Professor Roger Farmer discusses the cost to society of financial instability and how economics can help to improve people’s lives

The International Journal of Economic Theory issued a Festschrift in honour of Warwick Professor Roger E.A. Farmer this year. The Festschrift reviews and pays tribute to Roger’s ideas, his career and his intellectual legacy up to the present time.

What research projects are you currently involved with?

I have three or four projects in play at the moment. Some of these projects are theoretical in nature. Some of them are empirical. All of them are related to a theme that I call the indeterminacy agenda in macroeconomics.

Economists have long argued that business cycles are driven by shocks to the productivity of labour and capital. The models they developed have no room for the independent views of market participants to influence outcomes. In contrast, the indeterminacy agenda uses multiple-equilibrium models to integrate economics with psychology and, according to this agenda, the self-fulfilling beliefs of financial market participants are additional fundamental factors that drive periods of prosperity and depression.

Some of my theoretical work in this vein studies inefficiencies that are apparent in asset markets. Some of my empirical work in this vein involves an explanation for the disappearance of the Phillips Curve, a relationship that is supposed to characterise the connection between inflation and unemployment.

Let me begin with my work on asset markets, (Farmer 2018). Financial economists ask if the asset markets are efficient. The answer is yes – and the answer is no. The reason it’s yes and no is because economists define efficiency in different ways.

The Nobel Prize in 2013 was won by three economists working on the theory of financial markets. Two of these economists, Gene Fama and Robert Shiller put forward conflicting theories of market efficiency. Gene Fama was awarded the Nobel Prize for saying that financial markets are efficient, and Robert Shiller was awarded the Nobel Prize for saying that financial markets are not efficient. Fama defined efficiency to mean that you can’t make money in the financial markets – he called that informational efficiency. Shiller meant that it’s not possible for there to be an intervention by government that would make everybody better off. That second concept is called Pareto efficiency after the Italian social scientist Vilfredo Pareto.

In my view, the financial markets are probably informationally efficient: they are not Pareto-efficient. And that means that there are government interventions that can improve the welfare of all of us. My research explains how that can be.

My explanation is that when you trade in the financial markets, you’re not just trading with other people who are alive today. Almost all of the people who will buy or sell the assets that you’re buying or selling now are not yet born. In my book Prosperity for All I call that idea the ‘absence of pre-natal financial contracts.’ The fact that we cannot trade with those who are not yet born opens the door for Pareto inefficiencies. I’ve just written a piece that’s related to this idea for Project Syndicate where I suggest that national treasuries could exploit Pareto inefficiencies to raise revenue. Importantly, these revenues could pay for social care programmes, such as the NHS and pensions, without raising taxes.

My empirical work related to indeterminacy is on the relationship between unemployment and inflation. Here, I have shown that the indeterminacy agenda provides an explanation for a puzzle that has been perplexing central bankers in developed economies for more than a decade. According to New-Keynesian economics (this is the theory that guides policy at the Bank of England and at other central banks around the world), the fact that unemployment is currently at all-time lows should be causing a resurgence of inflation. But inflation has stubbornly refused to appear. In a 2011 paper (Farmer 2011), I developed the Farmer Monetary Model, a theory of inflation based on the indeterminacy agenda. In a series of papers with co-authors and graduate students (Farmer and Plotnikov 2018, Farmer and Nicolò 2018, 2019) we show that the Farmer Monetary Model provides a better fit to the data and a better understanding of the relationship between inflation and GDP growth than the conventional New-Keynesian model currently in use at the Bank of England.

What interested you about this area of research?

For forty years, macroeconomics has been dominated by a battle between classical ideas emanating from the universities of Minnesota and Chicago, and New Keynesian ideas, emanating from MIT. In the past decade or so, MIT has been dominant, and MIT trained economists have promoted an agenda that evolved out of an interpretation of Keynes developed by the MIT economist Paul Samuelson. According to this interpretation, the economy is Keynesian in the short run, when prices are sticky, and classical in the long-run, when all prices have had time to adjust. The MIT machine steamrollered over all opposition and became the dominant interpretation of Keynesian economics.

A parallel, but very different, macroeconomic agenda developed in the 1980s at the University of Pennsylvania. This is where I began my career. According to this alternative agenda, the economy is typically characterised by multiple equilibria and, as a consequence, economic fundamentals alone cannot explain the macroeconomy. We must also introduce psychology. This is what I did in my book The Macroeconomics of Self-Fulfilling Prophecies, which is still used today by graduate students around the world. I have been working on the idea that psychology matters for economics ever since, and I have shown that the indeterminacy agenda can explain most of the anomalies that Keynes sought to understand in a much more parsimonious way than the MIT New-Keynesian approach pioneered by Samuelson.

What I learned from my days at Penn, was that models of multiple equilibria, when combined with relatively minor adaptations of standard microeconomic theory, have a great deal of explanatory power. I have used the tools I learned at Penn to understand why prices appear sticky and why monetary policy is so powerful in influencing unemployment and real economic activity. I have also pushed the Penn school beyond its original bounds by showing how the indeterminacy agenda can explain involuntary unemployment and the stagnation that characterises great depressions.

What interested you about this area of research?

The economy is a complex evolving set of interlocking institutions and anyone who attempts to understand those institutions should probably begin from a place of humility. I nevertheless believe that economics as a tool has had some notable successes in helping to improve people’s lives.

Consider the theory and practice of central banking as it evolved in the United States. The Federal Reserve System was created in 1913, and at the time, the idea that a central bank should intervene in the financial markets by setting a price was considered to be radical. The Fed has not always been perfect in the way that it has managed the economy, and it has made a number of mistakes. But the history of the Fed is one of learning how to implement policies that are an improvement, in my view, over the unmanaged monetary system that preceded its creation.

Since the Great Depression, beginning with the intervention in macroeconomics that followed Keynes’ General Theory, we’ve been a lot more successful at managing economic fluctuations and at keeping inflation under control, than we were in the 18th and 19th centuries. There have been fewer recessions and the ones that have occurred, with the exception of the Great Depression, have been smaller in magnitude. That is a consequence – in my view – of good policy.

It doesn’t mean we don’t make mistakes – we do – and sometimes they are big mistakes. But there’s a steady improvement as we learn more about the way the economy works. Consider, for example, the experience of inflation targeting, which was first formally adopted by the Reserve Bank of New Zealand in 1990. Informally, it began shortly after Paul Volcker’s accession as Chairman of the Fed in 1979. The period, from 1979 to 2007, was one of relative stability as countries throughout the developed world brought inflation down from double digits in the 1970s to the low single digits where it has been for a couple of decades. In 2007 we hit an unexpected road bump, as the policy that had been used to control recessions was ineffective as the interest rate hit zero and could be lowered no further. We have learnt from that bump that central banks need a second way of intervening to prevent recessions over and above the policy of moving around a short-term interest rate. My theoretical and empirical work explains what that second policy should be and why we need it.

In my book Prosperity for All I argued that financial instability is a major cause of the mass human misery that we experience during big recessions. Many voices are arguing for governments to spend more to get out of a recession. I disagree. Although fiscal expansion might work in the short-run, it is slow to act. In my recent books, academic papers and op eds, I argue that there is an alternative more effective policy. The Bank of England should actively intervene to stabilize the financial markets.

Under a regime of inflation targeting, central banks are charged with moving around interest rates. Some central banks, the ECB is an example, have a single target: to stabilise inflation. Other central banks, the Bank of England and the Fed are examples, are charged with hitting a secondary target: to maintain real economic stability and high employment. We have known for a long time that a policy maker who wishes to hit two targets needs two instruments. One is not enough. The momentum and time is right to adopt a new tool.

It has often been argued that the second instrument should be fiscal policy; that is, expanding government expenditure or changing tax rates when a recession hits. The problem with that advice is that fiscal policy is a slow and clumsy instrument. In my view, it would be more effective to use interest rate policy to target inflation and to use active management of the financial markets to control unemployment.

A lot of the arguments I’ve been making for the past thirty-five years have begun to find their way into the public consciousness and into the current economic narrative of journalists, politicians and economists alike. Will we actually move to the full extent of managing the equity markets in the sense of targeting a return to equity? My guess is that it will take another major recession before that idea becomes accepted. And make no mistake, there will be another major recession: the only uncertainty is when it will occur.

Why did you decide to become an economist?

I stumbled into economics through having good teachers - I started out studying econometrics at the University of Manchester. I moved to Canada following Michael Parkin and David Laidler, two of my teachers at Manchester who moved to the University of Western Ontario (UWO) in the late 1970s. They encouraged me to follow them and they offered me a fellowship to study with them in Canada. When I arrived, I found that UWO had a stronger group in macroeconomics than in econometrics and I switched fields. I have never looked back.

Why did you join the Economics department at Warwick?

Like many people before me, I left the UK for the excitement of a foreign country. But I always intended to return. My plans changed once I had a son who grew up in California and I discovered that, once you put down roots, it’s harder to leave.

Now my son is grown up and is an economist in his own right and I have fulfilled my dream of returning to the UK. I am actively contributing to the public debate with the goal of influencing economic policy for the better.

Warwick has always had a strong connection with the Bank of England and with policy-making in Westminster. It’s an extremely strong and vibrant department. And it’s a place where there is scope for interacting with very smart graduate students, sharing my perspective on macroeconomics, and influencing how students think about the world.

Further Reading:

• Roger Farmer and Platonov, Konstantin, Animal spirits in a monetary model. European Economic Review, 2019, 115. pp. 60-77.
• Roger Farmer and Giovanni Nicolò, Some International Evidence for Keynesian Economics Without the Phillips Curve, The Manchester School (In Press).