William White — Getting Macro Back on Track

William White — the economists who saw the future — weighs in on what can be done to fix macroeconomics.

In the section I excerpt below White explains how modern macro will remain broken without inclusion of the economic insights of Nobel winning macroeconomist Friedrich Hayek — work White discusses under the label of “Austrian economics”:

traditional Keynesian models, like the modern models, are not very helpful when it comes to prediction and are of limited use to policymakers. Worse, models in the Keynesian tradition also ignore two other considerations suspected of having great practical importance in the current crisis: the insights of the Austrian school of thought and those of Hyman Minsky.

In contrast to the Keynesian framework, Austrian theory assigns critical importance to how the creation of money and credit by the financial system can often lead to cumulative imbalances over time. These imbalances, which ultimately come down to investments that do not end up profitable, eventually implode in the context of an economic crisis of some sort. In today’s terms, unusually rapid monetary and credit growth over the past decade or so led to asset price increases that seemed to have little to do with fundamentals. It also led to spending much higher than historical norms. For example, the household saving rate in many English speaking countries fell to zero or below, even as the ratio of investment to gross domestic product in China rose to almost 50 percent. From an Austrian perspective the danger would be that these imbalances would revert, respectively, to more justifiable and more normal levels. Over the past two years we have seen something of this nature, in both asset prices and spending patterns in the United States, the United Kingdom, and a number of other countries. This is at the heart of our problems. Moreover, for those with an Austrian perspective, the continued and unprecedented investment-fueled growth in China is more a danger signal than a sign of renewed sustainable growth.

Mistaken spending decisions eventually result in stocks of unprofitable (for corporations) or undesired (for households) investment/durable goods that will take a long time to depreciate. In today’s terms, many industries that expanded sharply in response to high demand are now too big and must shrink. Such industries at the global level include financial services (particularly global supply networks), car production, wholesale distribution, construction, and many other intermediate and primary inputs. Moreover, with many production facilities in Asia geared to sell to foreigners, who no longer have the means to pay, a massive geographical reallocation of production facilities seems in order. From this perspective, Keynesian demand-side stimulus might well have near-term benefits, but could eventually have less desirable effects if it impedes necessary adjustments in production capacities. Over time, such considerations matter.

Cash for clunkers programs in countries with very low household saving rates are not optimal. Nor are attempts to hold down exchange rates for countries with huge external trade surpluses. Nor are wage subsidies to support part-time work, if jobs in the industries being supported will never come back.

While all this restructuring takes place, the structural rate of unemployment will be higher and the level of potential out-put lower. Moreover, the reduced potential will come on top of the more traditional effects of downturns associated with such factors as lower investment—sometimes suppressed by tighter credit conditions—and employment and wages that do not adjust quickly (see Cerra and Saxena, 2008). This implies that all policies to expand aggregate demand could stimulate inflation pressures sooner than expected. Given that some of these policies, such as quantitative and credit easing, are themselves unprecedented, and their effects commensurately uncertain, the added uncertainty generated by shifts in aggregate supply cannot be judged welcome now.


there are other challenges to the conventional way of doing things as well. How can we blend into the Keynesian framework some of the insights of Austrian theory? In normal circumstances, using this Keynesian framework in a straightforward way to project output gaps and inflationary tendencies might seem satisfactory. For example, earlier this decade, such a framework seemed to provide an adequate explanation of the simultaneous observation of rapid growth, falling inflation, and very low real interest rates in the global economy (White, 2008). However, beneath this calm surface, Austrian “imbalances” were building up, which eventually culminated in the current crisis. The future macroeconomic research agenda must find ways to identify and react to these pressures. Fortunately, a significant amount of work in the area of identification has been done, and some promising areas for further progress suggested (see Borio and Drehmann, 2009).

One tendency that must be resisted is to see this work on imbalances as related solely to “financial stability.” In part, this tendency is related to the misconception that our current problems are limited to those of a financial crisis. Rather, an important aspect of the issue is how excessive credit and monetary creation can lead to imbalances outside the financial system, with significant macroeconomic implications.

Today, for example, households in the United States and a number of other countries seem likely to spend less, save more, and try to pay down debt. This seems likely to happen regardless of the capacity or incapacity of the financial system to give previous borrowers more credit. How the state of household and corporate balance sheets affects the desire to spend (as opposed to the capacity to spend) is a crucial issue for future research.

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