How the Economy Works

The first paperback English language edition of my book How the Economy Works has just been published by Oxford University Press.  I hope this edition finds a new audience that will take the time to consider the ideas I present.  The book provides, not only a history of contemporary economic thought, but also some fresh ideas for dealing with financial crises and for the design of a new financial architecture to prevent them from reoccurring.

Here are a few excerpts from the new Preface.

How the Economy Works, (HTEW) first appeared in 2010. By the time of its publication, the world was in the throes of the worst recession since the 1930s. Thirty-seven months after the NBER called the recession over, in June of 2009, the U.S. economy is still a long way from regaining all of the jobs lost during the crisis. I wrote this book to help you understand why this happened and to offer some new ideas to prevent similar financial crises from reoccurring in the future.

I am often asked if economics is a science. My response is very much yes. Economics is a science: but it is not an empirical science. The task of an economist is a bit like that of a team of research chemists. Imagine that the chemists are asked to identify an unknown substance subject to some rather unusual constraints. First, they can conduct no more than three experiments a century and second, as the team members change, new members are not permitted to read the research notes of their predecessors.

The experiments of economics are large disruptive events, like the Great Depression, the stagflation of the 1970s or the Great Recession of 2008. The research notes of our predecessors are the writings of the great economists who preceded us; writings that are no longer read by graduate students in economics who have been taught that economic history and the history of thought are unnecessary distractions from the business of building mathematical models grounded in rigorous theory.

All this needs to change. It is my hope, that by providing an introduction to the historical evolution of economic ideas, this book will encourage a few new minds to delve more deeply into the ideas that formed our subject

Since How the Economy Works first appeared in print, I have written more than thirty op ed pieces in the Financial Times, on Project Syndicate, VoxEU and on other blogs and media outlets. Those pieces are linked electronically on my website www.rogerfarmer.com. Many of them remained as top five or top ten most popular posts on the Financial Times Economists’ Forum for many months and some are still there as I write this preface. 

Collectively, these op eds present a coherent account of the Great Recession as it unfolded, beginning in 2009, when I was one of the first, if not the first, to mention the word Depression as a possible outcome following the collapse of Lehman Brothers in September of 2008. 

Economic literacy is as important to citizenship as literacy in mathematics and the physical sciences. It is more important than ever that we all understand how economic theory influences the policies that are having such a profound impact on our everyday lives. I hope that this reissue of HTEW in a, paperback edition, will contribute to that goal and that some of the new ideas I have provided will resonate, with you, the reader.

Teaching Economics

Students at the University of Manchester in England are unhappy with the way they are being taught and they are not alone. In a widely publicized, and highly articulate report, the Post-Crash Economics Society, a group of Manchester Univesity students, is highly critical of "business as usual" in the economics curriculum in the wake of the crisis.

There is much to agree with in their arguments.


Among the criticisms that the students level at the curriculum are these

1. The absence of classes on the history of thought
2. No classes on ethics
3. A narrow focus on neoclassical economics to the exclusion of alternative perspectives
4. Little or no economic history

I agree with much of this and there is wide agreement amongst teachers of economics that change is needed as reflected in the published  Bank of England Conference volume, organized and edited by Diane Coyle. As I argued at that conference, it is a mistake to neglect the teaching of economic history and the history of thought.  But; beware of what you wish for.

Economics is a science. Our data comes from the natural experiments thrown at us by large disruptive events like the Great Depression, the 1970s stagflation and, most recently, the Great Recession.  It is the task of economic historians to familiarize their students with the facts.  It is the task of historians of thought to illuminate their students with the insights from the economists who preceded us.

What of eclecticism in the choice of topics? Should we teach a neoclassical approach to the exclusion of all else?  Probably not. But the core approach to modern economics, both macro and micro, is the culmination of a process of intellectual argument in which ideas have been sifted, debated and compared with facts. Some have survived; others have not.

When Marx wrote Capital, his economics incorporated Ricardo's labor theory of value, a centerpiece of the mainstream economics of his day. The labor theory of value was jettisoned by mainstream economics when the theory of marginal utility was introduced by, among others, the Manchester based economist Stanley Jevons. Marginal utility was an advance over the labor theory of value, which is no longer taught in mainstream courses. 

In the 1980s, there was tremendous interest in the idea that the mathematics of chaos theory could help us to understand business cycles. Chaos theory, had already proven successful in the natural sciences where it is used to explain fluid dynamics. At a conference in Paris in the early 1980's, Buz Brock, an economist who teaches at the University of Wisconsin, convinced many of us that there is just not enough data for that idea to help explain business cycles.  Chaos theory never did become part of the mainstream curriculum in economics.

In a twenty year period following the Great Depression,  Keynesian economics dominated the teaching of macroeconomics.  The central idea in The General Theory is that capitalist economies are not self-stabilizing. That idea was lost to mainstream economics when Franco Modigliani and Paul Samuelson synthesized Keynesian ideas with neoclassical thought.  The idea that capitalist economies are not self-stabilizing survived in Post-Keynesian economics and is now being reintegrated into the mainstream in my own recent work.

There is a reason why economic thought moves slowly. It is our inability to conduct experiments. If every new idea led to the creation of a new school of thought, the proliferation of ideas would overwhelm our ability to absorb and synthesize existing ones.

On Page 23 of their report, the Manchester students cite John Stuart Mill

"He who knows only his own side of the case doesn’t know much about it. His reasons may be good, and no-one may have been able to refute them; but if he is equally unable to refute the reasons on the opposite side, and doesn’t even know what they are, he has no ground for preferring either opinion.” 

John Stuart Mill, On Liberty

My advice to students is this. Continue to question everything you are taught. Lobby for classes on alternative approaches: But also take the time to absorb those ideas that are in the mainstream. The very best mainstream economists were the radical students who questioned authority when they were undergraduates. It is those economists who you must engage if you are to make meaningful changes that will advance our understanding. That takes hard work, perseverance, and patience.

Expectations Employment and Prices

I am teaching two graduate classes this quarter, and that gives me the opportunity to publicize some ideas that I'm teaching in my classes, and that I have been working on for some time. I plan to put up a series of posts explaining the ideas in my 2010 book, Expectations Employment and Prices. I will also talk about extensions of the book that I have subsequently published in peer reviewed journals.

Here is how I characterized the project in the preface to EEP.

I have long believed that modern interpreters of Keynes missed the main point of The General Theory; high unemployment is an equilibrium phenomenon that can persist for a very long time if nothing is done by a government to correct the problem. This was the point of my 1984 paper, which argued that the natural rate hypothesis is false. In the intervening years, I had time to refine this idea. Expectations Employment and Prices is the result.

I began thinking about a book on Keynesian economics, based on a search theory of the labor market, in 2003. I have had many conversations with friends and colleagues along the way and the question I hear again and again is: why write a book? It has become the norm for serious economists to convey their ideas in articles.

There is a benefit to this approach since publishing an idea in a journal subjects it to a process of peer review. But there is also a downside to publishing in refereed journals, particularly when the goal is as ambitious as the project that I am engaged in. Even the very best journals (perhaps, particularly the very best journals) are biased towards publishing very good articles that contribute to what Thomas Kuhn in his 1962 book, The Structure of Scientific Revolutions, called 'normal science'.

A successful article in a top journal takes an established paradigm and solves a puzzle that researchers can identify as a valid question. I have a more ambitious goal: I want to overturn a way of thinking that has been established amongst macroeconomists for twenty years. The rejection of several different core assumptions at the same time poses a problem if one wants to publish journal articles since the pieces stand or fall together and there is no space in a twenty-page article to explain why.

I have always found, in writing research papers, that no idea is ever complete and the same is true of a book; but more so. As this project developed I added new pieces and changed old ones. The project gained new urgency when the world economy began to disintegrate at an alarming rate in the fall of 2008. I decided at that point that it was important to publish the ideas in whatever form they were currently in and to worry about polishing them later. The theory I develop here has direct relevance to the world economic crisis and it suggests a new and potentially important solution to the problem of maintaining global stability

In subsequent posts, I will chronicle the main ideas from Expectations, Employment and Prices and talk about the ways in which my ideas about alternative policy solutions have developed.

Regime Switching at the Lower Bound: A Research Topic for Students

I just returned from a conference at the San Franciso Fed on Monetary Policy and Financial Markets HERE where I discussed a paper by Fumio Hayashi and Junko Koeda. They use a novel way of identifying the effects of policy during periods of Quantitative Easing which recognizes that policy is different when interest rates are at the lower bound. An interesting take away from their paper is that QE is effective at reducing the output gap.

The Hayashi-Koeda paper suggests the following research topic for Ph.D. Students. H-K use an SVAR, i.e. a vector autoregression that is identified by making assumptions about the covariances of the variables. See Stock and Watson here for a summary of what that means.

The novelty in Hayashi Koeda is to allow for different coefficients of the VAR when the interest rate is at the lower bound. The pitfall here, is that although SVAR stands for "structural vector autoregression", there really isn't anything structural about it. An SVAR is just the reduced form of a DSGE model. And that means that the coefficients of the equations cannot be relied upon to remain constant if the policy rule changes.

Nothing new there -- we've known that for a long time. I was asked to discuss the paper because I've worked here (with Dan Waggoner and Tao Zha) on DSGE models where the parameters switch occasionally from one regime to another. Here is the interesting research topic. How are Regime switching SVARs of the kind estimated by Hayashi and Koeda, related to the Markov switching DSGE models that I studied with Dan and Tao?

Labor Markets Don't Clear: Let's Stop Pretending They Do

Beginning with the work of  Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think thats a very good approach. It's time to drop the assumption that the demand equals the supply of labor. 

Why would you want to delete the labor market clearing equation from an otherwise standard model?  Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles.

Hours spent in employment varies over time for three reasons.

First, people enter or leave the labor force.  Second, some people lose jobs and others find jobs. Third, people work longer or shorter hours. Most economists confound all three reasons by using only one data series; hours spent in paid employment. That's not a good idea.

Here's data on participation in blue on the right axis against unemployment in red on the left axis. The grey areas are recessions. Participation is smooth; it trends up until 2000 and then trends down.   All the action during recessions is in the unemployment rate.

Participation and Unemployment

Perhaps its variation in hours that explains demand and supply variations?  Nope.  Here is data on average weekly hours (in blue on the right scale) and the same series on unemployment for comparison.

Hours and Unemployment

Why is this a big deal? Because 90% of the macro seminars I attend, at conferences and universities around the world,  still assume that the labor market is an auction where anyone can work as many hours as they want at the going wage.  Why do we let our students keep doing this?