Econintersect: Two economics professors have looked at recent personnel changes at the Federal Reserve Bank of Minneapolis and see the reflection of a sea change in economic thinking. In their view the firing of two economists in Minnesota appears to reflect a new shift in economic thinking. The two authors of an article in Quartz are Miles Kimball (Universoty of Michigan) and Noah Smith (State University of New York at Stony Brook).
Kimball and Smith see a shift toward Saltwater and away from a Freshwater approach to economic theory. The two terms refer to two schools of economic thought that developed to represent two substantially different approaches to economic thinking during the 1970s.
The Freshwater school was so named because its adherents were more prevalent in the U.S. interior while the Saltwater school had a greater following on the two American coasts.
The thinking of the Freshwater school focused on “rational expectations” and strongly argued that markets and economic agents were rational and that disruptions occurred only because of rapid changes arising from such things as new technology. Such disruptions were viewed as healthy and recessions were a healthy and necessary readjustment to new realities.
Editor’s note: The adjustment of an economy through the mechanism of recession is similar to the older Austrian School view of the business cycle where recessions were viewed as a necessary mechanism to correct for “malinvestments” made during the expansionary phase of the cycle.
From the Kimball and Smith article:
They [Freshwater economists] believed that people are very, very smart and sensible in their economic decisions. Taken to its logical extreme, the idea of economic rationality led the Nobel-winning Freshwater pioneer Edward Prescott to argue that recessions are not economic failures, but instead are inevitable, healthy outcomes of economies responding to the uneven pace of technological progress. In other words, Prescott and the economists who followed his lead said that the government shouldn’t try to fight recessions.
If the Fed prints money to try to stimulate demand, they say, it will only succeed in creating inflation rather than reviving the economy. And given this view of rationality, Freshwater macroeconomics often pushes the idea that the government should keep its hands off the economy in other policy domains as well.
Prescott and his fellow-travelers established a bastion for this apotheosis of Freshwater macroeconomics at the University of Minnesota and the Minneapolis Fed. Patrick Kehoe carries that torch, being one of the greatest of the Freshwater macroeconomists to follow the founding generation, and one of the most extreme in his views.
Patrick Kehoe was fired last week by the Minneapolis Fed, as was his frequent co-author, Ellen McGrattan.
The Freshwater school gained an upper hand in economic influence during the 1980s as their policies seemed validated by the Paul Volcker monetary policy of using very high interest rates to break the back of the inflation that developed in the 1970s. They were further strengthened by the apparent success of supply side economics which de-emphasized the importance of demand in driving economic expansion and focused instead on the expansion of supply by creating advantages for capital to be allocated more freely with reduced inhibition from higher taxes and government regulation.
As Kimball and Smith explain, the Saltwater economists staged a modest comeback to gain at least part of the debate stage:
The Freshwater school gained enormous clout in the ’80s. But in the ’90s, there was a counterattack from the coast. The Saltwater macroeconomists believed that recessions were economic failures, and that monetary policy was important in fighting them. Led by Michael Woodford, they adopted the tools and language of the Freshwater economists, and managed to convince many of their Freshwater brethren to reluctantly agree that monetary policy can, in fact, boost the economy. But one bastion of hard-line freshwater thinking held firm: “Minnesota macro.” The researchers at the University of Minnesota and the Minneapolis Fed have largely hung onto the belief that monetary policy can affect inflation, but can’t fight recessions.
Well, Kehoe and McGrattan are still tenured professors at the University of Minnesota, but they are no longer with the Minneapolis Fed. So the bastion referred to by Kimball and Smith has now withdrawn to the “Keep”, to use a term from “The Lord of the Rings”.
Kimball and Smith (KS) ask what has caused the Minneapolis Fed and its chairman Narayana Kocherlakota (with backing of the bank’s board) to remove the two economists? After all Kocherlakota has long been a Saltwater guy.
KS say it is the failure of QE to make much headway in strengthening the economy. The QE experiment has been a $4 trillion (so far) supply side experiment, pushing money into the reserve accounts of the banks who are the suppliers of money and credit to the economy. But there has been no demand for that money; it remains on the books as excess reserves. That has been the factor that has caused Kocherlakota to change his thinking away from a supply side mindset.
What is the KS conclusion? The two authors, both with professed Freshwater sympathies, think the shake-up may be a good thing:
…speculating on the reasons for what ultimately might boil down to simple personality conflicts is not our purpose here. Nor do we seek to offer any judgment on Kocherlakota’s personnel decision, which could have far-reaching impacts on the relationship between central banks and universities and the type of employment contracts offered by Fed banks. Instead, we want to highlight the tectonic shifts in economics itself. From that perspective, the shakeup may turn out to be part of the understandable rebalancing of macroeconomics in the Saltwater direction, as economists try to comprehend the Great Recession and figure out how to avoid an encore.
Econintersect note: We basically endorse the KS conclusion. Why should either Freshwater or Saltwater philosophies be dominant? Perhaps one has greater strength in times of inflationary pressure (times of insufficient supply of needed “things”) and the other has greater strength in times of deflationary pressure (times of insufficient demand). A logical implication is that, if one is not “working” when the other school is (and vice versa), neither deserves dominance and we would be better off if both were left to drown in their own “water tanks”. A more general framework for economic thinking is what is needed.
Sources:
- The shakeup at the Minneapolis Fed is a battle for the soul of macroeconomics-again (Miles Kimball and Noah Smith, Quartz, 25 November 2013)
- Minneapolis Fed Board Backs Kocherlakota After Economists Ousted (Aki Ito, Bloomberg, 21 November 2013)
- Saltwater and freshwater economics (Wikipedia)
