The State of Macroeconomics

Because of these three articles in The Economist, everyone seems to be weighing in on the state of macroeconomics. I haven't because I've already said everything I want to say about this, and I didn't want to be repetitive. The links are:

• Macroeconomic Meltdown?,
• "The Great Multiplier Debate"
• "The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics"

Here's one bit:

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.

That is, the mechanism driving real effects in the standard versions of these models is sluggish price adjustment, but do we really believe this is the main mechanism through which real effects are being generated in the current crisis? if not, how much faith should we put in estimates derived from these models?

Update: Mark Gertler emails a response to this post (this also appeared at Free exchange earlier today):

The current crisis has naturally led to scrutiny of the economics profession. The intensity of this scrutiny ratcheted up a notch with the Economist’s interesting cover story this week on the state of academic economics.

I think some of the criticism has been fair. The Great Moderation gave many in the profession the false sense that we had handled the problem of the business cycle as well as we could. Traditional applied macroeconomic research on booms and busts and macroeconomic policy fell into something of a second class status within the field in favor of more exotic topics.

At the same time, from the discussion thus far, I don’t think the public is getting the full picture of what has been going on in the profession. From my vantage, there has been lots of high quality “middle ground” modern macroeconomic research that has been relevant to understanding and addressing the current crisis.

Here I think, though, that both the mainstream media and the blogosphere have been confusing a failure to anticipate the crisis with a failure to have the research available to comprehend it. Predicting the crisis would have required foreseeing the risks posed by the shadow banking system, which were missed not only by academic economists, but by just about everyone else on the planet (including the ratings agencies!).

But once the crisis hit, broadly speaking, policy-makers at the Federal Reserve made use of academic research on financial crises to help diagnose the situation and design the policy response. Research on monetary and fiscal policy when the nominal interest is at the zero lower bound has also been relevant. Quantitative macro models that incorporate financial factors, which existed well before the crisis, are rapidly being updated in light of new insights from the unfolding of recent events. Work on fiscal policy, which admittedly had been somewhat dormant, is now proceeding at a rapid pace.

Bottom line: As happened in both the wake of the Great Depression and the Great Stagflation, economic research is responding. In this case, the time lag will be much shorter given the existing base of work to build on. Revealed preference confirms that we still have something useful to offer: Demand for our services by the ultimate consumers of modern applied macro research – policy makers and staff at central banks – seems to be higher than ever.

Mark Gertler,
Henry and Lucy Moses Professor of Economics
New York University

I have also posted a link to his Mini-Course, "Incorporating Financial Factors Within Macroeconomic Modelling and Policy Analysis" in the daily links for tomorrow. This course looks at recent work on integrating financial factors into macro modeling, and is a partial rebuttal to the assertion above that New Keynesian models do not have mechanisms built into them that can explain the financial crisis. We still have work to do, but as Mark Gertler notes, "economic research is responding," and as I noted at the end of one of the posts linked above, "The models will be built - I guarantee you they are being built presently."