Sharp tests of economic theories are rare and hard to find, particularly in macroeconomics. Any examination of particular episodes in economic history necessarily involves counterfactuals, and these provide room for endless dispute. As an obvious example, assessing the impact of the Obama Administration’s 2009 stimulus requires an estimate of how things would have gone without the stimulus, and that is obviously hard to do.
Similarly, arguments about unemployment in the US get bogged down in disputes over whether it is structural or demand-driven and the extent to which policies such as the extension of unemployment benefits to 99 weeks have contributed.
There is, though, one way in which the current Great Recession/Lesser Depression provides a sharp test of a critical proposition in economics. All forms of classical economics involve, in one form or another, the claim that the causes of unemployment are to be found in labour markets, and not in macroeconomic variables such as the level of aggregate demand. That’s equally true of the Say’s Law version of classical economics criticized by Keynes, the New Classical macroeconomics of Robert Lucas and the attempts by Real Business Cycle theorists like Kydland and Prescott to explain cyclical fluctuations in terms of labor market shocks.
The crucial problem for all these theories is that labor markets and the associated institutions operate mainly at the national level. Even within the EU, different countries have very different labor markets. So, it is essentially impossible for labor markets in many different countries to move together, except as the result of macroeconomic influences operating at an international level. That means that the occurrence of a sharp and sustained increase in unemployment, taking place in many countries at once, is inconsistent with classical economics.
This point seems trivially obvious, but as far as I can tell hasn’t been made, or at least not clearly. Once it’s conceded, it seems impossible to avoid a view of the world that is basically Keynesian in its analysis of the macroeconomy. It is possible to hold such a view and reject Keynesian policies on pragmatic grounds, as in Friedman’s critique of ‘fine-tuning’. But the longer and deeper the recession the harder it is to sustain this view.
This seems like a good time to plug the fact that a paperback edition of Zombie Economics will be out soon (May 6) with a brand-new chapter on Austerity, bits of which have been seen here. On 9 May, I’ll be launching an Australian edition, where the added material is a chapter on Economic Rationalism. And a week or two ago, I received some copies of the Italian edition
fn1. Of course, you can cheat and label these macro influences “technology shocks”, then assume them to be internationally correlated. But in the ordinary meaning of technology, there is no plausible way in which economies as disparate as, say, the US and Greece can experience a common technology shock.