There's A Massive Tug-O-War Happening In Economics, And With Every Datapoint One Side Is Claiming Victory

Flickr/Dimo DimovThere’s a huge debate happening in the world of economics.

The debate is between the traditional Keynesians on one side (and their cousins the MMTers) and the Market Monetarists.

The Keynesians argue that the primary lever the government is able to pull right now, to rescue the economy is on the fiscal side. They argue that more spending is needed to juice the economy, and that too much budget cutting will inevitably tank the economy.

The Market Monetarists, who draw on the work of Milton Friedman, argue that the power all lies with the Fed. So long as the Fed adopts a framework for aggressively easing in the teeth of weakness, everything is OK. The primary advocates of this school of thinking are folks like Scott Sumner and David Beckworth, economists who advocate that the Fed adopt a Nominal GDP target.

Recent developments have set the two sides up perfectly.

In late 2012, the Fed adopted what’s known as an “Evans Rule” that commits to low rates until employment gets much lower. At the same time, Washington DC started to raise taxes and cut spending (the sequester).

So we have our perfect laboratory.

The Fed is easing. The government is cutting.

If the Fed is all-powerful, it should be able to counteract the sequester.

If what matters is fiscal policy, then the government cutting should prove seriously problematic.

With every datapoint, the two sides go back and forth.

Just at the end of April, Mike Konczal writing at Wonkblog declared the Keynesians the winner, saying it was clear that the economy was slowing and that inflation expectations were falling:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

Then yesterday, economist David Beckworth declares that the monetarists are winning.

It almost seems unfair, as if the evidence is biased toward Market Monetarist’s views. First it was the better-than-expected employment report last week and now it is the forecast-beating retail sales report. These developments should not be happening, especially now with sequestration, if the fiscal multiplier were large. But they are happening and underscore the case that the monetary policy can offset the drag of fiscal austerity.

This latest evidence for the Sumner Critique–the understanding that fiscal multiplier will be effectively zero when the central bank is stabilizing aggregate demand–should not be surprising since the Fed has been offsetting structural austerity since 2010, a fact lost on many Keynesian-minded folks. This post-2010 period is one of the great macroeconomic natural experiments now unfolding, pitting U.S. monetary policy against U.S. fiscal policy.

And then of course, just when it looks like things are going better, we get an ugly new York Fed manufacturing report.

The debate continues.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.