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Saturday, June 30, 2012

'Macroeconomics and the Centrist Dodge'

I think I've made this point repeatedly, though I tend to use the term ideological instead of political, but just in cast the message hasn't gotten through:

Macroeconomics and the Centrist Dodge, by Paul Krugman: Simon Wren-Lewis says something quite similar to my own view about the trouble with macroeconomics: it’s mostly political. And although Wren-Lewis bends over backwards to avoid saying it too bluntly, most – not all, but most – of the problem comes from the right. ...
By now, the centrist dodge ought to be familiar. A Very Serious, chin-stroking pundit argues that what we really need is a political leader willing to concede that while the economy needs short-run stimulus, we also need to address long-term deficits, and that addressing those long-term deficits will require both spending cuts and revenue increases. And then the pundit asserts that both parties are to blame for the absence of such leaders. What he absolutely won’t do is endanger his centrist credentials by admitting that the position he’s just outlined is exactly, exactly, the position of Barack Obama.
The macroeconomics equivalent looks like this: a concerned writer or speaker on economics bemoans the state of the field and argues that what we really need are macroeconomists who are willing to approach the subject with an open mind and change their views if the evidence doesn’t support their model. He or she concludes by scolding the macroeconomics profession in general, which is a nice safe thing to do – but requires deliberately ignoring the real nature of the problem.
For the fact is that it’s not hard to find open-minded macroeconomists willing to respond to the evidence. These days, they’re called Keynesians and/or saltwater macroeconomists. ...
Would Keynesians have been willing to change their views drastically if the experience of the global financial crisis had warranted such a change? I’d like to think so – but we’ll never know for sure, because the basic Keynesian view has in fact worked very well in the crisis.
But then there’s the other side – freshwater, equilibrium, more or less classical macro.
Recent events have been one empirical debacle after another for that view of the world – on interest rates, on inflation, on the effects of fiscal contraction. But the truth is that freshwater macro has been failing empirical tests for decades. Everywhere you turn there are anomalies that should have had that side of the profession questioning its premises, from the absence of the technology shocks that were supposed to drive business cycles, to the evident effectiveness of monetary policy, to the near-perfect correlation of nominal and real exchange rates.
But rather than questioning its premises, that side of the field essentially turned its back on evidence, calibrating its models rather than testing them, and refusing even to teach alternative views.
So there’s the trouble with macro: it’s basically political, and it’s mainly – not entirely, but mainly – coming from one side. Yet this truth is precisely what the critics won’t acknowledge, because that would endanger their comfortable position of scolding everyone equally. It is, in short, the centrist dodge carried over to conflict within economics.
Do we need better macroeconomics? Indeed we do. But we also need better critics, who are prepared to take the risk of actually taking sides for good economics and against dogmatism.

Before adding a few comments, I want to be careful to distinguish the "Keynesianism" discussed above from the New Keynesian model. I'll end up rejecting the standard NK model, but in doing so I am not rejecting Keynesian concepts. As Krugman summarizes, these are things like "the concept of the liquidity trap..., acceptance ... that wages are downwardly rigid – and hence that the natural rate hypothesis breaks down at low inflation.

Let me start by noting that one of the best examples of a  macroeconomic model being rejected that I know of is the New Classical model and its prediction that only unanticipated money matters for real variables such as employment and GDP. At first, Robert Barro and others thought the empirical evidence favored this model, but over time it became clear that both anticipated and unanticipated money matters. That is, the prediction was wrong and the model was rejected (it had other problems as well, e.g. explaining both the magnitude and duration of business cycles).

However, the response has been interesting, and it proceeds along the political lines discussed above. Some economists just can't accept that money might matter, and therefore that the government (through the Fed) has an important role to play in managing the economy. And unfortunately, they have acted more like lawyers than scientists in their attempts to discredit New Keynesian and other models that have this implication. After all, markets work, and they work through movements in prices, so a sticky price NK model must be wrong. QED.

Now, it turns out that the New Keynesian model probably is wrong, or at least incomplete, but that's a view based upon evidence rather than ideology. Prior to the crisis, I was a fan of the NK model. Despite what those who couldn't let go of the markets must work point of view argued, I believed this model was better than any other model we had at explaining macroeconomic data. But while the NK model did an adequate job of explaining aggregate fluctuations and how monetary policy will affect the economy in normal times with mild business cycle fluctuations, i.e. from the mid 1980s until recently, it did a downright lousy job of explaining the Great Recession. When it got pushed into new territory by the Great Recession, the Calvo type price stickiness driving fluctuations in the NK model had little to say about the problems we were having and how to fix them.

Thus, from my point of view the Great Recession rejected the standard version of the NK model. Perhaps the model can be fixed by tacking on a financial sector and allowing financial intermediation breakdowns to impact the real economy -- there are models along these lines that people are working to improve -- we will have to see about that. A more general NK model that has one type of fluctuation in normal times -- the standard price stickiness effects -- and occasional large fluctuations from endogenous credit market breakdowns might do the trick (there were models of this type prior to the recession, but they weren't the standard in the profession, and they weren't well-integrated into the general NK structure). So we may be able to find a more general version of the model that can capture both normal and abnormal times. But, then again, we may not and, as I've said many times, we need to encourage the exploration of alternative theoretical structures.

But no matter what happens, some economists just won't accept a model that implies the government can do good through either monetary of fiscal policy, and they work very hard to construct alternatives that don't allow for this. There is less resistance to monetary policy, the evidence is hard to deny so some of these economists will admit that monetary policy can affect the economy positively (so long as the Fed is an independent technocratic body). But fiscal policy is resisted no matter the theoretical and empirical evidence. They have their ideological/political views, and any model inconsistent with them must be wrong.

Update: Noah Smith responds to Paul Krugman here.

    Posted by on Saturday, June 30, 2012 at 11:07 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (61)



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