Warring Economists and The Great Sleep

I sincerely hope that all of you are now busy exploring your economics textbooks. Really. Well at least I hope you are paying close attention the the war being fought within the economics profession. As arcane as it sounds, that war will affect your lifestyle for years to come. We all have a vested interest in the war’s outcome. If the wrong side wins we may well plunge into depression. The stakes are that high.

So while it sounds like a nasty bout of internecine academic sniping, the war between economists is crucial to our welfare.

Nowhere is that war more manifest than at the Federal Reserve Board. And nowhere will the verdict be more important.

If you follow the financial news carefully you will have noted that the big Fed annual shindig took place in Wyoming last week. Bernanke’s speech there was given a ton of coverage as being indicative of how the Fed saw the state of the economy. More to the point his speech was supposed to give us insight into what the Fed was prepared to do if the economy failed to break free of its current becalmed and weak state.

The quick answer is the he said nothing of note.

This failure to make profound announcements has befuddled many. It shouldn’t. The problem is the war between economists.

The simple matter of fact is that the Fed is horribly and, perhaps, irretrievably, divided between neoclassical and Keynesian policy advocates. The division has spilled over into a very public fight, and has embroiled all the usual suspects.

The central question seems to be: do we need more support for the economy? or do we now prepare to undo the work we have done so far? Bernanke himself appears to be stuck between the two.

Looking at the economy from a Keynesian perspective one thing screams out: the unemployment level is too high and we have the tools to make the correction. So why aren’t we?

From the neoclassical perspective the answers are totally different. The actions taken so far have destabilized the economy and we are about to plunge into an inflationary and bad money crisis of our own making.

Essentially the difference boils down to the diagnosis. Do we have a demand deficiency, which is the Keynesian answer; or a supply deficiency, which is the neoclassical answer. Policy responses are radically different depending upon the side you take in the argument.

What is especially disappointing to me is that this debate was resolved a long time ago. My own education typifies that resolution. Anyone who learned economics in the aftermath of the Depression, and relied on Samuelson’s text or a text in the same genre, would look at today’s crisis and know immediately that the response is to prime demand. That means government spending and deficits etc. But all that was expunged after the monetarist debates led by Friedman and the “new classical” approach of Lucas. Their victory meant that anyone educated after the 1980’s would never respond in a Keynesian manner. They would never have read any Keynes. He was eliminated from the curriculum.

So the debate that has resurfaced has already been had. And was already won. That we are wasting time on it is both an indictment of economics, and a truly awful indictment of the post 1980’s years of illusion. The so-called great moderation of the thirty years since Volcker squeezed away inflation was not a function of the victory of the theories of Friedman and Lucas, but was an aberration caused by the coincidence of global and domestic trends that are now being undone.

We are back to the 1930’s.

Let’s hope that Keynes wins again. Otherwise the Great Sleep will continue, possibly for a decade or more.