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Wednesday, May 26, 2010

"An Outsider's View of Modern Macroeconomics"

Rajiv Sethi on macro theory:

An Outsider's View of Modern Macroeconomics, by Rajiv Sethi: Following up on a testy exchange with David Andolfatto, Mark Thoma has written a thoughtful post in which he discusses the state of modern macroeconomic theory, the appropriateness of appeals to professional authority, the shortcomings of some canonical models, and the way forward. I posted a brief comment in response, with a few constructive suggestions for mainstream macroeconomists from the perspective of an outsider. I have made these points on various occasions before, and reproduce them here (slightly edited and expanded with links to earlier posts):

  1. Rational expectations is not a behavioral hypothesis, it's an equilibrium assumption and therefore much more restrictive than "forward-looking behavior". It might be justified if equilibrium paths were robustly stable under plausible specifications of disequilibrium dynamics, but this needs to be explored explicitly instead of simply being assumed. 
  2. Think about whether a theory of economic fluctuations should be shock-dependent (in the Frisch-Slutsky tradition) or shock-independent (in the Goodwin tradition). Go back and look at Goodwin's  1951 Econometrica paper to appreciate the importance of the distinction.
  3. Build models in which leverage, collateral, and default play a central role. The work of John Geanakoplos on this is an excellent starting point. He uses equilibrium theory but allows for heterogeneous priors (so differences in beliefs can persist even if they are common knowledge.) More broadly, take a close look at Hyman Minsky's integrated analysis of real and financial activity. 
  4. Do not assume that flexible wages and prices imply labor market clearing. They do in equilibrium (by definition) but wage and price flexibility in disequilibrium can make matters worse. Keynes recognized this, and Tobin explored these mechanisms formally. Arbitrary assumptions of "sticky prices" are not necessary to account for persistent unemployment or under-utilization of capacity.
  5. Finally, show some humility. There are anonymous bloggers out there, some self-taught in economics, who may know more about the functioning of a modern economy than you do.

The last point is directed at David Andolfatto, whose arrogant appeal to professional authority jolted the normally polite Mark Thoma to respond with (justifiable) belligerence. Andolfatto's entire post was dripping with condescension, but I found the following passage particularly disturbing:

DeLong tells us that we can learn a lot of economics from Krugman. You will be forgiven for wondering whether DeLong can even tell whether he is learning economics or not. DeLong is, as far as I can tell, an historian.

As I said on Mark's blog, it could be argued that economic historians (and historians of thought) have had more useful things to say about recent events than the highest of high priests in macroeconomics. Andolfatto seems to be confusing an understanding of modern macroeconomic theory with an understanding of the modern macroeconomy. The two are not the same, and the former is neither necessary nor sufficient for the latter.

Contrast the tone of Andolfatto's post with the following passage from a recent essay by Narayana Kocherlakota, president of the Minneapolis Fed:

I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policymakers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown.

Because of this failure, macroeconomics and its practitioners have received a great deal of pointed criticism both during and after the crisis. Some of this criticism has come from policymakers and the media, but much has come from other economists. Of course, macroeconomists have responded with considerable vigor, but the overall debate inevitably leads the general public to wonder: What is the value and applicability of macroeconomics as currently practiced?

Kocherlakota goes on to defend the many advances made in macroeconomic research over the past four decades, but openly acknowledges the enormous challenges that remain. He goes on to say:

The seventh floor of the Federal Reserve Bank of Minneapolis is one of the most exciting macro research environments in the country. As president, I plan to learn from our staff, consultants, and visitors.

I hope that some of those visitors (real or virtual) will be voices of dissent from beyond the inner circle of research macroeconomics. It is in this spirit of openness that my comments are offered.

    Posted by on Wednesday, May 26, 2010 at 12:24 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (87)


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