Encyclopedia of Law & Economics - 0620 LAW AND MACROECONOMICS



Richard L. Gordon

Professor of Mineral Economics, Pennsylvania State University

© Copyright 1997 Richard L. Gordon


1. Introduction
2. The Nature of Macroeconomics Recalled
3. The Tools to Consider
4. An Overview of the Macroeconomic Policy Debates
5. Viewpoints
6. The Skeptics
7. The Rise of Macroeconomics
8. Alternative Views of Stability Problems
9. The Return of Classical Macroeconomics
10. Market Clearing Rational Expectation Models
11. Further Challenges
12. Real Business Cycles
13. State of Policy
14. Confronting Cyclicality
15. The Causes Considered
16. Imperfect Competition and Unemployment: The MicroeconomicBackground
17. The Effort at Application
18. New Keynesian Models
19. The Policy Failure Alternative
20. Conclusions
21. Backgound to the Article
22.Bibliographic Note
Bibliography on Law and Macroeconomics (0620)


This article argues that imperfections in the working of individual (nonfinancial)markets are not a clear source of macroeconomic instability and that betterregulation of these markets is not the way to lize the economy. Improvement heremeans both increased surveillance and removing government-fostereddeficiencies. The basic arguments are (1) the long-standing disarray thatdistinguishes macroeconomics from microeconomics greatly increased startingin the 1970s, (2) great dispute exists over the workability of different "classic"macroeconomic measures, (3) despite at least seven decades of advocacy ofmicroeconomic measures for macroeconomic goals, no defensible case exists, (4)support for microeconomic measures rests on a belief in a high degree of marketfailure about which microeconomists have become more skeptical, (5) theseweaknesses imply that no clear macroeconomic benefits offset themicroeconomic drawbacks of regulations of individual markets, and (6) extensivederegulation would produce substantial microeconomic and macroeconomicbenefits, but the microeconomic case is much stronger.

JEL classification: K00, E00

Keywords: Macroeconomics, Keynes, Law and Economics

1. Introduction

This article examines contentions that imperfections in the working of individual(nonfinancial) markets are a source of macroeconomic instability and that betterregulation of these markets is the most feasible way to offset theseimperfections. Improvement here means both increased surveillance andremoving government-fostered deficiencies. The overriding theme is theapproach has little support.

The basic arguments are (1) the long-standing disarray that distinguishesmacroeconomics from microeconomics greatly increased starting in the 1970s,(2) great dispute exists over the workability of different "classic" macroeconomicmeasures, (3) despite at least seven decades of advocacy of microeconomicmeasures for macroeconomic goals, no defensible case exists, (4) support formicroeconomic measures rests on a belief in a high degree of market failure aboutwhich microeconomists have become more skeptical, (5) these weaknesses implythat no clear macroeconomic benefits offset the microeconomic drawbacks ofregulations of individual markets, and (6) extensive deregulation would producesubstantial microeconomic and macroeconomic benefits, but the microeconomiccase is much stronger.

Dealing with these points requires much effort. The prior two paragraphs, notonly make sweeping assertions, but use numerous ambiguous terms. The articlethen seeks to undertake four tasks. (1) The terms are clarified. (2) Selected partsof the debates over macroeconomics are reviewed. As the literature review belowseeks to suggest, the presentation necessarily cannot even fully cover everyidea encountered. Choice is limited to those that seem more relevant. Others can(and indeed in the refereeing process did) stress different viewpoints. (3) Themicroeconomics of market behavior are sketched. (4) Perspective is provided onthe history of proposals to use microeconomic policies to secure macroeconomicgoals.

2. The Nature of Macroeconomics Recalled

While economists occasionally use the term macroeconomics to describe anyhighly aggregative analysis, the more usual concepts relate to economy-wideinstabilities, particularly in unemployment rates but also involving inflation andbalance of payments problems. This clearly is the stress of the manymacroeconomics texts. Since the rise of extensive formal studies ofmacroeconomics, the traditional concerns with the allocation of resources inmarkets became microeconomics.

Actually, both branches deal with the total economy. Macro concentrates onhow the combined behavior produces instabilities. Micro stresses how well eachcomponent of the economy performs the task of making useful goods availableto consumers.

Nothing in economics is neat, and this is true of the borders between macroand microeconomics. The banking system is both a micro and a macro concern.The role of banks in money supply is a basic concern of macroeconomics. Therole of banks in serving individuals involves employing the standard tools ofmicroeconomics. In practice, a further fuzzing arises from conventions adoptedin standard texts. Economic growth, at least as conventionally modeled, is clearlya microeconomic problem, and any correction is by policies affecting individualmarkets. To be sure, more applied discussions recognize the impacts ofalternative government tax and spending policies. For example, U.S. politicaldebates present, albeit in the overly loose fashion necessarily adopted inpolitical debates, a choice between a Democratic model focusing on growthpromoting government spending and a Republican view focused on makingmore money available for private sector investment. Conventionally, micro textsat both the advanced undergraduate and graduate level ignore economic growth.(A major exception is Mas-Colell, Whinston, and Green, 1995.) Macro texts, incontrast, typically cover growth.

Unemployment is central because it is harder to explain or correct thaninflation and balance of payments problems. The basic causes and cures of thelast two were established by the eighteenth century (as in David Hume's essaysthat relate to economics). In contrast, neither what causes unemployment norwhat if anything can be done about it is well determined. Many explanationsexists, but all have severe (and widely examined) drawbacks. This article arguesthat indeed these defects are so severe that any public policies must assume thatthey are dealing with a mysterious disease whose origin and untreated responseare unknown.

What is most important here is that macroeconomics concentrates onmonetary and fiscal policy. Increasing or decreasing control of individualnonfinancial markets has a decidedly secondary role. Macroeconomic theoristswho contend that problems in nonfinancial markets or in their regulation are themain cause of instability often do not advocate cures involving directly alteringcontrol of these markets. One has to resort to nonconformist writings to findstrong arguments for regulatory approaches to instability. Kelman's (1993) effortto examine the issue tries valiantly to find good rationales but only identifiesdrawbacks.

3. The Tools to Consider

The central policy distinction made here is between the monetary and fiscalpolicies that are the focus of traditional macroeconomics and regulatoryinitiatives. Monetary policy relates to control by various means of the supplyof money in the economy. (Such financial innovations as mutual funds thatinvest in short-term securities and allow owners to withdraw funds by writingchecks and credit and debit cards have increased the always difficult problem ofdistinguishing money from other financial assets. This problem is not relevanthere.) Fiscal policy relates to the effects of government tax and spending policy.

Regulation here means those government policies that control the behaviorof individual firms and households in the economy. The concept consideredhere is somewhat broader than that used in other discussions of regulation. Inparticular, a key element proves government policies governing thecompensation and rights of workers and the treatment of trade unions."Regulatory" economists tend to leave most of these issues to labor economists.Stress is on good market controls; the only labor policies treated are health andsafety regulation. Regulatory policies are the focus of many articles in thisencyclopedia. For that reason and because of space limitations, I neitherdelineate in detail nor evaluate the microeconomic problems of such policies.The formidable difficulties of producing predictable results from such policiesis taken as proved elsewhere.

A more critical consideration is that the scope of proposed regulations maybe greater when macroeconomic considerations are added to microeconomicconcerns. The macroeconomics literature talks of incomes policy that involvescontrols of prices and wages throughout the economy. Microeconomic practiceemphasizes concentrating on sectors in which monopoly power exists or marketsfail to internalize all costs. This distinction can be interpreted in at least threedifferent ways. First, the two arguments may be equivalent ways of stating thesame view; economywide may really only mean monopoly sectors. Second,macroeconomists may see more monopoly than do microeconomists. Third,macroeconomists may feel that many sectors that cause no microeconomicproblems are macroeconomic threats. Some indications arise that enthusiasts ofwage and price controls, in fact, see a greater prevalence of extensive monopolypower than do microeconomists specializing on monopoly problems.

4. An Overview of the Macroeconomic Policy Debates

Stress here is on conflict between "Keynesians" and classical economists. Bothapproaches encompass many different, often mutually incompatible specificanalyses. For present purposes, examples of each position that seemed mostgermane are presented. The Keynesian position is identified with the view thatreal economies have features that produce large, undesired, and undesirableinstability and that feasible "active" public policies exist to improve onunregulated performance. Active means closely viewing economic behavior andreacting to it.

The classical position involves numerous criticisms of the Keynesianoutlook. In particular, an influential new classical group of macroeconomists hasdramatically expanded the demonstration of the impediments to successfulgovernment programs to stabilize the economy. A key unfluence on acceptanceof the case is rejection by economists from all viewpoints of the 1930s belief thatdeep extended depressions are an ever present danger. The arguments are notconclusive. However, they have enough plausibility that serious considerationmust be given the possibility that feasible active policies are ill-defined, if notnonexistent.

Even if this conclusion is rejected, it still can be inferred that whatever isdone must be limited by implementation problems. Behind the bitter debates mayonly be a minor quarrel about exactly how small is the scope for action. Theanalysis here focuses on this narrowing of the ambitions of active monetary andfiscal policy from the more ambitious proposals of the 1936 to 1968 period. Tothe extent they support anything, modern Keynesians advocate restrainedintervention that has been called coarse tuning (Lindbeck, 1993, p. 154) (inobvious response to the excessive prior claims that one could fine tune theeconomy). Much effort was devoted to arguing that active policies weredesirable without indicating whether the activism significantly differed fromfollowing policy rules. Attention turns to arguing that, given these limitationsand the widely known microeconomic drawbacks, increased regulation ofnonfinancial markets is not an attractive alternative stabilization policy.

Unfortunately, reasonably treating these supposedly limited questionsrequires examination most of the thorniest issues of both macroeconomics andmicroeconomics. In particular, the proposition that regulating individual marketsis a desirable macroeconomic policy presumes that actual economies are bestdescribed by theories of imperfect markets. Acceptance of the empiricalrelevance of such theories, moreover, does not suffice to justify marketregulation. It must also be shown that such regulation is a desirable way tooffset the effects of market imperfections. In particular, the intervention mustreduce unemployment and not produce other effects, such as increased inflationor undesirable impacts on the regulated markets, that cause harms that outweighthe employment benefits.

The issues have been major concerns in economics for nearly sevendecades. All of the key questions remain unresolved and indeed often not evenclearly raised. The characteristics, causes, and cures of economic instability andhow best to analyze them are all bitterly debated. A growing stress on theoreticprowess may have caused analysts inadequately to consider the empiricalrelevance of the theories. At least three issues arise about macroeconomics. Thefirst is what comprises the theoretically sound models of instability. The secondis which of these models best explains reality. The issue about theory choicestressed here is whether market imperfections are the primary causes ofeconomic instability. It must be shown that the theoretically possible alternativemechanism prevails in practice.

The third concern stressed here is what the realistic models say about thecorrectability of behavior. They must show that the characteristics of theeconomy also allow effective stabilization policy.

5. Viewpoints

The combination of possible viewpoints produces a mass of alternativepositions about problems, solutions, and the best ways to analyze them. Evenwithout considering the many variant positions on how to analyze the issues,at least five policy postures can be delineated. Several different ways exist toreach each of the policy outlooks. Given the underlying complexity, thecategories are devised as epitomes to make the discussion manageable. (Theclassification initially was designed to recognize distinctions made by Kelman(1993) and overcome their drawbacks, particularly his failing to distinguishbetween the two radically different branches of new classical economics.) Theclassification is among traditional Keynesians, microinterventionists,deregulators, microkibbitzers (or Kennedy Keynesians), and skeptics aboutintervention.

To examine alternative routes to these policy postures, the valuableambitious survey by Snowdon, Vane, and Wynarczk (1994) distinguishes amongclassical Keynesians, new Keynesians, Post-Keynesians, monetarists, marketclearing classicists, real business cycle advocates, and Austrians. As discussedbelow, the last four each develop somewhat different cases against activestabilization policy.

The position associated here with Keynesians, as noted, is that activemonetary and fiscal policy is effective and preferable as an anti-unemploymenttool. This certainly is the classical Keynesian position, and a large part of newKeynesian economics is devoted to defending against new classical criticism.Some post-Keynesian economists advocate wage and price controls.

Monetary and fiscal policy can take many forms. Thus, general approval ofactive stabilization involves support of many different specific practices. Whatis feasible is ill-discussed. The present treatment stresses the problems of anyforms of activism and does not examine exactly what might be feasible. Forreasons discussed below, labeling these views Keynesian is common but notnecessarily universal.

The microinterventionists and deregulators believe that better governmentsupervision of individual firms throughout the economy can contribute toreducing unemployment or at least allow the reduction to occur with lessinflation than if only monetary and fiscal policy are used. Microinteventionistsbelieve that unemployment is a serious problem originating from inherent marketfrictions and most appropriately cured by increasing regulation of individualmarkets. Deregulators, who tend to doubt the severity of economic instability,see government as creating the critical barriers to good performance and wantto decrease regulation.

The increased regulation outlook had its height in the 1930s. The extensivethrashing about for explanation of the profound economic collapse in thatdecade produced many theories. A number stressed the role of rigidities in theeconomy. The supporters differed considerably in what they proposed.Suggestions were then made for either extensive national economic planning toregulate private market behavior or radically restructuring the economy byvigorous application of U.S. antitrust laws (see below). Some of the advocatessurvived long after World War II but attracted little intellectual support.Politicians, to be sure, have acted on acceptance of the belief. In contrast, theoverregulation thesis is largely noted in passing by the most avidantigovernment economists. (Kelman gives the macroeconomic elements ofthese arguments greater prominence than they ever have secured in theeconomic literature.)

The failure of massive depressions to emerge since World War II lessened,but did not eliminate, concerns. The question of whether more directlyconfronting market or government imperfections was an effective strategypersisted but never dominated. Support for such measures was limited.

At least two episodes arose in the United States. They were inspired largelyby the persistent problems of taming inflation generated by the Korean and VietNam wars. Towards the end of the Eisenhower presidency, much discussionarose of cost inflation. The Kennedy administration devised a response, but itwas the alternative option discussed next. The Nixon administration wasenduring inflationary problems reflecting lingering effects of the Viet Nam Warand then was hit with the 1973-74 oil price shocks. The administration adoptedfirst a set of general price controls and then initiated what proved an extendedconcentration on regulating energy for many reasons including allegedmacroeconomic benefits. The much explored energy experience (see Bradley'smassive 1995 effort to sum up the experience) illustrated the severemicroeconomic problems that can arise.

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