Rudi Bachmann on German Macroeconomics, Walter Eucken, and Ordoliberalism

Rudi Bachmann is an associate professor of economics at the University of Notre Dame and a research affiliate at the Center for Economic Policy Research. Rudi has published widely on macroeconomic issues in top journals and is an active member of the German Economic Association. He also blogs and writes popular press articles for the German media. Rudi joins David on Macro Musings to discuss the German economic history and how the German approach to macroeconomics is distinctly different from the approach taken in the United States.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Rudi, welcome to the show.

Rudi Bachmann: Thanks so much for having me, it's a great pleasure.

Beckworth: We're glad to have you on. I'm looking forward to our conversation. I ask all macroeconomists who come on the show the same question I'll now ask you, how did you get into macroeconomics?

Bachmann: I know this question, and I was thinking I'm going to have a very different response than anyone else you have had so far.

Beckworth: Okay.

Bachmann: Because the reason is actually a moment, believe it or not.

Beckworth: That's a great story I want to hear.

Bachmann: If you want to hear the story.

Beckworth: Yes.

Bachmann: If I remember, a lot of American economists say they had these great already high school classes in economics and that's how they got inspired. Then they had these great teachers in economics in college and that's how they got into economics. I had none of that, at all. For reasons, which we actually will talk a bit about, economics is not part of the high school curriculum at all in Germany, so I wasn't exposed to economics during high school time. There were nil, basically. The two economic lessons from my somewhat left social science teachers basically were free trade is bad because it exploits the third world, and the government should do deficit spending. That was my economic knowledge going into college.

Bachmann: I didn't major at all in economics first, so I was more of a literary type if you can imagine, I sometimes can't imagine anymore. My main major was actually comparative literature and philosophy and Spanish as a minor. That's how I started out. The first semester undergraduate, unlike in the US, we start with our major right away, that's not so much liberal arts education anymore. After the first semester I was thinking, I was sitting in this comp literature classes thinking this ain't for me. I'm not going to be happy here. This is just mumbo jumbo, I have no idea what these guys are talking about.

Bachmann: At the time, my then girlfriend or my ex-girlfriend, I should say, she was actually studying business administration at a different university. I studied with her for her exams, accounting exams, but also economics exams because they had to take some economics classes. I figured, wow, that's kind of interesting that stuff, social science, but I always was good in math in high school, there's also a lot of math and calculation stuff. I figured that's kind of interesting.

Bachmann: That's basically when I decided I need to shed some of this more humanities type stuff. I kept some of it on, I actually ended up double majoring in philosophy and in economics. That's where I decided I needed to do something else and frankly, she gave the idea and I tried it out and I fell in love. I dis-fell in love with her but I fell in love with economics and it stayed with me ever since.

Bachmann: Then I had good teachers at my undergraduate college in Germany and then obviously going to Yale was basically what sealed the deal then, taking this big step from local university, not very well known in Germany, to the big stage in the United States. That's the story how I got into economics at least. Then macroeconomics, I was always interested more in the big questions and not so much in nitty gritty detail questions.

Beckworth: What was this young lady's name?

Bachmann: Christina.

Beckworth: We can thank Christina for making the world a better place by her influence on you. We now have your research, your work. This is the butterfly effect via economics.

Bachmann: Yes.

German Perspective on Macroeconomics

Beckworth: Okay, it's very interesting. You're now at Notre Dame and you're in the Department of Economics there. One of the interesting things that you've done is you've commented on this approach to macroeconomics, which is the German perspective, the German macroeconomics. You've written some posts on this, you've commented on it, and it's interesting because I think many American observers will sometimes sit back and ask, what is the government of Germany doing? Why aren't they doing things the way that we would prescribe them? Or something I've looked at more closely is the European Central Bank, at least up until Mario Draghi and his QE programs, we thought they were being way to cautious. I think you have some perspective to shed on this. There's a certain perspective that the Germans bring to bear on macroeconomics that's different than the Anglo-American perspective.

Bachmann: Yeah, I think part of it is perception and I think part of it is actually substance. I want to start with the perception. I think as far as in a very narrow sense academic macroeconomics is concerned, that has been largely a transitory phenomenon. It's true that German economics and therefore German macroeconomics was a bit insulated after the World War II essentially, and I'll talk a bit more that maybe a bit later. That's now several decades ago and that I would argue has largely, that gap has largely closed.

Beckworth: Right.

Bachmann: In other words, young German macroeconomists whether they are trained in the United States or trained in Germany, they write essentially the same papers, they use the same methods, they use the same frameworks that US trained economists do, so there is no daylight between the two. They are also successful. These are not provincial, there's a good young macroeconomics tradition in Germany that play the international game and is part frankly, of the international academic conversation in macroeconomics. The question is a bit why aren't these guys apparently more heard in the policy circles? Why isn't German economic policy following them much more?

Beckworth: Yes.

Bachmann: First of all, you could argue there's a question, I'm going to sidestep this, I'm just going to mention this, there's a question is really US macroeconomic policy listening so much to recommendations of leading macroeconomists in the world.

Beckworth: Good point.

Bachmann: For example, did we have enough fiscal stimulus? A lot of US macroeconomists would argue we didn't have enough to the extent that the federal government had undercut it in that we didn't have it. But I'm going to side step that issue. That's a whole other debate. I think part of it, in Germany part of it is of course maybe just still a transitory phenomenon in the sense that these young guys they still have a lot of ... They want to publish, they still want to play the academic game, so they're still a bit shy, so it's basically just a life cycle issue in some sense. They just haven't matured enough. That generation that plays the international game hasn't matured enough to actually say okay, now I have published by third AER or something, it's enough I'm going to go into policy circles. That's I think part of it, but I don't think it explains the whole thing.

Bachmann: Now, the question is what is more deeply structural, potentially different in the way Germans approach economic more generally and macroeconomic policy. My view, now we have to go back a bit, has deep historical routes both in terms of the history of thought and if you want to say it in big words, the philosophical traditions in Germany, but also the way that Germany became a nation.

Beckworth: Okay.

Bachmann: Let's go back actually to the 19th century, I think that's where we need to start to understand that. In the 19th century, Germans were already special because they were obviously to become or the last of the major states in Europe at least to become a nation. This nation building in the 19th century when liberal philosophical thought upon which a lot of the Anglo-Saxon American economic framework was built was just not a topic in Germany. It didn't get vet by at the time social philosophers or political philosophers at the time. They were much more concerned with this nation building, much more perhaps mercantilistic and a lot of this liberal thought and this liberal framework and then the stuff that came out of it, the neoclassical framework, the marginalist revolution, I don't think this played a major role in German discourse. That's one thing special.

Bachmann: Then you had the Nazi regime with a vary statist economy, essentially a command economy. There's a reason why it's called National Socialist Party, right? It was in that sense an extremely command economy. Basically, with almost 100 years delay, in the 1950s there was this group of economists that finally tried to establish general liberal thought, general liberal philosophy into German discourse. At the time, I think it was quite necessary and quite frankly, the Americans were probably happy about it because if you look back at this, if you look actually at the historic records, it wasn't clear at all in the early beginnings of the new republic in Germany that this would become a market economy with flexible prices. There were honest debates, tough debates about whether it should become more like a command economy. Because the debate, which type of economy, capitalist or command-based economy, at that time wasn't decided at all. Now, with the hindsight of several years, it is decided historically, but at the time, that wasn't at all clear.

Bachmann: The Americans were probably happy that we had what they called the ordo-liberals, which is a framework that is very rules-based, the government should set rules, basically rules so that both democracy can flourish but also a free market economy, a free competitive market economy can flourish. Of course, historically it came a bit late. At the time economically in Anglo-Saxon countries, we had other problems and other things were discussed like Keynes' theory of efficiency of aggregate demand, his theory of the great depression, which basically again, wasn't really taken into account in German economic discourse. That only appeared in the '70s when already the problems of German economics ... Germany was always a bit beyond the frontier and that had to with its general delay in nation building. That's one strand that explains why especially what's called ordo-liberals still have basically a lot of power grip in terms of economic policy advising in Germany. They played an important role, they had a role to play in the '50s and '60s to make sure that Germany actually became a market economy and they're still surviving in some sense in terms of influence.

Bachmann: The other thing I think that's important to notice is I would say German mentality and German philosophy are much more of a view of the state as a principle agent in and of itself rather than a means to an end. That's the difference to Anglo-Saxon practices where the state is essentially a means to an end and sometimes it's good that the state intervenes and does things and sometimes it's not. It's kind of state dependent and case by case versus the Germans have this view of the state as an entity, sui generis if you wish, that has its own rationality and just as a little anecdote to illustrate this, a lot of faculties in economics departments in Germany for traditional reasons are actually called state sciences. Not social sciences as would be clearly in the Anglo-Saxon world, but they are state scientists. How to run the state, basically. That's the tradition where they come from.

Bachmann: Now paradoxically, that means that on the one hand they have these at the same time these ordo-liberals, these rules-based guys in German policy have on the one hand a skepticism about the power of the state, and I think quite frankly, a healthy skepticism about the power of the state. They think very much about political economy issues for example, but then they don't think the state should, beyond that rules framework, the state should do much beyond that.

Bachmann: On the other hand, the Anglo-Saxon macroeconomic pragmatists have a much more relaxed view of the state of sometimes the state should intervene or not, but on the other hand from the German point of view, they would say they have a bit of a naive view of the poser of the state, of the influence of the state and its own inner workings in terms of political economy. To be fair, that I think is a fair criticism.

Bachmann: The state in our standard macroeconomic neo-Keynesian models is a very simple entity and owns things like political economy. Bureaucracy and all these things just never appear. When America macroeconomists just say do this and that, I don't know, increase government spending, then a lot of these political economy considerations that come with it are a bit naively swept under the rug, I would say. The problem is people to be heard in the modern media, they go often to these very extreme positions. A guy like Krugman never cares about political economy. Our guys at home sometimes are stubbornly clinging to the idea that the state should never under any circumstances help the economy just because it's against the rules.

Bachmann: Just to finish this up, because for a lot of people especially in the policy making arena, they view the state as something very important, as this rules maker, they come and the ordo-liberals, if you look at their writings, they basically argue like lawyers, not so much like Anglo-Saxon trained economists, which are much more flexible about rules. Sometimes you have to have rules but sometimes you need to break them depending on the situation. They are very much about rules. They argue a lot like lawyers. You can see this, a lot of the academic influence in these ministries, the finance minister or the minister of commerce, it's a lot of people that argue like lawyers and not like economists. That's basically where they struggle to break rules, this insistence on rule baseness of economic policy comes from in this very clear aversion to discretionary influences in macroeconomic policy.

Beckworth: Okay, I want to come back to those two forces there you said. One is kind of a generational catching up with understandings in other places. Your second point there was the sanctity of the state itself and how it's viewed differently. One thing you noted in your writings I found interesting is and you alluded to this is that economists over there do not hold the same stature as they do in the US. In the US, it seems like and many other academics get frustrated with economists because they're the final arbiters, the final judges of what's good policy and what's not. We have the Paul Krugmans, we have Larry Sumner.

Bachmann: But it's not just that. I don't know whether you've seen it, there's a beautiful graph that Justin Wolfers at some point out in the New York Times. It just basically plots a Google search, a Google news search I think, plots about newspaper articles mentioning economists versus historians, political scientists and other social scientists. The economists just basically have been dominating that public discourse.

Beckworth: Right.

Bachmann: And marginalizing political scientists or historians, for example. It's just an absolutely, interesting, phenomenal graph. I don't think you would have that in Germany, quite frankly.

Beckworth: Right, there was interesting. The Paul Krugmans of the world, they have newspaper columns in the New York Times. Where in Germany, what you argue and you point out that the lawyers are the ones with the most stature, the most esteem, and they're the ones that are listened to, so the finance minister who is pretty well known, he's a lawyer, right?

Bachmann: Yes, and he listens to lawyers, the people around him. I don't know the Germans are so much into blogging, so I'm not going to say that they're a lot of lawyer bloggers that influence public discourse. That's just maybe a more America thing and the Germans will catch up again in 20 years or something. The inner circle, the academic inner circles, a lot of them are lawyers. Not exclusively, but a lot of them are lawyers and argue from a legalistic framework. That's indeed the case.

Bachmann: The other thing that's interesting and that's German's love for philosophers. I guy like Jurgen Habermas, for example, an eminent social philosopher of the critical theory type, Frankfurt school, he would have much more newspaper ... If he pronounces something about Euro breakup or Brexit or anything European for example, where you would think someone would need eminent economic expertise to say something competently, he would get much bigger newspaper space than any economist in Germany and he would be listened to by the intelligentsia. That's certainly true. There's this somewhat pejorative German word, [German term], which is someone is a bit stingy, a bit nitpicky, a small-minded person in some sense. But the first word, [German term], is an old-fashioned expression for business man in some sense, for someone who trades stuff. Germans have this deeply rooted aversion to anything related to commerce, trade, business, and by extension, I guess economics. That's something deeply rooted.

Beckworth: Very interesting.

Bachmann: It is what it is.

Beckworth: I want to come in a minute and mention and economist here that I was reading about who is very influential in some of this thinking as well. Maybe we need for our listeners to summarize exactly what is the German perspective. I'm drawing upon this article in Vox by Peter Bofinger and he suggested three things, and if you want to correct to those or add to those, let me know. His three things that would define German macroeconomics would be number one, almost a religious dedication to balanced fiscal budgets, so there's no such thing as a counter cyclical balanced budget where you run a deficit during a recession, run surpluses during the good years, and balance over the business cycle. It's just pure hard core all the time balanced budgets, number one.

Beckworth: Number two, a strong commitment to price stability almost to a fault. He mentions if they're going to err, they err on the side of disinflation or going down. They would definitely be in favor of an asymmetric inflation target. For example, the European Central Bank's target is just under 2%. For them, if they go down to 1%, no problem, the more the better. The third thing is price flexibility, so let relative prices do their work. They really stress price flexibility as the solution to a mass unemployment problem or what you've mentioned before, aggregate demand deficiency. Let price flexibility be the solution. As a consequence, if you're going to focus on price flexibility, you've got to get the structural forms right. Germany had the big wage cuts for unions, so they stressed structural reform as a way to get price flexibility. He lists those three things. Is that an accurate list of the German macro perspective?

Balanced Budgets, Price Stability, and Price Flexibility

Bachmann: I would say yes and no. But part of this is ... I want to frame this a bit more. Again, going back to this rules based thing. A balanced fiscal budget is a rule that makes sense from a legalistic point of view. It's an easy rule. It's just from introspection, it's subject obviously to the fallacy of composition. That's something that a household should do, a private household probably should do. Again, price stability is an easy rule.

Beckworth: Right.

Bachmann: I think that's part of it. This is very formalistic argument rather than the more nuanced thing that feels a balanced budget is sometimes a good idea and sometimes not a good idea and price flexibility may sometimes be a good idea and sometimes be not such a good idea. The same with inflation. Partly again, and by the way, just as an aside here, one needs to be a bit careful, which has to do with the fact that a lot of criticism obviously about what's called now German macroeconomics, whatever that is supposed to be, is coming from certain political figures namely the Krugmans of the world, right?

Beckworth: Right.

Bachmann: All the three pillars you have just mentioned, if you interviewed John Cochran, he would probably nod and say, not bad macroeconomics.

Beckworth: I was actually thinking about his when I read this.

Bachmann: And he's an American, as American as apple pie.

Beckworth: Some of these things I like too. Some of these things are reasonable perspectives to hold.

Bachmann: Exactly, so there's a bit of a political strategy of course, in the ideological discourse to brand these stupid Germans, they haven't caught up to the newest macroeconomic ideas. There would be a lot of US macroeconomists that would subscribe to that. Then the other thing, another German macroeconomist has made some of these points in a very compelling way. Michael Broder, one of former presidents of the German Economic Association in a letter to the Royal Economic Society in Britain where he basically argued some of these things have nothing to do with ideology, they are reflecting of German self-interest.

Bachmann: Just maybe to give you an example, the balanced budget rule for example. It's not clear that from the German perspective as a very open economy, expansionary fiscal policy is all that optimal from a purely ... You could argue the Germans should have an interest in keeping the Eurozone together and maybe that's a long run interest, and indeed from a long run perspective they should do more, but from a purely very short run self-interest, it's not clear that even if the fiscal expansion worked, if you have a lot of imports going abroad, that's what Krugman wants to stabilize itself, but it's not clear that it would actually help the German economy much. That explains perhaps some of this aversion against expansionary fiscal policy.

Beckworth: Okay.

Bachmann: The other thing about price flexibility supply side reforms, Germans in their recent experience actually at least prima facie saw that it worked. You mentioned it, the so-called Hartz reforms, actually four of them, which basically the social democrat, Chancellor Schroeder in the early '90s basically introduced and it actually led to a successful revamping of the German economy out of a time where Germany let's not forget, around 2000 the famous article in the Economist was called the Sick Men of Europe and sick men meant economically sick. Germany got out of that, so from their narrow perspective, supply side reforms actually worked.

Bachmann: Now, we can debate whether this was due to the fact that they had a fixed exchange rate and they undercut their competitors and they didn't play by the rules as Krugman would argue probably of a currency union and that's a fair argument. But that's a much more indirect thing. They basically saw that their supply side reforms worked. From their national self-interest they would say, why don't you guys do it too?

Beckworth: Right.

Bachmann: It may be a misunderstanding of how currency unions work, there's a point to be made but just from a very narrow self-perspective point of view, that's certainly the case. Inflation in particular, and that is indeed a bit puzzling, I will admit that. Actually, we're probably talk about this in the second part of it when we talk about is raising inflation even such a good idea? Even independently of that, it is true that for some reasons the hyper inflation in the interval period that's still something, even though it's so long ago, almost 100 years now, that's still sometimes that almost gets, I want to say transmitted with the mother milk. That's goes into the psyche.

Beckworth: It's in the DNA.

Bachmann: You can see this in survey after survey that people have looked towards attitudes against inflation. Fear of inflation is in German's mind. I'm not defending this. Maybe this is part of the national psychosis but it is what it is. Part of it is tradition, historical experience. Part of it is also ideology of course, blind ideology, but part of it is also, I would argue, national self-interest.

Beckworth: It is interesting to see this emphasis on inflation. From my perspective, it seems almost an excessive concern about inflation. Yet, there's a historical precedent of course, the early 1920s. That was a big event. But what I guess I find puzzling, and I'm hoping Rudi you can share some perspective on this since you know the German macroeconomic perspective better than most people, is that even though the Germans went through that horrible experience of the early 1920s, they also went through the Great Depression. They also had deflation in the late '20s, early '30s and there have been some studies that argue that played a pivotal role in bringing Hitler and the Nazis to power, that was a key catalyst. The Great Depression in some ways was just as damaging as the hyperinflation. Yet it seems, and again I may be mistaken, but it seems that Germans tend to remember only the hyperinflation episode. Why do you think they forget the Great Depression so much?

Bachmann: That's a good question and I don't think I have an answer to that, quite frankly. I fully agree with you that's the obvious question that one should ask. Maybe it's because there was another, not hyperinflation, but strong inflation in the '70s and a social democratic government. It defines the Lucas critique and what you can do with the Phillips curve. Basically actually thought that the Phillips curve is something that's politically exploitable led to somewhat tumultuous years in the '70s. Obviously, we're not talking about hyperinflation but we're talking about inflation where it's I don't know, 8-10% or something like that. Maybe that's part of it where this got a bit out of control. I'm purely speculating here.

Beckworth: I've seen prominent Germans, for example I believe it was the individual, I don't know if he was the prime minister back then, but the leader of Germany right before World War II, they interviewed him when he was older and he drew the link between the hyperinflation of the '20s and Hitler and he said, that's the reason Hitler was here because of the hyperinflation. I was just, I was like, I'm an American and I know better than that. That's a stretch to go from one to ... It may have played some role, maybe got the ball rolling and some social breakdown occurred, but the Great Depression was at least as consequential.

Bachmann: Absolutely, I agree with you. I'm myself a bit puzzled about this national obsession, but to a certain extent these things are done at some point. I guess economics has to shut up and psychiatry has to ...

Beckworth: This sounds like a great research topic for someone out there to fully explore and write some articles on. I want to move forward and we'll come back to the point you made earlier that this German perspective actually worked for Germany. You mentioned inflation did go up in the '70s, you said maybe 8% or so, but one thing that-

Bachmann: Don't quote me on that, I would need to back it up. It was higher than usual.

Beckworth: Higher than usual.

Post-1970 German Performance

Bachmann: They had relatively high public sector unions wage increases, for example that led to big budget deficits that were somewhat permanent and so that was a bit of a tumultuous ... That was prefaced by a relatively tumultuous public sector union strikes. This is a bit of a-

Beckworth: Okay.

Bachmann: Again, just in terms of association, a time of high public sector union wage deals, higher inflation, people on the street, just an era of somewhat social instability. Obviously, nothing compared to what we had in the 1920s and the 1930s, but something that was a bit of a counterpoint to the relatively golden era, at least economically, maybe not societally, but economically of the 1950s and '60s where you had these phenomenal times of catch up growth in Germany, and the so-called [German term], the economic miracle that Germans always talk about. This was the first time after the war that things didn't look quite so good anymore. Maybe that's just part of. You can argue unemployment was also higher in the '70s. Again, at some point, as I said, it's a metaphor for a psychiatrist.

Beckworth: The beauty of doing this interview and having the internet in front of me right here, I'm now looking at Germany's CPI looking at the inflation rate, and it peaks about at, it looks like 7.5% almost 8% in the mid '70s, but it goes down. It doesn't last very long. I guess the point that I was going to make is that actually, it may have been high for the Germans, but that was actually relatively good performance compared to what happened in the US and the UK.

Bachmann: Absolutely, the Bundesbank was actually deciding against and giving trouble to the government at that time because they had this very strong monetarist, Milton Friedman-influenced ascent.

Beckworth: Yes, interesting. That's a case where you have monetary dominance over fiscal dominance.

Bachmann: Yes, and you can see this until the ECB, the Bundesbank has and it probably still is although it doesn't do much anymore, it's still one of the most respected institutions in Germany. If you were to run a public survey, and I'm blanking on the specific ones, I'm pretty sure you can find that online. If you were to run a survey, who was one of the major public institutions, it would the Supreme Court and the Bundesbank, absolutely no doubt about it especially in earlier times. They have this idea of being tough guys that play by the rules and help the common worker or something. I don't know, this is just something that Germans are proud of.

Beckworth: Interesting. You see a much better macroeconomic performance in terms of low inflation during this period. I guess my point is despite the challenges they had during that time, these German rules seemed to work better, they seemed to have a better inflation outcome during the '70s than what happened in the US, so there's something to be said for that. Also, the productivity growth pickup they had, you mentioned that they had in early 2000s with the wage reforms. You're right, there's some success they can point to and say hey, this worked for us. Interestingly, Ben Bernanke-

Bachmann: Again, the obvious counter argument and I'm in full agreement with is of course, if you live in a monetary union with a fixed exchange rate regime and you can't simply undercut your competitors, sure they could do that too, the point is this relatively competitiveness is always a relative thing. Not everyone can become more competitive. Every nation can become more productive over time but not every nation can become more competitive in that sense because it's just a relative thing. In that sense, they benefited obviously quite a bit from being a large country within a monetary union but still a relatively small open economy that doesn't necessarily influence world prices.

Beckworth: Yes.

Bachmann: I think that's where the supply side reforms actually work in that context. It is not so clear that this would necessarily be a model for the United States or necessarily a model for the more peripheral countries.

Beckworth: Yes, in fact, you see that critique today. In fact, this article by Peter Bofinger he concludes, why has Germany been so successful, he argues, despite the German model? He argues, it's been feeding off demand growth in the rest of the world. Even now, people are calling for Germany to spend more, to shore up the rest of the European Union. That's a fair point. That would be the critique to what they have argued and what they have said. I want to bring up one individual's name. In this article by Peter Bofinger, he argues he is a very important individual in the thought of German economics. Even the lawyers who decide policy, who shape policy, they point to this Walter, is it Eucken?

Bachmann: Eucken, Walter Eucken.

Beckworth: Walter Eucken. Was he truly an influential figure in economic thought in Germany?

Bachmann: Absolutely. He basically, single-handedly as the so-called Freiburg school, he single-handedly dominated the academic discourse I would say in the '50s and '60s. Then the Keynesians did come in and for a very short time, so in that sense it's actually not quite true that Germans never were interested or never took up Keynesian ideas. The '70s, the social democrat government was Keynesian fiscal policy. That was the heyday of Keynesianism. There are entire institutions in Germany essentially build around Keynesian counter cyclical fiscal policy ideas. It's not true that Germans are in the way of this, it's just that with some trouble in the '70s, like everywhere else Keynesian ideas became a bit in disrepute, it's not unlike the United States. Then the question is how fast could they surface in the more recent times and apparently the US had more Keynesians still surviving versus in Germany they indeed were essentially banned, had been banned from the political economic discourse.

Bachmann: But certainly, he influenced German economic academia. Again, until the '50s-'60s I would say partly in some major universities even until the 1980s-1990s. His ideas still dominated German economic policy advice and indeed, as I said, that guy from the perspective of the '50s, I would on the one hand defend that guy because it was necessary after this very statist anti-liberal economy that the Nazis built up. They did many other bad things obviously, but this was sort of part of it. The Germans had never experienced really a liberal economy. Introducing this ideas of competition, of price flexibility, stable money was a complete revolution in German at the time. There were major forces, especially on the social democratic side that were much more in favor ... The social democrats at the time were much were socialists. Then in the '50s basically they became social democrats in favor of a market economy with then corrective measures, redistributive and corrective measures.

Bachmann: The policy debate in the early '50s and late '40s wasn't decided at all. This guy with his school of thought actually made sure that Germany became a liberal market economy with some social policy that came with it, but in principle it was market economy. At the time, I bet you, I don't have a way of knowing this, but I bet you that the American occupiers were very happy that that guy basically won. Because otherwise, you would have had another quasi-socialist outpost in the midst of Europe. At the time, it was perfectly good.

Beckworth: He was a product of his time.

Bachmann: He was a product of his time. The problem is his ideas at some point, to the extent that they were good became commonplace, there was no revolution anymore. Then his followers, his disciples they became as often is the case with disciples, they became third rate in some sense. They became preachers, religious and not clear thinkers anymore. I will say though, people tend to forget this in the day and age of the internet, but we know that Eucken was intellectually extremely isolated, just for logistical reasons. When you live in a country that was bombed, these guys just literally didn't have access to Keynes' writing. It's not like they could go online and read the newest economic discourse out of Anglo-Saxon countries.

Bachmann: This guy was basically isolated and he didn't even the chance, maybe he didn't seek it out, that's fair. Probably he didn't seek it out but it wasn't in his face either the way it is today where you have Simon Wren-Lewis and Paul Krugman writing blogs and telling you every other day how crappy your economics is, and that just wasn't the case in the 1950s, obviously.

Beckworth: Walter Eucken, and let me spell his last name for our listeners. It's E-U-C-K-E-N. Walter Eucken I would argue from this discussion and what I've read up on him that Walter Eucken is the most influential economist you've never heard of. That's for Americans because his influence, as you mentioned, it was in academia. The teachers of the policy leaders today, the Angela Merkels, the finance minister, all the leaders right now, their thinking is shaped by his work.

Bachmann: Absolutely, that's not a bad to put it. I will say, he was insular but not quite completely insular. He did apparently know what we would call the Chicago school.

Beckworth: Some of his views were similar.

Bachmann: Yes, exactly. It was not completely ingenious new things.

Beckworth: I guess my point is if we look at some of the challenges the Eurozone has faced, the ECB, its seeming reluctance to do quantitative easing, get aggressive, I mean to me speaking of Paul Krugman he's called at both the Bank of Sweden as well as ECB, he's invoked the term sado-monetarism. I think fairly in the case of 2011, the ECB raised interest rates twice even though there had been full recovery. You look at it and go, what were they thinking? I think it's the influence of individuals like Walter Eucken.

Beckworth: The thing is no one in America at least, maybe even in the UK, but in the west I'd never heard of this individual and I think most people haven't, yet I would argue he is a huge influence. His legacy is still being felt today in Europe. Just like today you might argue Milton Friedman has a huge lasting influence on some of the policies we do. Central banks in most parts of the world have the legacy of Milton Friedman, his fingerprints are still there. It's fascinating and I think it's good to know who these people are.

Bachmann: It's very reminiscent of Keynes' saying of the defunct economist.

Beckworth: I thought that exactly, yes.

Bachmann: He's one of those defunct economists that you may not be aware of, that's exactly it.

Beckworth: Yes, it would be something good for maybe a grad student to write a paper on in their program. Okay, so moving forward, we're using up a lot of our time here, but this has been a fascinating conversation, what do you see happening in Europe? Let's say overall, do you see the European Union staying together going forward? Do you do Brexit being the first piece of the puzzle that's been taken out and it's weakened the rest of the puzzle or are you hopeful for the European Union?

Bachmann: I am I guess a hopeless optimist, so yes I'm going to say I'm hopeful. But this is not based on any economics expertise, it's just a gut feeling simply because it's still clear that there's a lot at stake here, I think including ... I'm obviously not part of a generation that has experienced a war, but at least I'm part of a generation that actually had people to talk to that had experienced a war, my grandfather for example, or at least my parents that grew up right in the postwar economy. This has always driven me. If you look at German chancellors, they have always been pro European and basically there's a lot of boilerplate there but I buy it when they say at the end of the day what drove them to European integration and unification was this absolute desire to never again make a war possible in Europe through integration because we're just so close together.

Bachmann: That's true that as these generations die out, this will be less of an issue, but I think it is the case. While this may seem a bit farfetched that at some point Germans and French could pull the guns and the tanks at each other again, we should always be wary of this. It's so fundamental I think and most European politicians still know that, that at the end of the day they've always pulled themselves together even in the face of crisis.

Bachmann: That doesn't mean that there couldn't be a time of crisis where partly because of the wrong way we do immigration, that the internal tensions get so big that the whole thing blows up. There is now a path with positive probability where you have Marine Le Pen winning in France. You have the five stars I believe they are called, the Grillo guy in Italy winning. At some point, it will explode, there's no question. But I don't even want to think what will happen then. It's just going to be a disaster.

Beckworth: Let's move forward, I want to look at some of your research. We have about 10 minutes left here. I want to transition into your work because you've done some interesting work yourself. It's been great to have you on to talk about German macroeconomics because it has been on people's minds. But let's talk about some of your work. I guess in the time I have left, I've got two areas I want to look at. One of them is this idea of uncertainty. What role does uncertainty play in a recession. You've looked at it both from a firm perspective and a household perspective.

Beckworth: There's been people like Nick Bloom, Steven Davis, Scott Baker who created this policy uncertainty index, people who generally I sympathize ... I'm a free market guy, I like supply side reforms. There's been a group from that perspective who have argued there's a lot of uncertainty that's happened since 2008 that explains a slow recovery. I haven't been entirely convinced by that. I'm wondering, what did you find? Is uncertainty itself a cause or is it a consequence of the recession or is a bit of both?

Role of Uncertainty in the Great Recession

Bachmann: That's the $60 million question, isn't it? I would say what we know is ... I know we are running out of time but let me just step back a bit. As you probably know and your listeners about macroeconomics, the big puzzle that macroeconomists are still struggling with is finding the ultimate root causes of fluctuations. We know a lot how once we assume a certain source of a fluctuation what that does to the economy, how that propagates, how that is amplified. That we understand very well, for example with monetary policy shocks.

Bachmann: But what are the ultimate shocks that ultimately drive aggregate fluctuations? None of the proposed whether monetary policy shocks, fiscal policy shocks, technology shocks, all kinds of demand shocks has been super convincing. They have all problems attached to them. This is not to say that they don't have a role to play obviously. I want to say every five, six years or 10 years maybe, you see a new shock candidate popping up in macroeconomics. It's literally that pace. We had the shock debate, some of you may have followed that. Somewhat in parallel came the uncertainty shock debate. The intuition is clear, it's an old intuition. If you have investments to make that have a certain irreversibility to them that you can't undo immediately or that are costly to undo, in a more uncertain environment, you're just going to wait until you pay that cost and lose potentially. That's a very intuitive mechanism. You can work out the math but I think it's very intuitive that you get these wait and see effects.

Bachmann: People have argued that this is exactly what could happen. With increased uncertainty, people just wait and see, have this delayed investment, delayed hiring, and that itself could lead to recession. Here's what we know, would say. What we know and this is a new business cycle fact that I think wasn't known 10 years ago that started with the work of Nick Bloom's and I have contributed some of this with my own publication of this work. We have established relatively clearly that pretty much any proxy, and certainly it's difficult to measure and that's sort of a whole different story, but any proxy that we throw at it, uncertainty, risk, however you want to call it, any second moment so to speak that we can measure is robustly counter cyclical. That we know.

Bachmann: It is true that all these proxies to measure uncertainty and risk are higher in recessions than they are in booms. This is a new business cycle fact that's very well established, there's no doubt about it. The question is then, what do we make of this? Does that mean that indeed it is the cause or an effect or simply an effect of recessions. Ultimately, I still think we don't know quite frankly. I have argued a lot in my literature that a big chunk of it is that uncertainty what I have called an epiphenomenon. It's something that's ultimately caused by recessions or downturns in a more general sense and not really a general cause. There are hints to this. If you look at the data, uncertainty tends to actually lag the recessions a bit, and so there are hints of this in the data. Ultimately, as always in macroeconomic questions, causality is hard to settle because we can't do experiments. We can't causally shock the economy with an uncertainty shock and then see what happens.

Beckworth: Right. The identification problem.

Bachmann: Yeah, the identification problem in macro is massive and that leads to that.

Beckworth: Okay, that's interesting. It's easy to tell the story, assume there is some great recession and assume it's caused by really bad monetary policy, let's repeat the 1930s. Let's get down to where we have a huge collapse in the real activity. Even in a situation like that, you would think, just your priors and intuitions would say uncertainty would increase. Even though it's not a cause, you would expect uncertainty as a byproduct, as a consequence to go up. The question is how powerful of an explanation can it be on its own as a driver of that? I've read some arguments for the 1930s, some of the New Deal legislation that seemed really radical at the time may have been a regime change. Again, it's not clear to me that we have a good understanding and I think that's what you're echoing.

Beckworth: Let me move on in the time we have left to one other issue and this one I found really interesting and kind of went up against my prior point, this is what you found about inflation expectations and people's desire to spend money. Tell us, what would theory tell you, econ 101, talk about shoe leather cost and then what did you actually find in the data?

Inflation Expectations

Bachmann: We wanted to test ... This is an exercise in going back to, methodologically going back to rather than test whole DSGE models, dynamic stochastic general equilibrium models with a lot of Bayesian estimation. There's an alternative in traditional economics to test simple elements of starter models, specific equations, specific mechanisms. If people remember, the way in standard neo-Keynesian macroeconomics at least, the transmission mechanism both for monetary policy and fiscal policy, how it works is not the old style ISLM mechanism that the government spends more money therefore income goes up and therefore people consume more. This is not present all in the neo-Keynesian model.

Bachmann: The neo-Keynesian model is both for monetary policy and fiscal policy works as follows, especially for fiscal policy for example. As firms want to produce more, they have to do this as a higher margin of cost, so they want to drive up prices. But because of some stickiness in these prices, they actually delay this price adjustment, so you get inflation expectations. These inflation expectations and the same is true a bit more directly for monetary policy, these inflation expectations then lead to declines in the real interest rate if the nominal interest rates are not counteracted, which especially would be the case in a zero lower bound kind of environment where you wouldn't change the nominal rate, so the real rate would be determined by the negative of the inflation expectation. You increase inflation expectation, the really wage it goes down, that generates aggregate demand and that gives you the boom. That's the mechanism in most standard models that we used to think about stabilization policy.

Bachmann: We wanted to just know is it true? Is it true that in the cross section that is, if households have high inflation expectations and we don't make a causal statement here at all but we just looked at that in the cross section, the households that have high inflation expectations tend to also have a higher inclination to buy durables and you can do this because the consumer basically asks about both questions. They ask about the subjective inflation expectations and whether they think it's a good time to buy durables and cars and houses. There is variance of that question.

Bachmann: The answer is the correlation is essentially zero. It doesn't matter whether you are on a zero lower bound episode or before. It doesn't play a role. It's zero of anything but really it's a statistical zero with one exception, okay with one exception and that's interest rates. The people that seem to be very much informed about the economy and we proxy this by people that have good inflation expectations twice in a row because some of these households you get to observe twice in a row. People that observe the economy, they have the standard effect. There you can see the inflation expectations work, so that they understand monetary policy. Apparently, they understand the mechanism, they behave accordingly.

Bachmann: What you also find, and I think you'd find almost even more interesting I would argue is that ... A lot of people could argue, the survey data and people don't know anything, and they don't know what the answer, they're really bored, they want to go to dinner, they're really annoyed by these people that call them up. Okay, fine. If you look at it actually, in most other aspects, people behave or at least answer in a way that's completely consistent with economic theory, for example. They will tell you if they have better business expectations, better financial expectations for themselves, lower unemployment expectations, they will actually spend more.

Bachmann: The traditional quantity mechanism, current and expected higher income that's the old Keynesian transmission mechanism that doesn't go to inflation expectations, that's alive and well in the data. At least in the sense that people respond to this with higher willingness to buy. This counterpoint would mean how the neo-Keynesian mechanism for inflation expectations, which is the old Keynesian ISLM if you wish multiplier effect through income and income expectations. That contrast that we found in the data was striking. That made me in some sense a bit of an old Keynesian actually.

Beckworth: I'm sure Paul Krugman would love to hear that because if you've been reading him, he keeps saying hey, the old ISLM model was powerful during the great recession.

Bachmann: I wouldn't go that far. The ISLM model is a good heuristic. It's still a crappy model in terms of economics. When we find this mechanism is in the data, we need to think harder about why is it that this should be the case? We need in other words better and more modern macro foundations in the way that we would be satisfied.

Beckworth: This surprised me, your results really surprised me and I guess my question is what was the range on the inflation expectations? Is this something that is maybe a threshold effect that if it's low to medium ranged inflation that people don't respond because inflation is well anchored.

Bachmann: No, we ran non-linear specifications.

Beckworth: Okay.

Bachmann: Again, the only thing worked is this putatively informed macro visits that actually you observed the economy well. I will say though, I will say there is another paper out there by Michael Weber, another German from Chicago Booth and his team, they look at a slightly different exercise. They can claim also much more causality. They looked, there was in 2005 again in Germany, there was a pre-announced VAT increase after an election. Before the election, everyone promised there wouldn't be any tax increases and then they came in, the grand coalition between social democrats and conservatives came in. Before they said no tax increases and then they raised VAT by 3% or something. But they did it in a way that they said it goes into effect two years later. But what you see you have an immediate and therefore pretty much causal effect in inflation and inflation expectations, immediate reflecting this VAT thing. There they actually find the normal response, the stimulative response especially for durables.

Bachmann: In other words, our conclusion taking these two papers together, if that's what you want to do, if you think that inflation expectation management gets you a stabilization policy, the right mechanisms, you really need to talk about it. It's salient. This VAT experiment was super salient. This was after an election. Basically, the electorate got hosed because they were promised no tax increases. Then they got the 3% increase, so this was all over the news, everyone knew about it. If you want to do this, then you really need to talk about it in a way that monetary policy maybe even can't. I think there's a bit of a discrepancy also between fiscal policy and monetary policy.

Bachmann: At the end of the day, not many people listen to what they do at the Board. This is always the talk of the in crowd a bit, but you need to reach Main Street if you want to do this in a way that maybe with these unconventional fiscal policy measures through sales tax increases, I guess we don't have that in the US at the federal level. But something unconventional on the fiscal side that you might actually reach people much more. To me, at the end of the day, I would argue it's a salience issue.

Bachmann: It's not that people don't necessarily understand this mechanism. For example, what we see they do understand is relative price increases. They will tell you if they expect house prices relatively to increase, then they will argue that now is a good time to buy a house. They totally understand relative prices and relative price increases. What I think is lacking is a general understanding of increases in the general price level, which is a relative price not necessarily within periods but across periods. That's difficult and that is something that you would need to communicate if you wanted to go down that route with monetary policy.

Beckworth: All right, well thank you. That's been a lot of fun discussing this. Our guest today has been Rudi Bachmann of Notre Dame. Rudi, thank you for being on the show.

Bachmann: Thanks for having me, it was great.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.