Shortly after the financial crisis in 2008, many economists had to rethink their approach to the market. Everyone knew we had a panic because the stock market and the housing market collapsed. American economy was reaching to the bottom. Many people considered it as a second worst recession after the great the Great Depression. But what was the cause? Who were responsible for the crisis? What can we learn from this turmoil? In the recent New York Times Sunday magazine article, Nobel Prize winner Paul Krugman offered his explanation for the causes and insight toward fixing the economy.
In the article, Krugman addresses several problems underlying the recent state of the economy. He traces the cause for our recession all the way back to academia. The problem is rather subtle. He argues that faulty thinking about the market is the primary reason that has led to the 2008 and 2009 recession. The crisis has evoked the two schools of macroeconomics thought for long have stayed dormant: the “freshwater” and the “saltwater” economist. Both have their own ideology in resolving the crisis.
As Krugman put it “freshwater economists are, essentially, neoclassical purists.” They assume that people are rational and markets work. They do recognize the use of Keynesian theory but just do not trust the government interference. Therefore, they usually prefer monetary policy over fiscal policy. On the other hand, Krugman says that “saltwater economists are pragmatists.” Their approach is to do apply any methods that can keep the economy running smoothly whether it’s a fiscal or monetary policy. They usually favor Keynesian theory.
Freshwater economists base their practices on the perfect market. They trust that the market system will not ever fail, but as we all know the financial market did fail in 2008. The government had to step in to bail out the system. Freshwater economists rely on the models that they have used for a long time to predict the markets’ performance. They want the markets to operate on their own. They think that government intervention will make it worse.
Consider an economy in the long run and the effects of fiscal policy. When the government alters its spending, they will directly affect the economy’s performance. Freshwater economists usually don’t buy into the notion of government purchases. When the government increases their purchase by a certain amount, it will increase the demand for goods and services. According to the equation of supply and demand for the economy’s output, disposable income and consumption are unchanged. Total output is constrained by the factors of production. An increase in government spending must be balanced out by other variable. In this scenario, it is investment. It must decrease with an equal amount. Investment decreases because interest rate rises (Mankiw, pg. 69). Most economists would agree that government purchases would lead to a reduction in national saving and hence raising the interest rate.