I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930's were behind us. We knew how to increase demand, and would do it if we needed to.
The orthodox have lost faith in that promise; only the heterodox still believe it. And the heterodox have nothing in common, except for keeping the faith.
The orthodox haven't lost hope. They hope that monetary and fiscal policy will be enough to get us out of this recession, and that the limits on monetary and fiscal policy will not be binding this time around. And they are probably right. But they have lost faith that monetary and/or fiscal policy will always be enough - that there are no limits.
And if the Eurozone too turns Japanese, they may start to lose even that hope.
There are two types of macroeconomist.
The first says "What do you mean you can't increase aggregate demand? You run out of paper? Ink? You scared of inflation?"
The second says "But monetary policy won't work at the zero lower bound. And there are limits on fiscal policy, because we daren't let the national debt get too big."
Scott Sumner and Modern Monetary Theorists are examples of the first type of macroeconomist. They have nothing in common, except that one thing. But that one thing is more important than all their differences. And they are heterodox.
Traditional Keynesians and monetarists, the competing schools of the old orthodoxy, belonged to the first type of macroeconomist. They differed only on tactics. They kept the faith. But they have now gone, and only monetary cranks sing the old religion.
The second type of macroeconomist represents the new orthodoxy. Few orthodox macroeconomists today will admit point-blank to having lost the faith, any more than a bishop, no matter how liberal, will admit to being an atheist. But if you believe that monetary policy is ineffective at the zero bound, and that there are limits to how long you can have a big fiscal deficit, it comes to the same thing. You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.
Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. "If we had better regulation and/or supervision of financial markets and institutions, we wouldn't have gotten into this mess in the first place". That's probably true, but it's also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can't really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith.
Good financial regulation and supervision are important in their own right. A good financial system will better serve the interests of borrowers and lenders. It will create benefits on the supply side. And financial crises will almost certainly cause demand to fall. But just because something causes demand to fall doesn't mean monetary and fiscal policy can't work. The whole point of Keynesian policy was that when (not if) something did cause demand to fall, monetary or fiscal policy could and should be used to increase it back again.
Even suppose the financial system totally collapsed. Why should that prevent monetary and fiscal policy working to increase demand? The biggest flaw of orthodox macroeconomic models is that they have no financial sector. So, if the financial system disappeared, that ought to mean those models would work even better.
This is what I sensed to be the overarching but unspoken theme of a conference at Carleton on the economic and financial crisis. I may do subsequent posts on more specific topics.