I was given a manuscript by Oxford University Press, the publisher of Roger Farmer’s How the Economy Works, which was released yesterday. My review, which in the interest of disclosure was of my own volition, is below. Also in the interest of disclosure, I’ve been offered a published copy of the book, but this was not in exchange for a review, positive or otherwise.
Don’t let the ambitious title fool you; Roger Farmer’s new book, How the Economy Works, is actually a targeted policy proposal embedded in an attempted synthesis of Keynesian and new-classical economics. Coming on the heels of the crisis, it might more aptly be called How to Make the Economy Not Not Work. Walking the tightrope between Keynesian and classical, Farmer manages to deal fairly with the basics of each approach. Thus, the first part of the book, which focuses on history of economic thought, exists mainly in the rather limited universe of the mainstream. However, Farmer seeks to do more than just summarize, seeking a “new approach” to go forward from this “third turning point,” the first two being the Depression and the Keynesian collapse in the 70s.
What does he take from the preexisting paradigms? He accepts the basic concept of using classical microfoundations based on rational decisions to scale up to the macroeconomy. From Keynesian economics, he accepts the idea of market failure; as for behavioral economics, which models the “failure” of individual decision-making, Farmer does bother. The methodological underpinnings common to both mainstream approaches remain, as Farmer fundamentally believes in equilibrium analysis as a sound way of probing the economy. Farmer’s primary innovation stems from the principle that demand is determined not by income but by wealth, which along with other fundamentals is determined by confidence. This move is important because it discredits the viability of fiscal policy in a recession.
Don’t think that Farmer is just a standard monetarist, though- he actual promotes a pretty radical idea for stabilizing the economy in rough times. He argues that given the issues with the zero interest rate bound of monetary policy, the Federal Reserve and other central banks should actually target a stock market index. They would do so by creating an index fund, and as part of their policy announcements, prescribe a price path for this fund, whereby they will guarantee the repurchase of shares in this fund at the set prices. The idea is to make stocks a lower-return, lower-risk venture so that it is always safe to invest in them, and thus to facilitate reallocation of funds among succeeding and failing enterprises. This asset price stabilization would ensure confidence and thus employment-generating wealth creation.
Given his proposal, it’s striking that Farmer actually ends the book in a discussion of Hayek. Farmer’s proposal involves such deep intervention in the economy that it would cause Hayek to roll in his grave. Government provision of a price path for stocks is not so different from a price path for wages or for specific commodities. While he claims the middle ground with classical economics by emphasizing the market nature of the actual price determination process. his ideas seem far more Keynesian than classical.
There are many places he doesn’t go in this book. He discusses demand at length and of course refers to fundamentals, arguing that confidence should be considered a fundamental in its determination. Straddling the mainstream Keynesian-classical nexus, Farmer offers no discussion of the distributional roots of demand. Because wealth is a key link in his argument, Farmer attributes the current crisis as a collapse in demand due to a collapse in wealth. However, it’s unclear if restored confidence can square the circle, as many now argue that the wealth was fictitious in the first place. Without the anesthetic of the housing bubble, it’s arguable that our economy would not have supported low unemployment rates through 2006, but instead would have been generally stagnant as the country followed a low growth path.
What then? If we resign ourselves to modest stock price growth, proxying modest economic growth, then we’ll realize that things aren’t as good as they could be, and even in its “steady state,” the economy simply isn’t working. Don’t get me wrong- this would be a huge advance; real economic transformation will only arise when we realize that the steady state of our economy does not offer the job creation we desire or the wealth distribution that many seek. What will it look like? How will we get there? Farmer simply doesn’t go there, and these questions are firmly in the book’s blind spot. The money question- will it work?- remains in doubt.
Nevertheless, I think Farmer’s regulatory proposal has a lot to offer. While financial swings may not be the root cause of the crisis, they have certainly exacerbated it. Allowing the Fed to take a more active role in the path price of the stock market would remove a lot of uncertainty from the economy. It’s certainly dubious that the Fed would ever accept this sort of power- remember that we are only a few years removed from a chairman who was a disciple of Rand and Hayek. Along the same lines, this book is quite useful- it’s a good crash course in the mainstream of economics, and it ends with a bang. One would hope that the discerning reader will not simply leave the details of the economy’s other fundamentals (beyond confidence) to the classicals and new-classicals, as Farmer does.
Farmer demonstrates that thinking outside the box within the mainstream does not have to be constituted solely by behavioral economics or large rstimulus packages, but I would still cautiously consider the book a missed opportunity. Clearly, Farmer has done enough to anger colleagues on both sides of the spectrum (although his obvious personal affection for folks such as Lucas, Prescott, et al. will pardon him from exile). Given that he is willing to do something unique within the existing paradigm, why stop there? Why are mainstream economists unwilling to view distribution as an endogenous determinant of demand? A truly radical rethinking, I would argue, must go there. Farmer doesn’t, but I think his effort can at least push the mainstream a little bit in the right direction.