The economic crisis and the crisis in economics

An alternative interpretation is that mainstream macroeconomics is in big trouble.  You can think about this in terms of whether standard thinking provides plausible answers to four current policy issues.  (Daron Acemoglu of MIT has an important essay in preparation, arguing that there are deeper problems for economics, including for the most fundamental microeconomics - such as how we think about firms and reputations - in the light of the crisis.)

First, let's begin with whether macroeconomics can answer definitively or even informatively the most important question of the day.  Are we in danger of falling into another Great Depression, with a prolonged, worldwide fall in output and employment?

The mainstream answer to this question is: no, because we've learned a lot about economics since the Great Depression and because we also learned a great deal about policy both during and after the 1930s.

I'm not so convinced.  For example we know that a key policy mistake in the early 1930s was to allow banks to fail.  This will not happen again, at least not for “systemic institutions” - as the G7 made clear in October.  But bank failure was a problem because it contributed to a big contraction in credit - this has been well established in the work of Ben Bernanke and others.   Unfortunately, we know relatively little about how to stop today's process of falling credit around the world, known as “global deleveraging.”


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The fourth question is: what are the implications for the eurozone?  Again, there is a huge divergence of opinions among economists on this point.  Personally, I'm struck by the growing pressure on some of the weaker sovereigns that belong to the euro currency union.  Greece faces the most immediate problems, as demonstrated both by widening credit default swap spreads and - over the past few weeks - increasing spreads of Greek bonds over German government bonds.  The cost of servicing Greek government debt is thus rising at the same time as Greece has to roll over debt worth around 20 percent of GDP in the coming year.

Greece has a debt-to-GDP ratio over 90 percent, and the perceived risk of default is significant.  In our baseline view, Greece receives a fairly generous bailout from other eurozone countries (and probably from the EU).  This, however, does not come early enough to prevent problems from spreading to Ireland and other smaller countries (which then also need to implement fiscal austerity or to receive support).  Italy is also likely to come under pressure, due to its high debt levels, and here there will be no way other than austerity.  With or without a bailout, Greece and other weaker euro sovereigns will need to implement fiscal austerity.

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