Crisis, what crisis? Arrogance and self-satisfaction among macroeconomists, by Simon Wren-Lewis: My recent post on economics teaching has clearly upset a number of bloggers. There I argued that the recent crisis has not led to a fundamental rethink of macroeconomics. Mainstream macroeconomics has not decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result. To some that seems self-satisfied, arrogant and profoundly wrong. ...
Let me be absolutely clear that I am not saying that macroeconomics has nothing to learn from the financial crisis. What I am suggesting is that when those lessons have been learnt, the basics of the macroeconomics we teach will still be there. For example, it may be that we need to endogenise the difference between the interest rate set by monetary policy and the interest rate actually paid by firms and consumers, relating it to asset prices that move with the cycle. But if that is the case, this will build on our current theories of the business cycle. Concepts like aggregate demand, and within the mainstream, the natural rate, will not disappear. We clearly need to take default risk more seriously, and this may lead to more use of models with multiple equilibria (as suggested by Chatelain and Ralf, for example). However, this must surely use the intertemporal optimising framework that is the heart of modern macro.
Why do I want to say this? Because what we already have in macro remains important, valid and useful. What I see happening today is a struggle between those who want to use what we have, and those that want to deny its applicability to the current crisis. What we already have was used (imperfectly, of course) when the financial crisis hit, and analysis clearly suggests this helped mitigate the recession. Since 2010 these positive responses have been reversed, with policymakers around the world using ideas that contradict basic macro theory, like expansionary austerity. In addition, monetary policy makers appear to be misunderstanding ideas that are part of that theory, like credibility. In this context, saying that macro is all wrong and we need to start again is not helpful.
I also think there is a danger in the idea that the financial crisis might have been avoided if only we had better technical tools at our disposal. (I should add that this is not a mistake most heterodox economists would make.) ... The financial crisis itself is not a deeply mysterious event. Look now at the data on leverage that we had at the time, but too few people looked at before the crisis, and the immediate reaction has to be that this cannot go on. So the interesting question for me is how those that did look at this data managed to convince themselves that, to use the title from Reinhart and Rogoff’s book, this time was different.
One answer was that they were convinced by economic theory that turned out to be wrong. But it was not traditional macro theory – it was theories from financial economics. And I’m sure many financial economists would argue that those theories were misapplied. Like confusing new techniques for handling idiosyncratic risk with the problem of systemic risk, for example. Believing that evidence of arbitrage also meant that fundamentals were correctly perceived. In retrospect, we can see why those ideas were wrong using the economics toolkit we already have. So why was that not recognised at the time? I think the key to answering this does not lie in any exciting new technique from physics or elsewhere, but in political science.
To understand why regulators and others missed the crisis, I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself. And I fear that the academic sector was not exactly innocent in this either. A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking. The really big question of the day is not what is wrong with macro, but why has the financial sector grown so rapidly over the last decade or so. Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy? And why are there so few economists trying to answer that question?
I have so many posts on the state of modern macro that it's hard to know where to begin, but here's a pretty good summary of my views on this particular topic:
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 okay 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. [e.g. see Woodford's comments, "recent events have made it clear that financial issues need to be integrated much more thoroughly into the basic framework for macroeconomic analysis with which students are provided."]
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. see Rajiv Sethi's discussion of John Geanakoplos' Leverage Cycles). 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.
This post of an email from Mark Gertler in July 2009 argues that modern macro has been mis-characterized:
The current crisis has naturally led to scrutiny of the economics profession. The intensity of this scrutiny ratcheted up a notch with the Economist’s interesting cover story this week on the state of academic economics.
I think some of the criticism has been fair. The Great Moderation gave many in the profession the false sense that we had handled the problem of the business cycle as well as we could. Traditional applied macroeconomic research on booms and busts and macroeconomic policy fell into something of a second class status within the field in favor of more exotic topics.
At the same time, from the discussion thus far, I don’t think the public is getting the full picture of what has been going on in the profession. From my vantage, there has been lots of high quality “middle ground” modern macroeconomic research that has been relevant to understanding and addressing the current crisis.
Here I think, though, that both the mainstream media and the blogosphere have been confusing a failure to anticipate the crisis with a failure to have the research available to comprehend it. Predicting the crisis would have required foreseeing the risks posed by the shadow banking system, which were missed not only by academic economists, but by just about everyone else on the planet (including the ratings agencies!).
But once the crisis hit, broadly speaking, policy-makers at the Federal Reserve made use of academic research on financial crises to help diagnose the situation and design the policy response. Research on monetary and fiscal policy when the nominal interest is at the zero lower bound has also been relevant. Quantitative macro models that incorporate financial factors, which existed well before the crisis, are rapidly being updated in light of new insights from the unfolding of recent events. Work on fiscal policy, which admittedly had been somewhat dormant, is now proceeding at a rapid pace.
Bottom line: As happened in both the wake of the Great Depression and the Great Stagflation, economic research is responding. In this case, the time lag will be much shorter given the existing base of work to build on. Revealed preference confirms that we still have something useful to offer: Demand for our services by the ultimate consumers of modern applied macro research – policy makers and staff at central banks – seems to be higher than ever.
Henry and Lucy Moses Professor of Economics
New York University
[I ... also posted a link to his Mini-Course, "Incorporating Financial Factors Within Macroeconomic Modelling and Policy Analysis"... This course looks at recent work on integrating financial factors into macro modeling, and is a partial rebuttal to the assertion above that New Keynesian models do not have mechanisms built into them that can explain the financial crisis. ...]
Again, it wasn't the tools and techniques we use, we were asking the wrong questions. As I've argued many times, we were trying to explain normal times, the Great Moderation. Many (e.g. Lucas) thought the problem of depressions due to, say, a breakdown in the financial sector had been solved, so why waste time on those questions? Stabilization policy was passé, and we should focus on growth instead. So, I would agree with Simon Wren-Lewis that "we need to recognise the political environment at the time." But as I argued in The Economist, we also have to think about the sociology within the profession that worked against the pursuit of these ideas.
Perhaps Ricardo Cabellero says it better, so let me turn it over to him. From a post in late 2010:
Caballero says "we should be in “broad-exploration” mode." I can hardly disagree since that's what I meant when I said "While I think we should see if the current models and tools can be amended appropriately to capture financial crises such as the one we just had, I am not as sure as [Bernanke] is that this will be successful and I'd like to see [more] openness within the profession to a simultaneous investigation of alternatives."
Here's a bit more from the introduction to the paper:The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. To be honest, this inability to predict does not concern me much. It is almost tautological that severe crises are essentially unpredictable, for otherwise they would not cause such a high degree of distress... What does concern me of my discipline, however, is that its current core—by which I mainly mean the so-called dynamic stochastic general equilibrium approach has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. ...To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fire sales, risk-shifting, contagion, and the like.1 However, much of this literature belongs to the periphery of macroeconomics rather than to its core. Is the solution then to replace the current core for the periphery? I am tempted—but I think this would address only some of our problems. The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer. In contrast, the periphery is not nearly as ambitious, and it provides mostly qualitative insights. So we are left with the tension between a type of answer to which we aspire but that has limited connection with reality (the core) and more sensible but incomplete answers (the periphery).This distinction between core and periphery is not a matter of freshwater versus saltwater economics. Both the real business cycle approach and its New Keynesian counterpart belong to the core. ...I cannot be sure that shifting resources from the current core to the periphery and focusing on the effects of (very) limited knowledge on our modeling strategy and on the actions of the economic agents we are supposed to model is the best next step. However, I am almost certain that if the goal of macroeconomics is to provide formal frameworks to address real economic problems rather than purely literature-driven ones, we better start trying something new rather soon. The alternative of segmenting, with academic macroeconomics playing its internal games and leaving the real world problems mostly to informal commentators and "policy" discussions, is not very attractive either, for the latter often suffer from an even deeper pretense-of-knowledge syndrome than do academic macroeconomists. ...
My main message is that yes, we need to push the DSGE structure as far as we can and see if it can be satisfactorily amended. Ask the right questions, and use the tools and techniques associated with modern macro to build the right models. But it's not at all clear that the DSGE methodology is up to the task, so let's not close our eyes -- or worse actively block -- the search for alternative theoretical structures.