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 Comepition and Unemployment: The Microeconomic Background  

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 better regulation of these markets is not the way to lize the economy. Improvement here means both increased surveillance and removing government-fostered deficiencies. The basic arguments are (1) the long-standing disarray that distinguishes macroeconomics from microeconomics greatly increased starting in the 1970s, (2) great dispute exists over the workability of different "classic" macroeconomic measures, (3) despite at least seven decades of advocacy of microeconomic measures for macroeconomic goals, no defensible case exists, (4) support for microeconomic measures rests on a belief in a high degree of market failure about which microeconomists have become more skeptical, (5) these weaknesses imply that no clear macroeconomic benefits offset the microeconomic drawbacks of regulations of individual markets, and (6) extensive deregulation would produce substantial microeconomic and macroeconomic benefits, but the microeconomic case is much stronger.

1. Introduction  

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

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

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

2. The Nature of Macroeconomics Recalled  

While economists occasionally use the term macroeconomics to describe any highly aggregative analysis, the more usual concepts relate to economy-wide instabilities, particularly in unemployment rates but also involving inflation and balance of payments problems. This clearly is the stress of the many macroeconomics texts. Since the rise of extensive formal studies of macroeconomics, the traditional concerns with the allocation of resources in markets became microeconomics.

Actually, both branches deal with the total economy. Macro concentrates on how the combined behavior produces instabilities. Micro stresses how well each component of the economy performs the task of making useful goods available to consumers.

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

Unemployment is central because it is harder to explain or correct than inflation and balance of payments problems. The basic causes and cures of the last two were established by the eighteenth century (as in David Hume's essays that relate to economics). In contrast, neither what causes unemployment nor what if anything can be done about it is well determined. Many explanations exists, but all have severe (and widely examined) drawbacks. This article argues that indeed these defects are so severe that any public policies must assume that they are dealing with a mysterious disease whose origin and untreated response are unknown.

What is most important here is that macroeconomics concentrates on monetary and fiscal policy. Increasing or decreasing control of individual nonfinancial markets has a decidedly secondary role. Macroeconomic theorists who contend that problems in nonfinancial markets or in their regulation are the main cause of instability often do not advocate cures involving directly altering control of these markets. One has to resort to nonconformist writings to find strong arguments for regulatory approaches to instability. Kelman's 1993 effort to examine the issue tries valiantly to find good rationales but only identifies drawbacks.

3. The Tools to Consider  

The central policy distinction made here is between the monetary and fiscal policies that are the focus of traditional macroeconomics and regulatory initiatives. Monetary policy relates to control by various means of the supply of money in the economy. (Such financial innovations as mutual funds that invest in short-term securities and allow owners to withdraw funds by writing checks and credit and debit cards have increased the always difficult problem of distinguishing money from other financial assets. This problem is not relevant here.) Fiscal policy relates to the effects of government tax and spending policy.

Regulation here means those government policies that control the behavior of individual firms and households in the economy. The concept considered here is somewhat broader than that used in other discussions of regulation. In particular, a key element proves government policies governing the compensation 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 and safety regulation. Regulatory policies are the focus of many articles in this encyclopedia. For that reason and because of space limitations, I neither delineate in detail nor evaluate the microeconomic problems of such policies. The formidable difficulties of producing predictable results from such policies is taken as proved elsewhere.

A more critical consideration is that the scope of proposed regulations may be greater when macroeconomic considerations are added to microeconomic concerns. The macroeconomics literature talks of incomes policy that involves controls of prices and wages throughout the economy. Microeconomic practice emphasizes concentrating on sectors in which monopoly power exists or markets fail to internalize all costs. This distinction can be interpreted in at least three different ways. First, the two arguments may be equivalent ways of stating the same 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 microeconomic problems are macroeconomic threats. Some indications arise that enthusiasts of wage and price controls, in fact, see a greater prevalence of extensive monopoly power 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. Both approaches encompass many different, often mutually incompatible specific analyses. For present purposes, examples of each position that seemed most germane are presented. The Keynesian position is identified with the view that real economies have features that produce large, undesired, and undesirable instability and that feasible "active" public policies exist to improve on unregulated performance. Active means closely viewing economic behavior and reacting to it.

The classical position involves numerous criticisms of the Keynesian outlook. In particular, an influential new classical group of macroeconomists has dramatically expanded the demonstration of the impediments to successful government programs to stabilize the economy. A key unfluence on acceptance of the case is rejection by economists from all viewpoints of the 1930s belief that deep extended depressions are an ever present danger. The arguments are not conclusive. However, they have enough plausibility that serious consideration must be given the possibility that feasible active policies are ill-defined, if not nonexistent.

Even if this conclusion is rejected, it still can be inferred that whatever is done must be limited by implementation problems. Behind the bitter debates may only be a minor quarrel about exactly how small is the scope for action. The analysis here focuses on this narrowing of the ambitions of active monetary and fiscal policy from the more ambitious proposals of the 1936 to 1968 period. To the extent they support anything, modern Keynesians advocate restrained intervention that has been called coarse tuning (Lindbeck 1993, p. 154) (in obvious response to the excessive prior claims that one could fine tune the economy). Much effort was devoted to arguing that active policies were desirable without indicating whether the activism significantly differed from following policy rules. Attention turns to arguing that, given these limitations and the widely known microeconomic drawbacks, increased regulation of nonfinancial markets is not an attractive alternative stabilization policy.

Unfortunately, reasonably treating these supposedly limited questions requires examination most of the thorniest issues of both macroeconomics and microeconomics. In particular, the proposition that regulating individual markets is a desirable macroeconomic policy presumes that actual economies are best described by theories of imperfect markets. Acceptance of the empirical relevance of such theories, moreover, does not suffice to justify market regulation. It must also be shown that such regulation is a desirable way to offset the effects of market imperfections. In particular, the intervention must reduce unemployment and not produce other effects, such as increased inflation or undesirable impacts on the regulated markets, that cause harms that outweigh the employment benefits.

The issues have been major concerns in economics for nearly seven decades. All of the key questions remain unresolved and indeed often not even clearly raised. The characteristics, causes, and cures of economic instability and how best to analyze them are all bitterly debated. A growing stress on theoretic prowess may have caused analysts inadequately to consider the empirical relevance of the theories. At least three issues arise about macroeconomics. The first is what comprises the theoretically sound models of instability. The second is which of these models best explains reality. The issue about theory choice stressed here is whether market imperfections are the primary causes of economic instability. It must be shown that the theoretically possible alternative mechanism prevails in practice.

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

5. Viewpoints  

The combination of possible viewpoints produces a mass of alternative positions about problems, solutions, and the best ways to analyze them. Even without considering the many variant positions on how to analyze the issues, at least five policy postures can be delineated. Several different ways exist to reach each of the policy outlooks. Given the underlying complexity, the categories are devised as epitomes to make the discussion manageable. (The classification initially was designed to recognize distinctions made by Kelman 1993 and overcome their drawbacks, particularly his failing to distinguish between the two radically different branches of new classical economics.) The classification is among traditional Keynesians, microinterventionists, deregulators, microkibbitzers (or Kennedy Keynesians), and skeptics about intervention.

To examine alternative routes to these policy postures, the valuable ambitious survey by Snowdon, Vane, and Wynarczk (1994) distinguishes among classical Keynesians, new Keynesians, Post-Keynesians, monetarists, market clearing classicists, real business cycle advocates, and Austrians. As discussed below, the last four each develop somewhat different cases against active stabilization policy.

The position associated here with Keynesians, as noted, is that active monetary and fiscal policy is effective and preferable as an anti-unemployment tool. This certainly is the classical Keynesian position, and a large part of new Keynesian 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 of active stabilization involves support of many different specific practices. What is feasible is ill-discussed. The present treatment stresses the problems of any forms of activism and does not examine exactly what might be feasible. For reasons discussed below, labeling these views Keynesian is common but not necessarily universal.

The microinterventionists and deregulators believe that better government supervision of individual firms throughout the economy can contribute to reducing unemployment or at least allow the reduction to occur with less inflation than if only monetary and fiscal policy are used. Microinteventionists believe that unemployment is a serious problem originating from inherent market frictions and most appropriately cured by increasing regulation of individual markets. Deregulators, who tend to doubt the severity of economic instability, see government as creating the critical barriers to good performance and want to decrease regulation.

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

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

At least two episodes arose in the United States. They were inspired largely by the persistent problems of taming inflation generated by the Korean and Viet Nam wars. Towards the end of the Eisenhower presidency, much discussion arose of cost inflation. The Kennedy administration devised a response, but it was the alternative option discussed next. The Nixon administration was enduring inflationary problems reflecting lingering effects of the Viet Nam War and then was hit with the 1973-74 oil price shocks. The administration adopted first a set of general price controls and then initiated what proved an extended concentration on regulating energy for many reasons including alleged macroeconomic benefits. The much explored energy experience (see Bradley's massive 1995 effort to sum up the experience) illustrated the severe microeconomic problems that can arise.

Many of those involved during the 1980s in developing more acceptable theories of how rigidities cause economic instability are cautious about making policy suggestions. The point is made in the editors' introduction to Mankiw and Romer's anthology of U.S. writings developing such models. One author in Mankiw and Romer (Bryant, v. 2, p. 28) notes "almost anything can be modeled as optimizing behavior." The Winter 1993 issue of the Journal of Economic Perspectives had a symposium on the work in which the developers??-D. Romer, Greenwald and Stiglitz, a leading old Keynesian-Tobin, and a new classical economists-King all express reservations about the empirical relevance of the theories. Gordon, Robert J. (1990), "What is New-Keynesian Economics?, " 28 Journal of Economic Literature, (September) 1125-1171.

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Note to Professor Gordon:

The following publications are cited in the text, but were several citations in the bibliography.

Lucas, Robert (2x 1972)

Lucas, Robert (2x 1988)

Harberler (which year?)

Fischer (which year ?)

Please pay attention to the "???" in the text

Copyright 1996-98 Richard L. Gordon