Macroeconomic Policy and Sustainability

Read this article for additional perspective about macroeconomic goals and the inherent conflict among them as they relate to a global environmental context.

The Current State of Macroeconomics

The state of mainstream macroeconomics today can be roughly divided between New Classical and New Keynesian perspectives. The New Classical approach is heavily Walrasian. In this view, the macroeconomy is best seen as a system of interlinked markets, all tending towards equilibrium. Disturbances or shocks may temporarily divert markets from equilibrium, but they will tend to return to equilibrium without government intervention. Equilibrium in the labor market means that all unemployment is voluntary, based on workers' offering or withdrawing labor at different wage rates. Absent government or union intervention, wage levels will move towards equilibrium, with a "natural" rate of unemployment based on voluntary decisions by workers. Government intervention intended to stimulate the economy or reduce unemployment can only have a very short-term effect, to the extent that people are surprised by policy actions or subject to money illusion. Once expectations have adapted to a new policy environment, the only long-term effect of expansionary policy will be a higher price level.

Clearly the New Classical perspective is well named, since it has eliminated all the essential components of the Keynesian view, returning macroeconomic theory to the analyses and policy prescriptions of the 1920's – though with much greater mathematical sophistication.

The problem with this approach is that is so obviously in conflict with reality. No government in the world follows its minimalist policy prescriptions, and with good reason. In the United States, we see that as soon as a stock market downturn leads to a mild economic slowdown, the Federal Reserve Bank springs into action with a series of interest rate cuts. A conservative Administration promotes tax cuts to stimulate the economy. These monetary and fiscal adjustments, of course, are standard Keynesian expansionary policy. In addition, the structure of a modern economy includes numerous Keynesian automatic stabilizers such as graduated income taxes and unemployment insurance. Any government which truly dismantled this Keynesian set of policy functions would soon be confronted with catastrophic recessionary conditions, and would undoubtedly reverse their policies or be rapidly thrown out of office by enraged voters.

New Keynesians are more cognizant of economic reality, and less enamored of elegant Walrasian abstractions. They seek to discover imperfections, asymmetries, and coordination failures which interfere with the smooth workings of markets, and can lead to disequilibrium, instability, and involuntary unemployment. They are accordingly less skeptical of the functions of government, harking back to the original Keynesian view that if markets cannot solve economic problems, government intervention is essential. In a review of modern macroeconomics, Olivier Blanchard suggests that the distance between New Classicals and New Keynesians has recently diminished: "most macroeconomic research today focuses on the macroeconomic implications of some imperfection or another".

There is a third, non-mainstream, view of macroeconomics which finds fault with both New Classical and New Keynesian perspectives. David Colander, propounding this view, argues that both are founded in a fundamentally Walrasian approach which "has not taken the complexity of the aggregate economy seriously either in its assumptions of individuals ability to deal with that complexity, or in the structure of its models". In order to make economic relationships tractable in theory, mainstream macroeconomics assumes relatively simple, price-mediated relationships between variables. Problems of disequilibrium or unemployment in the macroeconomy then arise from such problems as "sticky" wages or prices which fail to adapt to changes in supply and demand. But what Colander calls a "post-Walrasian" approach sees the economy as complex and potentially chaotic, with multiple potential equilibria and internal processes different from those of microeconomic price adjustment.

This view harks back to an earlier critique of mainstream Keynesianism, associated especially with Joan Robinson and Axel Leijonhufvud. These writers attacked the Hicksian interpretation of Keynesian theory, including IS-LM analysis and Samuelson's formalization of the neoclassical synthesis. Their argument was that by assuming smooth, well-behaved macroeconomic relationships between interest rates and investment demand, the IS-LM formulation abandons Keynes' basic insights concerning the instability of capitalist systems.

More specifically, Leijonhufvud argued that the neoclassical focus on such phenomena as "sticky" wages and liquidity traps accepts a basically classical, Walrasian environment, and implicitly endorses the classical view that recessions result from a failure of wage rates to fall, or other "imperfections" in self-adjusting markets. Leijonhufvud pointed out that this is quite different from what Keynes actually maintained. Keynes argued that recessions and depressions occur despite, or partially as a result of, falling wage rates, with the fundamental cause being unstable investment leading to negative multiplier effects:

...the contention that the unemployment which characterizes a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts. It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing. Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or in its productivity. Labour is not more truculent in the depression than in the boom – far from it. Nor is its physical productivity less. These facts from experience are prima facie evidence for questioning the adequacy of a classical analysis.

Robinson comments on the IS-LM analysis that:

If Keynes' own ideas were to be put into this diagram, it would show IS as the volatile element, since it depends upon expectations of profit; the case where full employment cannot be reached by monetary means would be shown by IS falling steeply and cutting the income axis to the left of full employment.

The implication of this more radical interpretation of Keynes is that government intervention is essential to stabilize an inherently unstable macroeconomy. In addition, it casts severe doubt on the "rationality" of market capitalist economies and the social optimality of market outcomes. More recently, Leijonhufvud has called for a "not-too-rational" macroeconomics, and has suggested an imperfect information model whose outcomes are sometimes stable, due to buffer stocks of liquid assets, but can become unstable under certain conditions.

We can see, then, that in macroeconomic theory plus ça change, plus c'est la même chose (the more things change, the more they stay the same). The battles between classical, neo-classical Keynesian, and radical Keynesian views are still being fought out, just with more elaborate mathematics. Of these three schools, however, it is the radical Keynesian which offers the best foundation for an ecological macroeconomics. In this as in other areas, the ecological economics perspective is inherently in opposition to the classical view of self-adjusting markets. It takes its inspiration from those economists who have focused on disequilibrium and imbalances, starting with Malthus, who worried both about population growth and the possibility of a "general glut" or depression. The bland optimism about market efficiency characteristic of classical and New Classical views severely underrates the kinds of problems that concern social economists and ecological economists, including resource overuse, environmental damage, income, wealth, and power inequity, and institutional weakness.

Thoughtful proponents of New Keynesianism may also be in tune with ecological economists on a number of issues. The imperfections, asymmetries, and market failures which they see as leading to macroeconomic problems may often also be associated with environmental and resource abuses and social inequities. But the more radical macroeconomic formulation ­– that market economies are inherently prone to severe disequilibrium, and that informed social intervention is essential for a sustainable society ­– is closer both in spirit and in content to the radical critiques of "optimal" market outcomes and smooth economic growth which have been advanced by Herman Daly, Richard Norgaard, and many others associated with an ecological economics perspective.