream has been challenged by these empirical facts. Today, several years after the outbreak of the international economic crisis, supply side effects do not seem to be increasing employment as the modern mainstream claimed they would. Aggregate demand has to play a more important role in macroeconomic analysis than hitherto. That is, there is a need for alternative explanations of how a modern macro economy is expected to function and how the macroeconomic outcome could be manipulated by the right economic policy proposals. As expressed by the contents of the present book, a Post Keynesian understanding proposes such an alternative theoretically, methodologically and in terms of policy measures.

This book will present new materials and approaches, especially new evidence and new views on the potential problems of public debt, the European Union and the present crisis, Central Banking, hysteresis in an agent based framework, the foundations of macroeconomics and the problems of uncertainty.

1 The Great Recession

An introductory view

Mogens Ove Madsen and Finn Olesen

DOI: 10.4324/9781315648132-1

When the economic crisis materialized in 2008, caused by the ongoing financial crisis, hardly anyone from the modern macroeconomic mainstream expected it to be a persistent crisis. Many argued that, this time, it would be a rather short-lived period with only minimal negative economic setbacks. However, as we know now, that was unfortunately not the case. As such, the macroeconomic system showed beyond any kind of dispute that problems of instability are not randomly determined. Rather, instability might be systemic and might be caused by built-in malfunctions in the financial sector (see, for example, Leijonhufvud, 2014).¹ Furthermore, you have to remember that such malfunctions were one of the main results of a process of financial deregulation in the USA as well as in Europe. As such, mature economies have undergone a general process of ever-increasing financialization for years – a process whereby financial markets, financial institutions and financial elites gain greater influence over economic policy and economic outcomes.

That is, the setbacks were of such a magnitude that many economies had tremendous problems maintaining a high enough level of effective demand resulting in negative GDP growth rates, massive unemployment and huge budget deficits. These effects were devastating to such a degree that it seems right to term this crisis the ‘Great Recession’.

Internationally, Europe seems to have been hit harder than the USA. Presently, recovery is ongoing with certainty in the USA while real recovery is still to be seen within the European Union (EU) – not least because of differences in how fiscal and monetary policies are conducted in the USA and in the EU.

As such, many important questions need an answer. For instance, why does European economic policy – addressing the conduct of fiscal and monetary policy within the EU – seem to be more conservative than in the USA in dealing with the crisis, the latter having generally been more demand-oriented than has been the case for the EU?² In particular, many members of the EU have felt the restrictions of the fiscal policies of austerity keeping their economies in the trap of permanent recession.³ The outcome of such a fiscal policy strategy has been one of massive unemployment, budget deficits that would not come down, increasing public debt positions and an inflation regime of, at best, zero inflation and, at worst, even one of deflation. That is, the European process of integration has not been a successful one in recent years. Rather than bringing prosperity to its members it has delivered the opposite. As such, the Great Recession has highlighted the inadequacies of the institutional set-up of the European and Monetary Union (EMU), actually reinforced by the tightening of the Stability and Growth Pact in 2012.

More surprisingly, the huge negative economic consequences of such a devastating fiscal policy strategy could easily have been foreseen, as explained by Truger (2013); as he points out, that follows from careful textbook reading of standard macroeconomic theory together with an eye on available empirical results. Monetarily speaking, the strategy has, in general, traditionally been to follow a Taylor rule-based interest policy. Nevertheless, such a strategy breaks down when the nominal interest rates set by central bankers hit a floor of zero. In such a situation, conventional monetary policy has no probability of success.⁴ Furthermore, with deflationary tendencies such a ‘zero-bound’ scenario only makes the real interest rate to go up, which, of course, further decreases the investment demands of firms and consumption demands of households. That is, the modern macroeconomic mainstream has been serious challenged by empirical facts.

Today, more than seven years after the outbreak of the international economic crisis, effects of the supply side policy do not seem to be able to combat the recessive tendencies in Europe by themselves. That is, changes in relative prices are not effective enough to make a disequilibrium situation of excess supply in the goods and labour market go away and put the macro economy back on track on its long-run optimal equilibrium path, as stated by the mainstream, with their dynamic stochastic general equilibrium (DSGE) models – models that, with their ‘Lucasian foundations had less and less relation to reality’ (Skidelsky, 2014: 223).

Therefore, macroeconomics is not only a story of aggregate supply, low inflation rates, full employment and structural budget deficits of around zero. Presently, as was the case in the 1930s with the Great Depression, macroeconomics is also still a story of lack of effective demand, existence of involuntary unemployment and the need for the right fiscal and monetary policy to be pursued to stimulate GDP growth rates. When there is an economic crisis, uncertainty presents an urgent problem. That is, to some degree the future is truly unknown. By the actions of today, households and firms, together with government, are partners in creating what eventually will become the economic environment – the economic institutional set-up – and thereby determine the macroeconomic output of the future (see, for example, Dow, 2015).

Seen from a Post-Keynesian perspective, there is no room for a representative agent with rational expectations. Processes of intertemporal consumption optimization – the quest for first best solutions – is a fantasy that is not empirically supported by facts. Rather, such a statement has been falsified by evidence. In general, we have to accept that the micro foundation of macroeconomics is not one of perfection, as argued by most mainstreamers. Rational economic behaviour can be different from that which lies behind the actions of the rational economic man. Due to the existence of uncertainty, epistemologically as well as ontologically, the economic behaviour of real-life households and firms is conducted in a manner that is characterized by a kind of bounded rationality. Mistakes occur, and these are not only of a stochastic nature; rather, errors in real-life economic processes are often at least to some degree of a systematic nature. That is, the macroeconomic system is not a closed deterministic functioning – ergodic – system. Rather, it is an open, social dependent and changeable system – in essence, it is a path-dependent system that works in a non-ergodic way (see, for example, Lawson, 1997; Davidson, 2003–4, 1984; Chick and Dow, 2005).

As such, there is a need for an alternative macroeconomic understanding. In correspondence with real-life phenomena, macroeconomics has to be able to address the right way for economic processes to unfold. Likewise, macroeconomics needs to change its views on economic policy. Fiscal policy, as well as monetary policy, conducted the right way has a very important role to play in trying to achieve the best macroeconomic outcome possible. That is, in general, economic policy should focus on employment problems and not follow a strategy of austerity; when creating more employment, both the problems of budget deficits and public debt and deflationary tendencies go away by themselves. Seen from a Post-Keynesian perspective, one way of pursuing economic policy in the right manner could be to follow the strategy suggested by Hein (2013–14: 348), which is built on three pillars:

the reregulation of the financial sector in order to prevent future financial excesses and financial crises, the reorientation of macroeconomic policies toward stimulating and stabilizing domestic demand… and the reconstruction of international macroeconomic policy coordination and a new world financial order, so as to rebalance the world and regional economies.

As expressed by the contents of this book, a Post-Keynesian understanding proposes such an alternative to the modern macroeconomic mainstream theoretically and methodologically, as well as economic policy wise, in accordance with the above-mentioned statements. Furthermore, following such an alternative strategy, ‘the world we live in would be a more prosperous and civilized economic society’ as pointed out by Davidson (2015: 382).

Economic policy aspects of real life

In Chapter 2, James Galbraith addresses the importance of the General Theory. As in physics, where the Newtonian mechanics had been taken over by Einstein and his theory of relativity, Keynes's main achievement with his General Theory was to break away from the old understanding of Euclidean economics and bring light to a more modern, non-Euclidean world of economics. In such a new world, the theoretical focus had to be put on an economic system where the financial sector in a crucial manner interacts with the processes of production. As such, the determination of employment is dependent on the economy as a whole and on the level of effective demand. However, this was, in general, not how the messages of Keynes were interpreted. Rather, he was ‘simplified, modified, he was undermined, he was forced into the intellectual coffin of equilibrium analysis. His vision was obliterated,’ as Galbraith tells us. In modern times, this meant the appearance of new Keynesianism, with its focus on trying to give an explicit micro foundation for macroeconomic theory; that is, a story of intertemporal optimizing agents using rational expectations. Policy wise, the rephrasing of Keynes might seem appropriate. However, mainstreamers, in general, have had a rather naive perception of the still ongoing crisis. It was perceived as just a matter of getting more fuel on the tank – bringing back the economy to its equilibrium trend. Unfortunately, the crisis is more severe than can be portrayed by a fuel tank analogy. The crisis could be one of secular stagnation. But we need more than this. We have to incorporate institutional matters as well, Galbraith argues. As such, economists should take at least four questions into consideration: 1) the limitation of the use of resources, 2) the potential lack of a stabilizing hegemonic power, 3) the effect of technological change on employment and 4) the role of bank money in creation booms and bobbles.

Chapter 3, by Peter Skott, addresses the important question of the interplay between public debt and the case of stagnation. Furthermore, he also puts forward a modern view on functional finance. As such, he argues that fiscal policy and public debt may be required to maintain full employment and avoid secular stagnation. This conclusion emerges from a range of different models, including overlapping generations (OLG) specifications and stock-flow consistent (Post-)Keynesian models. One of the determinants of the required long-run debt ratio is the rate of economic growth. Therefore, according to Skott, low growth leads to high debt, and empirical correlations between growth and debt may reflect this causal effect of growth on debt, rather than a negative effect of debt on growth. Based on this result, Skott draws a very important conclusion regarding austerity policies: the level of government consumption and the structure of taxation influence the required debt ratio and, paradoxically, austerity policies are counterproductive on their own terms: cuts in government consumption lead to an increase in the required level of debt.

In Chapter 4, the Euro crisis and contradictions of neoliberalism in Europe are discussed by Engelbert Stockhammer. In general, he finds that neoliberalism has not given rise to a sustained profit-led growth process, but to a finance-dominated accumulation regime in which growth relies either on financial bubbles and rising household debt (‘debt-driven growth’) or on net exports (‘export-driven growth’). The financial crisis that began in the market for derivatives on the US subprime mortgage market has translated into the worst recession since the 1930s. In Europe the crisis has been amplified by an economic policy architecture (the Stability and Growth Pact) that aimed at restricting the role of fiscal policy and insulating monetary policy and central banks from national governments. The crisis has thus led to a sharp economic divergence between core and peripheral countries. As such, the EU has been hit hard by the Great Recession. That is, the European process of integration has not been one of prosperity for most members in recent years.

In Chapter 5, Jonathan Perraton discusses the fate of the Nordic social democratic model. The recent crisis has generated renewed interest in more cooperative national arrangements. As such, many contributions have focused almost exclusively on the labour market and largely accepted mainstream economics explanations of economic performance. Nevertheless, Perraton states, the post-war success of corporatist economies, notably in Nordic countries, rested on high rates of investment, particularly in internationally tradable industries. This was seen by both policy-makers and scholars as central to generating prosperity throughout the economy and sustaining living standards and government expenditure. Maintaining the profit rate in the tradable sector was seen as central to sustaining growth and welfare in these economies. However, modern mainstream contributions miss the capital side of the bargain. The neglect of corporatism's disciplining effect on business and the investment response in the 1990s is to miss a key part of the story of corporatism. From a Post-Keynesian perspective, capital accumulation is crucial to determining employment levels, as well as growth and prosperity, and there is clear evidence among Nordic economies, as elsewhere, that investment plays a key role in determining employment. This is the main conclusion drawn by Perraton.

In Chapter 6, Jesper Jespersen addresses the problem of low growth rates in Europe. With an empirical focus on EU(15), he is able to depicture three crucial macroeconomic relationships which, since 1970, have undergone declining development, making the macroeconomic environment of Europe a more pessimistic one. First, the ratio of real investment/GDP has come down from a level of approximately 26 per cent to around 18 per cent. Second, he establishes with a high degree of statistical significance the negative relationship between the real investment ratio and the rate of unemployment: the higher the level of private investment the lower the rate of unemployment becomes. Third, as such, low investment rates seem to influence labour productivity negatively. Based on these empirical facts, Jespersen concludes that it is essential to get the causality right: a higher level of investment has positive employment consequences, which reduces both the level of unemployment and the public budget deficit. Or, stated alternatively, with a keen eye, economically and politically, on maintaining a high level of employment, potential problems with budget deficits go away by themselves. That is, the European austerity policy is, in general, the wrong way to try to achieve a higher level of economic prosperity within the member countries of the European Union.

The foundation of macroeconomics

In Chapter 7, Finn Olesen discusses if and how important macroeconomic events change macroeconomic thinking. Historically speaking, as a consequence of the Great Depression in the 1930s, the then mainstream economic understanding was seriously challenged by empirical facts, theoretically as well as methodologically. As such, the Great Depression gave way to what was later termed the ‘Keynesian Revolution’, which for decades came to dominate the scene of macroeconomics almost totally. Still later, the understanding of macroeconomics once again became classical at its core as the Keynesian understanding was questioned by, for instance, the monetarists. Nowadays, modern macroeconomic mainstream is characterized and benchmarked by the use of DSGE models. These models are populated with agents who perform a process of intertemporal consumption optimization using rational expectations in an economic environment which might be affected by exogenous shocks. However, in the longer run, the economy is brought back to its equilibrium path with certainty. Due to the economic crisis of recent years – the Great Recession – the mainstream macroeconomic understanding is once again challenged (both theoretically and methodologically). However, this time, it is debatable if the criticism raised against th...

Table of contents

• Cover Page
• Halftitle Page
• Series Page
• Title Page
• Copyright Page
• Table Of Contents
• List Of Figures
• List Of Tables
• Notes On Contributors
• 1 The Great Recession: an introductory view
• 2 Keynes ‘in the twenty-first century’: tradition, circumstance, fad and pretence in the wake of the Great Crisis
• 3 Public debt, secular stagnation and functional finance
• 4 Neoliberal economic policy, growth models and the crisis in the Euro area
• 5 Corporatism and capital accumulation: the fate of the Nordic model
• 6 Structural budget deficits: getting causality right
• 7 The making of a revolution: how important are economic crises?
• 8 The need for macro foundations for microeconomic theory
• 9 Microfoundations: on the use and misuse of theories and models in economics
• 10 Böhm-Bawerk meets Keynes: what does determine the interest rate, and can it become negative?
• 11 The socio-economic philosophy of Keynes: lessons for the twenty-first century
• 12 Towards a theoretical foundation of Animal Spirits: probability, uncertainty and intentionality
• 13 Two generations of path dependence in economics?
• Index