Saltwater school (economics)
Encyclopedia
In economics, the freshwater school (or sometimes sweetwater school) comprises macroeconomists who, in the early 1970s, challenged the prevailing consensus in macroeconomics research. Key elements of their approach was that macroeconomics had to be dynamic, quantitative, and based on how individuals and institutions make decisions under uncertainty. Many of the proponents of this radically new approach to macroeconomics were associated with Carnegie Mellon University
, the University of Chicago
, the University of Rochester
and the University of Minnesota
. They were referred to as the "freshwater school" since Pittsburgh, Chicago, Rochester, and Minneapolis are located nearer to the Great Lakes
. The established consensus was primarily defended by economists at the universities and other institutions located near the east
and west coast
of the United States
, such as Berkeley
, Harvard, MIT, University of Pennsylvania
, Princeton
, Columbia
, Stanford, and Yale
. They were therefore often referred to as the saltwater schools.
The terms 'freshwater' and 'saltwater' were first used in reference to economists by Robert E. Hall
in 1976, to contrast the views of these two groups on macroeconomic
research. More than anything else it was a methodological disagreement about to what extent researchers should employ the theory of economic decision making and optimization when striving to account for aggregate ("macroeconomic") phenomena.
To a large extent, the saltwater–freshwater dichotomy is a thing of the past. In his overview article from 2006, Greg Mankiw writes:
Researchers associated with "the freshwater school" found that government economic policies are of utmost importance for both the economy's abilities to respond to shocks and for its long-term potential to provide welfare to its citizens. These economic policies are the rules and structure of the economy. They might be how markets are regulated, what government insurance programs are provided, the tax system, and the degree of redistribution, etc. Most researchers that have been associated with "the freshwater school" have, however, found it hard to identify mechanisms through which it is possible for governments to actively stabilize the economy through discretionary changes in aggregate public spending.
:
Saltwater economists typically tended to find "examples of irrational behavior interesting and important." They now generally accept the use of rational expectations in modeling, but are more willing to relax the assumption and question models based on the assumption. Like behavioral psychologists, they tend to be interested in situations where individuals and groups do not behave as one would expect given rationality.
Freshwater economists, in contrast, have in general been interested in accounting for the behavior of large groups of people interacting in markets, and believe that understanding market failures requires framing problems that way.
"Saltwater Keynesian
economists" argue that business cycles represent market failures, and should be counteracted through discretionary changes in aggregate public spending and the short-term nominal interest rate. This is contrasted by "freshwater economists", like e.g. John B. Long, Jr. and Charles Plosser
. There are obviously market failures. However, individuals and firms do as best as they can given the economic environment, including these market failures. Market failures might be important for amplification and propagation of business cycle. However, it does not follow from these findings that governments can effectively mitigate business cycles fluctuations through discretionary changes in aggregate public spending or the short-term nominal interest rate. Instead they find that governments more effectively should concentrate on structural reforms that target identified, important market failures.
In 2009 Paul Krugman
commented that "since then [forty years ago] macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense". However, Krugman noted that the difference had become mainly theoretical during The Great Moderation
, but that the financial crisis cast the dichotomy in a new, harder light.
Carnegie Mellon University
Carnegie Mellon University is a private research university in Pittsburgh, Pennsylvania, United States....
, the University of Chicago
University of Chicago
The University of Chicago is a private research university in Chicago, Illinois, USA. It was founded by the American Baptist Education Society with a donation from oil magnate and philanthropist John D. Rockefeller and incorporated in 1890...
, the University of Rochester
University of Rochester
The University of Rochester is a private, nonsectarian, research university in Rochester, New York, United States. The university grants undergraduate and graduate degrees, including doctoral and professional degrees. The university has six schools and various interdisciplinary programs.The...
and the University of Minnesota
University of Minnesota
The University of Minnesota, Twin Cities is a public research university located in Minneapolis and St. Paul, Minnesota, United States. It is the oldest and largest part of the University of Minnesota system and has the fourth-largest main campus student body in the United States, with 52,557...
. They were referred to as the "freshwater school" since Pittsburgh, Chicago, Rochester, and Minneapolis are located nearer to the Great Lakes
Great Lakes
The Great Lakes are a collection of freshwater lakes located in northeastern North America, on the Canada – United States border. Consisting of Lakes Superior, Michigan, Huron, Erie, and Ontario, they form the largest group of freshwater lakes on Earth by total surface, coming in second by volume...
. The established consensus was primarily defended by economists at the universities and other institutions located near the east
East Coast of the United States
The East Coast of the United States, also known as the Eastern Seaboard, refers to the easternmost coastal states in the United States, which touch the Atlantic Ocean and stretch up to Canada. The term includes the U.S...
and west coast
West Coast of the United States
West Coast or Pacific Coast are terms for the westernmost coastal states of the United States. The term most often refers to the states of California, Oregon, and Washington. Although not part of the contiguous United States, Alaska and Hawaii do border the Pacific Ocean but can't be included in...
of the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, such as Berkeley
University of California, Berkeley
The University of California, Berkeley , is a teaching and research university established in 1868 and located in Berkeley, California, USA...
, Harvard, MIT, University of Pennsylvania
University of Pennsylvania
The University of Pennsylvania is a private, Ivy League university located in Philadelphia, Pennsylvania, United States. Penn is the fourth-oldest institution of higher education in the United States,Penn is the fourth-oldest using the founding dates claimed by each institution...
, Princeton
Princeton University
Princeton University is a private research university located in Princeton, New Jersey, United States. The school is one of the eight universities of the Ivy League, and is one of the nine Colonial Colleges founded before the American Revolution....
, Columbia
Columbia University
Columbia University in the City of New York is a private, Ivy League university in Manhattan, New York City. Columbia is the oldest institution of higher learning in the state of New York, the fifth oldest in the United States, and one of the country's nine Colonial Colleges founded before the...
, Stanford, and Yale
YALE
RapidMiner, formerly YALE , is an environment for machine learning, data mining, text mining, predictive analytics, and business analytics. It is used for research, education, training, rapid prototyping, application development, and industrial applications...
. They were therefore often referred to as the saltwater schools.
The terms 'freshwater' and 'saltwater' were first used in reference to economists by Robert E. Hall
Robert Hall (economist)
Robert Ernest "Bob" Hall is an American economist and a Robert and Carole McNeil Senior Fellow at Stanford University's Hoover Institution. He is generally considered a macroeconomist, but he describes himself as an "applied economist"....
in 1976, to contrast the views of these two groups on macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
research. More than anything else it was a methodological disagreement about to what extent researchers should employ the theory of economic decision making and optimization when striving to account for aggregate ("macroeconomic") phenomena.
To a large extent, the saltwater–freshwater dichotomy is a thing of the past. In his overview article from 2006, Greg Mankiw writes:
Differences
According to saltwater economic theory, the government has an important 'discretionary' role to play in order to actively stabilize the economy over the business cycle.Researchers associated with "the freshwater school" found that government economic policies are of utmost importance for both the economy's abilities to respond to shocks and for its long-term potential to provide welfare to its citizens. These economic policies are the rules and structure of the economy. They might be how markets are regulated, what government insurance programs are provided, the tax system, and the degree of redistribution, etc. Most researchers that have been associated with "the freshwater school" have, however, found it hard to identify mechanisms through which it is possible for governments to actively stabilize the economy through discretionary changes in aggregate public spending.
Rationality versus irrationality
Economists usually disagree on how to evaluate rational-expectations assumptionRational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
:
Saltwater economists typically tended to find "examples of irrational behavior interesting and important." They now generally accept the use of rational expectations in modeling, but are more willing to relax the assumption and question models based on the assumption. Like behavioral psychologists, they tend to be interested in situations where individuals and groups do not behave as one would expect given rationality.
Freshwater economists, in contrast, have in general been interested in accounting for the behavior of large groups of people interacting in markets, and believe that understanding market failures requires framing problems that way.
Fiscal policy
"Freshwater economists" often reject the effectiveness of discretionary changes in aggregate public spending as a means to efficiently stabilize business cycles. They emphasize that the government budget constraint is the unavoidable connection between deficits, debt, and inflation."Saltwater Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
economists" argue that business cycles represent market failures, and should be counteracted through discretionary changes in aggregate public spending and the short-term nominal interest rate. This is contrasted by "freshwater economists", like e.g. John B. Long, Jr. and Charles Plosser
Charles Plosser
Charles Irving Plosser is the president of the Federal Reserve Bank of Philadelphia. An academic macroeconomist, he is well known for his work on real business cycles, a term which he and John B. Long, Jr. coined...
. There are obviously market failures. However, individuals and firms do as best as they can given the economic environment, including these market failures. Market failures might be important for amplification and propagation of business cycle. However, it does not follow from these findings that governments can effectively mitigate business cycles fluctuations through discretionary changes in aggregate public spending or the short-term nominal interest rate. Instead they find that governments more effectively should concentrate on structural reforms that target identified, important market failures.
In 2009 Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
commented that "since then [forty years ago] macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense". However, Krugman noted that the difference had become mainly theoretical during The Great Moderation
The Great Moderation
In economics, the Great Moderation refers to a reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed to have been caused by institutional and structural changes in developed nations in the later part of the twentieth century...
, but that the financial crisis cast the dichotomy in a new, harder light.
Freshwater theories
- Bounded rationalityBounded rationalityBounded rationality is the idea that in decision making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision...
- Rational expectationsRational expectationsRational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
- Real business cycle theoryReal business cycle theoryReal business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...
- Ricardian equivalenceRicardian equivalenceThe Ricardian equivalence proposition is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending...
- Say's lawSay's lawSay's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...
- Treasury viewTreasury ViewIn macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has no effect on the total amount of economic activity and unemployment, even during times of economic recession. This view was most famously advanced in the 1930s by the staff...
- Efficient-market hypothesis
External links
- The State of Economics:The other-worldly philosophers in The Economist.comThe EconomistThe Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
. - Background on "fresh water" and "salt water" macroeconomics, by Robert Waldmann