Ezra Klein apparently asks for the difference between the models that Krugman and Delong use and the models that their opponents use.

So first there are some different Schools out there. I’ll give a rough and ready estimate of what I think they are.

Real Business Cycle

I think there are still some people who essentially believe that Real Business Cycles are correct. I assume Casey Mulligan is in this camp. I think Cochrane and Fama are implicitly in this camp though I don’t know if they have stated as much.

In this world markets always clear, government spending must reduce private spending and running up the deficit always leads to lower investment and growth.

For these guys recessions represent people for various reasons deciding not to work. It might be a productivity shock. It might be government disincentives.

If you want a nice little nerd rundown you can check this out:

http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc.pdf

Recalculation

There are some people, I am thinking Arnold Kling here, who believe in what I might call a neo-Austrian view. I don’t think there are any formal models here and I might be mistaken but I think many in this camp eschew formal models. What there is, is a basic sense that markets work as an evolutionary process.

Within that process transitional pains are to be expected and recessions are just a big version of that.  Arnold is currently the most vocal intellectual in this School but if you had to nail down what the Peter Schiffs of the world are thinking, its probably closest to something like Recalculation.

If anyone says that the government caused a bunch of people to buy houses they couldn’t afford and now we are working through the pains of that, they are effectively a Recalculationist.

In summary, for these guys recessions are caused by mistakes which take time to be corrected. There is no treatise as such but you can try:

http://bit.ly/93uTMM

Mismatch

There are some people who think that the problem is matching the right workers with the right jobs. Kocherlakota and Stephen Williams are in this camp.

For them a recession is basically a giant shift in priorities. What makes them different from recalculationist is that there need be no “mistake.”

There might have been mistakes but that’s not the key. The key is that the economy is shifting. Some will say that the recession is just an inflection point in a long trend. Some will cite the housing bubble but not make a big deal out of it being an error, just that priorities have changed.

For the super nerd version check out

http://home.uchicago.edu/~shimer/wp/mismatch-print.pdf

New Keynesians

Then there is basically everyone else who is some version of a New Keynesian. This literature is much bigger than I am but the bedtime story that we are told in graduate school is that the modern models began with this guy. You might have heard of him.

http://www.economics.harvard.edu/files/faculty/40_Small_Menu_Costs.pdf

For these guys recessions are about an excess demand for some type of financial instrument.

Some people see it as explicitly bonds. This means everyone is trying to save at the same time but this is impossible.

Some people see it as explicitly money. This means everyone is trying to build up cash reserves at the same time but this is impossible.

Some people see it as explicitly high credit instruments. This means everyone is trying to run away from risky investments at the same time but this leads to a cascade that makes moderately risky investments very risky, which in turn makes mildly risky investments very risky and so forth.

I tend to think that all three work together as an agglomeration because of a host of transaction cost and principle-agent problems. But that is beyond the scope of this post.

For the most part the central issue in this line of thinking is: how can swapping around financial instruments which are in some sense just pieces of paper have these huge effects on the real economy? For this to work the connection between the real economy and the financial economy has got to be sticky in some way. The bedtime story is that Greg offered one of the first consistent reasons why.

By and large most economists are working with some type of New Keynesian model. The difference is the focus or the details. In terms of policy, however, I think political economy concerns dominate.

My thoughts tend this way: look this all about money (or bonds or credit) and so the focus of everything is the Fed.

I was a stimulus skeptic. I could see the reasoning but I thought it better to focus all of our attention on monetary policy. I also suggested then and now that if fiscal stimulus must be done, that it should consist entirely of tax cuts or increases in direct assistance to the poor.

However, this was for political economy reasons. Not model reasons. If someone asked whether I thought GDP was higher or lower as a result of the Obama stimulus, I would answer: higher.

On the other hand, Brad and Paul like to focus on spending. I suspect this is in no small part because they think government spending is too low anyway. Why not kill two birds with one stone: build some roads and get some jobs.

A lot of the spending guys like to focus on the higher multiplier of spending when compared to tax cuts. I think this is to some extent a red-herring. We get more bang for the buck with spending but we can also move more bucks with tax cuts. For example, a complete payroll tax holiday in 2009 would have resulted in something like 900B in stimulus in a single year.   With ARRA I think we got something like 300B and even then much of that was from the tax cut portion. Spending money just takes time.

At the end of the day, your choice of New Keynesian instruments: monetary policy, government spending or tax cuts depends mostly on political economy concerns. That is, your view of the fundamental relationship between the government and the economy.

Additional Readings: Two simple but powerful pieces that are worth reading in my mind.

Barro’s Critique of all things Keynesian:

http://www.sjes.ch/papers/1989-III-7.pdf

Mankiw’s Defense of the Basic Keynesian Observation:

http://www.economics.harvard.edu/files/faculty/40_royalpap.pdf

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