Economic History and the Recession
If you ask a modern economic historian—like, say, me—if I know why the world is currently in the grips of a financial crisis and a deep downturn, I will say that I do know and I will give you this answer:
This is the latest episode in a long history of similar episodes of bubble—crash—crisis—recession, episodes that date back at least to the canal bubble of the early 1820s, the 1825-6 failure of Pole, Thornton, and company, and the subsequent first industrial recession in Britain. We have seen this process at work in many other historical episodes as well—1870, 1890, 1929, and 2000, for example. For some reason asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that overreward subordinates for taking risk; sometimes it is government guarantees; sometimes it is the selection of the market as a long run of good fortune leaves the financial market dominated by cockeyed unrealistic overoptimists.
Then the crash comes. And when the crash comes the risk tolerance of the market collapses: everybody knows that there are immense unrealized losses in financial assets and nobody is sure that they know where they are. The crash is followed by a flight to safety. The flight to safety is followed by a steep fall in the velocity of money as investors everywhere hoard cash. And the fall in monetary velocity brings on a recession.
I will not say that this is the pattern of all recessions: it isn’t. But I will say that this is the pattern of this recessions—that we have been here before.
Macroeconomic Theory and the Recession
If you ask the same question of a modern macroeconomist—like, say, the extremely sharp Narayana Kocherlakota of the University of Minnesota—you will find that he says that he does not know:
Why do we have business cycles? Why do asset prices move around so much?... [M]acroeconomics has little to offer by way of answer to these questions...
He will say that there are models that attribute economic downturns to various causes:
[M]ost models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)...
That is, downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.
But he will say that all these strike him as implausible just-so stories that do not illuminate: not to be taken seriously:
The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic.... None of these disturbances seem compelling, to put it mildly...
And so nobody really believes them:
Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables...
Just What Is Going on Here?
This leads me to ask two questions:
First, it does not seem to me that it is the case that nobody really believes these just-so stories. Ed Prescott of Arizona State University really does believe that large-scale recessions are caused by economy-wide episodes of the forgetting of the technological and organizational knowledge that underpins total factor productivity—with the exception of episodes like the Great Depression, which Prescott says was caused by the extraordinary pro-labor pro-union policies of Herbert Hoover that pushed real wages far above equilibrium values. Casey Mulligan of the University of Chicago really does appear to believe that large falls in the employment-to- population ratio are best seen as “great vacations”—and as the side-effects of destructive government policies like those in place today, which are leading workers to quit their jobs so they can get higher government subsidies to refinance their mortgages. (I know; I find it incredible too.) Things that strike Kocherlakota as “patently unrealistic” are not viewed as such by many of his modern macroeconomic peers and colleagues. Why not? Why do they find these just-so stories satisfactory?
Second, whether modern macroeconomics attributes our current difficulties either to causes that I agree with Kocherlakota are “patently unrealistic” or simply confesses ignorance, why do they have such a different view than we economic historians do? Whether they have rejected our interpretations and understandings or simply have built up or failed to build up their own in ignorance of what we have done, why have they not taken and used our work?
The second question is particularly disturbing to me. There is, after all, no place for economic theory of any flavor to come from than from economic history. Someone observes some instructive case or some anecdotal or empirical regularity, says “this is interesting; let's build a model of this,” and economic theory is off and running. Theory is crystalized history—it can be nothing more. After the initial crystalization it does develop on its own according to its own intellectual imperatives and processes, true, but the seed is still there. What happened to the seed?
This situation is personally and professionally dismaying. I do not say that the macroeconomic model-building of the past generation has been pointless. I don’t think that it has been pointless. But I do think that the assembled modern macroeconomists need to be rounded up, on pain of loss of tenure, and sent to a year-long boot camp with the assembled monetary historians of the world as their drill sergeants. They need to listen to and learn from Dick Sylla about Cornelius Buller’s bank rescue of 1825 and Charlie Calomiris about the Overend, Gurney crisis and Michael Bordo about the first bankruptcy of Baring brothers and Barry Eichengreen and Christy Romer and Ben Bernanke about the Great Depression.
If modern macreconomics does not reconnect—if they do not realize just what their theories are crystallized out of, and what the point of the enterprise is—then they will indeed wither and die.