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Wednesday, September 01, 2010

The Great Depression in Economic Memory

Jean Pisani-Ferry argues that "In extraordinary times, history is, in fact, a better guide than models estimated with data from ordinary times":

The Great Depression in Economic Memory, by Jean Pisani-Ferry, Commentary, Project Syndicate: The dispute that has emerged in the United States and Europe between proponents of further government stimulus and advocates of fiscal retrenchment feels very much like a debate about economic history. Both sides have revisited the Great Depression of the 1930’s – as well as the centuries-long history of sovereign-debt crises – in a controversy that bears little resemblance to conventional economic-policy controversies.
The pro-stimulus camp often refers to the damage wrought by fiscal retrenchment in the US in 1937... So, are we in 1936, and does the budgetary tightening contemplated in many countries risk provoking a similar double-dip recession?
Clearly there are limits to the comparison. ... Nevertheless, the 1937 episode does seem to illustrate the dangers of attempting to consolidate public finances at a time when the private sector is still too weak for economic recovery to be self-sustaining. (Another case with similar consequences was Japan’s value-added tax increase in 1997, which precipitated a collapse of consumption).
Fiscal hawks also rely on history-based arguments. The economists Carmen Reinhart and Kenneth Rogoff have studied centuries of sovereign-debt crises, and remind us that today’s developed world has a forgotten history of sovereign default. A particularly telling example is the aftermath of the Napoleonic wars of the early nineteenth century, when a string of exhausted states defaulted on their obligations. The 1930’s are relevant here as well, given another series of defaults among European states, not least Germany.
What history tells us here is that defaults are not the privilege of poor, under-governed countries. They are a threat to all... Again, there are limits to comparisons...
In normal times, history is left to historians and economic-policy debate relies on models and econometric estimates. But attitudes changed as soon as the crisis erupted in 2007-2008. Indeed, central bankers and ministers were obsessed at the time by the memory of the 1930’s, and they consciously did the opposite of what their predecessors did 80 years ago.
They were right to do so. In extraordinary times, history is, in fact, a better guide than models estimated with data from ordinary times, because it captures variance that standard time-series techniques ignore. If one wants to know how to deal with a banking crisis, the risk of a depression, or the threat of a default, it is natural to examine times when those dangers were around, rather than to rely on models that ignore such dangers or treat them as distant clouds. In times of crisis, the best guides are theory, which captures the essence of a problem, and the lessons of past experience. Everything in between is virtually useless.
The danger with relying on history, however, is that we have no methodology to decide which comparisons are relevant. Loose analogies can easily be regarded at proofs, and a vast array of experiences can be enrolled to support a particular view. Policymakers (whose knowledge of economic history is generally limited) are therefore at risk of being drowned in contradictory historical references.
History can be an essential compass when past experience provides unambiguous headings. But an undisciplined appeal to history risks becoming a confusing way to express opinions. Governance by analogy can easily lead to muddled governance.

My argument is a bit different. In "extraordianry times," the questions that are important change, and economists build models to answer those questions. When those same questions are asked again, it's natural to look to the models built to answer them:

Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.
The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice? Hopefully, it is the ability to answer questions that are the least important, so the modeling choices that are made reveal what the modelers though was most and least important.
The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment, or when we found ourselves in mild, "normal" recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, or when prices depart from fundamentals. When this crisis hit, I looked into our tool bag of models and policy recommendations and came up empty (for the most part). It was disappointing. There was really no choice but to go back to older Keynesian style models for insight.
The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades,; did not even envision that this could happen, let alone build it into their models. Markets work, they don't break down, so why waste time thinking about those possibilities.
So it's not the math, the modeling choices that were made and the inevitable sacrifices to reality those choices entail reflected the importance the people making the choices gave to various questions. We weren't forced to this end by the mathematics, we asked the wrong questions and built the wrong models. ...
The fight - and main question in academics - has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it's been a fairly brutal fight at times - you've seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.
What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important (some don't even believe that policy can help the economy, so why put effort into studying it?).
I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.

Paul Krugman:

Brother, Can You Paradigm?: A few months back one of my original mentors in economics — someone who got his graduate training in the pre-fresh-water era — asked me whether there was anything about the current crisis that required fundamentally new analysis. We agreed that there wasn’t.
This is one of the untold tales of the mess we’re in. Contrary to what you may have heard, there’s very little that’s baffling about our problems — at least not if you knew basic, old-fashioned macroeconomics. In fact, someone who learned economics from the original 1948 edition of Samuelson’s textbook would feel pretty much at home in today’s world. If economists seem totally at sea, it’s because they have carefully unlearned the old wisdom. If policy has failed, it’s because policy makers chose not to believe their own models.
On the analytical front: many economists these days reject out of hand the Keynesian model, preferring to believe that a fall in supply rather than a fall in demand is what causes recessions. But there are clear implications of these rival approaches. If the slump reflects some kind of supply shock, the monetary and fiscal policies followed since the beginning of 2008 would have the effects predicted in a supply-constrained world: large expansion of the monetary base should have led to high inflation, large budget deficits should have driven interest rates way up. And as you may recall, a lot of people did make exactly that prediction. A Keynesian approach, on the other hand, said that inflation would fall and interest rates stay low as long as the economy remained depressed. Guess what happened?
On the policy front: there’s certainly a real debate over whether Obama could have gotten a bigger stimulus. What we do know, however, is that his top advisers did not frame the argument for a small stimulus compared with the projected slump purely in political terms. Instead, they argued that too big a plan would alarm the bond markets, and that anyway fiscal stimulus was only needed as an insurance policy. Neither of these arguments came from macroeconomic theory; they were doctrines invented on the fly. Samuelson 1948 would have said to provide a stimulus big enough to restore full employment — full stop.

So what we have here isn’t really a lack of a workable analytical framework. The disaster we’re facing is the result of the refusal of economists, both in and out of the corridors of power, to go with the perfectly good framework we already had.

As the video from George Evans hopefully makes clear, we are starting to ask the right questions and building the models we need to answer them. Hopefully, decades from now when economists have moved on to other questions and another crisis hits, the theorists who are so defensive of the models being built today won't mind if economists of the future try to learn something from their work.

    Posted by on Wednesday, September 1, 2010 at 09:53 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (19)


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