Macroeconomics: Adjusting the Big Picture

Three experts weigh in on how to better handle, and even avoid, the next global financial crisis

Is macroeconomics worthless? Far from it. Here are three economists trying to draw lessons from the global economic crisis so the world does a better job of keeping growth on track next time.

Hyun Song Shin, 49, Princeton UniversityBig Idea: The Federal Reserve should pop credit bubbles early by raising interest rates.The financial crisis arose, in large part, because companies and households borrowed too much. Shin faults macroeconomists for developing models that didn't allow for the possibility of risks such as a bubble in lending or a deterioration of credit standards. "Over the past 10 years our mainstream colleagues in macroeconomics have somewhat neglected finance," he says.

The economists at the Federal Reserve, too, weren't looking at the right problems, says Shin: "These things crept up behind the backs of the central bankers. It was a blind spot."

Shin says the Fed should nudge rates up when credit is expanding rapidly. He's looking for data that give hints of trouble, such as heavy secured borrowing by financial firms. Creating better models of the economy is "not easy, but I think it's too defeatist to say it's impossible," says Shin.

Roger E.A. Farmer, 54, University of California at Los AngelesBig Idea: The Fed should make large-scale purchases of equities to restore investor confidence and get the economy back on track.Farmer thinks Fed stock purchases would be more effective than the Obama Administration's deficit spending. He frets that if the government puts more money in the public's pockets via increased spending or tax cuts, people won't spend it as long as they feel poor because of stock market losses.

The answer, in Farmer's view, is for the Fed to set a target for how high it wants the stock market to be by a certain date, then commit to buying enough shares (through broad-based index funds) to hit that target. Higher stock prices will make people feel wealthier and spend more, creating prosperity. Symmetrically, he would have the Fed sell to hold down prices in boom times.

Similar ideas have been tried before in Hong Kong, Taiwan, and Japan. They've had mixed results but are credited with helping to rescue Hong Kong from the Asian financial crisis in 1998. "I get a lot of interest from other economists," he says, "but it takes a long while for new ideas to spread."

Thomas Sargent, 65, New York University and Hoover InstitutionBig Idea: The economy is volatile, in part, because households and businesses hold "fragile beliefs" that shift quickly.In the 1970s, Sargent was one of the thinkers behind "rational expectations," which says that ordinary people can correctly anticipate the range and likelihood of possible future outcomes.

Sargent now says that theory was an oversimplification. In real life, he explains, households and businesses are highly uncertain. Developments such as an unexpected government action or a major company going bust can cause people to drastically revise their beliefs about what might happen next.

The good news: Beliefs may shift back again through unexpected positive events. Sargent is not willing to say how that might happen, but he notes that in the early 1980s the Federal Reserve was able to lower the public's expectations about long-term inflation. That, in turn, caused actual inflation to fall, ending a period of stagflation.

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