Economist's View

"Catastrophe Theory and the Business Cycle"

As a follow up to the recent post on non-linear dynamics that continued the discussion on what's wrong with modern macroeconomics, here is a paper written many years ago by Hal Varian that extends the Goodwin-Kaldor model of business cycles. It is old-fashioned macro, but the interesting part is the wealth effect causing the difference between recessions and depressions. In particular, the results of the paper imply that shocks to wealth that change savings propensities -- as we are seeing now -- can cause recoveries that "may take a very long time, and differ quite substantially from the recovery pattern of a [typical] recession."

Here are a few selections from the paper:

Catastrophe Theory and the Business Cycle, by Hal Varian: In this paper we examine a variation on Kaldor's (1940) model of the business cycle using some of the methods of catastrophe theory. (Thom (1975), Zeeman (1977)). The development proceeds in several stages. Section I provides a brief outline of catastrophe theory, while Section II applies some of these techniques to a simple macroeconomic model. This model yields, as a special case, Kaldor's business cycles. ... In Section III, we describe a generalization of Kaldor's model that allows not only for cyclical recessions, but also allows for long term depressions. Section IV presents a brief review and summary.

On Buiter, Goodwin, and Nonlinear Dynamics

Rajiv Sethi continues the discussion on the state of modern macroeconomics:

On Buiter, Goodwin, and Nonlinear Dynamics, by Rajiv Sethi: A few months ago, Willem Buiter published a scathing attack on modern macroeconomics in the Financial Times. While a lot of attention has been paid to the column's sharp tone and rhetorical flourishes, it also contains some specific and quite constructive comments about economic theory that deserve a close reading. One of these has to do with the limitations of linearity assumptions in models of economic dynamics:

When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner.  There is no ‘bounded instability’ in such models.  The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories.  What they were left with was something that, following an exogenous  random disturbance, would return to the deterministic steady state pretty smartly.  No L-shaped recessions.  No processes of cumulative causation and bounded but persistent decline or expansion.  Just nice V-shaped recessions.

Buiter is objecting here to a vision of the economy as a stable, self-correcting system in which fluctuations arise only in response to exogneous shocks or impulses. This has come to be called the Frisch-Slutsky approach to business cycles, and its intellectual origins date back to a memorable metaphor introduced by Knut Wicksell more than a century ago: "If you hit a wooden rocking horse with a club, the movement of the horse will be very different to that of the club" (translated and quoted in Frisch 1933). The key idea here is that irregular, erratic impulses can be transformed into fairly regular oscillations by the structure of the economy. This insight can be captured using linear models, but only if the oscillations are damped - in the absence of further shocks, there is convergence to a stable steady state. This is true no matter how large the initial impulse happens to be, because local and global stability are equivalent in linear models.

A very different approach to business cycles views fluctuations as being caused by the local instability of steady states, which leads initially to cumulative divergence away from balanced growth. Nonlinearities are then required to ensure that trajectories remain bounded. Shocks to the economy can make trajectories more erratic and unpredictable, but are not required to account for persistent fluctuations. An energetic and  life-long proponent of this approach to business cycles was Richard Goodwin, who also produced one of the earliest such models in economics (Econometrica, 1951). Most of the literature in this vein has used aggregate investment functions and would not be considered properly microfounded by contemporary standards (see, for instance, Chang and Smyth 1971, Varian 1979, or Foley 1987). But endogenous bounded fluctuations can also arise in neoclassical models with overlapping generations (Benhabib and Day 1982, Grandmont 1985).

The advantage of a nonlinear approach is that it can accomodate a very broad range of phenomena. Locally stable steady states need not be globally stable, so an economy that is self-correcting in the face of small shocks may experience instability and crisis when hit by a large shock. This is Axel Leijonhufvud's corridor hypothesis, which its author has discussed in a recent column. Nonlinear models are also required to capture Hyman Minsky's financial instability hypothesis, which argues that periods of stable growth give rise to underlying behavioral changes that eventually destabilize the system. Such hypotheses cannot possibly be explored formally using linear models.

This, I think, is the point that Buiter was trying to make. It is the same point made by Goodwin in his 1951 Econometrica paper, which begins as follows:

Almost without exception economists have entertained the hypothesis of linear structural relations as a basis for cycle theory. As such it is an oversimplified special case and, for this reason, is the easiest to handle, the most readily available. Yet it is not well adapted for directing attention to the basic elements in oscillations - for these we must turn to nonlinear types. With them we are enabled to analyze a much wider range of phenomena, and in a manner at once more advanced and more elementary. 

By dropping the highly restrictive assumptions of linearity we neatly escape the rather embarrassing special conclusions which follow. Thus, whether we are dealing with difference or differential equations, so long as they are linear, they either explode or die away with the consequent disappearance of the cycle or the society. One may hope to avoid this unpleasant dilemma by choosing that case (as with the frictionless pendulum) just in between. Such a way out is helpful in the classroom, but it is nothing more than a mathematical abstraction. Therefore, economists will be led, as natural scientists have been led, to seek in nonlinearities an explanation of the maintenance of oscillation. Advice to this effect, given by Professor Le Corbeiller in one of the earliest issues of this journal, has gone largely unheeded.

And sixty years later, it remains largely unheeded.

"What if a Recovery Is All in Your Head?"

Robert Shiller wonders if the recovery is based upon a self-fulfilling prophecy:

What if a Recovery Is All in Your Head?, by Robert J. Shiller, Commentary, NY Times: Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy.

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned... but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession ... is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

Certainly, people did not always believe that there is a regular “business cycle” that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression... “Recession,” a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. ...

Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover... A depression came to be another matter entirely.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article ... titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase...

In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course.

For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means. ...

The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.

Barry Ritholtz responds [Note: Updated version posted at Barry's request]:

How Overrated is Sentiment in Economics?, by Barry Ritholtz: There is a small cadre of Economists — original thinkers, contrarians, out of the box theorists — whom  I respect a great deal. It is a modest list ranging from Richard Thaler to David Rosenberg to Robert Shiller, with lots of smart econ wonks in between.

This morning, however, I find myself somewhat disagreeing with one of the smarter of the economists, Professor Bob Shiller... Hence, it is with trepidation that I point out the flaws in Shiller’s discussion about the recovery, (titled “What if a Recovery Is All in Your Head?“). It is a thought provoking but unpersuasive argument... To be fair, he uses the column to incite a debate, rather than defend the position that the recovery is “mostly mental.”

I find numerous things worth challenging in the column... Let me offer 10 items..:

1. Time: The typical post-war Recession lasts 8 months, not “a couple of years”; We are now in month 23. If people started to spend because they sensed it was “late in the recession” or somehow intuited that it was time for the contraction to end, well then, based upon history, that would have been somewhere around August 2008.

2. Not Totally Irrational: One of my complaints about economics is it over-emphasizes people as rational, unemotional actors. However, when it comes to sentiment, economics seems to make the same mistake in the opposite direction — it assumes that people are foolish, unthinking creatures unable to engage in ANY rational thought whatsoever. All sentiment, no rationality at all.

The reality is quite different: Sometimes, people behave the way they do because they have figured out a problem and are responding to it intelligently.

Home Economicus does not really exist — but then again, neither does Homo Idiotus.

3. Healthy Fear of Job Loss: Employed people began to spend their money more carefully when they saw coworkers getting laid off in increasing numbers. That is a rational act in the face of an increasing possibility of a loss of income. This is unlikely to change in the near future, so long as large public layoffs remain a news item. Is this a Sentiment factor — or a rational response to changing conditions?

4. Asset Deflation: Consumers cut back their spending when they saw their biggest assets (Homes, Stocks) lose a significant value. Again, a rational response to a change in personal financial conditions, or bad sentiment?

5. False Belief System: Earlier this year, the Dow had dropped over 5,000 points in 6 months. One of the collective fallacies our culture operates under is the delusion that the market is some kind of astute forecasting machine. It is not — it represents the collective wisdom of 10 million panicked monkeys. That millions of slightly clever, pants wearing primates can combine their collective ignorance, their intellectual foibles, biases and false beliefs somehow into something resembling intelligence was one of the false beliefs of the era. Unfortunately, this is a condition the monkeys are prone towards (Witch burning, bloodletting, organized religion, etc.).

Note however that this does not reflect collective negative sentiment, but is actually the result of what happens when a faulty belief system dominates a society.

6. Doom Warnings Began Making Sense: Many of the doomsayers have been warning of the coming apocalypse for years. ... Why did this group suddenly gain traction in 2008? Maybe it was because  the population is not nearly so stupid as the politicians believe. The masses saw with their own two eyes the decay in the economy. Suddenly, the warnings were not as far fetched as they previously seemed.

7. Reacting to Flat Income: Families have recognized their incomes have remained flat to negative over the past decade, while their expenses have increased. What should be the rational reaction to this realization? (Hint: a new car, a bigger house, a new vacation are not on the list of options).

8. Time to Exit the Bunkers: Ten months ago, people were betting the economic world was coming to an end. The economy was in freefall, consumers froze, dramatically reduced spending. But the freefall is now over, and while its arguable whether the recession is over (by some measures it is, others not) most of us will agree that the Great Recession ended sometime in Spring of ‘09.

The US consumer is no longer frozen like deer in headlights. Is that sentiment, of just the reality of the situation — what happens when the ice melted?

9. The Cheerleaders Now Look Like Fools: At the onset of a recession, we often see cheerleaders, OpEd writers, and money losing fund managers make the argument that there is no economic slowdown — that the weakness is only in people’s minds. I call these people the Pervasive Pollyannas of Prosperity. (Think Phil Gramm, Amity Shlaes, Don Luskin). Some are partisans, others are dumb, others still merely incompetent — a few are all three. Yet despite their best efforts of the cheerleaders, the economy still went into freefall.  Perhaps the public has learned (a teeny bit) who to listen to and who to ignore.

10. Deleveraging: We know why this recession was so deep and long — the wanton use of leverage by people and financial institutions. The deleveraging that is taking place is a long slow process. It is rational, it is intelligent, and it will be how families will restore their balance sheets — the paradox of thrift be damned . . .

I appreciate that Professor Shiller was not arguing in favor of “its all mental.” He sought to spark a debate; I hope this response rose to the challenge . . .

I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.

But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.

Stabilities and Instabilities in the Macroeconomy

More on what's wrong with modern macro, this time from Axel Leijonhufvud:

Stabilities and instabilities in the macroeconomy, by Axel Leijonhufvud, Vox EU: Fifty-some years ago, students were taught that the private sector had no tendency to gravitate to full employment, that it was prone to undesirable fluctuations amplified by multiplier and accelerator effects, and that it was riddled with market failures of various sorts. But it was also believed that a benevolent, competent, democratic government could stabilize the macroeconomy and reduce the welfare consequences of most market failures to relative insignificance.

Fifty years later, around the beginning years of this century, students were taught that representative governments produce pointless fluctuations in prices and output but, if they can be constrained from doing so – by an independent central bank, for example – free markets are sure to produce full employment and, of course, many other blessings besides. Macroeconomic policy doctrine had shifted from stabilizing the private to constraining the public sector.

This long swing in our understanding of the economy spans a half-century of prolific technical accomplishments in economics (Blanchard 2008). But what the story shows is that, ontologically, economics has been completely at sea, drifting on the surface in currents of our own making. We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.

Top-Down versus Bottom-Up Macroeconomics

When Paul DeGrauwe presented this paper at the What's Wrong with Modern Macroeconomics conference (papers here), his argument that rational expectations models are the intellectual heirs of central planning seemed to ruffle a few feathers:

Top-down versus bottom-up macroeconomics, by Paul De Grauwe, Commentary, Vox EU: There is a general perception today that the financial crisis came about as a result of inefficiencies in the financial markets and economic actors’ poor understanding of the nature of risks. Yet mainstream macroeconomic models, as exemplified by the dynamic stochastic general equilibrium (DSGE) models, are populated by agents who are maximising their utilities in an intertemporal framework using all available information including the structure of the model – see Smets and Wouters (2003), Woodford (2003), Christiano et al. (2005), and Adjemian, et al. (2007), for example. In other words, agents in these models have incredible cognitive abilities. They are able to understand the complexities of the world, and they can figure out the probability distributions of all the shocks that can hit the economy. These are extraordinary assumptions that leave the outside world perplexed about what macroeconomists have been doing during the last decades.

Evidence on rationality from other sciences

These developments in mainstream macroeconomics are surprising for other reasons. While macroeconomic theory enthusiastically embraced the view that some if not all agents fully understand the structure of the underlying models in which they operate, other sciences like psychology and neurology increasingly uncovered the cognitive limitations of individuals (see e.g. Kahneman 2002, Camerer et al. 2005, Kahneman and Thaler 2006, and Della Vigna 2007). We learn from these sciences that agents only understand small bits and pieces of the world in which they live, and instead of maximising continuously taking all available information into account, agents use simple rules (heuristics) in guiding their behaviour (Gigerenzer and Todd 1999). The recent financial crisis seems to support the view that agents have limited understanding of the big picture. If they had understood the full complexity of the financial system, they would have understood the lethal riskiness of the assets they piled into their portfolios.

Top-down and bottom-up models

In order to understand the nature of different macroeconomic models, it is useful to make a distinction between top-down and bottom-up systems.

• In its most general definition, a top-down system is one in which one or more agents fully understand the system. These agents are capable of representing the whole system in a blueprint that they can store in their mind. Depending on their position in the system, they can use this blueprint to take command or to optimise their own private welfare. An example of such a top-down system is a building that can be represented by a blueprint and fully understood by the architect.
• Bottom-up systems are very different in nature. These are systems in which no individual understands the whole picture. Each individual understands only a very small part of the whole. These systems function as a result of the application of simple rules by the individuals populating the system. Most living systems follow this bottom-up logic (see the beautiful description of the growth of the embryo by Dawkins 2009).

The market system is also a bottom-up system. The best description made of this bottom-up system is still the one made by Hayek (1945).

Hayek argued that no individual is capable of understanding the full complexity of a market system. Instead, individuals only understand small bits of the total information. The main function of markets consists in aggregating this diverse information. If there were individuals capable of understanding the whole picture, we would not need markets. This was in fact Hayek’s criticism of the “socialist” economists who took the view that the central planner understood the whole picture and would therefore be able to compute the whole set of optimal prices, making the market system superfluous.

Rational expectations models as intellectual heirs of central planning

My contention is that the rational expectations models are the intellectual heirs of these central-planning models. Not in the sense that individuals in these rational expectations models aim at planning the whole, but in the sense that, as the central planner, they understand the whole picture. These individuals use this superior information to obtain the “optimum optimorum” for their own private welfare. In this sense, they are top-down models.

In a recent paper, I contrast the rational expectations top-down model with a bottom-up macroeconomic model (De Grauwe 2009). The latter is a model in which agents have cognitive limitations and do not understand the whole picture (the underlying model). Instead, they only understand small bits and pieces of the whole model and use simple rules to guide their behaviour. I introduce rationality in the model through a selection mechanism in which agents evaluate the performance of the rule they are following and decide to keep or change their rule depending on how well it performs relative to other rules. Thus agents in the bottom-up model learn about the world in a “trial and error” fashion.

These two types of models produce very different insights. I mention three differences here. First, the bottom-up model creates correlations in beliefs that in turn generate waves of optimism and pessimism. The latter produce endogenous business cycles which are akin to the Keynesian “animal spirits” (see Akerlof and Shiller 2009).

Second, the bottom-up model provides for a very different theory of the business cycle compared to the business cycle theory implicit in the rational expectations (DSGE) models. In the DSGE models, business cycle movements in output and prices arise because rational agents cannot adjust their optimal plans instantaneously after an exogenous disturbance. Price and wage stickiness prevent such instantaneous adjustment. As a result, these exogenous shocks (e.g. productivity shocks, or shocks in preferences) produce inertia and business cycle movements. Thus it can be said that the business cycle in DSGE models is exogenously driven. As an example, in the DSGE model, the financial crisis and the ensuing downturn in economic activity is the result of an exogenous and unpredictable increase in risk premia in August 2007.

In contrast to the rational expectations model, the bottom-up model has agents who experience an informational problem. They do not fully understand the nature of the shock or its transmission. They use a trial-and-error learning process aimed at distilling information. This process leads to waves of optimism and pessimism, which in a self-fulfilling way create business cycle movements. Booms and busts reflect the difficulties of economic agents trying to understand economic reality. The business cycle has a large endogenous component. Thus, in this bottom-up model, the financial crisis and the ensuing economic downturn should be explained by the previous boom.

Finally, the bottom-up model confirms the insight obtained from mainstream macroeconomics (including the DSGE models) that a credible inflation targeting is necessary to stabilise the economy. However, it is not sufficient. In a world where waves of optimism and pessimism (animal spirits) can exert an independent influence on output and inflation, it is in the interest of the central banks not only to react to movements in inflation but also to movements in output and asset prices so as to reduce the booms and busts that free market systems produce quite naturally. ...

What's Wrong with Modern Macroeconomics: Comments

I really hope that the conversation in the comments to the post What's Wrong with Modern Macroeconomics: Conference papers will continue:

Barkley Rosser said... I should have guessed that de Grauwe might have a good paper.

So, Mark, what have you to say to the assembled masses there that you are willing to report back to us about the spot-on paper by Alan Kirman?

reason said in reply to Barkley Rosser... Barkley,
thanks for the tip. The Kirman paper is my reading on the train now.

Mark Thoma said... One thing I learned from it is that I need to read the old papers by Sonnenschein (1972), Mantel (1974), and Debreu (1974) since these papers appear to undermine representative agent models. According to this work, you cannot learn anything about the uniqueness of an equilibrium, whether an equilibrium is stable, or how agents arrive at equilibrium by looking at individual behavior (more precisely, there is no simple relationship between individual behavior and the properties of aggregated variables - someone added the the axiom of revealed preference doesn't even survive aggregating two heterogeneous agents).

I need to learn the full extent to which this work undermines the whole microfoundations approach (hence Kirman's call to study the properties of networks so as to generate endogenous cycles from phase transitions rather than trying to model individual agents from first principles - that's not his sole reason for wanting to turn to this approach, but it's part of it).

I didn't understand that extent to which representative agent models are an analytical convenience to work around this problem (the DSGE theorists who understood this kept quiet about it).

You can get interactions among agents while maintaining identical agents, i.e. network effects do not necessarily require heterogeneity, but most interesting cases, it seems to me, do involve both heterogeneity and agents whose decisions are interdependent.

(Robert Solow said all you get is that excess demands have to sum to zero, i.e. Walras Law and a couple of other properties, but it's not much).

So that was the most important thing I learned, and it's something I should have known already. Once I learn a bit more about the results in these papers, I hope to post something about it. (A small part of my remarks wondered if learning models might not help to overcome this problem since they might give you a path to the equilibrium, and the number of equilibrium paths might be determinate and equal to one giving uniqueness, but it was pure speculation).

Barkley Rosser said... Mark,

The missing man in the critique of the representative agent model is Michael Jerison of SUNY-Albany. In his much-cited JEP paper on "Whom does the representative agent represent?", Kirman used (and cited) an example from a still unpublished paper by the sadly neglected Jerison.

Kirman is an interesting figure in all this as he was originally a general equilibrium theorist (well, originally a game theorist, and then a GE theorist). While he has differences with his old GE comrades, they all respect his critique because it does start with the SMD theorem, which is well known to all of them and very fundamentally disruptive. The DSGE modelers conveniently cover that one up, along with some other major problems.

Of course, in a world of multiple equilibria, learning may lead you anywhere.

Sebastion said... A good reference for anyone with access to the Mas-Colell et al micro textbook is their chapter 4 on aggregate demand and in particular chapter 4D on the existence of a representative consumer. Unfortunately, chapter 4 is usually NOT being taught in standard micro classes

Roberto Cruccolini said... And it might be good after having read chapter 4 to continue with chapter 17E in MasColell, called "Anything goes: The Sonnenschein-Mantel-Debreu Theroem". There you are, even in the advanced-micro bible you can read about those results, which are also at least extremely interesting for modern "microfounded" macro.

I think, this phenomenon of forgetting and/or neglecting former knowledge, e.g. the whole discussion and aspects of aggregation, which is really central to the methodology of modern macro, as the notion of microfoudations via optimizing agents was one of the core-arguments of New Classical Makro Revolution, is deeply unsettling. You could also add the oblivion of coordination & interaction problems, of discontinuities & emergence as probably central aspects of makroeconomics, which seem to be the reasons, why macro was once thought to be necessarily a different approach than micro.

There seem to be two ways to deal with this finding. One is to complain about the way modern macro has developed, and to suggest other/better solutions; this is, what we see most of the time right now.

That is of course worthwhile and understandable, but there remains a strange aspect: nearly all of nowadays criticisms were already mentioned 20 or 30 years before (recall Solow 1978 at the same conference as Lucas & Sargent, or Summers 1986 in response to Prescott, or Blinder 1987, or, which is sort of funny, Kirman 1989 & 1992 and - again - 2009,...)

And this leads to the interesting question, why modern macro/new classical methodology & thinking was so successful in conquering the field:

why did economists think, that Lucas 1976 said something new, given the reflections of Marshall how to theorize given ever changing structures, given Haavelmos ideas on the autonomy of economic relations, given the debates between Keynes and Tinbergen of econometrics and structural instability, and so on?

And why did they follow him in applying a Walrasian program using the representative-agent methodology given all these challenging aggregation results (see for the makro-production-function Fisher 1969 or Fisher&Felipe 2003 & 2006 and the bunch of literature to the Cambridge Capital Controversies and of course the literature interpreting the Sonnenschein-Mantel-Debreu results, f.e. Rizvi 1994 or 2006)

And in what sense does it make sense to describe modern macro models as "microfounded", if at the same time, you need some Friedman-1953-as-if argumentation to justify & make plausible your way of modeling, which is often referred to, that the inner functioning of your model is a black box and unknown, only built to generate predictions, not less. but certainly not more, in the sense that we think the way of modeling is reasonably realistic and corresponding to some mechanisms in the real world. Why should we, or why is this commonly called "microfoundations"??

johnchx said... MT wrote: "One thing I learned from it is that I need to read the old papers by Sonnenschein (1972), Mantel (1974), and Debreu (1974) since these papers appear to undermine representative agent models."

Yes; I have the impression that it's been clear for a very long time that representative agent models lack microfoundations -- that is, that classical micro assumptions are insufficient to support the existence of a representative agent, that the necessary conditions are unknown, and that the known sufficient conditions are extremely restrictive (e.g. perfectly homogeneous agents). I've tended to view this as evidence that many of those advancing the banner of microfoundations simply weren't serious.
If one really cared about understanding macro fluctuations in terms of the behavior of individual households and firms, one would study the behavior of individual households and firms; a representative agent framework would be entirely unsatisfactory.

I think it's also telling that most of the famous names associated with microfoundations in macro have been theoreticians rather than microeconometricians. I suspect that we may be able to learn more about real microfoundations of macro from, say, James Heckman than from Lucas or Barro.

Am I wildly off-base?

Herman said... Mark Thoma,
May I suggest elevating Roberto Cruccolini's very interesting comment above as a separate new post.

reason said in reply to Herman... Or even on Steven Keen's book "Debunking Economics" which covers most of the same territory in a very readable fashion.

Update: More from Alan Kirman: Economic theory and the crisis.

What's Wrong with Modern Macroeconomics?

The travel references are referring to this. (My first trip to Germany - I set up a bunch of posts before I left - through Sunday just in case - but will add what I can.)

"Let A Hundred Theories Bloom"

Joseph Stiglitz says there's a diverse set of ideas within the economics profession, ideas that go beyond the "self-regulating, fully efficient markets that always remain at full employment" pushed by some economists. These ideas have had trouble finding their way into the mainstream, and that has limited our ability to move beyond the confines of standard approaches to macroeconomic modeling. But that may change (and hopefully will change) for the better since the crisis has "given new impetus to the exploration of alternative strands of thought that would provide better insights into how our complex economic system functions":

Let A Hundred Theories Bloom, by George Akerlof and Joseph Stiglitz, Commentary, Project Syndicate: BUDAPEST – The economic and financial crisis has been a telling moment for the economics profession, for it has put many long-standing ideas to the test. If science is defined by its ability to forecast the future, the failure of much of the economics profession to see the crisis coming should be a cause of great concern.

But there is, in fact, a much greater diversity of ideas within the economics profession than is often realized. This year’s Nobel laureates in economics are two scholars whose life work explored alternative approaches. Economics has generated a wealth of ideas, many of which argue that markets are not necessarily either efficient or stable, or that the economy, and our society, is not well described by the standard models of competitive equilibrium used by a majority of economists.

Behavioral economics, for example, emphasizes that market participants often act in ways that cannot easily be reconciled with rationality. Similarly, modern information economics shows that even if markets are competitive, they are almost never efficient when information is imperfect or asymmetric (some people know something that others do not, as in the recent financial debacle) – that is, always.

A long line of research has shown that even using the models of the so-called “rational expectations” school of economics, markets might not behave stably, and that there can be price bubbles. The crisis has, indeed, provided ample evidence that investors are far from rational; but the flaws in the rational expectations line of reasoning—hidden assumptions such as that all investors have the same information—had been exposed well before the crisis.

Just as the crisis has reinvigorated thinking about the need for regulation, so it has given new impetus to the exploration of alternative strands of thought that would provide better insights into how our complex economic system functions – and perhaps also to the search for policies that might avert a recurrence of the recent calamity.

Fortunately, while some economists were pushing the idea of self-regulating, fully efficient markets that always remain at full employment, other economists and social scientists have been exploring a variety of different approaches. These include agent-based models that emphasize the diversity of circumstances; network models, which focus on the complex interrelations among firms (such as those that enable bankruptcy cascades); a fresh look at the neglected work of Hyman Minsky on financial crises (which have increased in frequency since deregulation began three decades ago); and innovation models, which attempt to explain the dynamics of growth.

Much of the most exciting work in economics now underway extends the boundary of economics to include work by psychologists, political scientists, and sociologists. We have much to learn, too, from economic history. For all the fanfare surrounding financial innovation, this crisis is remarkably similar to past financial crises, except that the complexity of new financial products reduced transparency, aggravating fear about what might happen should there not be a massive public bailout.

Ideas matter, as much or perhaps even more than self-interest. Our regulators and elected officials were politically captured – special interests in the financial markets gained a great deal from rampant deregulation and the failure to adapt the regulatory structure to the new products. But our regulators and politicians also suffered from intellectual capture. They need a wider and more robust portfolio of ideas to draw upon.

That is why the recent announcement by George Soros at the Central European University in Budapest of the creation of a well-funded Initiative for New Economic Thinking (INET) to help support these is so exciting. Research grants, symposia, conferences, and a new journal – all will help encourage new ideas and collaborative efforts to flourish.

INET has been given complete freedom – with respect to both content and strategy – and one hopes that it will draw further support from other sources. Its only commitment is to “new economic thinking,” in the broadest sense. Last month, Soros assembled a remarkable group of economic luminaries, from across the spectrum of the profession –theory to policy, left to right, young and old, establishment and counter-establishment—to discuss the need and prospects for such an initiative, and how it might best proceed.

For the past three decades, one strand within the economics profession was constructing models that assumed that markets worked perfectly. This assumption overshadowed a wide body of research that helped explain why markets often work imperfectly – why, indeed, there are widespread market failures.

The marketplace for ideas also often works in a way that is less than ideal. In a world of human fallibility and imperfect understanding of the complexity of the economy, INET holds out the promise of the pursuit of alternative strands of thought – and thereby at least ameliorating this costly market imperfection.

As I've noted before, I don't think it was the tools or the topics we study that was the problem, it was the questions the leaders in the profession emphasized (or ridiculed as the case may be). The emphasis on particular questions leads to a dominant presence of this line of work in journals, the source of advancement within the profession, and this crowds out alternative approaches. It will be interesting to see which of these ideas, if any, will now "find its time."

"Supply-Side Economics, R.I.P."?

Bruce Bartlett says supply-side economics should "should declare victory and then go out of existence.":

Supply-Side Economics, R.I.P., by Bruce Bartlett: Today is the official publication date of my latest book, The New American Economy. In this post I'd like to explain a little bit about why I wrote it and how I arrived at my present state of mind, which seems to be confusing to many of my friends.

The book grew out of an op-ed I had in the New York Times back in 2007. In it I argued that supply-side economics (SSE) should declare victory and then go out of existence. Everything that was true about it had by then been fully incorporated into mainstream economic thinking and all that was left was a caricature. Continuing to maintain a separate identity for SSE only created unnecessary conflict with mainstream economists, I argued.

As a member of Jack Kemp's congressional staff back in the late 1970s, I had a front-row seat to the creation of SSE. ... I was the person on Kemp's staff whose job it was to actually draft and promote the Kemp-Roth tax bill, which was adopted by Ronald Reagan during the 1980 campaign and enacted into law in August 1981. It brought the top marginal income tax rate down from 70 percent to 50 percent, among other things. ...

I continue to believe that what the supply-siders did was good for the economy, good for the country and good for the advancement of economic science. The best economists in the country were pretty clueless about our economic problems during the Carter years. It was widely asserted that the money supply had no meaningful effect on inflation, that marginal tax rates had no incentive effects, and that it would take decades or another Great Depression to break the back of inflation.

As all economists now know, these ideas were wrong. All economists today accept the importance of the money supply--perhaps too much; during the recent crisis many asserted that fiscal stimulus was unnecessary because an increase in the money supply was the only thing necessary to restore growth. (How this would have been accomplished when interest rates were close to zero was never explained.) All economists now accept the importance of marginal tax rates to economic decisionmaking...

During the George W. Bush years, however, I think SSE became distorted into something that is, frankly, nuts--the ideas that there is no economic problem that cannot be cured with more and bigger tax cuts, that all tax cuts are equally beneficial, and that all tax cuts raise revenue.

These incorrect ideas led to the enactment of many tax cuts that had no meaningful effect on economic performance. Many were just give-aways to favored Republican constituencies, little different, substantively, from government spending. What, after all, is the difference between a direct spending program and a refundable tax credit? Nothing, really, except that Republicans oppose the first because it represents Big Government while they support the latter because it is a "tax cut." I think these sorts of semantic differences cloud economic decisionmaking rather than contributing to it. As a consequence, we now have a tax code riddled with ... schemes of dubious merit...

The supply-siders are to a large extent responsible for this mess, myself included. We opened Pandora's Box when we got the Republican Party to abandon the balanced budget as its signature economic policy and adopt tax cuts as its raison d'être. In particular, the idea that tax cuts will "starve the beast" and automatically shrink the size of government is extremely pernicious.

Indeed, by destroying the balanced budget constraint, starve-the-beast theory actually opened the flood gates of spending. ...[I]f, as Republicans now maintain, taxes must never be increased at any time for any reason then there is never any political cost to raising spending and cutting taxes at the same time, as the Bush 43 administration and a Republican Congress did year after year.

My book is an effort to close Pandora's Box and explain to people why I believe that SSE should go out of business--or declare victory and go home, if that makes the idea easier to accept. To the extent that it has any valid insights left to inform policymaking they should be used to design a tax system capable of raising considerably more revenue at the least possible economic cost. Going forward, I believe that financing an aging society and a permanent welfare state is the biggest economic problem we face. ...

As I thought about the cycle that SSE had gone through from a response to the failure of Keynesian economics in the 1970s to triumph in the 1980s to caricature in the 2000s, it occurred to me that SSE and Keynesian economics had a lot in common. Each had been developed in response to serious economic problems that the existing orthodoxy was incapable of dealing with, both struggled for acceptance but were ultimately implemented to great success, both were then misapplied in inappropriate circumstances, thus leading to them becoming discredited.

So basically the book is about the rise and fall of Keynesian economics followed by the rise and fall of SSE. Although the Keynesian part of the book was originally intended to flesh out my model of the rise and fall of economic theories, it turned out to have very valuable lessons for today. Indeed, the circle appears to have come around to where Keynesian theories are now the best ones we have for dealing with today's economic crisis. ...

The General Theory, I think, was really just Keynes' way of making some relatively simple ideas look scientific in order to make them more acceptable to policymakers. The first idea is that deflation was the central economic problem. Second is that it was impractical to cut money wages to reduce unemployment and restore equilibrium. And third is that monetary policy was impotent because the economy was in a liquidity trap. ...

Economist Irving Fisher added an additional component ... by showing that the zero-bound problem is a very serious impediment to monetary policy... Fisher also explained that deflation magnified the real value of debt, which became a crushing burden on both households and businesses that reduced spending and growth.

What both Keynes and Fisher said was that when the economy is in a deflationary depression the collapse of private spending had to be compensated for by public spending, because that was the only way to get money circulating and make monetary policy effective. While monetary policy would drive the recovery it needed fiscal policy in order to work.

When the economic crisis hit in the fall of last year, I was very grateful for having studied the Great Depression and absorbed the work of great thinkers like Keynes and Fisher because, as Yogi Berra might have said, it was déjà vu all over again.

It seemed obvious to me right from the beginning that there was a close parallel between the causes of the Great Depression and the current crisis. The principal difference is that the former was caused by a collapse of the money supply resulting from the closure of many banks and the disappearance of their deposits, while the latter was caused by a fall in velocity resulting from a sharp decline in consumer spending following bursting of the housing bubble. (Because GDP equals the money supply times velocity, a decline in velocity has exactly the same effect as a decline in the money supply--nominal GDP must shrink, which causes both prices and output to fall.) ...

[M]y ... analysis led me to support a large fiscal stimulus. Without public spending on goods and services I didn't see any way for monetary policy to be effective... I was disappointed that so little of the February stimulus package went to the purchase of goods and services, which drives spending, and so much into economically ineffective transfers, which don't. But I understood that time was of the essence and that taking the time to design a better package would have required even more effort to overcome the economy's inertia, not to mention the political obstacles.

In researching my book I saw many points early in the Great Depression when a little bit of the right monetary and fiscal stimulus might have turned things around and made it just a run-of-the-mill recession. But as effective action was delayed year after year, more and more effort was needed to get the economy off a dead stop. It was only when all constraints on spending and money growth were cast aside during World War II that the Great Depression really ended.

I believe that relatively modest action early last year could have forestalled the current crisis or at least mitigated it substantially. I think the tax rebate was wrongheaded and a complete waste of money, and that the money would have been better spent cleaning up the housing mess. ...[B]ut the Bush administration's obsession with tax cuts as the sole cure for every economic problem--even when they involved nothing more than mailing out government checks--blinded it to alternative policies that might have nipped the housing problem in the bud and prevented the banking system from imploding.

By September, it was obvious to me that substantial government funds would be necessary to bail-out the financial system and prevent a systemic collapse that would have cost vastly more and imposed vastly greater economic hardship. I thought this argument was pretty straightforward and been well accepted by economists ever since the time of Walter Bagehot in the late 18^th century. ...

I remain incredulous that serious economists not only opposed TARP, but also argued that tax cuts were the only fiscal stimulus the government should have engaged in--if it did anything at all. ... I really don't understand how tax cuts would have done the slightest bit of good when millions of people had no income because they were unemployed, when businesses had no profits to tax, and investors had huge capital losses that will offset all of their gains for years to come. Given such economic conditions--resulting from a lack of demand, not supply--it's nonsensical to think that tax cuts would have helped. Indeed, one can make a case that the tax cuts included in the stimulus bill were its least effective element.

Many of my friends believe I have abandoned supply side economics and become a Keynesian. ... But as I try to explain in my book, my views haven't changed at all; it's circumstances that have changed. I believe that my friends are still stuck in the 1970s when tax rates were considerably higher and excessive demand (i.e., inflation) was our biggest economic problem. Today, tax rates are much lower and a lack of demand (i.e., deflation) is the central problem. I really don't understand why conservatives insist on a one-size-fits-all economic policy consisting of more and bigger tax cuts no matter what the economic circumstances are; it's simply become dogma totally disconnected from reality.

Nor do I understand the conservative antipathy for Keynes, who was in fact deeply conservative. He developed his theories primarily for the purpose of saving capitalism from some form of socialism. Same goes for Franklin D. Roosevelt, whose biggest economic mistake, I believe, was not that he ran big budget deficits, as all conservatives believe, but that he didn't run deficits nearly large enough until the war forced his hand. ... People can judge for themselves if I prove my case. ...

I'm between classes so I don't have time to add much, but the op-ed linked above that Bartlett says motivated him to write the book sparked a long, detailed, and intense discussion here when it was first published among Bruce Bartlett, Paul Krugman, Brad DeLong, Jamie Galbraith, and Lawrence White among others (I weigh in too, but I would not write it the same way today). See:

• Supply-Side Economics: Paul Krugman Responds

• Brad DeLong: How Supply-Side Economics Trickled Down...

"The Struggle Ahead"

Robert Solow on the need for further stimulus, the need to shift demand from consumption to investment, and the need for a new macroeconomics:

3 Questions: Robert Solow on the struggle ahead, MIT News: Economist Robert Solow's seminal work in the 1950s and 1960s showed how new technologies create a large portion of economic growth, an achievement for which he was awarded the 1987 Nobel Prize in Economics. With the economy seemingly in need of a technological boost again, the emeritus Institute Professor sat down with MIT News for a talk in his office this week.

Q. What is your assessment of the economy now, and where is it going?
A. Forecasting is hard and dangerous, and I don't do it. But it appears that the worst of the recession is over. However, the economy will be getting better slowly. And saying the economy is getting better is not the same thing as saying the economy is doing well. Real GDP fell by about 3.5 percent during the recession. But capacity increased 2.5 percent. We were producing 6 percent less than we knew how to produce. That gap has to narrow to reduce unemployment. If we rely only on the normal self-curing powers of a market economy, it may take until late in 2010 or early 2011 before we reduce that gap. So for that reason we should not rule out further stimulus in the next six to nine months. It's not easy because we have this enormous deficit. But we should recognize that even if the economy improves on its own, it won't do very much.

"The Anti-History Boys"

Brad DeLong:

The anti-history boys, by J. Bradford DeLong, Commentary, Project Syndicate [earlier version]: If you asked a modern economic historian like me why the world is currently in the grips of a financial crisis and a deep economic downturn, I would tell you that this is the latest episode in a long history of similar bubbles, crashes, crises, and recessions that date back at least to the canal-building bubble of the early 1820s, the 1825-1826 failure of Pole, Thornton & Co, and the subsequent first industrial recession in Britain. We have seen this process at work in many other historical episodes as well – in 1870, 1890, 1929, and 2000.

For some reason, asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that over-reward subordinates for taking risk. Sometimes the cause is government guarantees. And sometimes it is simply a long run of good fortune, which leaves the market dominated by unrealistic optimists.

Then the crash comes. And when it does, risk tolerance collapses; everybody knows that there are immense unrealized losses in financial assets and nobody is sure that they know where they are. The crash is followed by a flight to safety, which is followed by a steep fall in the velocity of money as investors hoard cash. And that fall in monetary velocity brings on a recession.

I will not say that this is the pattern of all recessions; it isn’t. But I will say that this is the pattern of this recession, and that we have been here before.

But if you ask the same question of a modern macroeconomist – for example, the extremely bright Narayana Kocherlakota of the University of Minnesota – you will find that he says that he does not know, and that macroeconomic models attribute economic downturns to various causes. Most, he points out, “rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)…”

That is, downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers suddenly develop a taste for extra leisure, or a great rusting as the speed at which oxygen corrodes accelerates, reducing the value of large things made out of metal.

But modern macroeconomists will also say that all these models strike them as implausible stories that are not to be taken seriously. Indeed, according to Kocherlakota, nobody really believes them:

 “Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility” in their mathematical models.

This leads me to ask two questions:

First, is it really true that nobody believes these stories? Ed Prescott of Arizona State University really does believe that large-scale recessions are caused by economy-wide episodes of forgetting the technological and organizational knowledge that underpin total factor productivity. One exception is the Great Depression, which Prescott says was caused by real wages far exceeding equilibrium values, owing to President Herbert Hoover’s extraordinary pro-labour, pro-union policies.

Likewise, Casey Mulligan of the University of Chicago really does appear to believe that large falls in the employment-to-population ratio are best seen as “great vacations” – and as the side-effect of destructive government policies like those in place today, which lead workers to quit their jobs so they can get higher government subsidies to refinance their mortgages. (I know; I find it incredible, too.)

Second, regardless of whether modern macroeconomists attribute our current difficulties to causes that are “patently unrealistic” or simply confess ignorance, why do they have such a different view than we economic historians do? Regardless of whether they have rejected our interpretations and understandings or simply have built or failed to build their own in ignorance of what we have done, why have they not used our work?

The second question is particularly disturbing. After all, economic theory should be grappling with economic history. Theory is crystallized history – it can be nothing more. Someone observes some instructive case or some anecdotal or empirical regularity, and says, “This is interesting; let’s build a model of this.” After the initial crystallization, theory does, of course, develop according to its own intellectual imperatives and processes, but the seed of history is still there. What happened to the seed?

This is not to say that the macroeconomic model-building of the past generation has been pointless. But I do think that modern macroeconomists need to be rounded up, on pain of loss of tenure, and sent to a year-long boot camp with the assembled monetary historians of the world as their drill sergeants. They need to listen to and learn from Dick Sylla about Alexander Hamilton’s bank rescue of 1825; from Charlie Calomiris about the Overend, Gurney crisis; from Michael Bordo about the first bankruptcy of Baring brothers; and from Barry Eichengreen, Christy Romer, and Ben Bernanke about the Great Depression.

If modern macroeconomists do not reconnect with history – if they do not realize just what their theories are crystallized out of and what the point of the enterprise is – then their profession will wither and die.

I'm not sure this answers Brad's question in general, but I think the general lack of interest in economic history may come, in part, from the rejection of Keynesian economics. The reason this group ignores economic history and the types of interpretations Brad is placing on it, certain parts of history anyway, may be, as David Laidler notes, that this group believes Keynes was a detour from the true path. Why learn this history when you think it is irrelevant?

People like Robert Lucas, for example, believe that modern models have little to offer when it comes to explaining the Great Depression or our recent experience:

Talking about "My Keynesian Education" at the 2003 HOPE conference on The IS-LM Model: Its Rise, Fall, and Strange Persistence (Michel De Vroey and Kevin Hoover 2004) Lucas pointed, almost as an aside, to

the problem that the new theories, the theories embedded in general equilibrium dynamics of the sort that we know how to use pretty well now – there's a residue of things they don't let us think about. They don't let us think about the U.S. experience in the 1930s or about financial crises and their real consequences in Asian and Latin America, they don't let us think very well about Japan in the 1990s (2004, p 23)

This remark dates from 2003, when the final "Greenspan boom" was in full swing, and the "residue" of problems to which Lucas referred did indeed seem rather remote from the immediate but apparently well-established economic environment in which it was made, and we should judge its offhand tone in this context. Viewed with hindsight, though, the remark was ominous, because those same models now, in 2009, do not help us to think about problems that are dominating the current evolution of the entire world economy - some residue!

But even though Lucas believes that modern models are not very useful, he is unwilling to learn from the past because he thinks it was an unproductive detour from the true path, i.e. there is nothing to learn:

As everyone knows, what was soon labeled new-classical economics emerged largely from Lucas’s own efforts... Initially, it was his replacement of adaptive by rational expectations that attracted most of the attention, but the closely related explicit application to traditionally macro questions of micro general equilibrium analysis marked a much more fundamental change in the then dominant approach to macro-economics, because it broke the area's last remaining intellectual links to Keynes' General Theory. Moreover, though Lucas’s contribution launched a radically new vision of how a market economy functions, he himself thought of it more modestly as involving the exploitation of newly available analytic techniques to deal with age-old problems that the macro-economic theory of the 1960s and the macro-econometrics that went with it had proved unable to address. Viewing the General Theory through the prism created by this macro-economics, he saw it as having created an unhelpful detour in the discipline’s otherwise orderly history, and interpreted its temporary success as a consequence of the historical situation that had prompted its writing.

In Lucas' view, Keynes had not advanced economics but had merely offered an ad hoc political response to the circumstances of the Great Depression, a response which, seen in relation to what Lucas believed to have been the already long-established internal dynamic of economics, was of no lasting scientific value. In 2004, he made this point as follows:

"Keynes's real contribution is . . .not Einstein-level theory, new paradigm, all this . . ..that's just so much hot air. . . [I]n writing the General Theory, Keynes was viewing himself as a spokesman for a discredited profession. . . .in a situation
where people are ready to throw in the towel on capitalism and liberal democracy and go with fascism or corporatism, protectionism, socialist planning. . . . What he hits on is that the government should take on new responsibilities . . . for stabilizing overall spending flows. . . . And . . . for everybody in the post-war period – I'm talking about Keynesians and monetarists both – that's the agreed upon view.. . .

So I think this was a great political achievement. It gave us a lasting image of what we need economists for. I've been talking about the internal mainstream of economics, that's what we researchers live on, but as a group we have to earn our living by helping people diagnose situations that arise and helping them understand what is going on and what we can do about it. That was Keynes's whole life. He was a political activist from beginning to end. (2004, pp 23-24)

The history is not just forgotten, it's intentionally ignored..

"Dark Age in Macroeconomics?"

This is Nick Rowe (it's in response to Paul Krugman and follows up on one of Nick's previous posts):

Dark Age in Macroeconomics? A History of Taught approach, by Nick Rowe: (Or maybe the title should be: "Notes from the Phelps/Lucas Administration"; or "Notes to supplement our fading memories of the late 1970's".)

Is this a Dark Age in macroeconomics? In other words, have we collectively forgotten some (important) stuff that we used to understand?

I want to approach this question by looking at what was taught in the past to economics graduate students, so we can compare what is left out now to what was left out then.

I have a sample of one: my own lecture notes from grad school. I began my MA at UWO in 1977, and continued into the PhD. I took everything in macro/money that was offered. At the time, UWO was arguably the top Canadian department in macro/money (OK, Western grads would argue for; Queens grads would argue against), and would hold up well against anywhere in the world.

Macro 1 (David Laidler). Required course. Review and critique of ISLM (lags, stocks flows and the government budget constraint, are the IS and AD curves really demand curves? [no], the missing AS curve). Crowding out debate. Non-Walrasian macro (Barro and Grossman). Say's Law. Phillips Curve (up to Phelps and Friedman). Consumption function (Friedman/Modigliani). Demand for money. Investment demand.

Macro 2 (Michael Parkin). Required for those continuing to the PhD. (I can't resist quoting from the first page of my notes here: "Economics [is] Understand + Explain Phenomena using Rational models. How could Rational Behaviour [lead to] Disaster? Market Failure."). Review and critique of Neoclassical model of labour market. Lucas and Rapping (from the Phelps volume), and why their model was logically incoherent (Michael Parkin was right on this point). Mortensen's (also from Phelps volume) search theory of unemployment. Theories of implicit wage contracts (sticky wages). Theories of price adjustment (proto New-Keynesian). ISLM plus Phillips Curve (distinction between proto New-Keynesian and New Classical interpretations of Phillips Curve). Adaptive vs. Rational expectations. Policy Irrelevance Proposition ("[deviations of output from y* are] just noise, but obviously false").

Money 1 (Don Patinkin/Peter Howitt). Optional. Hume. Fisher. Lavington. Wicksell. Keynes' Tract, Treatise, and General Theory. Patinkin's Money interest and Prices. Are money and bonds net wealth? Commodity money. Solow/Swan growth model. Money and growth. Optimal quantity of money. Transactions costs. Baumol/Tobin and Miller/Orr models of demand for money.

Money 2 (Joel Fried). Optional. Microfoundations of money, Menger, Ostroy, Jones. Money in general equilibrium theory. Clower constraints. Transactions costs. Financial markets. Tobin. CAPM. Efficient Markets. Modigliani/Miller theorem. Term structure of interest rates. Tobin portfolio choice. Friedman and Monetarism. International finance. Dornbusch overshooting. Exogenous vs endogenous money. Canadian monetary policy.

Advanced Macro (Peter Howitt). Optional. (Lovely quote from the first page: "We are Aristotelian monks, trying to solve anomolies to stop future generations wasting their time doing the same thing.". Non-Walrasian disequilibrium theory (Clower, Leijonhufvud, Barro/Grossman, Malinvaud, Benassy, etc.). Stability. Catastrophe theory(!). Price adjustment under oligopoly. Optimal control theory. Inventories. Phelps/Winter price setting with transient monopoly power (from the Phelps volume, proto New-Keynesian).

(I learned some more money/macro in David Laidler's History of Thought class. But I was the only graduate student in that class, so I'm not going to count it. My colleague Calum Carmichael, who took the same course as an undergraduate, estimates that about one quarter of the Honours economics students took that class.)

I make the follow observations:

1. The Phelps volume was clearly very influential in the late 1970's. This supports Paul Krugman's memory, and my own.

2. The beginnings of the split between New Classical and New Keynesian approaches was already apparent in the late 1970's. I saw several references to the distinction between Fisher and Phelps on the interpretation of the Phillips Curve. (Fisherian market-clearing with misperceptions vs Phelpsian disequilibrium price adjustment). This too supports Paul Krugman's memory.

3. We received a very broad education in short run macroeconomics and monetary theory. Probably much broader than today's students. That tends to support the Dark Age hypothesis.

4. But there is one glaring omission from our education: we did lots of short run business cycle theory but almost no long run growth theory. We briefly covered the Solow growth model, but only as a prelude to money and growth. There was no interest in growth theory per se! If growth theory is important, and it is, that directly contradicts the Dark Age hypothesis. We barely touched on half of macro! The late 1970's were the Dark Age, for growth theory.

Why did we ignore growth theory?

Growth theory wasn't on the agenda. It wasn't that growth was unimportant; just that there seemed to be nothing important to say about it. All the exciting policy debates were about inflation and unemployment, not long run growth. All the exciting theoretical developments were about inflation and unemployment, not long run growth. "Endogenous" growth theories (a stupid misnomer, because growth is endogenous in Solow too, just with an extremely simple functional relationship to the exogenous variables, namely g=n) came later.

Fiscal policy has been off the agenda for much the same reasons, until recently.

(5. We spent surprisingly little time on open economy macroeconomics as well, for a Canadian school.)

OK. Let's compare notes!

This is very similar to my own experience, we also did very little growth theory (nothing beyond Solow-Swan, also as a prelude to looking at whether money was "superneutral"), and I didn't take any international at all - it wasn't part of the macro sequence (the international economy was not considered very important for understanding business cycle fluctuations). The emphasis was on short-run stabilization policy, monetary policy in particular. However, my experience was a bit different in that by the time I got to graduate school in the early 1980s, the split between saltwater and freshwater economists was well underway.

Paul Krugman says:

But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?

The answer was that they split. One faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever.” That faction became New Keynesian, saltwater economics.

The other faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can’t.” That faction became real business cycle, freshwater economics.

Here's what I said about this just under two and a half years ago (edited slightly). As you can see, even though this was written well before Krugman's statement, it basically agrees with his assertion that everyone knew the New Classical model was in trouble by 1980 or 1981 (the Mishkin paper noted below was published, I believe, in 1982, but given the long publication lags the results were well known long before then). It also agrees with his comments that one faction, the New Keynesians, built upon the old Keynesian structure by giving it rational agents and microfoundations who operated in an environment beset with rigidities of one type or another (these rigidities prevent agents from fully neutralizing nominal shocks such as changes in the money supply), and the other faction reemerged as the real business cycle school:

I entered graduate school in 1980. Though it started with a pretty traditional IS-LM framework with some AD-AS thrown in, most of our time was spent learning the New Classical model. Much of the research effort at that time, at least the effort I was made aware of, was to try and punch holes in the result that comes out of the New Classical framework that only unanticipated money can affect real variables like output and employment.

This assault came on both theoretical and empirical fronts. Mishkin, for example, had published an empirical paper in the early 1980s that challenged work by Barro and others from the later 1970s supporting the New Classical model and its implication that only surprise money matters. On the theoretical front, the old Keynesian model -- which had been criticized for, among other things, lacking microeconomic foundations and lacking rational expectations -- was being reconstructed into the New Keynesian model. This model would eventually overcome theoretical objections that plagued the older Keynesian model, and it would also do a better job than the New Classical model of explaining the magnitude and persistence of business cycles and other features of the macroeconomic data. We learned some about Real Business Cycle models - but for the most part that work went on elsewhere and would surface later with more force as an alternative to the New Keynesian framework. But we were certainly made aware of the real business cycle model, e.g. arguments about reverse causality to explain statistical money income correlations. I'd say the same about growth theory - we did the Solow-Swan basics, but very little beyond that. Stabilization policy was the main issue we worried about at the time.

Does money matter? I thought so, that's what my dissertation was all about, it gave theoretical and empirical reasons to doubt the New Classical result that expected money does not affect output, but the issue of whether money matters was not settled until later. We now accept, for the most part, that the Fed can affect real interest rates and also affect the real economy, but at that time there was a very strong split within the profession on this issue. It wasn't until later that a general belief that anticipated monetary policy was a potentially useful stabilization tool surfaced in the profession. It's sometimes surprising to me today how complete the conversion on that issue has been, though it's certainly not 100%.

So, it wasn't generally agreed that money mattered, i.e. that money was a useful policy tool for stabilizing the real economy. But the Keynesian economics I learned at the time, which was in the implicit and explicit labor contracting framework for the most part, did say that money mattered. In fact, since the point was to challenge the New Classical result that money did not matter, the focus was mostly on monetary policy. As for fiscal policy, the Keynesian model we talked about - beyond the simple IS-LM version we learned at first - paid very little attention to fiscal policy, though papers such as Barro's "Are Bonds Net Wealth" were part of the conversation. Thus, when I went to graduate school - and this was partly due to who was teaching the courses - the primary focus was on whether and how changes in monetary policy affected the real economy.

In any case, even though it was a few years later than Nick's experience, we also spent considerable time on the ideas that Krugman notes have since been lost as we entered our recent "Dark Ages."

I have a sample of one: my own lecture notes from grad school. I began my MA at UWO in 1977, and continued into the PhD. I took everything in macro/money that was offered. At the time, UWO was arguably the top Canadian department in macro/money (OK, Western grads would argue for; Queens grads would argue against), and would hold up well against anywhere in the world.

Macro 1 (David Laidler). Required course. Review and critique of ISLM (lags, stocks flows and the government budget constraint, are the IS and AD curves really demand curves? [no], the missing AS curve). Crowding out debate. Non-Walrasian macro (Barro and Grossman). Say's Law. Phillips Curve (up to Phelps and Friedman). Consumption function (Friedman/Modigliani). Demand for money. Investment demand.

Macro 2 (Michael Parkin). Required for those continuing to the PhD. (I can't resist quoting from the first page of my notes here: "Economics [is] Understand + Explain Phenomena using Rational models. How could Rational Behaviour [lead to] Disaster? Market Failure."). Review and critique of Neoclassical model of labour market. Lucas and Rapping (from the Phelps volume), and why their model was logically incoherent (Michael Parkin was right on this point). Mortensen's (also from Phelps volume) search theory of unemployment. Theories of implicit wage contracts (sticky wages). Theories of price adjustment (proto New-Keynesian). ISLM plus Phillips Curve (distinction between proto New-Keynesian and New Classical interpretations of Phillips Curve). Adaptive vs. Rational expectations. Policy Irrelevance Proposition ("[deviations of output from y* are] just noise, but obviously false").

Money 1 (Don Patinkin/Peter Howitt). Optional. Hume. Fisher. Lavington. Wicksell. Keynes' Tract, Treatise, and General Theory. Patinkin's Money interest and Prices. Are money and bonds net wealth? Commodity money. Solow/Swan growth model. Money and growth. Optimal quantity of money. Transactions costs. Baumol/Tobin and Miller/Orr models of demand for money.

Money 2 (Joel Fried). Optional. Microfoundations of money, Menger, Ostroy, Jones. Money in general equilibrium theory. Clower constraints. Transactions costs. Financial markets. Tobin. CAPM. Efficient Markets. Modigliani/Miller theorem. Term structure of interest rates. Tobin portfolio choice. Friedman and Monetarism. International finance. Dornbusch overshooting. Exogenous vs endogenous money. Canadian monetary policy.

Advanced Macro (Peter Howitt). Optional. (Lovely quote from the first page: "We are Aristotelian monks, trying to solve anomolies to stop future generations wasting their time doing the same thing.". Non-Walrasian disequilibrium theory (Clower, Leijonhufvud, Barro/Grossman, Malinvaud, Benassy, etc.). Stability. Catastrophe theory(!). Price adjustment under oligopoly. Optimal control theory. Inventories. Phelps/Winter price setting with transient monopoly power (from the Phelps volume, proto New-Keynesian).

(I learned some more money/macro in David Laidler's History of Thought class. But I was the only graduate student in that class, so I'm not going to count it. My colleague Calum Carmichael, who took the same course as an undergraduate, estimates that about one quarter of the Honours economics students took that class.)

I make the follow observations:

1. The Phelps volume was clearly very influential in the late 1970's. This supports Paul Krugman's memory, and my own.

2. The beginnings of the split between New Classical and New Keynesian approaches was already apparent in the late 1970's. I saw several references to the distinction between Fisher and Phelps on the interpretation of the Phillips Curve. (Fisherian market-clearing with misperceptions vs Phelpsian disequilibrium price adjustment). This too supports Paul Krugman's memory.

3. We received a very broad education in short run macroeconomics and monetary theory. Probably much broader than today's students. That tends to support the Dark Age hypothesis.

4. But there is one glaring omission from our education: we did lots of short run business cycle theory but almost no long run growth theory. We briefly covered the Solow growth model, but only as a prelude to money and growth. There was no interest in growth theory per se! If growth theory is important, and it is, that directly contradicts the Dark Age hypothesis. We barely touched on half of macro! The late 1970's were the Dark Age, for growth theory.

Why did we ignore growth theory?

Growth theory wasn't on the agenda. It wasn't that growth was unimportant; just that there seemed to be nothing important to say about it. All the exciting policy debates were about inflation and unemployment, not long run growth. All the exciting theoretical developments were about inflation and unemployment, not long run growth. "Endogenous" growth theories (a stupid misnomer, because growth is endogenous in Solow too, just with an extremely simple functional relationship to the exogenous variables, namely g=n) came later.

Fiscal policy has been off the agenda for much the same reasons, until recently.

(5. We spent surprisingly little time on open economy macroeconomics as well, for a Canadian school.)

OK. Let's compare notes!

"Economists Need to Study Bubbles"

Robert Shiller says economists and their models need to take bubbles seriously (compare Dani Rodrik's "Blame Economists, not Economics"):

Economists need to study bubbles, reinvent models, by Robert Shiller, Commentary, Project Syndicate: The widespread failure of economists to forecast the financial crisis ... has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come. ...

[T]he current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. ... You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable ... that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

"New Models for a New Challenge"

Stephen Cecchetti, Piti Disyatat and Marion Kohler on "whether our macroeconomic models are still relevant," and if not, what needs to change:

Integrating financial stability: new models for a new challenge, by Stephen G Cecchetti, Piti Disyatat and Marion Kohler, September 2009: Introduction Reflecting on the financial crisis that is not yet over, it is natural to ask whether our macroeconomic models are still relevant. For all of their elegance and beauty, with their microeconomic foundations and complex endogenous dynamics, they provided the basis for monetary policy that delivered a quarter of a century of stability. The Great Moderation was great - inflation was low, growth was high, and both were stable. At least, that's what we thought. In retrospect, signs of smugness abounded. Academic journals are filled with papers explaining that this stability was, in large part, a result of good policy. And policymakers listened. The economy was inherently stable, with strong self-correcting forces. The financial crashes that were so common before the mid-20th century were banished by our deep and profound understanding that had been translated into mathematical models.

What a difference a year makes!

The models neither stopped the crisis from happening nor provided guidance on how policies could cushion its impact. They failed utterly in guiding our construction of an institutional framework capable of preventing systemic financial failure. Yes, there were warnings.¹ And yes, there were models that hinted at the sources of the difficulties we now face. And yes, the economic reasoning provides the lens through which we can start to understand what happened and why. But, in the end, we ignored the risks.

In this essay, we begin with a brief review of the pre-crisis consensus that provided the basis for stabilization policy as it has been conducted since around 1980. Our main conclusion is obvious: we need to build economic models that integrate the financial sector in a serious way, accounting for the role of intermediaries with all of their linkages, both with each other and with the real economy. And, most importantly, these models must be capable of endogenously creating financial stress that can build up until the pressure leads to a crisis - that is, models in which booms and busts are normal. ...

... 4. Conclusion For macroeconomics, the biggest lesson of the financial crisis is that our models need to find a more meaningful role for finance. Episodes of financial stress are too frequent, and seem too costly, to be treated just as events that are "bad luck" and therefore of little consequence to forward-looking stabilization policy, as suggested by Lucas (2009). Rather, we should ask whether policy can and should intervene to make financial stress less likely and less damaging when it inevitably comes.

While the New Keynesian workhorse models are built around a role for stabilization policies, they appear to have stopped too soon. Understanding how to deliver economic stability must include an understanding of how to avoid financial instability.

Modeling financial booms and busts requires a model where financial imbalances matter for the real economy. As we have suggested in this essay, this means questioning a number of fundamental assumptions of the current workhorse macroeconomic models, including whether capital markets function properly, whether individuals behave rationally, whether we can really rely on the fiction of a representative agent, and whether markets clear.

As daunting a task as this may seem, prospects for progress are encouraging. Not only is there a clear awareness of the challenge (Bean (2009)), but work is already under way: heterogeneous agent models are being solved, bounded-rationality and learning are being actively explored, agent-based models are being simulated, and incomplete financial markets as well as substantive financial frictions are being introduced.

It is our hope and expectation that successfully integrating financial imbalances into models of real fluctuations will yield a toolkit for policymakers. It will guide us in the creation of new stabilization tools as well in the improved use of old ones. It will help us understand how to measure financial stress in real time and allow for transparency and accountability of policymaking in the same way that price measurement is essential for holding inflation targeting central banks accountable. Getting there will not be easy, but then, the challenge to conventional monetary policymaking 50 years ago surely appeared daunting as well. Hopefully, this time it will not take as long to get things worked out.

"How We Got to Where We are Today"

One more from Paul Krugman on the state of macroeconomics:

Memories of the Carter Administration, by Paul Krugman: One of John Updike’s novels was titled Memories of the Ford Administration; needless to say, it wasn’t about Gerald Ford — basically it was about sex, because Updike remembered the Carter years as the golden age of extramarital affairs. Similarly, this post isn’t about Jimmy Carter – it’s about macroeconomic theory. (Sorry.)

For the late 1970s was when macroeconomics experienced its great divide. It’s a period engrained in the memory of those of us who were young economists at the time, trying to find our own paths. Yet I haven’t seen a clear explanation of what went down at the time. So here’s a sketch, which I hope a serious intellectual historian will fill in someday.

Has Economics Failed Us?

A modest defense of macroeconomics:

A “modest” intellectual discipline, by Gilles Saint‑Paul, Vox EU: The current crisis has spurred a debate on the training and usefulness of economists. Some contend that economists are useless since they failed to forecast the crisis. Others claim that their training is inadequate because it relies heavily on applied mathematics at the expense of a broad view of how the economy works, informed by other disciplines such as psychology, sociology, and political science. Hence, ten British institutional economists have written a letter to the Queen, in response to that of Besley and Hennessy, where they state that “economics has turned virtually into a branch of applied mathematics, and has been become detached from real world institutions and events.”

“Consequently a preoccupation with a narrow range of formal techniques is now prevalent in most leading departments of economics throughout the world, and notably in the UK. The letter by Professors Besley and Hennessy does not consider how the preference for mathematical technique over real-world substance diverted many economists from looking at the vital whole. It does not consider the typical omission of psychology, philosophy or economic history from the current education of economists in prestigious institutions. It mentions neither the highly questionable belief in universal ‘rationality’ nor the ‘efficient markets hypothesis’ – both widely promoted by mainstream economists. It also fails to consider how economists have also been ‘charmed by the market’ and how simplistic and reckless market solutions have been widely and vigorously promoted by many economists. What has been scarce is a professional wisdom informed by a rich knowledge of psychology, institutional structures and historical precedents.”

In France, a similar debate has been going on for years between mainstream economists trained in micro, macro, and econometrics and a variety of critics who usually complain that economics is immoral, too mathematical, not pluridisciplinary enough, or sometimes too right-wing.

While economics is admittedly quite a “dry” discipline, I firmly believe that replacing the training of economists by some soft transdisciplinary melting pot would be a catastrophe.

"Did Economists Ever Get it Right?"

Antonio Fatás on the state of macroeconomics:

Did Economists Ever Get it Right?, by Antonio Fatás, Commentary, MorningStar (originally): Paul Krugman has written a nice essay on the NY Times about How did economists get it wrong?. Other economists have written on the same topic: Eichengreen, Lane, Thoma, DeLong.

My reading of these articles is that there is a good deal of consensus around the following points:

1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy...

2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.

3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin...:

The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. ... Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.

Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.

4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).

One thing that I find missing in all those articles is whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.

It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.

We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

On point 4, I'll just add one thing. Besides the anchoring from ideology and beauty, part of the problem too, as I've argued before, is that we weren't asking the right questions. [I should also add that the reason we didn't ask the right questions may be tied to ideology, and perhaps the elegance of the supporting theoretical structure as well, that led to the belief in self-correction and self-protection from large shocks that made massive meltdown very unlikely if not impossible.] I have criticized regulators for not having plans ready to deal with too big to fail institutions. One thing everyone seems to agree on is that the ad hoc response from regulators made things worse, and we need to be better prepared with plans to dismantle these firms without destabilizing markets next time around (and do our best to prevent problems from developing to begin with, including regulating connectedness). The fact that we were caught without such plans was a big handicap in dealing with the unfolding crisis.

But the same can be said about macroeconomics. We didn't plan for a big crisis either. That is, we didn't take the threat of a large breakdown seriously enough to take the time to develop a theoretical framework that could anticipate these problems and guide us in how to deal with them if they occurred. There were stabs in this direction, but it was by no means a major effort or thought to be one of the more important research questions. We spent a lot of time developing stabilization policy, but it wasn't within a framework that was particularly helpful for the kinds of problems we are facing today. We had no plans on the shelf that we could rely upon when the crisis hit, and what we have seen from macroeconomists is the same kind of ad hoc scramble for an effective response that many of us have criticized regulators for. But if macroeconomists had taken the possibility of a massive meltdown seriously before it happened and developed the theoretical apparatus we are now calling for now that we have seen that such events are, in fact, possible, then perhaps regulators would have been more inclined to think through this possibility and get ready for it. I don't think the blame is all theirs.

"The Triumph of Central Banking?"

Paul Volcker discusses the usefulness of macroeconomic policy:

Paul A. Volcker In Conversation with Gary H. Stern, Minneapolis Fed (pdf): ...Economic knowledge and central banking

Stern: You’ve obviously been involved for a long time directly with the Federal Reserve, at senior levels, from the mid ’70s and even earlier than that in the Treasury as well. In your view, has macro policy or monetary policy changed significantly over those many years? Or are we still pretty much at the state of knowledge, and is the state of our responses pretty much where it was?

Volcker: [Laughter] It’s interesting you ask that question because I recently commented to some of my economist friends that I’m not aware of any large contribution that economic science has made to central banking in the last 50 years or so.

Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.

The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.

Right now, we are in the midst of a very large unsettled question. Are the unprecedented Federal Reserve and other official interventions in financial markets a harbinger of the future? Is reasonable financial stability really dependent on such government support?

On the technical side, there has been continuing change in the approach of central banks to the market, away from more quantitative approaches like the volume of bank reserves to much more emphasis on precise control of short-term interbank interest rates. The point is that in establishing and conducting policy, you need some means of reaching operational decisions. Those approaches have differed and evolved. But none of that breaks new conceptual ground.

Stern: Well, let me explore that a little further because I happened to be reading some of the [Federal Open Market Committee meeting] transcripts from the 1970s, after the oil price shock but before you became chairman, so neither of us was at the meetings.

Volcker: Well, actually I was at the meetings from 1975 as president of the New York Fed.

Stern: Of course, right. So these transcripts were a little earlier in the ’70s. Anyway, all the talk was about “cost-push” inflation and how monetary policy couldn’t do anything about it. That was not only the consensus in the United States, but Federal Reserve officials who were traveling in Europe and talking with their counterparts heard the same message. Looking back at that from today’s perspective, I think you’d be hard-pressed to find policymakers or economists who would accept that view.

Volcker: No, I think that’s basically true. You know, the clearest articulation of that point of view was in Burns’ farewell speech, “The Anguish of Central Banking,” which was a long lament about how the Federal Reserve couldn’t deal with inflation because of all the political and economic pressures, and wasn’t that too bad. He made that speech at an IMF [International Monetary Fund] meeting about two months after I had become chairman.

So, when I gave my valedictory speech, I called it “The Triumph of Central Banking?” I put a question mark at the end. Somebody ought to write about this, how central banks became so important in the public mind and in their own mind in the past 10 years or so. Independence of central banking became part of the approach in almost every country. And I think you can make a case that it’s been a little overdone, that central banks suffer from hubris, like everybody else.

Stern: I think that might be right, and I want to explore that a little bit, but I would say, you’re personally responsible for that, because not only did you and your colleagues at the Fed succeed in bringing down inflation, but you did so when the general consensus was that nothing could be done about inflation, that we just had to live with it. So I think your success in bringing down double-digit inflation helped to establish the significance of monetary policy and central banks.

Volcker: You know, talking about whether economists have learned anything or contributed to monetary policy in the last several decades, Chairman Bernanke gave a speech at Princeton right after he took office which was an intellectual review of economists’ views of monetary policy.

I don’t recall all the substance of it, but he said basically that economists were ahead of central bankers in understanding important issues, going back to the 1920s and before and certainly in the Great Depression. But he went on to say that there was one area where the policymakers were ahead of the economists.³

It was an interesting comment. I don’t know if he made it because he knew I was in the audience at the time. But he said something to the effect that the academic economists had to learn from central banking about the importance of maintaining a strong sense of price stability. He has translated that into inflation targeting, I guess.

The effectiveness of policy

Stern: You mention that you thought, maybe now, or certainly in the last 10 years, there was a point where we had too much confidence, too high a level of expectations for monetary policy. I’ve been thinking about that as well, because obviously we’ve had a very significant financial shock to the economy, and one of the consequences of that has been a long and deep recession, and high unemployment. You’re familiar with all this. There seems to be a view that policy, both monetary and fiscal, can somehow fix this quickly. I guess I’m very uncomfortable about that.

Volcker: I don’t think it can. I’ve been dealing with this in a political environment. The other day I’d gotten a paper prepared for the presidential advisory board that I’m the chairman of. It talked about housing and mortgages and so forth. It concluded, “We’ve got to do something to support housing,” so it recommended means of spurring mortgage creation.

But then it went on, “We’ve got to do something to support consumption.” There I begin to wonder. We can do something to support consumption, but are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?

Stern: Right.

Volcker: It’s not an easy question, if you try to explain that. Mr. Obama is out there every day having to explain things and would he say, “Well, I don’t think I want to push a big stimulus on consumption”? I don’t think he’s about to say that, but he probably should be saying that.

Stern: The pressure seems to be now from the press I follow, “You’ve got to find policies that will create jobs,” and again, who could object to that? But it’s not obvious that there are a lot of tools that would be effective at that in the short run.

Volcker: No, I think this period we’re going through is kind of a curative process; it’s a purgative. There is something to the old view that you have to have a recession once in a while to deal with the excesses of a boom. And I think we had excesses in this boom, for sure, and we’ve got a really difficult recession. You want to relieve the sharp edges, without any question, but I don’t think it’s been possible to pump it up so there’s no recession at all.

Stern: Yes, and part and parcel of recessions are resource reallocations. And we clearly had too many resources in housing and probably too many in finance and in autos—just to name three obvious places.

Volcker: Exactly. We need a recovery that emphasizes investment and competitiveness, and that ends or reduces our dependence on foreign borrowing. ... [Interview conducted July 15, 2009.]

What's Wrong with Macroeconomics?

Some recent contributions to "what's wrong with macroeconomics?":

• Nick Rowe: John Cochrane, Paul Krugman, and Say's Law, again
• Brad Delong: In Which Nick Rowe Says John Cochrane Commits "Small But important" Errors...
• Free Exchange: Which caricature do you prefer?
• Mario Rizzo: The Great Moderation in Macroeconomics
• Vernon Smith and David Colander: Causes of the Crisis
• Robert Gordon: Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis? [introduction posted below]
• David Warsh: Economics and Its Discontents [posted below]
• Paul Krugman: Freshwater Rage [posted below]
• Brad DeLong: More Musings on the Total Intellectual Train Wreck that is Today's Chicago School...
• Free Exchange: What the economists aren't explaining
• Barkley Rosser: How Seriously Wrong John Cochrane Is

Added 9/15:

• Brad DeLong: The Chicago School's Intellectual Collapse Continued: Richard Posner Is Uranus...
• Peter Dorman: Did Krugman Get it Right on How the Economists Got it Wrong?
  (part 2)
• Murat Iyigun: Paul: Hand Johnny Some Rope, Will You?
• Justin Wolfers: Lucas on the Shortcomings of Modern Macro

Added 9/16:

• Malin Hu: The Curious Case of Macroeconomics
• Mark Thoma: Who Has All the Answers?
• Murat Iyigun: Johnny B. Goode

Added 9/17:

• John Quiggin: The Macro Wars
• John Quiggin: Micro-based macro-introduction
• Mark Thoma: "Did Economists Ever Get it Right?"
• Narayana Kocherlakota: Some Thoughts on the State of Macro

Added 9/18:

• Arnold Kling: On the state of macro
• Justin Wolfers: The macro wars ... or not
• Michael Roberts: About the Great Marcoeconomic Debate
• Barry Ritholtz: The Mystery of the Awful Economists (3/05 alternate link)
• Barry Ritholtz: Mystery of the Awful Economists, part 2 (4/05)
• Barry Ritholtz: Mystery of the Awful Economists (Part III) (4/05)
• Barry Ritholtz: The Illusory World of Economic Forecasting (9/06)
• Barry Ritholtz: RIP Chicago School of Economics: 1976-2008
• Barry Ritholtz: Read It Here First: “What Good Are Economists?”
• Barry Ritholtz: Why Economists Missed the Crises

Added 9/19:

• David K. Levine: An Open Letter to Paul Krugman
• Gilles Saint‑Paul: A "modest" intellectual discipline
• David Gruen: Outside the Bubble
• Paul Krugman: Memories of the Carter Administration

Added 9/20

• Stephen Cecchetti, Piti Disyatat and Marion Kohler: Integrating financial stability: new models for a new challenge
• Brad DeLong: The Intellectual Bankruptcy of the Chicago School Infests St. Louis...

Added 9/21

• Karl Smith: Krugman vs. Cochrane
• Brad DeLong: The State of Macro: Narayana Kocherlakota Leaves Me Puzzled

Added 9/22

• Leiter Reports: Alex Rosenberg on Cochrane and Economics
• Alex Tabarrok: What it means to predict a crisis
• Brad DeLong: Karl Smith Is Somewhat Bewildered by the State of Modern Macro

Also:

• Paul Krugman: How Did Economists Get It So Wrong?
• Barry Eichengreen: The Last Temptation of Risk
• Philip Lane: Economists and the Crisis
• David Altig: Economists got it wrong, but why?
• John Cochrane: How did Paul Krugman get it so Wrong?
• David Laidler: Lucas, Keynes, and the Crisis
• Mark Thoma: "The Great Multiplier Debate"
• Antonio Fatas and Ilian Mihov: Did economists ever get it right?
• Robert Levine: On Krugman
• The Economist: Lucas Roundtable (Lucas)
• The Economist: What went wrong with economics
• The Economist: The other-wordly philosophers
• The Economist: Efficiency and beyond
• Cosmic Variance: Mistaking Beauty for Truth
• Mark Gertler: The State of Macroeconomics (scroll down)
• Willem Buiter The unfortunate uselessness of most ’state of the art’ academic monetary economics
• Mark Thoma "The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics"
• Tim Harford Are those who sweat the big stuff in meltdown?
• Francesco Caselli: Economists are actively engaged in seeking remedies to the crisis
• Mark Thoma Macroeconomic Meltdown?
• Daniel Kahneman: Irrational everything
• Mark Thoma: Are Macroeconomic Models Useful?
• Roman Frydman: Mathematical Formalism in Economics
• Dani Rodrik: Blame economists, not economics
• Mark Thoma The State of Macroeconomics (scroll down)
• George Waters: "Equilibrium and Meltdown"
• Paul Krugman and Roman Frydman: "The Gratuitous Ignorance of Many of our Economists"
• Mark Thoma: Can Econometricians Tell Us which Macroeconomic Model is Best?
• David Colander, Hans Föllmer, Armin Haas, Michael Goldberg, Katarina Juselius, Alan Kirman, and Thomas Lux The Financial Crisis and the Systemic Failure of Academic Economics
• Kenneth Arrow: Risky business

[This list is incomplete, so please add any I've missed in comments.]

Who Has All the Answers?

Justin Fox:

Hyman Minsky didn't have all the answers, by Justin Fox: Economist Hyman Minsky, who never got much attention while he was alive, has become one of the big celebrities of this financial crisis. In Sunday's Boston Globe, Stephen Mihm has the best account of Minsky's life and significance that I've seen so far. A sample:

Today most economists, it's safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won't] cure.”

But did Minsky really have much to add beyond the crucial insight that financial systems are inherently unstable? His former student Eric Falkenstein, responding on his blog to Mihm's article, isn't so sure:

I was Minsky's TA while a senior at Washington University in St.Louis in 1987, and took a couple of his advanced classes, which regardless of the official name, were all just classes in Minskyism. He was a maverick, but perhaps a bit too much, being a little too dismissive of others, as he hated the traditional Samuelson/Solow Keynesians as much as the Friedmanite Monetarists. He always thought a market collapse was just around the corner. The S&P was 250 when I took his course, it went to 1500 in 2007 and then back to 735 in 2009. Does that prove he was right all along? ...

The problem ... is that his top-down theory is rejected by the data. Aggregate leverage ratios do not closely correspond to business cycles. If Minsky took microeconomics more seriously he could have made his theory more relevant, by noting that crises tend to occur in specific subsets in the economy: in 1990, hotels and Commercial real estate, in 2001, high tech, in 2008, mortgages. The mistake is not one made in aggregate, but in different sectors each recession. By noting these areas, but not the aggregate economy, had too much leverage, and depended on expected future increases in collateral value, he might have been more successful proselytizing his colleagues. But he was a traditional Keynesian, who liked to look at aggregate equations, like Profits=Investment + Deficits + Net Imports.

I think the broader point here is that there is no one Theory That Explains Everything in economics. Neoclassical economics certainly doesn't explain everything. Neither does Minskyism. Nor Austrian business cycle theory. Nor complexity theory. It seems like the best approach would be an eclectic one that takes lots of different economic models into account. But eclecticism doesn't get you far in academia.

There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available (as to how far this kind of "eclecticism" will get you in academia, I'll just note that this is exactly the advice Mishkin gives in his textbook on monetary theory and policy).

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by price rigidities of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the type of thorough analysis needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities ina  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could, and the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes if didn't, but that was no reason to ignore the answers when it did.

"Freshwater Rage"

Paul Krugman responds to the response to his criticism of macroeconomics:

Freshwater rage, by Paul Krugman: I’m still on the road, with only sporadic internet access. So I’ve missed out on much of the outpouring of rage over my magazine article. I gather, though, that the usual suspects are utterly outraged at my suggestion that freshwater macro has spent several decades heading down the wrong path. They’re smart! They work hard, using hard math! How dare I say such a thing?

And all of this, of course, without a hint of irony.

For when freshwater macro took over a good part of the field, its leaders gleefully dismissed all the work Keynesian economists had done over the previous few decades, often with sneers and sniggers.

And that same adolescent quality was evident in the reactions to the Obama administration’s attempts to deal with the crisis — as Brad DeLong points out, people like Robert Lucas and John Cochrane (not to mention Richard Posner, who isn’t a macroeconomist but gets his take from his colleagues) didn’t say that when serious scholars like Christina Romer based policy recommendations on Keynesian economics, they were wrong; the freshwater crowd declared that anyone with Keynesian views was, by definition, either a fool or intellectually dishonest.

So the freshwater outrage over finding their own point of view criticized is, you might think, a classic case of people who can dish it out but can’t take it.

But it’s actually even worse than that.

When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been. Freshwater macro became totally insular.

And hence the most surprising thing in the debate over fiscal stimulus: the raw ignorance that has characterized so many of the freshwater comments. Above all, we’ve seen the phenomenon of well-known economists “rediscovering” Say’s Law and the Treasury view (the view that government cannot affect the overall level of demand), not because they’ve transcended the Keynesian refutation of these views, but because they were unaware that there had ever been such a debate.

It’s a sad story. And the even sadder thing is that it’s very unlikely that anything will change: freshwater macro will get even more insular, and its devotees will wonder why nobody in the real world of policy and action pays any attention to what they say.

I am not quite as pessimistic about the prospects for change, but many people have their life's work wrapped up in a particular brand of model and they will defend that work aggressively, so I do agree that it's likely to come in spite of rather than because of the old guard.

"Economics and Its Discontents"

David Warsh says economics has served us well in dealing with the aftermath of the crisis and that, while macroeconomics has problems, "The last thing we needs is a civil war in economics":

Economics and Its Discontents, by David Warsh: In the aftermath of the worst scare since the 1930s, economists have identified a new culprit to share the blame for the subsequent mess – themselves, or rather those among their tribe with whom they disagree. No longer are greedy Wall Street bankers, feckless regulators and a blasé Federal Reserve Board the only suspects. The economics profession has joined them in the dock.

“How Did Economists Get It So Wrong?” asked Paul Krugman last week in The New York Times Magazine. “The Financial Crisis and the Systemic Failure of the Economics Profession, “ wrote David Colander, Alan Kirman and several others in Critical Review.

“The Other-Worldly Philosophers,” offered the headline of thoughtful examination in The Economist two months ago. On its cover, a textbook – “Modern Economic Theory” – melted into a puddle. The editorial began, “Of all the bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself.”

Is that really true? Or is the hubbub another case of what Sigmund Freud, in Civilization and Its Discontents, termed “the narcissism of small differences” – the tendency to exaggerate the dissimilarities of those who resemble us in an effort to buttress our own self-regard?

"Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis?"

Robert Gordon argues that "modern macro neglects the basic sources of both impulses and propagation mechanisms of business cycles," and that we should return to "1978-era macroeconomics." Here's the introduction to his paper:

Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis?, by Robert Gordon: 1. Introduction For more than three decades since 1978 hundreds of U. S. macroeconomists have developed what is often called the "modern macroeconomics" of business cycle fluctuations.[1] Until recently, there was evident self-satisfaction that macroeconomic truth had been discovered, that old errors had been buried, and that a long period of warfare between new classicals and new Keynesians had ended as a consensus had emerged based on Dynamic Stochastic General Equilibrium (DSGE) models that combined new-classical market clearing with the new-Keynesian contribution of sticky prices.[2]

Along the way numerous modern macroeconomists concluded that the U. S. "Great Moderation" of macroeconomic volatility in the 1984-2007 period (as compared to higher volatility in the earlier 1947-84 postwar interval) was a side benefit of modern analysis. However since 2007 the world economy has entered a crisis of sub-prime mortgage defaults, excessive leveraging followed by deleveraging, output and employment meltdowns, and an enormous destruction of wealth. The Great Moderation is dead. Neither the proponents of modern macro nor the adherents of Keynesian ideas anticipated the crisis in advance. But even the most avid supporters of the modern macro camp have thus far failed to provide any intellectual links with their preferred explanations of business cycle downturns based on technology retardation, changes in preferences, or tightness in monetary policy.

This paper is not an endorsement of 1936-era Keynesian thought, but rather revives an alternative intellectual paradigm called "1978-era macroeconomics."

"On Krugman"

Robert Levine of Rand emails this reaction to Paul Krugman's essay on the state of macroeconomics:

On Krugman, by Robert A. Levine, Rand: Being a saltwater economist, by ideology and a bicoastal education and career, I of course think that Paul Krugman’s “How Did Economists Get it So Wrong?” made some major points that needed making, and as usual made them very well.

But he also left two major omissions, inclusion of which may change the states of both theory and the economic outlook. Neither has either appeared in the commentaries I have seen.

The first omission is of Joseph Alois Schumpeter.¹ Krugman did mention the name in two sour asides; it apparently does not appear in any of the commentaries. Schumpeter is remembered by many of his colleagues as an unpleasant man as well as a political reactionary. I was not in a position, as an undergraduate in one of his courses shortly before he died, to judge the former. The latter was certainly true: he was a royalist.

He was also one of the seminal economists of the 20^th century. He was a rabid anti-Keynesian, but in fact his central concepts of innovation and entrepreneurship integrate well with Keynes and fill in a major gap. Keynes’s discussion of investment provides a complex analysis of the relationship of profits and interest rates; it says little about where the profits come from. That is what Schumpeter is about: not the routine buying and replacing of capital goods, strongly influenced by the close profit/interest relationship, but the “autonomous” investment stemming from doing new things in new ways. Such investment then invokes the Keynesian multiplier, the Keynesian (but post-Keynes) accelerator, and business cycles endogenous to the narrow profit/interest relationship but exogenously induced.

In particular, Schumpeter’s emphasis on innovation-induced “long waves” (which he named after their discoverer, Nicolai Kondratieff), starting with the industrial revolution and continuing through railroads, the telegraph, the telephone, automobiles, aircraft, radio, and—after Schumpeter—television and computers and the “information revolution” fills a crucial gap in the saltwater/freshwater debate. Much of the causation for the really major macroeconomic movements since World War II simply lies outside of that debate as now waged..

Schumpeter’s emphasis on the regular periodicity of Kondratieff and other shorter cycles has been generally and properly criticized; in the last century such regularity if it existed at all was interrupted at least by the two World Wars. But the concept of innovation, with creative destruction and all that goes with it, stands; it is widely accepted by economists—and then ignored as a macroeconomic factor, e.g., in the current debate.

This leads to the second omission, the failure to treat with the fundamental causes of the dreadful decade of the 1970s. Krugman covers it as a cause of the major parting of the waters between salt and fresh, which it is, but in fact the major cause of the dismal economy and the consequent dismal economics lay outside of both; rather, it was in the fundamental global redistribution led by consolidation of OPEC and the oil boycotts stemming from the Yom Kippur war and then the Iranian revolution. The oil sheiks took control of a crucial portion of world product. Oil consumers had to adjust, cutting back on their own portion either by slowing growth and increasing unemployment, or bidding for what was left, thus engendering inflation. Economists adjusted by inventing, and then arguing about, rational expectations. Stagflation brought about no good responses either in the real world or the economics stratosphere.

The 70s can be looked at as a Schumpeterian wave in reverse: instead of growth-engendering structural change, the assertion of power by the oil-producers was a growth-inhibiting (at least for the major developed economies) structural change—with consequences yet to be analyzed.

The developed economies, and the rest of the world, recuperated from the 70s via a true Schumpeterian wave created by computers and information technology, and ending, as Schumpeterian waves do, in the bursting of the IT bubble in the late 1990s.

Whether the housing/financial bubble has anything to do with Schumpeter is arguable: the attempt to spread home ownership through financial innovation might be treated as an example of useful entrepreneurship gone bad, or the pervasive financial devices themselves might be classed in the same genre.

Underlying much of the current malaise, however, is another real-economy factor not mentioned in the current debate, the rise of the developing economies, led by China and India. Like the oil producers of the 70s, they are claiming increasing portions of world product. Unlike the sheiks, however, they are producing more rather than rather than grabbing existing product. The needed adjustments for the developed world may nonetheless be traumatic, including stagflation as the world economy (apparently already led by China and India) returns to growth.

Whether this is “negative Schumpeterianism” is probably not worth worrying about. What we should worry about instead is coping with the consequences—to Us—of major economic restructuring. Financial reform and short-run monetary or Keynesian stimulus, necessary for short-run melioration have little to do with the long run. We may have to await the onset of another truly Schumpeterian technological wave, whenever that occurs.

A term of the 1930s, long-since forgotten, was “secular stagnation”; when the Great Depression was ended not by technology but by deficit spending to finance World War II, the fears that growth had ended until an unforeseeable future were forgotten. One hopes that this time the turnaround will be based on technology, not war or even indefinite peacetime deficits, with positive change beginning soon.

In my grandmother’s version of Keynes’s most famous statement, “We should live so long.”

---

¹ Another; name, completely omitted, is that of John Kenneth Galbraith, but his semi-institutional economics remains, of course, beyond the pale.

(Much of this commentary is based on Robert A. Levine, “Adjusting to Global Economic Change: the Dangerous Road Ahead”, RAND OP-243-RC)

"Economists and the Crisis"

This is from Philip Lane at the Irish Economy Blog:

Economists and the Crisis, by Philip Lane: As has been tracked by several previous posts on this blog, there is by now a considerable debate on what the crisis teaches us about the role of economists.

One dimension of this debate has focused on the failure by the economics profession to predict the onset of the crisis. A second quasi-related dimension relates to the failure to sufficiently appreciate the instability of the pre-crisis financial system. To some, these failures suggest that those economists who did not accurately predict the crisis should have no role in resolving the crisis and constructing the new post-crisis economic system. This debate is playing out at the global level and also in relation to the domestic situation.

These are all big issues and I do not attempt to provide a comprehensive set of answers here. Nevertheless, it may be useful to make a few points. I also mainly focus on the role of academic/research economists and the field of macroeconomics.

First, there is no doubt that the crisis has underlined a mis-allocation of research resources. Over the last 15-20 years, monetary economics in relation to the advanced economies has focused on the analysis of ‘low-amplitude’ business cycles. While business cycles were certainly shallow during this period, the social costs of rare-but-large crashes are so large that it is clear in retrospect that too few researchers were focused on the economics of large crises. (An exception relates to those who focused on emerging market economies, where a lot of analysis has been conducted of the recurrent crises that have affected these economies.)

One role for the economics profession is to attempt to forecast the future behaviour of the economy. This is mainly done by economists in policy roles (since policymaking requires projections of future economic performance) and economists in financial firms (since the return on financial investments also turn on future economic performance).

In fact, very few academic economists get involved in this task: to do it well really requires a lot of data resources and and the tracking of many variables, such that is a full-time task that is best conducted by large teams of economists. However, even if not involved in day-to-day forecasting, academic economists can play an important role by providing an independent voice and focusing on ‘big picture’ issues such as whether the forecasting models are well designed and taking a longer-term horizon for forecasting (most forecasting is concerned with quarter-by-quarter developments or, at most, a 1-3 year horizon).

In fact, the main contribution may not be in forecasting per se but in detailing possible contrarian scenarios in order to challenge the conventional wisdom. This can be very valuable but the limitation is that such ‘Cassandra’ warnings typically cannot be tied to a specific date and it is tempting for the mainstream to dismiss such warnings if they do not quickly come to pass. Moreover, if a forecaster’s reputation depends on short-term performance, a bearish economist may quickly lose credibility if boom conditions persist and the day of reckoning is postponed.

However, the main goal in outlining low-probability but high-cost risk scenarios is not so much to alter ‘central’ forecasts but to encourage decisionmakers to adopt prudent strategies that are robust to the occurrence of the ‘disaster’ scenario. In fact, the ideal is that decisionmakers are sufficiently prudent that the risk of the disaster scenario recedes and those offering the Cassandra warnings never see their worst fears realised.

Certainly, we can point to several academic and non-academic economists who were assiduous in making warnings about the consequences of the lending boom and these deserve great credit.

For many others in academia, their research activities were directed towards other questions. In relation to policy-relevant macroeconomics, a major focus has been on conducting research on ‘institutional design.’ That is, rather that focusing on macroeconomic forecasting, many have opted to contribute to the design of policy frameworks that can deliver enhanced stability and lower the cost of crises should they occur. This includes work on: the zero-bound problem in interest rate policy; macro-prudential financial regulation; counter-cyclical fiscal policies; tax policies vis-a-vis the property sector; the establishment of insurance devices such as reserve funds and rainy-day funds and other mechanisms to mitigate macroeconomic risks. Work on such issues has intensified since the onset of the crisis, together with much innovative work in areas such as the design of ‘non-orthodox’ monetary interventions.

Accordingly, the state of macroeconomics is in flux. While there is much to regret concerning the course of pre-crisis research, it is also true that many of the technical innovations over the last 20 years are now being applied in exciting ways to design crisis-resolution policies. Indeed, it is somewhat ironic that the crisis has led to a tremendous resurgence in interest in macroeconomics: economics is much more interesting in ‘bad times’ than in ‘good times’.

Another very promising development has been the enhanced integration of macroeconomics and finance. Many leading finance economists have responded very quickly to the crisis and have written superb analyses of various dimensions of the crisis and developed innovative new policies to restore financial stability and reduce the risk of future crises.

Many of these points apply equally to both the global and local economic situations. Regarding academic research on the Irish economy, I will point out a ’scale’ problem - the small size of the Ireland means that it is difficult to build a successful academic career by focusing on the local economy, in view of the limited publication opportunities and the small size of the domestic profession. This is a problem.

Finally, some have argued that the crisis has shown the limitations of economics. At one level, this is certainly true and an important lesson for all types of decisionmakers is to recognise that the future is uncertain and relying on Panglossian forecasts (where no downside risk is ever realised) is not an appropriate risk management strategy. It is also the case that economics needs to learn more from adjacent disciplines (psychology, history and the other social sciences). However, the likely evolution is an ‘adapted/enriched’ economics rather than a fully-symmetric multi-disciplinary approach, since the technical basis for most economic policy analyses is predominantly driven by economic factors.

Are Macroeconomic Models Useful?

There has been no shortage of effort devoted to predicting earthquakes, yet we still can't see them coming far enough in advance to move people to safety. When a big earthquake hits, it is a surprise. We may be able to look at the data after the fact and see that certain stresses were building, so it looks like we should have known an earthquake was going to occur at any moment, but these sorts of retrospective analyses have not allowed us to predict the next one. The exact timing and location is always a surprise.

Does that mean that science has failed? Should we criticize the models as useless?

No. There are two uses of models. One is to understand how the world works, another is to make predictions about the future. We may never be able to predict earthquakes far enough in advance and with enough specificity to allow us time to move to safety before they occur, but that doesn't prevent us from understanding the science underlying earthquakes. Perhaps as our understanding increases prediction will be possible, and for that reason scientists shouldn't give up trying to improve their models, but for now we simply cannot predict the arrival of earthquakes.

However, even though earthquakes cannot be predicted, at least not yet, it would be wrong to conclude that science has nothing to offer. First, understanding how earthquakes occur can help us design buildings and make other changes to limit the damage even if we don't know exactly when an earthquake will occur. Second, if an earthquake happens and, despite our best efforts to insulate against it there are still substantial consequences, science can help us to offset and limit the damage. To name just one example, the science surrounding disease transmission helps use to avoid contaminated water supplies after a disaster, something that often compounds tragedy when this science is not available. But there are lots of other things we can do as well, including using the models to determine where help is most needed.

So even if we cannot predict earthquakes, and we can't, the models are still useful for understanding how earthquakes happen. This understanding is valuable because it helps us to prepare for disasters in advance, and to determine policies that will minimize their impact after they happen.

All of this can be applied to macroeconomics. Whether or not we should have predicted the financial earthquake is a question that has been debated extensively, so I am going to set that aside. One side says financial market price changes, like earthquakes, are inherently unpredictable -- we will never predict them no matter how good our models get (the efficient markets types). The other side says the stresses that were building were obvious. Like the stresses that build when tectonic plates moving in opposite directions rub against each other, it was only a question of when, not if. (But even when increasing stress between two plates is observable, scientists cannot tell you for sure if a series of small earthquakes will relieve the stress and do little harm, or if there will be one big adjustment that relieves the stress all at once. With respect to the financial crisis, economists expected lots of little, small harm causing adjustments, instead we got the "big one," and the "buildings and other structures" we thought could withstand the shock all came crumbling down. On prediction in economics, perhaps someday improved models will allow us to do better than we have so far at predicting the exact timing of crises, and I think that earthquakes provide some guidance here. You have to ask first if stress is building in a particular sector, and then ask if action needs to be taken because the stress has reached dangerous levels, levels that might result in a big crash rather than a series of small stress relieving adjustments. I don't think our models are very good at detecting accumulating stress, in large part because when we are not at the long-run equilibrium, we model the short-run as though every market clears at every point in time. This means that there are no stresses continuously building in these models, the adjustments always relieve the stress and move us back toward long-run equilibrium. We have to do a better job of allowing for the build up of stress within our models, and then using these models to guide the measurement and monitoring of "stress levels" in particular markets, particularly asset markets, so we can take action when the levels are too high.)

Whether the financial crisis should have been predicted or not, the fact that it wasn't predicted does not mean that macroeconomic models are useless any more than the failure to predict earthquakes implies that earthquake science is useless. As with earthquakes, even when prediction is not possible (or missed), the models can still help us to understand how these shocks occur. That understanding is useful for getting ready for the next shock, or even preventing it, and for minimizing the consequences of shocks that do occur. 

But we have done much better at dealing with the consequences of unexpected shocks ex-post than we have at getting ready for these a priori. Our equivalent of getting buildings ready for an earthquake before it happens is to use changes in institutions and regulations to insulate the financial sector and the larger economy from the negative consequences of financial and other shocks. Here I think economists made mistakes - our "buildings" were not strong enough to withstand the earthquake that hit. We could argue that the shock was so big that no amount of reasonable advance preparation would have stopped the "building" from collapsing, but I think it's more the case that enough time has passed since the last big financial earthquake that we forgot what we needed to do. We allowed new buildings to be constructed without the proper safeguards.

However, that doesn't mean the models themselves were useless. The models were there and could have provided guidance, but the implied "building codes" were ignored. Greenspan and others assumed no private builder would ever construct a building that couldn't withstand an earthquake, the market would force them to take this into consideration. But they were wrong about that, and even Greenspan now admits that government building codes are necessary. It wasn't the models, it was how they were used (or rather not used) that prevented us from putting safeguards into place.

We haven't failed at this entirely though. For example, we have had some success at putting safeguards into place before shocks occur, automatic stabilizers have done a lot to insulate against the negative consequences of the recession (though they could have been larger to stop the building from swaying as much as it has). So it's not proper to say that our models have not helped us to prepare in advance at all, the insulation social insurance programs provide is extremely important to recognize. But it is the case that we could have and should have done better at preparing before the shock hit.

I'd argue that our most successful use of models has been in cleaning up after shocks rather than predicting, preventing, or insulating against them through pre-crisis preparation. When despite our best effort to prevent it or to minimize its impact a priori, we get a recession anyway, we can use our models as a guide to monetary, fiscal, and other policies that help to reduce the consequences of the shock (this is the equivalent of, after a disaster hits, making sure that the water is safe to drink, people have food to eat, there is a plan for rebuilding quickly and efficiently, etc.). As noted above, we haven't done a very good job at predicting big crises, and we could have done a much better job at implementing regulatory and institutional changes that prevent or limit the impact of shocks. But we do a pretty good job of stepping in with policy actions that minimize the impact of shocks after they occur. This recession was bad, but it wasn't another Great Depression like it might have been without policy intervention.

Whether or not we will ever be able to predict recessions reliably, it's important to recognize that our models still provide considerable guidance for actions we can take before and after large shocks that minimize their impact and maybe even prevent them altogether (though we will have to do a better job of listening to what the models have to say). Prediction is important, but it's not the only use of models.

"Why This New Crisis Needs a New Paradigm of Economic Thought"

[More Side of the road blogging - stopped for a moment at the Great Salt Lake.] When I talked to the senate's COP panel, one of many things that I emphasized was the need to develop plans in advance to deal with various contingencies. Without such plans policy actions - even justifiable ones - appear ad hoc and also face resistance that delays their implementation or prevents them from being put into place altogether.

For example, we need a plan on the shelf and ready to go for dismantling large banks that have failed, something that has received a lot of attention. It has received much less attention, but I also think we need a plan for disposing troubled financial assets when the need arises. I still believe that the crisis would have been much less severe if very early, prior to Lehman for sure, the government had moved aggressively to buy bad assets from bank balance sheets. it took far too long, and when they finally decided to do this (i.e. the original Paulson plan), they had no idea how to value the assets, there was considerable political resistance because nobody knew how the program would work (allowing lots of false information to enter the debate), and so on, and this program never really got off the ground. The assets are still there waiting for the miracle of rising asset prices to restore their value.

Having a plan ready in advance that specifies how assets will be valued, how taxpayers will be protected if the government overpays (overpaying can help with recapitalization, but it shouldn't be a gift), and so on, a plan that has been approved in advance by legislators (at least implicitly) so as to reduce political resistance, will overcome many of the technical problems and objections that prevented the bad asset removal programs from being used effectively in this crisis.

Keiichiro Kobayashi believes these toxic assets, many of which are still hidden on bank balance sheets, are still a problem and could result in a Japan style lost decade if the government does not remove them, and he calls for a new macroeconomic paradigm that puts these issues front and center (On his main point about whether financial sector recovery is necessary before the real economy can recover, I think we will recover either way, but agree that recovery would be faster if these assets were removed once and for all - but I should get back on the road...):

Why this new crisis needs a new paradigm of economic thought, by Keiichiro Kobayashi, Commentary, Vox EU: The policies being debated in the US and Europe today are almost identical to those that played out in Japan a decade or so ago. Japan experienced the collapse of its colossal property bubble in 1990 and then a series of crises as major banks and securities companies were overwhelmed by rapidly rising non-performing debts. The conventional wisdom among economists and politicians throughout the 1990s was that massive public expenditure and extraordinary monetary easing would give the necessary boost to market sentiments and prompt an economic recovery. Public opinion in the US and Europe today seems to be the same.

And indeed, throughout the 1990s, Japan did introduce major public works projects and tax cuts, yet the economy failed to stabilise, asset prices continued to fall, and the volume of non-performing debts continued to climb. Far from being dispelled, the sense of insecurity that had permeated the markets actually increased throughout the 1990s, ultimately leading to the collapse of several major financial institutions in 1997 and sparking an outbreak of panic.

Even after this, recovery efforts continued to be channelled through large-scale public expenditure, while the disposal of non-performing debts became bogged down. Only around 2001 did Japanese public opinion finally turn away from the belief that reductions in bad debt and financial system stability would follow an economy recovery. The public came to understand that the financial system had to be stabilised and market insecurity dispelled before any recovery could occur. Special inspections were conducted repeatedly by financial regulators and Japanese megabanks were forced to accept massive capital increases and a new round of mergers. Meanwhile, the Resolution and Collection Corporation and the Industrial Revitalisation Corporation of Japan restructured companies that had collapsed under enormous debt burdens and finally broke the back of the non-performing debt problem. This sparked a recovery of market confidence, and Japan enjoyed a period of economic expansion from 2002 to 2007.

"Keynes was Really a Conservative"

Bruce Bartlett argues that the conservative position that governments "do nothing in the face of the greatest economic downturn since the Great Depression" would endanger the very thing free market ideologues are trying to preserve, the capitalist system itself. This was something that Keynes understood very well.

Though this argues that Keynes was a conservative, I don't think it much matters what label we attach to Keynes, it is the idea that government intervention preserves rather than destroys the capitalist system that is important. If we had no government intervention at all, no automatic stabilizers such as unemployment compensation and food stamps, no Social Security for the elderly to fall back upon when equity and stock values plummet, no stimulus package, and no financial bailout package, conditions would be much, much worse and the calls to overthrow the basic capitalist system would be amplified far beyond what we hear even with these programs in place.

Keynes is right that these programs help to make the cyclical swings in capitalist systems less devastating and hence help to preserve the system that we have. But that's not the only reason to provide social insurance. The capitalist system is unmatched in its ability to provide goods and services, and to respond to changing demand, but it is also highly cyclic and the swings in the economy can cause great misery for people who have done nothing to deserve the misfortune the system has bestowed upon them. The people who have lost their jobs and their ability to provide for their families deserve our collective help not just because that's the only way to preserve the capitalist system, but also because it's the right and moral thing to do:

Keynes Was Really A Conservative, by Bruce Bartlett, Commentary, Forbes: Conservatives continue to decry the $787 billion stimulus package... At best, they think it accomplished nothing because the additional federal borrowing took as much out of the economy as the stimulus put in. At worst, the deficits and enlargement of government will lead to slower growth and inflation not too far down the road.

Those on the right have been making this same argument ever since ... John Maynard Keynes popularized the idea of using budget deficits to stimulate growth in ... 1936... For this reason, Keynes, even more so than Karl Marx, is the principal bête noire of free market economists. They believe governments should never do anything to counteract economic downturns. ...

What Keynes understood is that ...[i]n really severe downturns, such as we suffered in the 1930s and are suffering today, government action is essential to turn the economy around; the private sector simply can't do it on its own. He also understood that democratic societies cannot long tolerate high levels of unemployment. At some point, people will jettison capitalism for some sort of socialism, which would threaten democracy as well.

Keynes' efforts were motivated by a strong desire to maintain the liberal capitalist order. Honest conservatives have always understood this. In 1945, economist David McCord Wright noted that a conservative political candidate could easily run a campaign "largely on quotations from The General Theory." The following year, economist Gottfried Haberler, of the conservative Austrian school, conceded that the specific policy recommendations of Keynesian economics were not at all revolutionary. "They are in fact very conservative," he admitted.

Peter Drucker, a conservative admirer of Keynes, viewed him as not merely conservative, but ultraconservative. "He had two basic motivations," Drucker explained in ... 1991... "One was to destroy the labor unions and the other was to maintain the free market. Keynes despised the American Keynesians. His whole idea was to have an impotent government that would do nothing but, through tax and spending policies, maintain the equilibrium of the free market. Keynes was the real father of neoconservatism, far more than [economist F.A.] Hayek!"

John Kenneth Galbraith, whose politics were well to the left of Keynes,... agreed with this assessment. "The broad thrust of his efforts, like that of Roosevelt, was conservative; it was to endure that the system would survive," he wrote. But, Galbraith added, "Such conservatism in the English-speaking countries does not appeal to the truly committed conservative." ...

It was obvious to those on the political left ... that Keynes was one of socialism's greatest enemies, even if some on the right still view Keynes as a crypto-communist. ... Keynes told playwright George Bernard Shaw that the whole point of The General Theory was to knock away the Ricardian foundations of Marxism. ...

Indeed, the whole point of The General Theory was about preserving what was good and necessary in capitalism, as well as protecting it against authoritarian attacks... In order to preserve economic freedom..., which Keynes thought was critical for efficiency, increased government intervention ... was unavoidable. While pure free marketers lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism.

"It is certain," Keynes wrote, "that the world will not much longer tolerate the unemployment which … is associated--and, in my opinion, inevitably associated--with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom."

In Keynes' view, it was sufficient for government ... to use monetary and fiscal policy to maintain total spending (effective demand), which would both sustain growth and eliminate political pressure for radical actions to reduce unemployment. "It is not the ownership of the instruments of production which is important for the State to assume," Keynes wrote. "If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary."

One of Keynes' students, Arthur Plumptre, explained Keynes' philosophy this way. In his view, Hayek's "road to serfdom" could as easily come from a lack of government as from too much. If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism--total government control--and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. As Plumptre put it, Keynes "tried to devise the minimum government controls that would allow free enterprise to work."

The threat of totalitarianism may not be as great today as it was in the 1930s. But it would be naïve to believe that it was possible for the government to stand by and do nothing in the face of the greatest economic downturn since the Great Depression, as many conservative economists advised. The alternative to stimulus could ultimately have been something far worse from the conservative point of view, as Keynes well understood.

Solow: Dumb and Dumber in Macroeconomics

Continuing with the discussion on the state of macroeconomics, this is Robert Solow from an October 25, 2003 address at Joe Stiglitz' 60^th birthday conference. Solow gets extra credit for saying these things before the crisis hit, e.g. " I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, "stagflation," not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help." (Let me also point to a comment by Ping Chen at Free Exchange in response to the Lucas essay which I may highlight more explicitly later. Update: See also Jamie Galbraith's remarks at the Stiglitz conference):

Dumb and Dumber in Macroeconomics, by Robert M. Solow: So how did macroeconomics arrive at its current state? The answer might provide a lead as to where it ought to go.

The original impulse to look for better or more explicit micro foundations was probably reasonable. It overlooked the fact that macroeconomics as practiced by Keynes and Pigou was full of informal microfoundations. (I mention Pigou to disabuse everyone of the notion that this is some specifically Keynesian thing.) Generalizations about aggregative consumption-saving patterns, investment patterns, money-holding patterns were always rationalized by plausible statements about individual--and, to some extent, market--behavior. But some formalization of the connection was a good idea. What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.

How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? My impression is that this approach (which seems now to be the mainstream, and certainly dominates the journals, if not the workaday world of macroeconomics) has had no empirical success; but that is not the point here. I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, "stagflation," not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help. It is always possible to claim that those "pathologies" are delusions, and the economy is merely adjusting optimally to some exogenous shock. But why should reasonable people accept this? During the past three years, unemployment has increased by three million with real wages stagnant and productivity growing, possibly abnormally fast. Capacity utilization has fallen by 10 percent, with trivial inflation and some prices falling. Real business investment in equipment peaked in the third quarter of 2000, fell by 20 percent to the first quarter of 2002, and has risen by a scant five percent since then. Is this a stagnation pattern? Does it reflect large-scale, perhaps irrational, overinvestment in the 1990s? Should it not be studied as such? Why should anyone take it as the solution of an Euler equation? It would not be hard to imagine a better path for the economy. Why should the burden of proof fall on those who see an ordinary standard pathology here? The odd thing is to regard this history as the working out of an other-worldly model.

What is needed for a better macroeconomics? My crude caricature of the Ramsey-based model suggests some of the gross implausibilities that need to be eliminated. The clearest candidate is the representative agent. Heterogeneity is the essence of a modern economy. In real life we worry about the relations between managers and shareowners, between banks and their borrowers, between workers and employers, between venture capitalists and entrepreneurs, you name it. We worry about those interfaces because they can and do go wrong, with likely macroeconomic consequences. We know for a fact that heterogeneous agents have different and sometimes conflicting goals, different information, different capacities to process it, different expectations, different beliefs about how the economy works. Representative-agent models exclude all this landscape, though it needs to be abstracted and included in macro-models.

Lucas Roundtable: Ask the Right Questions

In The Economist, Robert Lucas responds to recent criticism of macroeconomics ("In Defense of the Dismal Science"). Here's my entry at Free Exchange's Robert Lucas Roundtable in response to his essay:

Lucas roundtable: Ask the right questions, by Mark Thoma: In his essay, Robert Lucas defends macroeconomics against the charge that it is "valueless, even harmful", and that the tools economists use are "spectacularly useless".

I agree that the analytical tools economists use are not the problem. We cannot fully understand how the economy works without employing models of some sort, and we cannot build coherent models without using analytic tools such as mathematics. Some of these tools are very complex, but there is nothing wrong with sophistication so long as sophistication itself does not become the main goal, and sophistication is not used as a barrier to entry into the theorist's club rather than an analytical device to understand the world.

But all the tools in the world are useless if we lack the imagination needed to build the right models. Models are built to answer specific questions. When a theorist builds a model, it is an attempt to highlight the features of the world the theorist believes are the most important for the question at hand. For example, a map is a model of the real world, and sometimes I want a road map to help me find my way to my destination, but other times I might need a map showing crop production, or a map showing underground pipes and electrical lines. It all depends on the question I want to answer. If we try to make one map that answers every possible question we could ever ask of maps, it would be so cluttered with detail it would be useless, so we necessarily abstract from real world detail in order to highlight the essential elements needed to answer the question we have posed. The same is true for macroeconomic models.

But we have to ask the right questions before we can build the right models.

Macroeconomic Models

Robert Skidelsky doesn't always get things completely right. For example, he often talks about "New Classical economics" as if that is the dominant paradigm today, but that term has a very specific meaning and refers to a class of models that is no longer popular in macroeconomics.

Let's back up. The New Classical model had four important elements, the assumption of rational expectations, the assumption of the natural rate hypothesis, the assumption of continuous market clearing that Skidelsky refers to below, and an assumption that agents have imperfect information. The imperfect information assumption was quite clever in that it allowed proponents of this model to explain correlations between money and income without acknowledging that systematic, predictable policy based upon something like a Taylor rule would have any effect at all (put another way, only unexpected changes in monetary policy matter, expected changes are fully neutralized by private sector responses to the policy).

The New Classical model did contribute to the movement in macroeconomics toward microeconomic foundations and to the use of rational agents within macro models, but the model itself could not simultaneously explain both the duration and magnitude of actual cycles, it had difficulty explaining some key correlations among macroeconomic variables, and it was difficult to understand why a market for the absent information did not develop if the consequences of imperfect information were as large as the New Classical model implied. In addition, one of the model's key results that only unexpected changes in money can affect real variables did not hold up when taken to the data (though there are still a few die-hards on this). So the profession moved on.

The New Classical model had replaced the old Keynesian model after it became widely believed that the models' shortcomings were partly responsible for the problems we had in the 1970s, and for the theoretical reasons that will be described in a moment. But while the New Classical economists were having their day in the sun, the Keynesians were quietly working behind the scenes to fix the problems that caused the old Keynesian model to go out of favor (or not so quietly in a few cases). The old Keynesian model had a poor model of expectations - if expectations were considered at all they were usually modeled as a naive adaptive process - and in addition, it was not clear that the relationships embedded within the old Keynesian model were consistent with optimizing behavior on behalf of households and firms. The New Keynesian model solved this by deriving macroeconomic relationships from microeconomic optimizing behavior, and by adopting the rational expectations framework. And they made one other change important change. In order for systematic monetary policy such as following a Taylor rule to affect real variables such as output and employment, there must be some type of friction that prevents the economy from immediately moving to it long run equilibrium value. The friction in the New Classical model is informational, agents optimize given the information that they have, but because the information is imperfect the decisions they make take the economy away from its optimal long-run path.

In the New Keynesian model the friction that gives monetary policy its power to affect output and employment is sluggish movement of prices and wages (generally modeled through something called the Calvo pricing rule, a source of controversy because there are questions about the extent to which this rule is consistent with micro-founded optimizing behavior, though others assert there are rationales for the Calvo structure that are sufficient - to some - to overcome these concerns).

To me, the New Keynesian model is about as mainstream as they get, so I'm puzzled by the opening to this column that claims modern macro completely embraces fully flexible prices. I think what he has in mind is some version of a Real Business Cycle model where prices are, in fact, assumed to be fully flexible, agents are rational etc. so that actual output is always equal to potential (so there's no need for policy to do anything but maximize the growth of potential output, hence the supply-side orientation of advocates of this approach). And I'm sure we could have a lively debate about which model has more proponents, but to say that mainstream economics subscribes fully to the notion of continuous market clearing when price rigidities are at the heart of a major class of modern models seems to miss the mark (and the assertion that agents are assumed to have perfect information is equally puzzling, they optimize given what they know, but they are not assumed to know everything and the efficient market hypothesis he discusses does not require this).

I don't disagree with the main message of the column that prevention of financial crashes through regulation is better than trying to cure them with policy, though I might quibble with particulars, but as someone who has been an advocate of the New Keynesian model, and quite resistant to pure Real Business Cycle approaches, I wanted to make clear that not all of us believe that assuming fully flexible prices and continuous market clearing is the proper way to model the economy. (A synthesis of the New Keynesian and Real Business Cycle models is what I have pushed in the past, though I'm now reconsidering the types of frictions that ought to be embedded in these models given recent events, and whether the mechanisms for generating bubbles in these structures are sufficient. I am also quite sympathetic to learning models as a replacement for the assumption of strict rationality):

Risky Risk Management, by Robert Skidelsky, Project Syndicate: Mainstream economics subscribes to the theory that markets "clear" continuously. The theory's big idea is that if wages and prices are completely flexible, resources will be fully employed, so that any shock to the system will result in instantaneous adjustment of wages and prices to the new situation.

This system-wide responsiveness depends on economic agents having perfect information about the future, which is manifestly absurd. Nevertheless, mainstream economists believe that economic actors possess enough information to lend their theorizing a sufficient dose of reality.

The aspect of the theory that applies particularly to financial markets is called the "efficient market theory," which should have blown sky-high by last autumn's financial breakdown. But I doubt that it has. Seventy years ago, John Maynard Keynes pointed out its fallacy. When shocks to the system occur, agents do not know what will happen next.

In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin. It is the shock, not the adjustments to it, that spreads throughout the system. The inescapable information deficit obstructs all those smoothly working adjustment mechanisms ― i.e., flexible wages and flexible interest rates ― posited by mainstream economic theory.

An economy hit by a shock does not maintain its buoyancy; rather, it becomes a leaky balloon. Hence Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks happening in the first place.

Today, that first lesson appears to have been learned... But, judging from recent proposals in the United States, the United Kingdom, and the European Union to reform the financial system, it is far from clear that the second lesson has been learned.

Admittedly, there are some good things in these proposals. For example, the U.S. Treasury suggests that originators of mortgages should retain a "material" financial interest in the loans they make, in contrast to the recent practice of securitizing them. This would, among other things, reduce the role of credit rating agencies. ... The underlying problem, though, is that both regulators and bankers continue to rely on mathematical models that promise more than they can deliver for managing financial risks.

Although regulators now place their faith in "macro-prudential" models to manage "systemic" risk, rather than leaving financial institutions to manage their own risks, both sides lumber on in the untenable belief that all risk is measurable (and therefore controllable), ignoring Keynes's crucial distinction between "risk" and "uncertainty."

Salvation does not lie in better "risk management" by either regulators or banks, but, as Keynes believed, in taking adequate precautions against uncertainty.

As long as policies and institutions to do this were in place, Keynes argued, risk could be let to look after itself. Treasury reformers have shirked the challenge of working out the implications of this crucial insight.

"Are Depressions Necessary?"

Chris Hayes takes up a notion I've never been very fond of, that recessions are necessary and healthy since they clear out inefficient firms, and spur the development of new innovation during the recovery phase. (Why do I think this is unnecessary? The entry and exit of firms driven by innovation and the development of new products can be part of a full employment equilibrium, that is, cycles are not needed to clear out old firms and spur innovation. Imagine an economy where a new idea allows a slightly more productive firm to enter a market and displace a less productive firm, and the workers migrate from the old to the new firm over time. If this happens at a constant rate in aggregate over time, there won't be any cycles at all, but we still manage to clear out the inefficient firms and replace them with more innovative rivals. The displaced workers from the the innovation driven structural adjustment are part of the natural rate of unemployment in such an economy):

Are Depressions Necessary?, by Christopher Hayes, The American Prospect: ...Are economic contractions, like the one we're currently experiencing, a good thing? ... It would be career suicide for any elected official to suggest that the widespread stress, misery and heartache being wreaked by ... contraction were are a good thing. But scratch the surface a bit and you'll find a surprisingly vibrant school of thought, one that reaches back all the way back to the Great Depression, that holds precisely this view.

Famed economist Joseph Schumpeter said that "a depression is for capitalism like a good, cold douche," one that rinses off accumulated dysfunction. Robber baron Andrew Mellon (who served as Herbert Hoover's treasury secretary) welcomed the Great Depression with these infamous words: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people"

It's not hard to find this same view among bankers, financiers and sundry Wall Streeters today. ...

The stakes for this argument are very high: if steep economic contractions are like forest fires, a necessary part of the system's self-calibration, we should more or less let them burn. If they are more like five-alarms raging through dense city neighborhoods, we should call in the fire department.

Economists are Seeking Remedies to the Crisis

Francesco Caselli of the London School of Economics rebuts a recent attack on the economics profession:

Economists are actively engaged in seeking remedies to the crisis, by Francesco Caselli, CIF: Larry Elliott's claim that "as a profession, economics not only has nothing to say about what caused the world to come to the brink of financial collapse last autumn, but also a supreme lack of interest", deserves a rebuttal.

The alleged lack of interest is belied by the outpouring of commentary and discussion that has swept the profession over the last couple of years and shows no sign of abating. I can think of few of the top academic stars in macroeconomics who have not been busy editorialising, blogging, and participating in discussions and policy events.

The evidence for the lack-of-interest charge is that "if, for example, you scroll down the list of papers scheduled for publication by the Review of Economic Studies, one of the prestigious UK journals, there is not the slightest sense that the world of general equilibrium and real business cycle models has been turned upside down in the past two years".

"A Discussion With Nobel Laureates in Economics"

Here is the Nobel lunch panel video I said I'd post. Topics include the value of economics, macroeconomics in particular, regulation, inequality, rationality, and efficient markets. Among other things, I was surprised to hear Becker support regulation, so long as it is automatic rather than discretionary (though Scholes disagrees):

Lunch Panel: A Discussion With Nobel Laureates in Economics: Whither Capitalism?:

Speakers:

• Gary Becker, Nobel Laureate, 1992; University Professor of Economics and Sociology, University of Chicago
• Roger Myerson, Nobel Laureate, 2007; Glen A. Lloyd Distinguished Service Professor in Economics, University of Chicago
• Myron Scholes, Nobel Laureate, 1997; Chairman, Platinum Grove Asset Management

Moderator:

• Michael Milken, Chairman, Milken Institute
  

It's become a Global Conference tradition for Michael Milken to moderate a discussion with Nobel laureates in economics, and this year is no exception. Topic A will be "whither capitalism" — that is, how the wrenching events of the last year will affect the long-term prospects of the global economy. Expect provocative commentary on subjects ranging from the logic of bank bailouts to the relevance of Japan's lost decade to President Obama's determination to tackle health-care reform. But if past performance is any indicator, don't be surprised if the conversation veers into terra incognito — great economists have a way of claiming the whole world of ideas as their own.

Update: Paul Kedrosky: "Did you enjoy the 'up with economists session?" That's a good summary of the session...

Blogginheads: Economics 2.0

The economy as a broken spaceship (08:02)
Are macroeconomic models just hogwash? (14:10)
Resizing and recasting the financial sector (30:46)
Did we have to bail out the banks? (37:35)
Why statistics can’t predict economic future (yet) (41:16)
Czar for a day: Mark and Arnold fix the economy (47:32)
Play entire video (56:51)

Update: New York Times Extract (2:53)

Macroeconomic Meltdown?

The state of macroeconmics:

Are those who sweat the big stuff in meltdown?, by Tim Harford, Commentary, Financial Times: ...I am struck by the soul-searching that has gripped the [macroeconomics] profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter ... complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

He is not alone in his frustration. Paul Krugman ... thinks macroeconomics is in a dark age, in the sense that rather than discovering new insights, we are actually going backwards and forgetting what we used to know. Mark Thoma ... opines: “I think that the current crisis has dealt a bigger blow to macroeconomic theory and modelling than many of us realise.”

We shall see. While many commentators have reached for Keynes – or some caricature of Keynes – as a solution to this crisis, this is not because he is the fount of all knowledge, but because he was asking good questions about problems that now seem relevant again.

Economists now understand much more than Keynes ever could about networks and complex interactions (thanks to agent-based modelling), psychology (thanks to behavioural economics) and the real world (thanks to econometrics). In principle, these advances should inform our understanding of the crisis. An early attempt is Animal Spirits, a book by George Akerlof, a Nobel laureate, and Robert Shiller, who identified the housing bubble early. But macroeconomics has a lot of momentum and it will take time to turn the oil tanker around.

Justin Wolfers,... an unabashed microeconomist, says that, “formally elegant but empirically irrelevant macroeconomists had a much harder time getting hired this year,” while Buiter reckons that the central banks have already jettisoned conventional macroeconomics in favour of a pragmatic combination of hunches and judgment calls. If so, the market for macroeconomic ideas seems to be self-correcting – much like the market for financial weapons of mass destruction. It is just a shame, in both cases, that the correction did not come more smoothly and much, much earlier.

Let me a bit more specific, and add something more to problems with macroeconomics I discussed in The Great Multiplier Debate and "The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics". The main mechanism generating fluctuations and policy effects in modern New Keynesian models is Calvo type sluggish price adjustment. I think this model is useful for “normal” times as a way of understanding economic fluctuations, and for learning about optimal policy, and it represents a step forward in understanding monetary policy in particular. But do people really think that all would be fine right now if prices – and they must have housing prices in mind when they think about sticky prices as an explanation for the current episode – had only adjusted faster? If housing prices had dropped even faster than they have already, all would be well in the world?

Okay, so maybe they don’t have housing prices in mind. Still, do we really think that sluggish price adjustment is the main mechanism at work in the present crisis? If not, then what use is the evidence from those models? Why do we keep hearing about theoretical simulations that give values for the multiplier that are small, large, zero, less than one, whatever? Do we really think that sluggish price adjustment captures the essence of the factors driving the present crisis? I don't.

The fundamental mechanism driving the economic fluctuations is wrong, and people seem to be missing that when they try to use the evidence from this model to comment on the present situation. There are two big problems. First, we have very little data from episodes like the current one to calibrate these models. What should, say, the elasticity of labor supply be in a severe recession? Do we know? That's a key parameter in these models, and we can only guess what it's value ought to be. Second, even if we have good data from similar episodes, why run it through a model that does not capture the fundamental problem driving the downturn?

Again, I think the New Keynesian model is very useful for understanding "normal" business cycles, but I am very hesitant to use this model as the basis for policy advice in the present crisis.

So where does that leave us? We do not have either the theoretical models or the empirical evidence we need to understand this episode thoroughly and completely, and to provide the policy advice that will cure the problem with any degree of certainty. Without solid theoretical models and the associated empirical evidence, we really have no choice but to fall back upon older models that were "built to answer the questions that are important at the moment," i.e. the old-fashioned Keynesian model, and to rely upon loose, but solid theoretical principles rather than a tightly constructed model and vast amounts of empirical evidence. It's quite understandable that economists who have been striving to push the profession in a positive, scientific, solidly theoretical and evidence based direction would resist going backward, and resist strongly, but what choice do we have? Until we have a better mousetrap, the simple, old fashioned one will have to suffice.

"Bah Humbug: Stagflation is around the Corner"

Roger Farmer is worried about stagflation, but says the "disaster scenario is not inevitable since we may get lucky":

Bah Humbug: Stagflation is around the corner, by Roger E. A Farmer, Commentary, Economists' Forum: Economic policy is in a muddle. Academic voices are flooding the blogosphere... On one end of the spectrum are classical revisionists who blame government for distorting market outcomes. On the other are Keynesians who think that fiscal deficits will rescue capitalism from its excesses. Both are partly wrong. Both are partly right.

The revisionist position was outlined at a recent conference ... at the Council on Foreign Relations. The revisionists blame government intervention for deepening recessions through raising distortionary taxes and, given the increase in the size of government that is taking place under the Obama administration, they see a decade of stagnation ahead. ...

But the idea that government is to blame for all our troubles is overstated. History has taught us that sometimes market economies may go wrong without any help from bad policy. Just ask a revisionist to explain what he means by a bubble.

The Keynesian position is the one that currently rules in Washington and economists in the Obama administration believe, following Keynes, that deficit spending will restore full employment. According to this view, we don’t need to worry about inflation until there is no excess capacity. ...

Who is right and what will happen in the next two years?

Over the next year, the US unemployment rate will continue to climb... and by the beginning of 2010 it will be well into double digits. Sometime around the middle of 2010, perhaps a little earlier perhaps a little later, GDP will stabilise and will begin to grow. But as the economy recovers, a new problem will arise. ...

Inflation will reappear while unemployment is still high; perhaps in double digits. ... If the Fed tackles inflation, as it has announced it will, it must raise interest rates... As the interest rate begins to increase, the Keynesians will blame the Fed for killing the recovery by raising interest rates too soon. We will enter a decade of stagnation which revisionists will blame on the Obama administration for raising taxes and the Keynesians will blame on the Fed for raising interest rates and killing off the recovery. ...

Since prediction is a risky business, it pays to hedge ones bets. The disaster scenario is not inevitable since we may get lucky. If market psychology dominates, as it did at the end of World War Two, bullish sentiment in the stock market and the housing market may inject new life into asset prices. If this happens, the economic recovery will be sustained and gdp will continue to grow without the reappearance of inflation. I am not hopeful. ... Of one thing I am certain: a sustainable recovery will not occur unless the stock market and the housing market recover first.

What matters the most is not actual inflation, though that is important, it is inflationary expectations that the Fed will be concerned with. If inflation reappears while unemployment is still high, but longer run inflation expectations remain anchored, then the Fed does not have to tighten up so much and potentially stall the recovery. What's important, though, is that the Fed's commitment to bringing down inflation once the economy has recovered sufficiently to withstand higher interest rates is taken seriously by the public. If the public begins to believe that commitment is weakening, and the danger of that happening is very real, then the Fed could very well find itself in the box described above.

Palley: "The Outlook for Macroeconomics and Macroeconomic Policy"

Heterodox economist Thomas Palley says:

I noticed that I posted Simon Johnson’s “Quiet Coup” and Dani Rodrik’s (mild) response. Here’s an alternative hypothesis. The economics profession has been party to the capture of economic policy and government by the financial oligarchy. I hope you will consider discussing this alternative hypothesis on your blog.

Here's the preface to his paper, "After the Bust: The Outlook for Macroeconomics and Macroeconomic Policy," outlining his arguments:

Preface, by Dimitri B. Papadimitriou, January 2009: “Change” was the buzzword of the U.S. presidential campaign, in response to a political agenda precipitated by financial turmoil and a global economic crisis. According to Research Associate Thomas I. Palley, the neoliberal economic policy paradigm underlying the current agenda must itself change if there is to be a successful policy response to the crisis. He observes that the financial downturn has exposed the faulty economics of the existing policy paradigm, thus presenting the opportunity for real change, but that there are profound political, intellectual, and sociological obstacles to such change.

The ideology of the economics profession—mainstream economic theory—remains unreformed, says Palley, and he warns of a return to failed policies if a deep crisis is averted. Since Post Keynesians accurately predicted that the U.S. economy would implode from within, there is an opportunity for Post Keynesian economics to replace neoliberalism with a more successful approach.

Palley outlines the policy challenges, noting that there is significant disagreement among economic paradigms about how to ensure full employment and shared prosperity. A salient feature of the neoliberal economy, which is supported by mainstream economic theory (e.g., free trade, deregulation, and the notion of a natural rate of unemployment), is the disconnect between wages and productivity growth that explains widening income inequality. Workers are boxed in on all sides by globalization, labor market flexibility, concern with inflation rather than with full employment, and a belief in “small government” that has eroded economic rights and government services. Financialization, the economic foundation of neoliberalism, serves the interests of financial markets and top management. Thus, reversing the neoliberal paradigm requires a policy agenda that addresses financialization and ensures financial markets and corporations are more closely aligned with the greater public interest.

Palley outlines several major obstacles to changing both economics and economic policy. Social democratic political parties are divided in terms of the merits of the neoliberal economic paradigm.Other obstacles include the dominance of neoliberal economics within the academic community and among policymakers, which is supported by a misplaced belief that neoclassical economics is a scientific fact. This belief is used by the academic establishment to block alternative points of view.

New Keynesian economics is a form of real-business-cycle theory in the tradition of Arthur C. Pigou rather than John Maynard Keynes, says Palley. Though mainstream economists are willing to recommend Keynesian policies in times of economic crisis, they are unwilling to change the core analytical assumptions driving modern neoclassical macroeconomics (an example of so-called“cuckoo” economics).The only satisfactory escape from this intellectual and political stew is the creation of a new, progressive Keynesian consensus. That will require placing economics at the center of the political stage.

The “Zig Zag Windings of the Flowery Path of Literature”

The article by Anatole Kaletsky I posted earlier today, Goodbye, homo economicus, did not get the best reception here and elsewhere, and there were also protests that arrived by email. Here's a follow-up on one aspect of the article, the use of formal mathematical models in economics. This article is by David Colander:

Marshallian General Equilibrium Analysis, by David Colander: In an assessment of Alfred Marshall, Paul Samuelson (1967) writes that “The ambiguities of Alfred Marshall paralyzed the best brains in the Anglo-Saxon branch of our profession for three decades.“ In making this assessment he carried on a tradition of Marshall-bashing that has a long history in economics, dating back to Stanley Jevons and F. Y. Edgeworth, who accused Marshallian economists of being seduced by “zig zag windings of the flowery path of literature.” (Edgeworth, 1925)

These harsh assessments of Marshall and his approach to economics have had their influence on the modern profession and, other than historians of economic thought, few young economists know much about him. Fewer still would see themselves as Marshallians.[1]

Today, Marshall is best remembered for his contribution to partial equilibrium supply and demand analysis.[2] For the true economic theorists of the 1990s, however, this contribution is de minimus; the partial equilibrium approach is for novice economists with no stomach for real economic theory—general equilibrium. The profession’s collective view of Marshall in the 1990s is that Marshall is passé--at most a pedagogical stepping stone for undergraduate students, but otherwise quite irrelevant to modern economics.

"Equilibrium and Meltdown"

George Waters of Illinois State University on the economic crisis and the state of macroeconomics:

Equilibrium and Meltdown, by George A. Waters: Equilibrium in economics is such a ubiquitous concept some might be surprised to hear that it is also controversial. It is hard to imagine doing much economic analysis without examining the intersection of supply and demand, but whether we should focus exclusively on equilibrium outcomes is a critical question. Though the importance of equilibrium might seem like an esoteric debate, the attitude toward this question has deep implications for economists’ views on the correct policy response to the current economic crisis.

Milton Friedman believed in equilibrium. An example of the intensity of his belief was his argument against requiring medical licenses for doctors on the grounds that more doctors would be allowed to practice, and market forces would weed out poor doctors and improve the quality of care. This argument makes perfect sense if we focus on the equilibrium outcome, but most people are instinctively repelled by this proposal. The concern arises from the consideration of how the world gets to such an equilibrium. To find out who the bad doctors are, some patients have to try them, get bad treatment and tell others about it. Since patients have little expertise in making judgments about doctors, a poor doctor could practice for many years without detection. I know this happens even with licensing requirements, but the situation could easily be worse without them. An equilibrium outcome cannot be divorced from the path to arrive at that state.

"The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics"

Willem Buiter on "'state of the art' academic monetary economics":

The unfortunate uselessness of most ’state of the art’ academic monetary economics, by Willem Buiter: The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member ... contained, like its successor..., quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity.; Indeed, it may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding .; It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.; Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes; rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability.; So the economics profession was caught unprepared when the crisis struck.

Paul Krugman: Who’ll Stop the Pain?

Will recovery from the slump be a long, drawn out, painfully slow process?:

Who’ll Stop the Pain?, by Paul Krugman, Commentary, NY Times: Earlier this week, the Federal Reserve released the minutes of the most recent meeting of its open market committee... Most press reports focused either on the Fed’s downgrade of the near-term outlook or on its adoption of a long-run 2 percent inflation target.

But my eye was caught by the following chilling passage...: “All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation.”

So people at the Fed are troubled by the same question I’ve been obsessing on lately: What’s supposed to end this slump? No doubt this, too, shall pass — but how, and when?

To appreciate the problem, you need to know ... we’re in the midst of a crisis that bears an eerie, troubling resemblance to the onset of the Depression; interest rates are already near zero, and still the economy plunges. How and when will it all end?

To be sure, the Obama administration is taking action to help the economy, but it’s trying to mitigate the slump, not end it. The stimulus bill, on the administration’s own estimates, will limit the rise in unemployment but fall far short of restoring full employment. The housing plan announced this week ... will help many homeowners, but it won’t spur a new housing boom.

What, then, will actually end the slump?

Well, the Great Depression did eventually come to an end, but that was thanks to an enormous war, something we’d rather not emulate. The slump that followed Japan’s “bubble economy” also eventually ended, but only after a lost decade. And when Japan finally did start to experience some solid growth, it was thanks to an export boom,... not an experience anyone can repeat when the whole world is in a slump.

So will our slump go on forever? No. In fact, the seeds of eventual recovery are already being planted.

Consider housing starts, which have fallen to their lowest level in 50 years. That’s bad news for the near term. It means that spending on construction will fall even more. But it also means that the supply of houses is lagging behind population growth, which will eventually prompt a housing revival.

Or consider the plunge in auto sales. Again, that’s bad news for the near term. But at current sales rates, as ... Calculated Risk points out, it would take about 27 years to replace the existing stock of vehicles. Most cars will be junked long before that,... so we’re building up a pent-up demand for cars.

The same story can be told for durable goods and assets throughout the economy: given time, the current slump will end itself, the way slumps did in the 19th century. ... But recovery may be a long time coming.

The closest 19th-century parallel I can find to the current slump is the recession that followed the Panic of 1873. That recession did eventually end without any government intervention, but it lasted more than five years, and another prolonged recession followed just three years later.

You can see, then, why some Fed officials are so pessimistic.

Let’s be clear: the Obama administration’s policy initiatives will help... — especially if the administration bites the bullet and takes over weak banks. But still I wonder: Who’ll stop the pain?

"The Great Multiplier Debate"

This is very good. I have some follow-up comments at the end:

Why Can't We All Just Get Along? The Great Multiplier Debate, by Menzie Chinn: I've been thinking about why the numbers that are typically bandied about in policy circles (at least that I'm familiar with) have so little impact on the overall general and blogosphere debate (see some examples here and here). I think it's part ideological, and part methodological. I can't do much about the first (e.g., tax cuts good, spending on goods and services bad -- unless on defense; or alternatively "let the market adjust no matter how long it takes"). But at least I can lay out why reasons why there is disagreement on the size of the multipliers. ...

The starting point in the analysis is to realize that there are three key ways in which to obtain "multipliers".

• Estimation of structural macroeconometric models, with identification a la the Cowles Commission approach.
• Calibration of microfounded models (including real business cycle models, and New Keynesian dynamic stochastic general equilibrium models).
• Estimation of vector autoregressions (VARs) and associated impulse-response functions, with identification achieved by a variety of means.

Traditional macroeconometric models. Most of the estimates I have cited [1] [2] are based upon the first approach. One estimates a model with many equations, including the components of aggregate demand (C, I, G, X, M), supply side (price setting, wage setting), and potential GDP. The framework most popular in policy circles is one that might be characterized as "the neoclassical synthesis", wherein wherein prices are sticky in the short run, and perfectly flexible in the long run. ... Now even within this category, there is a wide diversity of specifications...

A key reason for the academic disenchantment with these types of models included the view that the identification schemes used were untenable (e.g., why is income in the consumption function but not in the investment?). Another source is the combined impact of the inflationary 1960's and 1970's, and the Lucas Critique. On the latter point, I'd point out that unless policy changes are really massive, the Lucas Critique (a.k.a. Econometric Policy Evaluation Critique) isn't really relevant (see [1]).

Models with micro-foundations in general equilibrium Micro-founded models are often associated with real business cycle models. However, the association is not one-for-one. It's true the early real business cycle models worked off of utility functions and production functions. But the modern generation of dynamic stochastic general equilibrium (DSGE) models in the new Keynesian mode incorporate microfoundations as well (utility functions, production functions, investment functions, etc.) but also incorporate rigidities such as price stickiness. Purists will say everything has to be microfounded. Well, that's a matter of taste, but the fact of the matter is that it's very hard to calibrate simple real business cycle models without rigidities to match the moments of actual real world data, even after the data's been HP-filtered (I'm sure this blanket statement will get me in trouble, but I think that that's a fair assessment). So DSGEs do better at mimicking real data, especially after numerous rigidities are incorporated. ... For a survey of how DSGEs have been incorporated into policy analysis, see the survey by UW PhD Camilo Tovar.

It's useful at this point to ask how are these models calibrated? For the deep parameters (intertemporal rate of substitution, for instance), one can rely upon some estimates -- then pick the one that you like (and is in the range of estimates). Oftentime, the combination of parameter values is selected to mimic the time series properties of actual (filtered) data. So say one believes one should not appeal to ad hoc Keynesian models. It's not clear that RBCs or DSGEs get you away from the problem that one has to appeal to the data to get multipliers since the models are calibrated to mimic real world data. In other words, while the theoretical bases of the models may differ,... the differences in terms of multipliers might not be as big as one might think.

VARs Vector autoregressions are regressions of multiple variables on lags of themselves. The underlying shocks can be identified by putting them in a recursive ordering (called a Cholesky decomposition), or using restrictions based on theory (say, money has no contemporaneous impact on prices; or money has no impact on output in the long run). VARs were initially proposed as a way of getting around "incredible identifying assumptions", in the Cowles Commission approach to econometrics embodied in the old style macroeconometric models. But of course, people can disagree about which restrictions make the most economic sense. (For instance money is neutral in the long run seems natural, but not all theoretical models have that implication.)

The much cited Romer and Romer model of fiscal policy impacts is a particular sort of VAR, in which only one equation is focused on, and extra-model information is used to identify exogenous tax changes (remember, they don't analyze government spending changes). ... A good summary of where these types of fiscal multipliers come from was in Box 2.1 in Chaper 2 of the April 2008 World Economic Outlook.

My bottom line There are indeed a wide variety of estimates regarding the size of multipliers. Different models -- and assumptions within those model categories -- lead to different estimates. It's important to understand the underpinnings of those estimates (and this is where many of the people who cited the Romer and Romer study went wrong). Hence, one has to have an understanding of the very complicated models before taking strong stands in favor of one estime over another.

In my experience, as far as policy organizations such as central banks, government agencies and multilateral agencies go, reference is made to a number of models. Their assessments of multiplier magnitudes will then reflect some weighting of the various model predictions. That is why I will put more wieght upon assessments by organizations (that have to make decisions upon these judgments) than a single academic study, regardless of how well I respect the academics involved (and sometimes, these academics are working outside their area of research expertise...)

As an aside, here are the impacts of various fiscal experiments in response to a negative shock in a DSGE developed by the IMF... Notice that the public investment shows the biggest impact, while under the base assumptions the impact of transfers and tax cuts are about the same.

Models are built to answer specific questions. If you are interested in traveling to an unknown area of the city, then a street map - a model of the world that answers the how do I get there question - is useful. It is even more useful if it is built specifically for your question. If I am traveling by car, I want to know where the roads are, a map showing all of the underground conduits in the city and nothing else is useless. But suppose I try to use a map designed for a car to find the best route for traveling by bicycle. I can probably find a way there using this map, but it may not give the best possible answer. Some roads may be hard to travel on, it may not show smaller roads that a bicycle rider might want to take, and if it only shows, say, freeways where bikes are prohibited, then it isn't much use at all. But more importantly, it may omit bike routes. I don't know how it is where you live, but here there is a fairly extensive set of bike paths that are separate from the roads used by cars. And these routes can save you lots of time - if you know about them, i.e. if your map shows them. So the best map would show bike routes and roads suitable for bikes, and omit everything else, and it could also show things like elevation changes if it's an areas with lots of hills (which isn't usually part of a road map).

My point is this. Since the Great Moderation, and since Lucas convinced everyone that growth is where all the action is, the questions we have been asking have been mainly about growth and, where stabilization is concerned, about the use of optimal monetary policy rules to offset economic fluctuations (and whether monetary policy was responsible for the Great Moderation). Thus, the models were built to look at these particular questions. Nobody, or hardly anybody, was asking questions about the use of fiscal policy to stabilize the economy. Hence very few models were built to look at this issue. Because of that, because we are essentially using a map designed to guide cars to ask questions about the best way to travel by bicycle, we may not get the best answer to the question (that is, the answer to the question of what's the fastest way to get there - akin to asking about the fastest way for the economy to recover - may be wrong).

Why was fiscal policy ignored? Two reasons come to mind. First, we thought the economy was much more flexible than ever before. If a shock hit, even a big one, it might cause a bit of a pause, but the economy would quickly recover and keep on growing. It was the Terminator economy, and there was no shock big enough to keep it from quickly reassembling itself and picking up where it left off. And the two recessions during that time period, along with the experience of 9-11 and Katrina, all led people to believe that the economy had, in fact, undergone a shift and was now more robust than ever. The exact source of this shift was the subject of great debate, was it monetary policy, financial innovation, just good luck, better technology such as computers, the list was very long, but whatever the cause, the shift itself was taken to be permanent. Thus, the need for stabilization policy, fiscal policy in particular, was believed to be greatly diminished. The fact that fiscal policy might be needed in a deep recession because monetary policy would be rendered ineffective was discounted and ignored because the the belief was that a deep recession couldn't occur, the economy was too robust and flexible for that.

The second factor was the belief that if stabilization policy is needed, monetary policy was superior in every way to fiscal policy. Monetary policy could be implemented faster, with less distortions, it could be reversed quickly, it was in the hands of independent, public minded shepherds, there wasn't any dimension, or so it was thought, upon which fiscal policy would be better than monetary policy, and vast amounts of research were devoted to getting the monetary policy component of stabilization policy correct. In the process, fiscal policy was dismissed as irrelevant, at least as a stabilization tool, and largely ignored by researchers  (fiscal policy was still used to try to promote growth - that's the whole supply-side argument about cutting taxes, but not as a stabilization tool). That's not to say government spending and taxes weren't included in models and analyzed theoretically, or even empirically, but to the extent that happened, the questions were not focused on how fiscal policy could be used as a stabilization tool -- the models were not constructed to answer this question.

So it shouldn't surprise us that most of the estimates on multipliers come from the old style, many equation, structural macroeconometric models, the traditional approach described above. These models were built at a time when questions about fiscal policy were in the forefront, so answers to fiscal policy questions come out of this framework easily. For this reason, because the models were built with this question in mind, there is an abundance of evidence about fiscal policy multipliers, particularly government spending multipliers, from research conducted during this time period. The next approaches to macro modeling and estimation, the micro-founded models and the VAR models, came into being as the fiscal policy question was falling by the wayside (most VAR models do not even include government spending and taxes). Thus, as you may have noticed, there isn't much in the way of evidence from these models that we can reply upon (and that's not even considering the fact that we have very little data from recessionary episodes to inform us on these issues). The models will be built - I guarantee you they are being built presently - but for now we have what we have.

An Ideological Turf War

Paul Krugman:

Fiscal policy formalities (wonkish), by Paul Krugman: There seems to be an amazing amount of misunderstanding of the basics of fiscal policy, even among people who should know better. Leave on one side the remarkable parade of economists who think that the savings-investment identity proves that government action can’t increase spending; PGL points us to a higher-level fallacy: the widespread belief that Ricardian equivalence doesn’t just say that tax cuts have no effect — which it does — it also says that private consumption automatically offsets any rise in government spending, which is just wrong.

Justin Wolfers suggests that this is because economists just haven’t been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn’t true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.

And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.

What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don’t read anything that doesn’t come from their cult circle; they just weren’t aware of major bodies of work that didn’t happen to be in their preferred style.

This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They’ve been taught that there is one true faith, and have been carefully protected from heresy.

It’s a sad story.

It's even sadder. The two groups have lots to offer, New Keynesians can learn from RBC theorists, and the reverse is true as well, but ideological hard-headedness driven by a turf war among the leaders in each group, a war that is really about a quest for for professional fame has, I think, kept these two groups in opposition to the detriment of the profession.

A post from last August looked at this question:

"The State of Macro": Exactly three years ago, I wrote:

There is currently a movement within the economics profession to [synthesize real business cycle and new Keynesian models]. Real business cycle models, i.e. supply-side models, are adequate models of the long-run but do not explain demand side short-run economic fluctuations very well. Because of this, they are limited in their applicability. Models with wage and price rigidities, New Keynesian models, do have the ability to explain such short-run fluctuations but pay scant attention to long-run issues. Combining these two models, a real business cycle model for the long-run and a New Keynesian model of wage and price rigidity for the short-run, is a promising avenue for explaining macroeconomic fluctuations.

Olivier Blanchard explores this idea in more detail in "The State of Macro." Here's a bit of the paper (I can't find an open link - Update: open link - click on "choose download location" at top of page):

The State of Macro, by Olivier J. Blanchard, NBER Working Paper No. 14259, August 2008: The editors of this new Journal asked me to write about "The Future of Macroeconomics". ...

The theme is that, after the explosion (in both the positive and negative meaning of the word) of the field in the 1970s, there has been enormous progress and substantial convergence. For a while - too long a while - the field looked like a battlefield. Researchers split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies. Over time however, largely because facts have a way of not going away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good.[2] ...

1 A Brief Review of the Past

When they launched the "rational expectations revolution", Lucas and Sargent (1978) did not mince words:

That the predictions [of Keynesian economics] were wildly incorrect, and that the doctrine on which they were based was fundamentally flawed, are now simple matters of fact, involving no subtleties in economic theory. The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.

They predicted a long process of reconstruction:

Though it is far from clear what the outcome of this process will be, it is already evident that it will necessarily involve the reopening of basic issues in monetary economics which have been viewed since the thirties as "closed" and the reevaluation of every aspect of the institutional framework within which monetary and fiscal policy is formulated in the advanced countries. This paper is an early progress report on this process of reevaluation and reconstruction.

They were right. For the next fifteen years or so, the field exploded. Three groups dominated the news, the new-classicals, the new-Keynesians, and the new-growth theorists (no need to point out the PR role of "new" here), each pursuing a very different agenda:

The new-classicals embraced the Lucas-Sargent call for reconstruction. Soon, however, the Mencheviks gave way to the Bolcheviks, and the research agenda became even more extreme. Under Prescott's leadership, nominal rigidities, imperfect information, money, and the Phillips curve, all disappeared from the basic model, and researchers focused on the stochastic properties of the Ramsey model (equivalently, a representative agent Arrow-Debreu economy), rebaptized as the Real Business Cycle model, or RBC. Three principles guided the research:

Explicit micro foundations, defined as utility and profit maximization; general equilibrium; and the exploration of how far one could go with no or few imperfections.

The new-Keynesians embraced reform, not revolution. United in the belief that the previous vision of macroeconomics was basically right, they accepted the need for better foundations for the various imperfections underlying that approach.

The research program became one of examining, theoretically and empirically, the nature and the reality of various imperfections, from nominal rigidities, to efficiency wages, to credit market constraints. Models were partial equilibrium, or included a trivial general equilibrium closure: It seemed too soon to embody each one in a common general equilibrium structure.

The new-growth theorists simply abandoned the field (i.e. fluctuations). Lucas' remark that, once one thinks about growth, one can hardly think about something else, convinced many to focus on determinants of growth, rather than on fluctuations and their apparently small welfare implications. ...

Relations between the three groups - or, more specifically, the first two, called by Hall "fresh water" and "salt water" respectively (for the geographic location of most of the new-classicals and most of the new-Keynesians) - were tense, and often unpleasant. The first accused the second of being bad economists, clinging to obsolete beliefs and discredited theories. The second accused the first of ignoring basic facts, and, in their pursuit of a beautiful but irrelevant model, of falling prey to a "scientific illusion." (See the debate between Prescott and Summers (1986)). One could reasonably despair of the future of macro (and, indeed, some of us came close (Blanchard 1992)).

This is still the view many outsiders have of the field. But it no longer corresponds to reality. Facts have a way of eventually forcing irrelevant theory out (one wishes it happened faster). And good theory also has a way of eventually forcing bad theory out. The new tools developed by the new-classicals came to dominate.

The facts emphasized by the new-Keynesians forced imperfections back in the benchmark model. A largely common vision has emerged, which is the topic of the next section.

2 Convergence in Vision

2.1 The role of aggregate demand, and nominal rigidities

It is hard to ignore facts. One major macro fact is that shifts in the aggregate demand for goods affect output substantially more than we would expect in a perfectly competitive economy. More optimistic consumers buy more goods, and the increase in demand leads to more output and more employment. Changes in the federal funds rate have major effects on real asset prices, from bond to stock prices, and, in turn, on activity.

These facts are not easy to explain within a perfectly competitive flexible-price macro model. ...

Attempts to explain these effects through exotic preferences or exotic segmented-market effects of open market operations, while maintaining the assumption of perfectly competitive markets and flexible prices, have proven unconvincing at best. This has led even the most obstinate new-classicals to explore the possibility that nominal rigidities matter. ...

The study of nominal price and wage setting is one of the hot topics of research in macro today. ... The cast of characters involved ... nicely makes the point that the old fresh water/salt water distinction has become largely irrelevant: While research on the topic started with new-Keynesians, recent research has been largely triggered by an article by Golosov and Lucas (2007), itself building on earlier work on aggregation of state-dependent rules by Caplin and by Caballero, among others.

2.2 Technological shocks versus technological waves

One central tenet of the new-classical approach was that the main source of fluctuations is technological shocks. The notion that there are large quarter-to-quarter aggregate technological shocks flies however in the face of reason. Except in times of dramatic economic transition,... technological progress is about the diffusion and implementation of new ideas, and about institutional change, both of which are likely to be low-frequency movements. No amount of quarterly movement in the Solow residual will convince the skeptics: High frequency movements in measured aggregate TFP must be due to measurement error.[3]

This does not imply, however, that technological progress does not play an important role in fluctuations. Though technological progress is smooth, it is certainly not constant. There are clear technological waves. ...

2.3 Towards a general picture, and three broad relations

The joint beliefs that technological progress goes through waves, that perceptions of the future affect the demand for goods today, and that, because of nominal rigidities, this demand for goods can affect output in the short run, nicely combine to give a picture of fluctuations which, I believe, many macroeconomists would endorse today.

Fifty years ago, Samuelson (1955) wrote:

In recent years, 90 per cent of American economists have stopped being "Keynesian economists" or "Anti-Keynesian economists." Instead, they have worked toward a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neo-classical economics and is accepted, in its broad outlines, by all but about five per cent of extreme left-wing and right-wing writers.

I would guess we are not yet at such a corresponding stage today. But we may be getting there. ...

When I first posted this, I agreed. The two sides seemed to be converging and I thought that was a good development. But the current crisis has reopened old debates, exposed divisions that have never been fully healed, and we seem as far apart as ever.

I want to end with this quote from Lucas:

The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.

What's different this time, and it's a difference I hope will bring about some humility, is that the wreckage is not from the Keynesian model crashing, this time it is the Classical formulation of the world that is being called into question. Once the proponents of these models are willing to concede that point, something they are currently resisting, maybe we can come together and get somewhere useful.

"A Dark Age of Macroeconomics"

Quoting an email [from Paul Krugman], economists who "have spent their entire careers on equilibrium business cycle theory are now discovering that, in effect, they invested their savings with Bernie Madoff." I think that's right, and as they come to this realization, we can expect these economists to flail about defending the indefensible, they will be quite vicious at times, and in their panic to defend the work they have spent their lives on, they may not be very careful about the arguments they make. I don't know if the defenders of the classical faith have come to this realization yet, at least beyond the subconscious level, and the profession will most likely move in the same old direction for awhile due to research inertia if nothing else. But I think what has happened will have a much bigger impact on the profession and the models it uses to describe the world than most economists currently realize:

A Dark Age of macroeconomics (wonkish), by Paul Krugman: Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

There has been a tendency, on the part of other economists, to try to provide cover — to claim that Fama and Cochrane said something more sophisticated than they did. But if you read the original essays, there’s no ambiguity — it’s pure Say’s Law, pure “Treasury view”, in each case. Here’s Fama... And here’s Cochrane...

There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that’s not something that mystically takes place, it’s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line. ... [A]fter a change in desired savings or investment..., if interest rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often presented to freshmen. Here’s the diagram...

In this picture savings plus taxes equal investment plus government spending, the accounting identity that both Fama and Cochrane think vitiates fiscal policy — but it doesn’t. An increase in G doesn’t reduce I one for one, it increases GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works. But you do have to accept that it shows the fallacy of arguing that the savings-investment identity proves anything about the effectiveness of fiscal policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics. Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view — the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Given their understanding of macroeconomics, and I mean the basics not the hard stuff, it's becoming a lot easier to understand how financial economists missed the developing bubble and the effect it would have on the macroeconomy. We specialize mightily in academic economics, people will work on very narrow questions for their entire careers and become world class experts on that question, but they tend to forget what they learned in other areas over time, and they can't possibly keep up with developments outside their areas of specialization. So we rely and depend upon the expertise of others to inform us about areas in which we don't normally work. One thing I've learned from the current episode is not to automatically trust that the most well-known economists in the field have done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they've thought very hard about the problems they are speaking to. I used to think that, for the most part, the name brands in the field would live up to their reputations, that they would think hard about problems before speaking out in public, that they would provide clarity and insight, but they haven't. In fact, in many cases they have undermined their reputations and confused the issues. People have been deferential in the past, myself included, and these people have been given authority in the public discourse - even when they are demonstrably wrong their arguments show up in the press as a "he said, she said" presentation. But, unfortunately for the economics profession and for the public generally, the so called best and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.

[See also What Are Chicago's Economists Thinking?, by Brad DeLong.]

[Update: Greg mankiw responds to Paul Krugman.]

"Milton Friedman Knew This"

Brad DeLong is frustrated. People arguing that government spending displaces private consumption and investment on a one-to-one basis don't seem to realize that their argument rests on the (indefensible) presumption of a constant money multiplier and a constant velocity of money:

Time to Bang My Head Against the Wall Some More (Pre-Elementary Monetary Economics Department), by Brad Delong: Oh boy. John Cochrane does not know something that David Hume did--that the velocity of monetary circulation is an economic variable rather than a technological constant. Cochrane:

Fiscal Fallacies: First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending.  Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...

Let us take this slowly.

Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.

Suppose that Beverly has $500 in cash that she owes Carol, due in two months. Suppose that Alice and Carol are both unemployed and idle.

In one scenario in two months Beverly goes to Carol and pays her the $500. End of story.

In a second scenario Beverly says to Alice: "I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract." Alice takes the contract and goes to Carol. She shows the contract to Carol and says: "See. I will be good for the debt. Cook me meals so I will have the strength to build the deck--here's another contract in which I promise to pay you $500 within 90 days if you cook for me." Carol agrees.

Two months pass. Carol cooks and feeds Alice. Alice goes and builds the deck.

Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money to Carol. Beverly then says: "But now could I borrow the cash back by offering you a long-term mortgage at an attractive interest rate secured with an interest in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage lien with the town office. Carol gives Beverly back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes to Carol and pays her the $500.

The net result? (a) Alice who would otherwise have been idle has been employed--has traded her labor for meals. (b) Carol who would otherwise have been idle has been employed--has traded her labor for a secured lien on Beverly's house. (c) Beverly has taken out a mortgage on her house and in exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed her in the first place.

Alice has more income and consumption expenditure than if she hadn't taken Beverly's job offer. Carol has more income and saving than if she hadn't cooked for Alice and then invested her earnings with Beverly. Beverly has an extra capital asset (the deck) and an extra financial liability (the mortgage) than if she had never offered to hire Alice.

A deck has gotten built. Meals have been cooked and eaten. Two women have been employed. And all this has happened without printing any extra money.

John Cochrane would say that this is impossible. John Cochrane would say:

[I]f money is not going to be printed, it has to come from somewhere. If Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend, or does not lend to Deborah to spend on new investment. Every dollar of increased Beverly spending must correspond to one less dollar of Carol or Deborah spending.  Alice's job created by Beverly spending is offset by a job lost from the decline in Carol or Deborah spending. We can build decks instead of fountains, but Beverly stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...

John Cochrane is wrong.

You sometimes see this mistake in freshmen students in Economics 1, students who do not fully understand either the circular flow of economic activity or what a credit economy is. They think--like Cochrane--that the flow of spending must be constant unless somebody "prints money" because, you see, you need "money" in order to buy things.

The premise is true--you do need "money" to buy things--but the conclusion is false: the flow of spending is not necessarily constant. In the world in which Beverly does not hire Alice but instead pays the $500 directly to Carol, that $500 turns over only once--its velocity of circulation is equal to one. In the world in which Beverly does hire Alice, the velocity of circulation of the $500 is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to Alice, and from Alice to Carol.

Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant. And as the velocity of circulation varies, the amount of the flow of spending varies as well: it is now longer the case that if Beverly borrows a dollar from Carol that is a dollar that Carol does not spend.

Milton Friedman knew this. Irving Fisher knew this. Simon Newcomb knew this. David Hume knew this. John Cochrane does not know this: does not know that the velocity of circulation is an economic variable rather than a technological constant.

I do want to pound my head against the wall.

I do not know what else to do...

pgl has more. Arnold Kling calls Cochrane's essay, generously, "muddled."

"The Business Cycle Myth"

Robert Skidelsky:

The business cycle myth, by Robert Skidelsky, Project Syndicate: ...Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest". ...

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. ...

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models... It manages to combine technology-driven cycles of booms and recessions with markets that always clear (i.e. there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention. It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. ...

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny.

"A Line in the Sand"

If you look on the sidebar, you will see a link to "Bailouts and Stimulus Plans - Fama/French Forum," at least until it rolls off the list. It's a link to a post at a new blog by financial economists Eugene Fama and Kenneth French. However, if you look at today's daily links, you will see that the link to this post is not there. That's because I took it out, I didn't want to send people to read the post without explaining what was wrong with it first, and I didn't have time to explain.

Here's why I removed the link, and something that's worth taking a few moments to understand:

Eugene Fama Rederives the "Treasury View": A Guestpost from Montagu Norman: Back in the 1920s and 1930s--in the days that overly-clever bisexual academic dilettante John Maynard Keynes was trying to persuade us that if only we got the government to spend more money the unemployment rate might go down--by far the silliest argument against his position was the one put forward by the staff of the Chancellor of the Exchequer: the so-called "Treasury View."

The Treasury View was that nothing could boost employment: not government spending, not tax cuts, not private business decisions to expand their capacity, not irrational exuberance on the part of entrepreneurs--for the unemployment rate was what it was.

Back on Christmas Eve Paul Krugman whacked Caroline Baum of Bloomberg on the nose for rediscovering the Treasury View. Now Eugene Fama of the University of Chicago has rederived it from scratch (apparently without knowing anything of its history):

Bailouts and Stimulus Plans: There is an identity in macroeconomics... private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS]....

(1) PI = PS + CS + GS....

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt.... The added debt absorbs savings that would otherwise go to private investment.... [S]timulus plans do not add to current resources in use. They just move resources from one use to another.... I come back to these fundamental points several times below....

The Sad Logic of a Fiscal Stimulus

In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work.... Unfortunately, there is a fly in the ointment.... [G]overnment infrastructure investments must be financed -- more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount....

Suppose the stimulus plan takes the form of lower taxes... we can't get something for nothing this way either... lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes...

Fama's reasoning is dead wrong--and embarrassing. Fama's reasoning is dead wrong for an elementary reason. The accounting identity that savings are equal to investment is true only under a particular definition of investment--one that counts unwanted growth in inventories as part of investment--and under a particular valuation of unexpected inventory accumulation--that which values unwanted inventory accumulation at its cost.

In general, the value of unwanted inventory accumulation can't be equal to its cost--the inventory accumulation is unwanted and unexpected, meaning that they tried to sell it at a normal price and failed, and it is now sitting in a corner of a warehouse somewhere. ...

Moreover, unwanted inventory accumulation and decumulation today affects incomes and savings next week. Let's tell a story. Suppose that it is Friday, January 2, 2009, and all of a sudden the federal government borrows some money--reducing savings--and buys some extra stuff. Savings is still equal to investment on January 2: savings went down because the government ran a bigger deficit but investment also went down because firms sold extra and so their inventories dropped.

What happens on Monday, January 5? Over the weekend the firms mark the value of the goods in their remaining inventory up: inventories are now scarce. They revisit their production plans. Sunday night they call some extra workers and tell them to show up on Monday--that they are expanding production because they are now short of inventories. So when Monday rolls around more people are at work. Thus incomes are higher on Monday than they were on Friday. And in all likelihood savings will be higher as well, for consumers on Monday probably won't raise their consumption spending by as much as their incomes rose. Maybe on Monday purchases will be back in balance with production, and there will be no more unwanted inventory changes. Maybe it will take until Monday January 12 before the change in inventories is back to its desired level. Maybe it will take until ... 2010. But when the change in inventories does come back to its wanted level, production, employment, income, savings, and investment will all be higher than they were on January 1: the stimulus will have worked. Yet every single day savings are equal to investment according to the accounting conventions of the National Income and Product Accounts. Fama's conclusion--that stimulus programs cannot work--has nothing at all to do with his premise--that savings always equals investment in the NIPA framework. ...

Fama does not know enough national income accounting to know that that is what he is assuming. He does not understand the identity he deploys as equation (1). He thinks that "investment" means "growth in the value of the capital stock." He simply does not understand what the NIPA investment concept is, or that what he thinks of as "investment" is not in general equal to savings.

All of this is part of the undergraduate sophomore economics curriculum. It is gone over again very quickly in graduate school--for example, David Romer (2006), Advanced Macroeconomics 3e, p. 224:

If one treats goods that a firm produces and then holds as inventories as purchased by the firm, then all output is purchased by someone. Thus actual expenditure equals the economy's output, Y. In equilibrium, planned and actual expenditure must be equal. If planned expenditure falls short of actual expenditure, for example, firms are accumulating unwanted inventories; they will respond by cutting their production...

These mistakes are, literally, elementary ones. They were elementary when R.G. Hawtrey and the other staffers of the British Treasury made them in the 1920s. They carry the implication not just that government cannot stimulate or depress the economy, but that no set of private investment or savings decisions can stimulate or depress the economy either, and thus that there can be no business cycle fluctuations from any source whatsoever--because every action that shifts savings or investment simply moves resources from one use to another.

What is extraordinary is that these mistakes are being rederived today, at the end of the 2000s, without any consciousness of their past or of the refutations of them.

I think it is time to draw a line in the sand.

I, the ghost of Montagu Norman, have risen from my grave to do so.

I hereby warn all awards committees of all prizes whatsoever that a minimum, a minimum requirement for awarding any prize in economic science to anybody whatseover is that they know enough national income accounting to understand that the savings-investment identity is an accounting identity, not a behavioral relationship: the fact that this equation is always satisfied by definition has no implications for what the impacts of various changes in government policy are.

Jeebus save us...

Update: Two follow-up posts: Fama's Fallacy: Predecessors and
Fama's Fallacy, Take III.

Update: Boo, Eugene Fama by Arnold Kling.

Keynes and Morality Plays

Paul Krugman says  this is a "Great piece by Martin Wolf":

Keynes offers us the best way to think about the financial crisis, by Martin Wolf, Commentary, Financial Times: ...Like all prophets, Keynes offered ambiguous lessons to his followers. ... Now,... in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant in his teaching. I see three broad lessons. ...

The ... most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians ... argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. He wished to preserve as much liberty as possible, while recognising that the minimum state was unacceptable to a democratic society with an urbanised economy. He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.

This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy. Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold.

Yet Keynes would have insisted that such approaches are foolish.

Depression Economics: Normal Rules Don't Apply

Another entry at TPM Book Club:

Depression Economics: Normal Rules Don't Apply: Paul Krugman is trying to get us to understand that depression economics is different from the economics of good times, that "normal rules don't apply."

Let me try to illustrate this point by looking at some objections to depression economics policy measures, in particular two recent objections to fiscal policy. ...[...continue reading...]...