My grand unified theory (GUT) of macroeconomics is hereby named Kenyan Socialism. It combines elements of Marx, Keynes, Fisher, Minsky, Hicks, Wicksell, Kindleberger, Bagehot, etc. Like its cousin Marxism, it attempts an accurate description of our macroeconomic situation. It describes how things work - what are the variables in the various equations - and what the problems are. By defining problems, one has entered the political realm for a problem entails a value judgement. The problem needs to be "fixed" so that a desirable end-state / trend or goal can be reached. Fixing a problem in the economy necessarily involves political analysis. What is the best way to get it done. Will there be compromise?
Regarding macro and its variables, KS is falsifible and subject to revision. It is supported by empirical studies and historical case studies.
Basically, we are in agreement with the Krugman/Thoma/DeLong axis.
As Krugman writes:
By contrast, the Krugman/Thoma/DeLong axis (I still like it!) is basically using standard macroeconomics, applied to a nonstandard situation. The Hicks/Keynes model — in which demand drives output in the short run, interest rates are determined by the tradeoff between liquidity and yield, and extreme negative shocks push you into a liquidity trap in which conventional monetary policy loses traction and deficits don’t crowd out private spending — has worked very well in this crisis, which is why we keep using it with a few twiddles (such as emphasizing the role of private debt).
The point is that at this point we’re not having a debate between opposing models; we’re having a conflict in which one side has a model that has been working, while the other side has prejudices, and makes stuff up to justify those prejudices.
The Immediate Problem or the Task At Hand
Kenyan Socialists (me) have entered into a popular front with market monetarists against the great Output Gap* menace. This is out of political necessity and may change once the gap is closed.
The reason Kenyan Socialists are against the output gap and wish to close it as soon as possible is that it entails high unemployment. This means a lot of misery right here, right now with all that follows from that,** and means that labor is in a weakened bargaining position. It means higher inequality levels in the future and a general "banana-republicization" of society as well as making the economy more instable and vulnerable to speculative bubbles. It's bad.
How did we arrive at this output gap and what can we do to fix it?
The output gap is a result of long-term trends and instabilities. It came to a head in 2008 when the government didn't bail out Lehman Brothers. There was a panic; the velocity of money slowed; and aggregate demand dropped. Many people were thrown out of work. Having learned from what happened during the Great Depression and other economic crises, the government stepped in substituted its aggregate demand for the demand that had vanished.
Here - on page 17 - Romer describes the dialogue she had with Geithner:
Secretary of the Treasury Timothy Geithner and I used to have a running back and forth on just this topic. He liked to say there is more fiscal stimulus in financial rescue than in the Recovery Act. By this he meant that healing the financial system could have a big impact on things like consumer spending and investment—the same things that fiscal stimulus was supposed to stimulate.A KS would point out to Geithner that being overly solicitous of Wall Street is what got us into this mess. I would point out to the less focused OWS types that the economy needs banks and credit to run, at least it does as currently constituted.
I used to come back with, there is more financial rescue in fiscal stimulus than in the Treasury’s Financial Stability Plan. By this I meant that by stopping the freefall in the economy, the Recovery Act greatly helped to heal the financial system. Turning the economy around helped to raise the value of banks’ capital and lower loan defaults—two things that greatly reduced the chance of further panics.
The truth is, both the Recovery Act and actions to stabilize the banks were important and helped to reinforce each other. But I think there is a good case to be made that the Recovery Act was even more important than fiscal stimulus usually is, because this time the financial system was in such a precarious state.
In tandem with Bernanke they stabilized the economy and growth returned. Conservatives argued that all of the government action would cause inflation, but inflation never came. Conservatives said all of that government spending would invoke the bond vigilantes but they remained invisible and never arrived.
They stabilized the economy but did not create a "V" shaped recovery with catch up growth retuning us to trend level NGPD. Instead we are left with an "L" shaped recovery. Actually the Fed forecast that the output gap will be closed very gradually, but they have been wrong before. KS argues for government action to encourage a "V"-shaped recovery and close the gap more quickly seeing as the economy is vulnerable to shocks (see Europe for example) and long term unemployment damages the economy and society. And so we enter the realm of politics.
What is to be done?
Maybe it help to elucidate what Keynan Socialism - henceforth abbreviated as KS - is about by discussing what it is not.
KS does not embrace the theory of expansionary austerity. Expansionary austerity as proposed by the David Cameron and others is the notion that a government can summon the confidence fairy*** by balancing its budget via fiscal austerity. According to this theory, a government that cuts spending will inspire confidence in the investing class and business community so that they will create jobs and grow the economy. Empirical evidence contradicts this theory which suggest its a manifestation of ideology.
Bernanke appears to be a devotee of Irving Fisher and sees the Fed's job as being to prevent a deflationary spiral to take hold and hence to be the Lender of Last Resort. The European Central Bank should follow his example.
But he does not see the urgency of encouraging catch up growth in contrast to his colleague Charlie Evans who wants the Fed to target 3 percent inflation and 7 percent unemployment. And so we get opportunistic disinflation with a weak labor market. A weak labor market hurts demand and hurts workers' bargaining power. It makes it difficult for them to agitate for higher wages. Their compensation does not keep up with productivity growth, so where does the rest of the money go? To rents and capital or rather the top 1 percent.
So, to reiterate: the primary goal of KS is to manage the economy so that it grows at its trend rate NGDP. This means price stability and full employment. Conservatives will not argue outright against this goal. In fact a faction* of conservatives do support NGDP targeting and so support this goal. This heterodox group includes Ramesh Ponnuru of the National Review, Scott Summer, David Glaesner and other who are not wedded to the ideology of "hard" or "sound" money. They are not paranoid about inflation. This group may also include the economists at Goldman Sachs and JP Morgan who favor NGDP level targeting. I am not aware of their politics but would guess they are the socially liberal, fiscally conservative types. Since they are economists they may be less ideological they your average Wall Street denizen.
However some may argue for a lower NGDP trend rate like 3 percent whereas Kenyan Socialists would place it near 5 percent dependent on a number of economic variables like population growth rate and productivity. This could be argued once the gap is closed.
NGDP targeting by the Fed is not the only means to close the output gap. A more effective means would be Keynesian stimulus and fiscal policy. This would provide the most bang for the buck, but it is difficult to enact because of the dysfunctional politics of the United States. President Obama recently proposed a $450 jobs bill to lower unemployment and close the gap, but only the most ineffective parts of the plan were enacted into law by an obstructionist Republican Party who appears intent on wrecking so that their "anybody but Mitt" candidate can beat Obama. This is a policy of "destroy the town in order to save it."
KS believes fiscal action is the best way to close the output gap. In the previously linked speech, Romer discusses empirical studies which bear this theory out. Conservatives will favor tax cuts which are inefficient but may help with deleveraging.
The 19th century was characterized by many booms and busts and great technological advancement. After World War I, the attempt by central banks to reinstate the gold standard helped start the Great Depression. The earlier countries went off the gold standard, the sooner they exited the Great Depression. Fiscal stimulus via rearmament for WWII was key in pulling countries out of the depression. Post-war inflation helped with deleveraging which led to the golden era of 1945-1973 where rising productivity combined with rising wages and income.
In around 1973, the U.S.'s competitors in Europe and Japan come online. Inflation from the Vietnam war deficits, oil shocks and easy money was brought to an end by Paul Volker. The 1980s until 2007 saw the Great Moderation, where monetary policy moderated booms and recessions. This came to an end in 2008.
Bernanke and delfationary spiral
Latin American debt crices, 1997 East Asian Finanical crisi, Greece-Argentina, original sin and Italy, Dutch Tulip bubble, South Sea bubble,
[1st pass - to be continued and to be tightened and cleaned up - a work in progress]
*** coined by Krugman.