How to stabilise an unstable economy? The question split economists for much of the 20th century.
In one camp were the Keynesians, followers of John Maynard Keynes, who argued that the government could manage the overall level of demand. That would prevent a repeat of the mass unemployment of the Great Depression in the 1930s, when the economy was stuck in a slump.
In another camp were monetarists, led by Milton Friedman, who retorted that the best approach was to fix the money supply. Attempts to continuously boost employment would inevitably lead to a repeat of the ever-rising prices of the “Great Inflation” of the 1970s.
Nowadays most central bankers would probably place themselves in a third camp, usually known as “New Keynesians”.
On October 12 the Royal Swedish Academy of Sciences awarded the Nobel memorial prize, the top gong in economics, to two of that movement’s leading lights. The glory (and $1.7 million) will be shared by two Americans, Robert Hall of Stanford University and Michael Woodford of Columbia University. Mr Hall is best known for his theory of consumer spending and Mr Woodford for modelling how central banks could use interest rates as the main tool to keep the economy steady.
The prize committee credited the two men with rebuilding macroeconomics on “microfoundations”: in other words, representing economic outcomes as the result of the behaviour of individual consumers and businesses.
That was an intellectual break from the past. The Keynesians and monetarists built their models top-down, looking at how those aggregates, in the form of economic statistics, influenced each other (for example, how the total volume of money changed the rate of inflation). Microfoundations aimed at building such models bottom-up from individual decision-making. That followed a critique by the late Robert Lucas, Nobel laureate of 1995, that any model not based on the deep features of an economy would be a poor guide for policymakers.
For Mr Hall that meant examining how consumers choose to spend their income. In his model consumers have views about their own future income: will they get a pay rise, for instance, or is a sudden windfall just a passing bit of luck? Because they care about tomorrow as well as today, they “smooth” spending and react to changes in what they consider to be their lifetime spending power.
Track a particular person’s consumption over time and it should resemble a drunk walking home, randomly straying hither and thither—in response to unforeseen shocks—but staggering in the same general direction.
Mr Woodford, for his part, reached back to the work of Knut Wicksell, a Swedish economist active at the turn of the 20th century. (Indeed, Mr Woodford called his theories neo-Wicksellian rather than New Keynesian.)
Wicksell started from a model of a “pure credit economy” in which all money is created by banks making lending decisions. If interest rates were below a “natural” rate of return on investment then businesses would keep borrowing. That would lead to an inflationary boom. If rates were above this level, that would cause a deflationary cycle.
Central banks should not try to fine-tune the economy, as the old-style Keynesians suggested, or the money supply, but instead strive to bring interest rates into balance with this natural rate of return. This rate would not emerge from central banks’ choices but from things like technological progress and savers’ willingness to wait to see their investments pay off.
Mr Woodford’s book titled Interest And Prices (after a work by Wicksell) became the bible for many modern central bankers. It built a model of the macroeconomy with the help of New Keynesian ideas such as “sticky prices” (the notion that businesses try to not adjust how much they charge consumers too frequently) and “imperfect competition” (which allows prices to be sticky).
Its publication in 2003 coincided with neither a Depression nor a Great Inflation but rather with the Great Moderation, a happy spell of low inflation, steady growth and reduced economic volatility.
The New Keynesians have their detractors. For one thing, the neutral rate of interest cannot be observed. Jerome Powell, a former chairman of the Federal Reserve, once quipped that central bankers could only “know it by its works” and observe the effects of interest rates.
The natural rate can also shift dramatically in short order: a boom in investment for a new technology can suddenly raise demand for capital (as is happening with artificial intelligence) and thus call for a higher neutral rate of interest. Neither does it explicitly model the financial sector or the influence of interest rates on investors’ tolerance for making risky bets. The Great Moderation, which began in the 1980s, ended in the 2008 financial crisis.
There are problems, too, with Mr Hall’s model of consumption. The rational forward-looking consumers of his model ought to change their spending pattern only in response to unexpected news about their lifetime income.
They should expect that, over their lifetime, temporary windfalls would be offset by temporary costs. COVID stimulus cheques, for example, ought to have been squirrelled away for a rainy day rather than spent.
In reality, consumers often overreact to windfalls and underreact to important news about persistent changes to the economy. And random “shocks” may in fact carry useful information: a one-off prize, like the Nobel, might presage a future of lucrative speaking gigs, for instance. Even for prizewinning economists, it can be hard to extract the signal from the noise.
Unsteady as she goes
The Nobel arrives as Mr Woodford’s framework comes under new pressure. The neo-Wicksellian recommendation to central banks is to communicate in advance what they would do in response to a boom or bust.
The market can then anticipate interest rates in real-time based on its collective and evolving view of the economy — and it can do so better the more a central bank has revealed about its “reaction function”.
Yet Mr Powell’s successor at the Fed, Kevin Warsh, has pushed back against this approach, suggesting that it leads to a “hall of mirrors” in which markets watch the central bank and the central bank watches markets. A bit of uncertainty in how interest rates change is a good thing, Mr Warsh argues.
Besides facing this theoretical challenge, the framework is also assailed by a new economic reality. Central bankers have lately had to cope with a series of shocks to the supply side of the economy: from a pandemic to wars in Ukraine and now Iran.
High debt burdens in rich countries raise the spectre of interest-rate policy being used to manage the cost of borrowing rather than inflation. Rate-setters now must make uncomfortable decisions about how much inflation and unemployment they are willing to tolerate in order to keep the economy stable. New Keynesian theory is one thing; political-economy practice is quite another.