In his article released on March 21 2018 – Economics failed us before the global crisis – Martin Wolf the economics editor of The Financial Times expressed some misgivings about macroeconomics.
Economics is, like medicine (and unlike, say, cosmology), a practical discipline. Its goal is to make the world a better place. This is particularly true of macroeconomics, which was invented by John Maynard Keynes in response to the Great Depression. The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.
Martin Wolf argues that a situation could emerge when the economy might end up in self-reinforcing bad states. In this possibility, it is vital to respond to crises forcefully.
It seems that regardless of our understanding of the key causes behind the crises authorities should always administer strong fiscal and monetary policies holds Martin Wolf. On this way of thinking, strong fiscal and monetary policies somehow will fix things.
A big question is not only whether we know how to respond to a crisis, but whether we did so. In his contribution, the Nobel laureate Paul Krugman argues, to my mind persuasively, that the basic Keynesian remedies — a strong fiscal and monetary response — remain right.
While agreeing with Krugman, Martin Wolf holds the view that, we remain ignorant to how economies work. Having expressed this, curiously Martin Wolf still holds the view that Keynesian policies could help during an economic crisis.
For Martin Wolf as for most mainstream economists the Keynesian remedy is always viewed with positive benefits — if in doubt just push more money and boost government spending to resolve any possible economic crisis. It did not occur to our writer that without understanding the causes of a crisis, administering Keynesian remedies could make things much worse.
The proponents for strong government outlays and easy money policy when the economy falls into a crisis hold that stronger outlays by the government coupled with increases in money supply will strengthen monetary flow and this in turn will strengthen the economy. What is the reason behind this way of thinking?
In this way of thinking, economic activity is presented in terms of the circular flow of money. Spending by one individual becomes a part of the earnings of another individual, and spending by another individual becomes a part of the first individual’s earnings.
So if for some reason people have become less confident about the future and have decided to reduce their spending this is going to weaken the circular flow of money. Once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.
Following this logic, in order to prevent a recession from getting out of hand, the government and the central bank should step in and lift government outlays and monetary pumping, thereby filling the shortfall in the private sector spending.
Once the circular monetary flow is re-established, things should go back to normal and sound economic growth is re-established, so it is held.
The Problem with the Mainstream View
Given that the government is not itself a wealth generator, this means that whenever it raises its outlays it also lifts the pace of the wealth diversion from the wealth-generating private sector. Hence the more the government plans to spend the more wealth it is going to take from wealth generators.
By diverting real wealth towards various non-productive activities, the increase in government outlays in fact undermines the process of wealth generation and weakens the economy’s growth rate over time.