Is the world deeply divided?

There is a thoughtful article in the Financial Times by Paul De Grauwe which is found in

It notes the big disagreement between two opposing camps on macro-economics (the Ricardians versus Keynesians), regarding the application of budget deficits in a period of severe recession. It then argues that this disagreement between the two camps is not just of academic interest it matters a great deal for the future decisions of investors and policymakers.

For share investors, it tells them whether, as a consequence of the temporary budget stimulus, they should be buying or selling long term government bonds and whether they should expect inflation to deteriorate or to remain under control.

For policy makers, it tells them if the additional GDP is stable and sustainable – or whether it will produce big rises in interest rates and, with it, another big recession. They must also decide if monetary policy will simply build up massive amounts of liquidity and lead to higher inflation – or whether the central bank can withdraw the liquidity as fast as they injected it, with no risk of inflation.

Most people are not sure which camp is right (with a modest majority in the Keynesian camp). The world is deeply divided.

How can the science of macro-economics resolve the crisis? On this issue, Paul de Grauwe has no solution. Efficient markets cannot take care of themselves and are not superbly informed. They need a lot of prudential regulation to address animal spirits. But how much regulation is appropriate?

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14 years ago

How do you know there is a modest majority in the keynsian camp? Do you mean people generally or economists?

Joshua Gans
14 years ago

That’s certainly an interesting piece by De Grauwe. It will go on course reading list, so thanks, Fred.

There is always going to be someone decrying fiscal deficits, whatever the situation, and always some associated theoretical controversy. But taxonomies are always difficult in macroeconomics. In this case I don’t the ‘Keynesian v. Ricardian’ characterisation makes much sense.

Ricardian equivalence was a story about why tax cuts or rises shouldn’t make any difference to aggregate consumption spending (for a given level of government spending). This is in contrast to the prevailing — neolclassical, let’s call it — view that lower taxes (for a given level of government spending) and the resulting deficit would crowd out private investment. But both of these ostinsiively rival theories essentially presuppose an economy at full employment. Now it might happen that some Ricardians (and neoclassicals for that matter) disagree with some Keynesian as to whether tax cuts will raise activity in a certain situation; but this is because they disagree about what’s causing the unemployment — whether it’s treally voluntary, or caused by wage rigidities or whatever. That is, the Ricardian Equiivalence hypthesis is not central to the dispute. However, when we’re in the middle of a patently demand-side slump, with a huge pile of patently Keynesian unemployment, the ‘Ricardian’ model is simply irrelevant. I hope that makes some sense.

Having said all that, I don’t actua;lly know the theoretical underpinning of the Germans’ refusal to join in the fiscal stimulus. It looks more like a case of cynical free riding than anything else.

14 years ago

I think it was mainly domestic politics and I speculate that it might also have been a lack of real money (the latter coupled with a charming refusal to believe in ‘funny’ money). Free riding would have definitely re-inforced any and all of these.

The domestic politics is that nothing plays better than the mighty fiscally rectal germans bearing the weight of the profligate and eternally disappointing Euro-buddies. If you have bad macro news or want to announce a restricted budget, that is the Best. Excuse. Ever. (at least in Germany). If they decide they need it, they can always do it now that it can be clearly painted as if they were pushed into doing it by ongoing failure to live up to expectations elsewhere (my strong feeling is that that almost certainly wouldn’t be true, but it would be credible).

The lack of real money is that they might not be telling us how much they may yet be on the hook for for their own banks, and would rather not. The charming bit is that of course lack of money wouldn’t (and didn’t) stop most politicians we can think of!

Joshua Gans
14 years ago

He does indeed, Fred, but I remain doubtful that opposition to Keynesian stimulus in the current circumstances is based on the Ricardian Euivalence hypthesis. But it’s worth looking into.

Notwithstanding the above, I think the larger question DE GRawe raises — to what extent macroeconomic ideas influence macroeconomic outcomes (via private sector decisions, that is, not via government measures)– is fascinating.

14 years ago

I haven’t seen many prominent econ bloggers or commentators who seem to believe in a strong form of Ricardian equivalence or many who totally discount it, not even Krugman. It looks to me that the main opposition to stimulus spending, as compared to automatic stabilisers, is the belief that the spending does not do much good in a modern economy but does have costs in the recovery phase.