Monday, December 16, 2013

Freshwater and Saltwater Economists: A Creation Story

Back in the late 1970s, when I was first shaking hands with economics, the standard dividing line in macroeconomics was phrased as "monetarists" vs. "Keynesians." But that distinction was already becoming obsolete. Robert Hall stakes a claim to rephrasing the main dividing line in macroeconomics back in 1976 a way that has largely stood the test of time, as between "freshwater" and "saltwater" macroeconomists. As Hall wrote at the time:
"As a gross oversimplification, current thought can be divided into two schools. The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity." 
In a footnote, Hall offers a few examples which will give a smile to academic economists, if no one else:
"To take a few examples, [Thomas] Sargent corresponds to distilled water, [Robert] Lucas to Lake Michigan, [Martin] Feldstein to the Charles River above the dam, [Franco] Modigliani to the Charles below the dam, and [Arthur] Okun to the Salton Sea."
For those not up on their southern California geography, the Salton Sea is the largest lake in California. It is formed by the occasional long-ago overflow of the Colorado River, but it has no natural outlet--except for evaporation. Thus, as various kinds of salinity wash through the soil and into the Salton Sea, its salinity kept rising, making it saltier than the ocean.

As Hall points out, the old-style differentiation between monetarists and Keynesians was based on views about the effects of monetary and fiscal policy. Keynesians back in the 1950s typically believed that the supply of money and credit was not an important factor in determining the business cycle. Monetarists like Milton Friedman argued that it was. By the mid-1970s, the monetarists had won that argument and Keynesian thinking of that time often discussed both fiscal and monetary policies. As Hall wrote in 1976: "The old division between monetarists and Keynesians is no longer relevant, as an important element of fresh-water doctrine is the proposition that monetary policy has no real effect. What used to be the standard monetarist view is now middle-of-the-road, and is widely represented, for example, in Cambridge, Massachusetts."

At a more detailed level, Hall attributed much of the difference between the freshwater and saltwater macroeconomists to their views on expectations. In the freshwater view of that time, it was typically argued that economic actors had excellent foresight about the future effects of various policies--what is often called "rational expectations." In certain economic models with rational expectations, adjusting the money supply has no effect, because all economic actors can see what i happening and adjust all prices and wages accordingly. As Hall wrote in 1976: "By now, everyone more than a few yards from the ocean's edge bows in the direction of rational expectations."

But how much rationality was really likely? As Hall drily noted, some of the models seemed to presume that all economic actors had rationality "[e]qual to that of an MIT Ph.D. in economics with 9 years of professional experience." But even at that time, economists were experimenting perspectives on macroeconomic behavior. Some economists used information lags, in which people might take time to develop their rational expectations. Others thought about "adaptive expectations," in which people looked backward at what had  happened, but didn't make forward-looking predictions in the way that true rational expectations would require. Still others looked at reasons why prices or wages might not adjust, with a particular focus on contracts or other kinds of "sticky prices," which would later grow into a "New Keynesian" saltwater view of the economy.  As Hall wrote: "Macroeconomists of more brackish persuasions are skeptical of the explanatory value of information lags, and have developed a major alternative within the framework of rational economic behavior. The basic idea is that buyers and sellers of labor services rationally enter into contracts that fix the wage in money terms for some time into the future."

There was a time, not all that long ago back in the mid-2000s, when a number of economists thought that they had successfully put together a consensus macroeconomic model. It built on the freshwater ideas that macroeconomic models should be built on microeconomic behavior and the important of expectations of individual agents, while still allowing for the possibility of saltwater ideas like the stickiness of prices, the economic losses from recessions, and a role for government policy in ameliorating recessions.  For one explanation of these efforts at building a consensus model, see the article by Jordi GalĂ­ and Mark Gertler in the Fall 2007 issue of the Journal of Economic Perspectives,  "Macroeconomic Modeling for Monetary Policy Evaluation." Just to be clear, a shared model doesn't mean that macroeconomists would all agree. It means that economists with differing perspectives can use the same overall structure for analysis and argue about whether certain parameters have high or low values. This focuses the intellectual disputes in a useful way. But this consensus model, like pretty much all existing macroeconomic models, failed the test of providing a useful framework for understanding the Great Recession. The freshwater and saltwater camps separated again.

Here is one quibble with what Hall wrote back in 1976.  He argued: "As I see it, the major distinguishing feature of macroeconomics is its concern with fluctuations in real output and unemployment. The two burning questions of macroeconomics are: Why does the economy undergo recessions and booms? What effect does conscious government policy have in offsetting these fluctuations?" At the time when Hall was writing, this statement seemed accurate to me. The very idea of macroeconomics as a distinctive field grew out of that extraordinary recession called the Great Depression, and in the following decades up to the mid-1970s, the concern over economic fluctuations largely defined the field of macroeconomics.

But although this change wasn't yet visible in 1976 when Hall was writing, the U.S. economy had just entered a lengthy period of productivity slowdown. We were in the process of witnessing a period of enormous economic catch-up from Japan, soon to be followed by Korea and other nations of East Asia, and now in turn being echoed by rapid growth in China, India, and other emerging economies. Looking ahead, the U.S. economy faces challenges about whether it can return to and sustain a strong rate of growth into the future. In the aftermath of the Great Recession, many of the old arguments about causes of business cycles and policies for ameliorating them have obvious relevance.  But to me, macroeconomics should also be about the long-term patterns of economic growth.