« 'Freedoms Can Be Lost' | Main | Links for 7-05-14 »

Friday, July 04, 2014

Responses to John Cochrane's Attack on New Keynesian Models

The opening quote from chapter 2 of Mankiw's intermediate macro textbook:

It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to fit facts. — Sherlock Holmes

Or, instead of "before one has data," change it to "It is a capital mistake to theorize without knowledge of the data" and it's a pretty good summary of Paul Krugman's response to John Cochrane:

Macro Debates and the Relevance of Intellectual History: One of the interesting things about the ongoing economic crisis is the way it has demonstrated the importance of historical knowledge. ... But it’s not just economic history that turns out to be extremely relevant; intellectual history — the history of economic thought — turns out to be relevant too.
Consider, in particular, the recent to-and-fro about stagflation and the rise of new classical macroeconomics. You might think that this is just economist navel-gazing; but you’d be wrong.
To see why, consider John Cochrane’s latest. ... Cochrane’s current argument ... effectively depends on the notion that there must have been very good reasons for the rejection of Keynesianism, and that harkening back to old ideas must involve some kind of intellectual regression. And that’s where it’s important — as David Glasner notes — to understand what really happened in the 70s.
The point is that the new classical revolution in macroeconomics was not a classic scientific revolution, in which an old theory failed crucial empirical tests and was supplanted by a new theory that did better. The rejection of Keynes was driven by a quest for purity, not an inability to explain the data — and when the new models clearly failed the test of experience, the new classicals just dug in deeper. They didn’t back down even when people like Chris Sims (pdf), using the very kinds of time-series methods they introduced, found that they strongly pointed to a demand-side model of economic fluctuations.
And critiques like Cochrane’s continue to show a curious lack of interest in evidence. ... In short, you have a much better sense of what’s really going on here, and which ideas remain relevant, if you know about the unhappy history of macroeconomic thought.

Nick Rowe:

Insufficient Demand vs?? Uncertainty: ...John Cochrane says: "John Taylor, Stanford's Nick Bloom and Chicago Booth's Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago's Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth." ...
Increased political uncertainty would reduce aggregate demand. Plus, positive feedback processes could amplify that initial reduction in aggregate demand. Even those who were not directly affected by that increased political uncertainty would reduce their own willingness to hire lend or invest because of that initial reduction in aggregate demand, plus their own uncertainty about aggregate demand. So the average person or firm might respond to a survey by saying that insufficient demand was the problem in their particular case, and not the political uncertainty which caused it.
But the demand-side problem could still be prevented by an appropriate monetary policy response. Sure, there would be supply-side effects too. And it would be very hard empirically to estimate the relative magnitudes of those demand-side vs supply-side effects. ...
So it's not just an either/or thing. Nor is it even a bit-of-one-plus-bit-of-the-other thing. Increased political uncertainty can cause a recession via its effect on demand. Unless monetary policy responds appropriately. (And that, of course, would mean targeting NGDP, because inflation targeting doesn't work when supply-side shocks cause adverse shifts in the Short Run Phillips Curve.)

On whether supply or demand shocks are the source of aggregate fluctuations, Blanchard and Quah (1989), Shapiro and Watson (1988), and others had it right (though the identifying restriction that aggregate demand shocks do not have permanent effects seems to be undermined by the Great Recession ). It's not an eithor/or question, it's a matter of figuring out how much of the variation in GDP/employment is due to supply shocks, and how much is due to demand shocks. And as Nick Rowe points out with his example, sorting between these two causes can be very difficult -- identifying which type of shock is driving changes in aggregate variables is not at all easy and depends upon particular assumptions. Nevertheless, my reading of the empirical evidence is much like Krugman's. Overall, across all these papers, it is demand shocks that play the most prominent role. Supply shocks do matter, but not nearly so much as demand shocks when it comes to explaining aggregate fluctuations.

    Posted by on Friday, July 4, 2014 at 10:16 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (31)

          


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.