The economy is a balancing act of self-interests

Equilibrium isn’t the same as 'good'.

Back in the 1970s a great rift opened between 'salt water' (i.e., MIT, Harvard, Yale, Princeton) macroeconomists who believed that the government has a valuable part in fighting recessions, and 'fresh water' economists (Chicago, Minnesota, Rochester) who denied any such role. On the eve of the global crisis, it was often asserted that this rift had narrowed — but reactions to the crisis and government actions to deal with it showed that any appearance of a new consensus was an illusion, that the two sides were as far apart as ever. And those who advocated forceful action dropped any inhibitions about proudly declaring themselves Keynesians.

What does that mean? For people like Christina Romer, who was President Obama’s first chief economist, or Larry Summers, or yours truly, it doesn’t mean a drastic stylistic departure from ordinary supply-and-demand-type reasoning, which relies heavily on the concept of 'equilibrium' — roughly, a situation in which the economy’s participants are each doing what they imagine is in their self-interest, given what everyone else is doing. But it means acknowledging that equilibrium isn’t the same as 'good' — that if you take into account more or less realistic frictions, like the reluctance of workers to accept cuts in money wages, it’s entirely possible for an economy to get stuck in an equilibrium that involves sustained high unemployment.

Excerpted from a review in The New York Review of Books.