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Tuesday, May 25, 2010

Who's Really Standing in the Way of Progress on Macroeconomic Theory?

I want to follow up on the post highlighting attempts to attack the messengers -- attempts to discredit Brad DeLong and Paul Krugman on macroeconomic policy in particular -- rather than engage academically with the message they are delivering (Krugman's response). The attacks have served to mislead people as to what macroeconomic theory has to say about monetary and fiscal policy interventions during severe recessions, fiscal policy in particular. So it's a bit mysterious as to why this group thinks that personal attacks on the messengers, attacks that mislead people about modern macroeconomic theory and what it says about policy, somehow advance the cause they purport to be interested in.

One of the objections often raised is that Krugman and DeLong are not, strictly speaking, macroeconomists. But if Krugman, DeLong, and others are expressing the theoretical and empirical results concerning macroeconomic policy accurately, does it really matter if we can strictly classify them as macroeconomists? Why is that important except as an attempt to discredit the message they are delivering? Same with all the nonsense about their not understanding modern theory beyond old style textbook IS-LM, that's nothing but a blatant attempt to discredit them. And it's not even true, both have a thorough understanding of New Keynesian model coupled with that rare ability to see through the mathematical formalities and highlight it's most important elements. In addition, does the advancement of economics that you are so worried about really depend upon whether you find them likable at a personal level? Of course not. Attacking people rather than discussing ideas avoids even engaging on the issues. And when it comes to the ideas -- here I am talking most about fiscal policy -- as I've already noted in the previous post, the types of policies Krugman, DeLong, and others have advocated (and I should include myself as well) can be fully supported using modern macroeconomic models. There's not much of an argument to be had when it comes to the ideas themselves.

One way to try to get around this is to cite empirical evidence from past recessions showing that fiscal policy multipliers are small. Eggertsson deals with this objection in his paper by noting that things are very different at the zero bound. Things don't work the same when the policy rate is already at the zero bound and the Fed cannot push it any lower. Multipliers that are small away from the zero bound can become large, they can even flip sign in some cases. Because of this, evidence gathered from periods when the economy was not at the zero bound tell us almost nothing about the size of multipliers we should expect in episodes like we are experiencing today. The problem is that we have almost no data for episodes such as the Great Depression when the economy was at the zero bound, certainly not enough evidence to say anything specific about the magnitude of fiscal policy multipliers. There are economists who ought to know better who are still acting as though evidence from, say, World War II or some other episode somehow matters, but if we take modern theory seriously that evidence ought to be heavily discounted. To quote Eggertsson (pg. 2):

This illustrates that empirical work on the effect of fiscal policy based on data from the post-WWII period, such as the much cited and important work of Romer and Romer (2008), may not be directly applicable for assessing the effect of fiscal policy on output today. Interest rates are always positive in their sample, as in most other empirical research on this topic. To infer the effects of fiscal policy at zero interest rates, then, we can rely on experience only to a limited extent. Reasonably grounded theory may be a better benchmark with all the obvious weaknesses such inference entails, since the inference will never be any more reliable than the model assumed.

On that note about model reliability, let me address one further criticism highlighted by Robert Waldmann:

Speaking for myself only, I don't care what modern macro models say. I don't think that New Keynesian models add anything much of value to the Keynesian cross. I certainly haven't noticed any great empirical success. Oh also speaking only for myself, I have never bothered to keep up with macro theory. It is entirely possible that people understand new Keynesian DSGE models and think they are worthless.

Since he is clear that he is only speaking for himself, and his point is a bit broader than mine, let me be clear that I am the one making the claim that the view that the standard macroeconomic model is useless is a more generally held sentiment.

I thought about addressing this point in the original post, but since the point I was making there does not depend upon whether modern macro theory is valid or not -- my point was that the policies Krugman, DeLong and others are advocating can, in fact, be justified using modern models contrary to what was being implicitly or explicitly suggested in attacks on them -- so I decided to leave this out and address it later if it came up.

I don't know that I'd go as far as Robert, but I agree that the current macroeconomic models are unsatisfactory. The question is whether they can be fixed, or if it will be necessary to abandon them altogether. I am OK with seeing if they can be fixed before moving on. It's a step that's necessary in any case. People will resist moving on until they know this framework is a dead end, so the sooner we come to a conclusion about that, the better.

As just one example, modern macroeconomic models do not generally connect the real and the financial sectors. That is, in standard versions of the modern model linkages between the disintegration of financial intermediation and the real economy are missing. Since these linkages provide an important transmission mechanism whereby shocks in the financial sector can affect the real economy, and these are absent from models such as Eggertsson and Woodford, how much credence should I give the results? Even the financial accelerator models (which were largely abandoned because they did not appear to be empirically powerful, and hence were not part of the standard model) do not fully link these sectors in a satisfactory way, yet these connections are crucial in understanding why the crash caused such large economic effects, and how policy can be used to offset them.

There are many technical difficulties with connecting the real and the financial sectors. Again, to highlight just one aspect of a much, much larger list of issues that will need to be addressed, modern models assume a representative agent. This assumption overcomes difficult problems associated with aggregating individual agents into macroeconomic aggregates. When this assumption is dropped it becomes very difficult to maintain adequate microeconomic foundations for macroeconomic models (setting aside the debate over the importance of doing this). But representative (single) agent models don't work very well as models of financial markets. Identical agents with identical information and identical outlooks have no motivation to trade financial assets (I sell because I think the price is going down, you buy because you think it's going up; with identical forecasts, the motivation to trade disappears). There needs to be some type of heterogeneity in the model, even if just over information sets, and that causes the technical difficulties associated with aggregation. However, with that said, there have already been important inroads into constructing these models (e.g.). So while I'm pessimistic, it's possible this and other problems will be overcome.

But there's no reason to wait until we know for sure if the current framework can be salvaged before starting the attempt to build a better model within an entirely different framework. Both can go on at the same time. What I hope will happen is that some macroeconomists will show more humility they've they've shown to date. That they will finally accept that the present model has large shortcomings that will need to be overcome before it will be as useful as we'd like. I hope that they will admit that it's not at all clear that we can fix the model's problems, and realize that some people have good reason to investigate alternatives to the standard model. The advancement of economics is best served when alternatives are developed and issued as challenges to the dominant theoretical framework, and there's no reason to deride those who choose to do this important work.

So, in answer to those who objected to my defending modern macro, you are partly right. I do think the tools and techniques macroeconomists use have value, and that the standard macro model in use today represents progress. But I also think the standard macro model used for policy analysis, the New Keynesian model, is unsatisfactory in many ways and I'm not sure it can be fixed. Maybe it can, but that's not at all clear to me. In any case, in my opinion the people who have strong, knee-jerk reactions whenever someone challenges the standard model in use today are the ones standing in the way of progress. It's fine to respond academically, a contest between the old and the new is exactly what we need to have, but the debate needs to be over ideas rather than an attack on the people issuing the challenges.

    Posted by on Tuesday, May 25, 2010 at 12:33 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (39)

          


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