Political folklore has it that economists are infamously divided between Keynesian and classical explanations for the cause of the boom-and-bust cycle.
Of course, actual research into the economy just does not work that way. Still, a rough appreciation of these competing models is helpful in understanding the big problems in economic policy.
The classical economists and their co-intellectuals, the Austrians, understand recessions to be caused by real events, such as a huge spike in energy costs. They also argue that the bursting of an asset bubble caused by too much easy money or monetary stimulus can lead to a recession.
Keynesians believe that recessions are caused by a drop in demand for goods and services, precipitated by a shock to the economy that allows mistakes made by households and firms to ratchet down economic activity. This shock could also be an energy-price spike or the bursting of an asset bubble.
The first group would argue that recessions are a necessary response to such an event, while Keynesians believe government can largely plug the gap and mitigate the associated unpleasantness.
These two views represent only a minor disagreement among economists. For example, in an 800-equation model of the U.S. economy, one need modify only half a dozen equations to change the result. This results in huge policy differences, from austerity to stimulus.
So, with so much policy riding on modest differences in economic theory, studies that evaluate the actual data are critical. The challenge here is that we have few recessions to examine.
All of this is important in the backdrop of Ben Bernanke’s recent announcement that the Federal Reserve will soon end its stimulus policies. As many readers doubtless know, a vicious argument between continued stimulus (the Keynesian argument) and austerity (the classicalist argument) has raged these past two or three years. Many economists, including me, have argued that the benefits of stimulus have become trivial compared with its costs.
With the Fed ending its stimulus, that argument seems to have won, but that does not signal wholly good news.
Mortgage rates are rising, as are bond yields. Both signal inflationary potential, but may also be part of an improving outlook for housing and financial markets.
Either way, the Fed feels it is time to ease back monetary stimulus. The problem remains that labor markets are performing disastrously. Current job creation rates won’t get the United States back to full employment until sometime in the next decade.
Good times are not around the corner.•
Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at firstname.lastname@example.org.