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Freeman Essay #136: “A Review of Roger Farmer’s ‘How the Economy Works'”

In the August 2011 Freeman I reviewed Roger Farmer’s How the Economy Works.  My review is beneath the fold.

This book is slim. It’s also well written, which is always a pleasant surprise when the author is an academic economist. But don’t let the concision and breezy style fool you. UCLA economics professor Roger Farmer offers a big idea that he’s convinced will reduce both the frequency and size of economic booms and busts.

Unfortunately Farmer’s idea is as bad as it is big—and it’s very big. Central to his idea is his notion that investor “confidence” is an economic “fundamental”—along with factors such as tax rates, supplies of magnesium, and the prospect of war in the Middle East. If confidence is too high people try to live beyond their means, causing prices to rise. If confidence is too low people spend too little, causing aggregate demand and employment to fall. Being a fundamental, confidence can be at any level, regardless of the state of other fundamentals. So the economy needs some means of managing confidence lest it get stuck at a level that is economically destructive—and Farmer wants central banks to do this.

More specifically, Farmer believes investor confidence is most powerfully affected by equity prices: The higher equity prices are (as reflected in the price of a stock index) the higher confidence is. So a central bank can manage investor confidence by targeting the price of an all-inclusive index of the shares of the nation’s corporations. The immediate goal of active buying and selling by the central bank would be stabilizing average equity prices. By keeping investor confidence from sinking to dangerous lows or soaring to dangerous highs, the central bank would ensure stability.

Sounds simple, but Farmer accepts too much conventional wisdom about macroeconomic history in general and the Great Depression in particular to trust his analysis and prescription.

For example, he asserts that U.S. “banks were often subject to panics” because they “made illiquid loans [and therefore] typically had much less cash on hand than they needed to meet their liabilities in the form of deposits.” Farmer seems unaware that restrictions on branch banking in the United States prevented banks from adequately diversifying their portfolios, making them more subject to runs. So one historical illustration Farmer offers for why a loss of confidence can spread like a contagious disease is poorly grounded.

Farmer also ignores two other important streams of research that cast doubts on his analysis. The first is Robert Higgs’s work on “regime uncertainty.” Higgs marshals a great deal of evidence that during the 1930s Franklin Roosevelt and his New Dealers scared away private investors by creating economy-wide uncertainty. The length of the Great Depression was indeed the result of a loss of confidence, but it had nothing to do with animal spirits or market imperfections that prevent job seekers from matching up smoothly with employers; it had everything to do with unprecedented enterprise- and investment-killing government intrusions into the economy.

The second line of research I’ll describe broadly as “market-process macroeconomics.” This research includes the Austrian theory of the business cycle and the monetary-disequilibrium theory favored by my former teacher Leland Yeager, as well as what EconLog blogger Arnold Kling calls the “recalculation” theory. Although these three accounts of economy-wide fluctuations differ from each other, they all look beyond conventional aggregates (such as aggregate demand) and focus instead on the incentives and constraints that confront individuals, households, and firms.

Had Farmer absorbed the lessons of this scholarship, he might have been less eager to propose such a radical expansion of central-bank power.

This brief review affords too little space even to list the many problems infecting Farmer’s proposal—a sampling must suffice. Why should the central bank focus on the value of corporate equity rather than, say, on the value of other assets, such as real estate? Also, given widespread daily reporting of stock indexes, such as the Dow Jones Industrials, it’s likely that central banks would be pressured by politicians to manipulate such indexes for electoral purposes—even when those purposes run counter to the well-being of the economy.

Most importantly, if government enacts destructive legislation that changes real fundamentals in ways that drastically reduce the value of corporate equities, even a depoliticized central bank is unlikely to allow the target value of its stock index to fall by enough to reflect this unwise change in tax or regulatory policy.

While I hope Farmer’s proposal goes no further than the pages of his book, I nevertheless recommend it to readers seeking a clear overview of the development of mainstream macroeconomic thinking during the past century. In that, Farmer excels. As for policy, he fails—big time.