The crisis and the textbook

In August, 2008, a month before the Global Financial Crisis hit with unmistakable impact, I received the galleys for the 4th edition of my textbook, Principles of Economics. It is the adaptation of Greg Mankiw’s leading US text (co-written with Stephen King and Robin Stonecash). The edition had changed only a little from the one three years earlier. Perhaps the most significant addition was an extended discussion of climate change policy but also the juicier examples coming from the Freakonomics-like microeconomic research that had so captured popular enjoyment of economics. By the time the text was finally published, the GFC was among us and it was hard to imagine how this could not be the central part of macroeconomic discussion, let alone be absent from this most recent of writings.

In many respects, this anecdote is as much about the lags in traditional publishing as it is about economics being somehow off-base. But it is also true that the speed with which the crisis developed from something familiar to something scarily unfamiliar was striking. How could it not change the way economics is taught?

Fast forward just a few more months to the present and my concerns that the crisis was not front and centre in the book have been allayed. This is not to say it will not feature next time around, it is that it will impact on 5 per cent rather than 50 per cent of your average first year economics class.

My reasoning for this is quite straightforward. Macroeconomics is a discipline that deals with the movements of aggregates. There are two things that drive these:

First, there are accounting identities such as how the components of national expenditures must sum to the level of production or how the capital account balance must offset the current account. These are immutable and do not change - crisis or no crisis.

Second, there are behavioural relationships. These describe how broad sets of individuals make decisions and how they interact with one another. Being behavioural, these are hardly immutable and what is more, we do not know as much as we would like to know about them.

To take an example: the notion that consumption rises with current income. This assumption started with Keynes and was critical in understanding how actions that might stimulate income (such as a tax rebate or a handout) might lead to higher consumption and stimulate private activity. The rate at which this occurs drives the all important multiplier effect. However, for the better part of half a century, economists have noted that if you give someone $900 extra today, this does not change their lifetime income very much. So even if you happen to spend 80 per cent of your income, you might save more of that $900 than is your usual pattern. And if that occurs, so goes the multiplier.

So there is a debate about these measures. And in the textbook, it turns out that the precise relationship likely hinges upon liquidity. After all, you can manage or smooth your income over time quite easily if you can readily borrow during downtimes and save during uptimes. But take away a functioning banking system and that assumption does not necessarily hold. In that situation, interest rates may drop during downtimes but borrowing doesn’t occur. Hand someone some money then and it may well be spent.

What recent events have reinforced to economists is that there are three kinds of macroeconomics. First, there is the long-run, where if you wait, the cycle does not matter and you want to have your house in order, so as to grow in a sustainable fashion. Second, there is the short-run, where fluctuations do occur and government interventions such as keeping the money supply stable and allowing fiscal policy to move with the ebb and tide of the economy, smoothing the bumps.

But, finally, there is a liquidity crisis, where the financial sector stops working for a time and so forestalling crisis or reducing its effects requires active government intervention and management. It is scary because there is little science to this. And it is worrisome because there is an extent to which those actions may incur a debt of their own and slow recovery back to normalcy.

In the US, Europe and Japan, there is a liquidity crisis (for Japan it is their second in two decades). In Australia, for reasons that will be debated for years, we do not have that same crisis and are instead in the macroeconomics of the short-run. But even there with the storm coming over the horizon our policy-makers switched to a degree of crisis macroeconomic management with a pre-emptive stimulus package. There has been criticism that such measures were not necessary but it is equally possible that such measures did their job as intended.

The schism in modern macroeconomics between its three types is something that textbooks partition around but the current crisis has demonstrated that such compartmentalisation is inadequate to the task. Somehow, we need indicators as to whether we are moving from short-run to crisis mode and a way of agreeing upon a course of action for the latter. The last time this occurred globally, governments reacted very differently to the way they have now. Maybe not in the next edition but in future editions we will have learned enough about what worked given that massive bet to write a better textbook.