Without a QTM anchor, macro is nothing more than undergrad BS

If you’ve ever taught intro to macro, you know that undergrads like to use “self-fulfilling prophesy” arguments for things they don’t understand.  Thus I am somewhat dismayed to see Robert Shiller use the same basic argument to explain why the economy has started to recover.  And yet, despite the derisive title of this post, I am also a bit sympathetic to Shiller’s recent NYT piece:

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again “” in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession began in December 2007, according to the National Bureau of Economic Research, so it is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

.   .   .

President Roosevelt is widely remembered for saying, in 1933, that “the only thing we have to fear is fear itself.” But he was only repeating an oft-told message.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article in The Antioch Review titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase, but by the 1930s the idea was already as commonplace as the breakfast toast made with modern electric toasters. (Interestingly, the same Robert Merton documented the tendency for important ideas to be falsely attributed to celebrities.)

Like Shiller, I think that shifts in expectations are the driving force in business cycles.  But what bothers me about the self-fulfilling prophesy approach is that it treats expectations as sort of a free-floating concept, not anchored to fundamental determinants of long-run AD growth.  And I think there is a reason for this.  In some of my early posts I talked about how deflation always leads to a sort of dark ages of macro.  The problem is that economists use the wrong indicators for the stance of monetary policy; focusing on interest rates and the monetary base.  Both of these indicators tend to behave “perversely” during deflation.  Interest rates fall to low levels, and the public and banks tend to hoard base money.  So it looks like monetary policy is easy.  Once monetary policy is viewed as irrelevant, macroeconomics loses the only variable capable of anchoring long run expected NGDP growth.  And without the anchor provided by the Quantity Theory of Money, it’s all just undergraduate BS.  (No disrespect to any undergrads reading this, I am directing the same complaint against an outstanding Yale economist.)

Shiller is hardly the only economist who has written off monetary policy once rates hit zero.  And I give him credit for intuiting that expectations may be a more important driver of AD than fiscal policy.  But in the end, if macro can’t rely on certain basic principles, such as the long run relation between monetary policy and expected NGDP growth, then we really don’t have anything even worth calling a “social science.”

In the Great Depression many economists reverted to the crude prejudices of the man on the street.  It’s happening again.