How the Economy Works This page intentionally left blank How the Economy Works Confidence, Crashes and Self-Fulfilling Prophecies ROGER E. A. FARMER 1 2010 3 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education. Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2010 by Oxford University Press, Inc. Published by Oxford University Press, Inc. 198 Madison Avenue, New York, NY 10016 www.oup.com Oxford is a registered trademark of Oxford University Press. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Library of Congress Cataloging-in-Publication Data Farmer, Roger E. A. How the economy works : confidence, crashes and self-fulfilling prophecies / Roger E. A. Farmer. p. cm. Includes bibliographical references and index. ISBN 978-0-19-539791-8 1. Free enterprise. 2. Monetary policy. 3. Economic policy. I. Title. HB95.F37 2010 339—dc22 2009032289 987654321 Printed in the United States of America on acid-free paper Contents Preface xi Chapter 1 Introduction 1 The Collapse of Northern Rock 1 Classical and Keynesian Economics 3 The Size of Government 5 Efficient Markets 6 The Roaring Twenties 8 The Great Depression 10 Stagflation 12 Why Fiscal Policy Is the Wrong Approach 15 What Governments Should Do Instead 17 A New Paradigm and a New Policy 18 Chapter 2 Classical Economics 21 How the Economic Pieces Fit Together 24 Do Markets Work Well? 28 A Mark, a Yen, a Buck, or a Pound... 32 ...IsAllThat Makes the World Go Around 33 Helicopter Ben 34 Economic Frictions 36 vi CONTENTS Chapter 3 The Impact of Keynes on the World Economy 39 Maynard Keynes’s New Vision 40 Unemployment during the Great Depression 41 Keynes’s Escape from Classical Economics 43 Keynesian Theory 44 Keynesian Policy 46 Chapter 4 Where the Keynesians Lost Their Way 49 Keynes’s Theory of Prices 51 Bill Phillips and His Machine 52 Bill Phillips and His Curve 52 Two American Keynesians 54 The Natural Rate Hypothesis 57 The Bell Tolls for Bill Phillips’s Curve 60 Natural Rate Theory: Fact or Fiction? . 61 . Science or Religion? 62 Chapter 5 The Rational Expectations Revolution 65 Bob Lucas and Economic Policy 66 The French Influence 68 How Lucas Changed Macroeconomics Forever 70 Real Business Cycle Theory 72 New-Keynesian Economics 75 Quantity Theorists in Keynesian Clothes 78 Chapter 6 How Central Banks Impact Your Life 81 Who Owns the Fed? 82 Money Makes the World Go Around 83 The Modern Fed 84 Fighting Inflation 86 Fighting Unemployment 87 Why Inflation Matters 88 CONTENTS vii The Great Moderation 89 The Role of Good Luck 91 Minsky Moments 92 In Defense of Central Banks 93 The Future of Central Banking 94 Chapter 7 Why Unemployment Persists 97 Putting Unemployment Back into the Classical Model 98 Why This Didn’t Work: Shimer’s Puzzle 99 Is Unemployment Optimal? 100 Sand in the Oil 101 Why Search Markets Don’t Work Well 103 Why High Unemployment Exists 104 Why the Wage Doesn’t Fall 104 Classical and Keynesian Uses of Search Theory 106 Chapter 8 Why the Stock Market Matters to You 109 Do Fundamentals Drive Markets? 110 . Or Does Confidence Drive Markets? 111 Who Is Right? 112 Swings in Confidence Are Rational 113 Behavioral Economics or Rational Choice? 115 Wealth Matters 117 Where Keynesian Economists Went Wrong 118 Where Classical Economists Went Wrong 119 Stopping a Stampede 120 Chapter 9 Will There Be Another Great Depression? 123 Two Black Mondays 124 Greenspan the Wizard 126 The 2008 Crash 127 viii CONTENTS Housing and Stocks: Twin Peaks 128 Deregulation and Accounting Rules 130 The End of Glass-Steagall 131 Fair Value Accounting 132 Was Deregulation to Blame? 132 Illiquidity or Insolvency? 133 What Will Happen Next? 134 Chapter 10 Will Monetary and Fiscal Policy Work? 137 Traditional Monetary Policy 138 Quantitative Easing 139 Bernanke’s Plan 140 What Central Bankers Think 142 When the Bubble Bursts 142 Obama, Brown, and Sarkozy 144 Christina Romer’s Magic Multiplier . Is It Really That Big? 144 Learning from the Great Depression 146 The First Stage of Recovery 147 The Second Stage of Recovery 148 Tw o Reasons for Government Deficits 149 Do We Need a Bigger Government? 150 Will the Stimulus Restore Confidence? 151 Give Me a One-Armed Economist 151 Chapter 11 How to Solve a Financial Crisis 153 What Happened in 2008 154 Adding a New Policy Lever 155 Indices and Index Funds 156 A Plan to Prevent Bubbles and Crashes 158 Setting Up a Fund 159 Pulling the Lever 160 CONTENTS ix How to Fix the Banks 161 My Argument Summarized 163 Between Keynes and Hayek 165 Glossary 169 Notes 175 Bibliography 183 Index 189 This page intentionally left blank Preface Macroeconomics deals with unemployment, inflation, and interest rates: how they are connected and how they are influenced by government monetary and fiscal policy. How the Economy Works provides a verbal account of macroeco- nomics aimed at the general reader. I explain the difference between two main approaches, classical and Keynesian, and I show how they have influenced the policy debate that developed in the wake of the world financial crisis that began in the fall of 2007, with the fall of Northern Rock in the UK, and that exploded into a worldwide catastrophe, with the failure of Lehman Brothers in the United States in the fall of 2008. But that is not all. This book provides much more than an explanation of existing ideas. It introduces and explains some brand-new ideas that go beyond classical and Keyne- sian economics. I provide a fresh approach to the prevention of future financial crises and I offer practical policy solutions based on a coherent scientific foundation. The technical and mathematical details are explained elsewhere.1 This book is for you, the general reader, who wants to make sense of it all. xii PREFACE Why is there so much disagreement among journalists, politicians, and academic economists over the causes of recessions? What went wrong in 2008, and how can we fix it? Who was Keynes, and why are his ideas relevant today? What is the role of the Federal Reserve System, the Bank of England, and the European Central Bank, and how do they affect your life? Does it really make sense for governments around the world to spend hundreds of billions of taxpayer dollars, pounds, and euros that they don’t have? In this book, I answer all of these questions and I illustrate the answers with examples. To understand the 2008 financial crisis, it helps to understand what the main protagonists think and how they arrived at their views. The history of the twentieth century is the history of a struggle of ideas between classical and Keynesian economists that continues to this day. Broadly speaking, there were two transformative events in the twentieth century, each of which led to a revolution in thought. These were the Great Depression of the 1930s and stagflation in the 1970s. Before 1930, most economists were classical. Between 1930 and 1970, Keynesian thought was in the ascendancy, and from 1970 to the present day, there was a revival of classical thought ushered in by a set of new ideas called the rational expectations revolution. With the financial crisis of 2008, we have arrived at a third turning point that demands a new approach. By combining the best ideas of the rational expectations revolution with the most important insights from Keynes, I show in this book where we should go from here. One goal of this book is to provide a lightening tour of the history of economic thought from 1776 to the present day. I am painfully aware that this tour is incom- plete. Many key players are missing and the ideas of others have been simplified. To those readers who recognize these PREFACE xiii deficiencies, I plead guilty. In my own defense, I can say only that to do justice to my intellectual predecessors would take a much larger book than this one. A second goal is to present a new theory that is intelligible to the layperson, but at the same time detailed enough for an academic economist to see where I disagree with existing economic theory and how it needs to be changed. I’m not sure when the word wonkish arrived in the English language, but it is surely an apt description of some chapters of this book, particularly chapter 7, which is the most wonkish of the lot. I left this chapter in the book even though, after 12 rewrites, it still retains an aura of impenetrability. It is there for the academic economist or the serious general reader who is interested in the arcane question of what exactly goes wrong with the market economy and why unemployment persists. I take some solace in the words of Albert Einstein, who said “everything should be made as simple as possible, but no simpler.” Many people have helped me with this book. I want to thank my colleagues and students at UCLA—Andy Atke- son, Amy Brown, Francisco Buera, Ariel Burstein, Anton Cheremukhin, Hal Cole, Matthias Doepke, Corey Garriott, Gary Hansen, Christian Hellwig, Andrew Hollenhorst, Hugo Hopenhayn, Masanori Kashiwagi, Kei Kawakami, Hanno Lustig, Lee Ohanian, Paulina Restrepo, Hao Shi, Jonathan Vogel, Pierre-Olivier Weill, and Mark Wright.