SAN DIEGO Economists have got a problem. Dramatic action by central banks to counter a global financial crisis cannot be explained by traditional models of how monetary policy works, and the economics profession has got to go back to the drawing board.
"The standard models we teach...simply have no room in them for what most of the world's central banks have done in response to the crisis," Harvard professor Benjamin Friedman confessed before a packed room of his peers.
"If the model you are teaching has an "M" in it, it is a waste of students' time. Delete it," Friedman advised, sweeping aside the importance of the role of monetary aggregates that have been the foundation of macroeconomic theory for decades.
Asked if this meant that monetarism was dead, he said yes.
Presiding over the panel discussion, entitled "After the crisis, what did we learn and what should we teach?" at the annual meeting of the American Economic Association, was Federal Reserve Vice Chair Janet Yellen.
"The last time I had the pleasure of teaching intermediate macro was back in 2003, and I reflect often on how much things have changed and on the various ways in which I would not like to have to teach out of the (textbooks) that I used back then."
The Fed has re-written the central banking play book, cutting interest rates near zero and tripling its balance sheet by buying bonds to drive down borrowing costs, while pledging to hold rates ultra-low until the labor market recovers.
This bold action has drawn criticism from those concerned the Fed is stoking inflation in the future, when massive excess reserves in the banking system created by its actions are leant to consumers, in a wave of easy money that drives up prices.
Professors who say they agree with the Fed's creative approach to the 2007-2009 recession are nonetheless challenged by how to explain this brave new world of central banking to their students.
"The recent events...have given us a lot of reason to change what we teach when we talk about monetary policy," said Michael Woodford, a professor at Columbia University and one of the most influential current thinkers about monetary policy.
In future, Woodford said he would incorporate a lot more discussion about the importance of stability in the financial sector on the macro economy, and tell students why future expectations for central bank interest rates can be vital.
"Explain why expectations are important for aggregate demand," he told the panel.
In a deliberate effort to provide convincing forward guidance of its future policy, the Fed last month promised to keep rates near zero until unemployment reached 6.5 percent, so long as inflation did not look likely to rise above 2.5 percent. U.S. unemployment was 7.8 percent in December.
"Make it credible that the central bank will actually follow through with the policy it is indicating," Woodford said, referring to the importance of convincing businesses and households to invest and spend.
(Editing by Andrea Ricci)