Prompted by Mario Draghi’s decisive new tone in his recent comments, welcomed by Charles Wyplosz among others, I pulled off the shelf this morning Ben Bernanke’s Essays on the Great Depression. I was wondering what lessons from the 1920s and 1930s Mr Draghi might have in mind. The book (published in 2000) presents what had become the economics profession’s consensus that the single most important reason for the international propagation of depression was the Gold Standard. A couple of the essays pose the obvious resulting question – why was there no equilibrating real economy response to such a massive and prolonged monetary tightening? – and they present what became the consensus answer – it’s because nominal wages are sticky. But the absence of labour market adjustment and the consequent pro-cyclicality of productivity remained a ‘puzzle’ in macroeconomics for many years.
In fact, this was the subject of my doctoral thesis, at the height of the early 1980s madness of real business cycle theory. I looked at possible equilibrium explanations such as the efficiency wage hypothesis, using industry-level data. All industries turn out to behave completely differently over the course of the business cycle. It was the start of my journey from macroeconomics to micro. Meanwhile, in macroeconomics the ‘new Keynesian’ consensus took sticky nominal wages as a given.
The striking thing, though, about the Bernanke volume from 2000, and quite a lot of the discussion of the macroeconomy now, is that institutional features are largely absent from the macro policy debate. Yet perhaps the single most important lesson of the current crisis for economics is the importance of the institutions of the banking and financial sector. This is the heart of the Minsky critique of conventional models in Stablizing an Unstable Economy. The role of banking was as important in the 1930s too – see for example Benjamin Roth’s The Great Depression: A Diary. The Kay Review and the continuing Libor, money laundering and other banking scandals, are reminders that in addition to the (macro) challenge of preventing further economic slump, there is a big (microeconomic) policy challenge in market reform.
Interestingly, though, both Mr Draghi’s recent comments and Professor Wyplosz’s assessment centre on the structure of the banking sector, so the emerging attempt to stabilize the Eurozone may not be such an institution-free project. Still, the ‘meso’ layer of banking and financial markets also needs careful attention if policy makers are to get the ‘macro’ right.