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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.[1] 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.[1][2][3]
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.[1] 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:
An old adage holds that science progresses funeral by funeral. Today, with the benefits of longer life expectancy, it would be more accurate (if less vivid) to say that science progresses retirement by retirement. In macroeconomics, as the older generation of protagonists has retired or neared retirement, it has been replaced by a younger generation of macroeconomists who have adopted a culture of greater civility. At the same time, a new consensus has emerged about the best way to understand economic fluctuations. [...] Like the neoclassical-Keynesian synthesis of an earlier generation, the new synthesis attempts to merge the strengths of the competing approaches that preceded it.[4]
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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.[5]
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.[2]
Economists usually disagree on how to evaluate rational-expectations assumption:
Saltwater economists typically tended to find "examples of irrational behavior interesting and important."[6] 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.[7]
"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.[8]
"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 John B. Long, Jr. and Charles Plosser. 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.[9]