"IMF Calls for New Economic Thinking - Or Does It?"

Perry Mehrling on "new economic thinking":

IMF Calls for New Economic Thinking - Or Does It?, by Perry Mehrling, INET: History will record that the IMF’s conference last week (March 7-8), titled ”Macro and Growth Policies in the Wake of the Crisis” , marked a turning point in mainstream economic debate within academia, probably only one turning point among many others yet to come, but nonetheless a significant moment.

Olivier Blanchard, Director of Research at the IMF, struck the significant note in the opening minutes of the first session (2:50 in Session 1). According to him (and I paraphrase), before the crisis mainstream economic thinking had converged on a beautiful construction in terms of monetary policy, namely “inflation targeting”. We had convinced ourselves that it was enough to focus our attention on one target (inflation), and one instrument (the policy interest rate) to achieve that target.

One lesson of the crisis is that the pre-crisis consensus is not right--“Beauty is not synonymous with truth”--and we have to reconsider. The policy problem is one of multiple targets and multiple instruments, and the mapping from instruments into targets is complex. Economic policy is consequently much more complicated and messy than we had thought pre-crisis.

Where do we go from here? On the research front, so Blanchard continues in his closing remarks (8:00), this “brave new world” of policy-making is very exciting. We have the chance to revisit a large range of macroeconomic issues but now with the right microeconomic foundations, for example agency theory, imperfect information, and behavioral economics.

On the policy front, however, we must simply face the limits of our knowledge, and hence go slow. We cannot give up on inflation-targeting, but must proceed step by step, pragmatically, to add additional targets and instruments one by one, in an experimental fashion, in order to find out what works and what does not. We must “keep hopes, our hopes, in check”. Crises will probably happen again and we won’t be ready for them.

In summary, we need new economic thinking, but we can start from where we were before the crisis, with a conception that the underlying problem is microeconomic distortion of one kind or another from the perfect market ideal. And we need new economic policy also, but again we can start from where we were before the crisis, with the inflation targeting model that Otmar Issing says “doesn’t help you at all” as a practical central banker. That is one message anyway.

I take away a different message.

To me, the importance of this conference comes simply from the very public assertion that the pre-crisis consensus was wrong (okay, “not right”), and that we need now to be working toward something else. The significant point is that there is no consensus on what that something else should be. Some people, perhaps even most economists currently practicing, will work from the pre-crisis consensus, tweaking this or that.

But there is room also for more fundamental departures, for new approaches that have not yet been tried. Unless I mistake him, I think Blanchard would agree.

Otmar Issing, for example, offers a Nobel for anyone who provides a proper theoretical treatment that combines credit and money, financial quantities and financial prices. That is what economists like himself have always been looking for, and not found yet, certainly not in the pre-crisis academic consensus.

A decade ago, Olivier Blanchard wrote an influential paper, "What do we know about macroeconomics that Fisher and Wicksell did not?," in which he put forth a kind of Whig history of the progress of macroeconomic thinking up to 2000. Compared to today, suggested Blanchard, macroeconomics pre-1940 looks like “a period where confusion reigned, for lack of an integrated framework”.

According to his account, the inter-temporal general equilibrium model provided that missing framework.   Now, ten years later, we can see that framework in a different light, as the origin of the “beauty” that economists mistook for truth, and apparently still do, if only by force of intellectual habit. The important takeaway is that the crisis has opened the ground for alternative frameworks as well as tweaks of the existing one.

To be provocative, let me put it this way. We are living today in a period not unlike the inter-war period, a period where confusion reigns for lack of an integrated framework. We are living in a period of exploration and experimentation, not only in the policy world but also in the world of ideas. Let the new economic thinking begin.

To be continued….

Here's a few thoughts on this from previous posts. First:

... If you believe, as I do, that macroeconomics needs to change, there are three possible ways to proceed.

First, we could try to reform the DSGE model used widely today. How much would it help to do one or more of the folowing: (i) Within the DSGE model, develop better connections between the real and financial sectors. In particular, the model should allow for the endogenous collapse of financial intermediation. Recent models of financial frictions and endogenous leverage cycles give an indication of how to proceed. (ii) Replace rational expectations (and the efficient markets hypothesis) with a better approximation of how expectations are actually formed. One possibility along these lines is to added learning to the models. Another is behavioral economics. (iii) Replace the representative agent assumption with heterogeneous agents. It's hard to have realistic financial markets with one agent. However, adding heterogeneity is not as simple as it might seem. Generically, having heterogeneous agents in a model makes it difficult to aggregate across individuals – once the representative agent assumption is dropped you cannot, for example, guarantee that uniqueness or stability will appear at the aggregate level even if individual agents are well-behaved neoclassical agents. There are clever ways to allow for heterogeneity without sacrificing the ability to aggregate, but they aren’t fully satisfactory. If we are going to go this route, then more cleverness is needed. (iv) You may be surprised to learn that regulations such as capital requirements have very little theoretical backing -- they are largely ad hoc (see the talk by Franklin Allen). If the problem was a failure of regulation and not a failure of the model more generally, then perhaps better models of regulation are all that is needed (or, if you believe the crisis was caused by the Fed's pursuit of low interest rates, perhaps all we need is a better model of monetary policy). However, this brings up the question of whether the DSGE structure is an adequate foundation for models of regulation, and I am not convinced that it is. (v) This wasn't part of my remarks, but a physicist spoke at the conference and one of his main points was that financial markets are dictated by power laws, not the Gaussian distributions that are commonly assumed in theoretical work (often for analytical convenience). Is addressing this problem all that is needed?

The second way we might proceed is to adopt new models. Possibilities along these lines are: (i) To develop network (complexity) models and their associated measures of network characteristics such as centrality and degree distribution that can be used to estimate the risk of network failure. (ii) There is George Soros' Reflexivity theory, and (iii) there is the theory developed by Frydman and Goldberg, Imperfect Knowledge Economics. (Both of these had been discussed in earlier sessions.) (iv) We could begin the modeling process at the aggregate level and give up the insistence that the models be microfounded. This would, among other things, avoid the problems associated with aggregating from realistic microfoundations discussed above.

Third, take a whole new approach to theory. (i) The call for pluralism that Sheila Dow will talk about falls into this category (see here for more on this). (ii) Economics could give up trying to model itself after physics as it existed a century or more ago, drop the "natural" language, and embrace the methods of the "softer" sciences. These disciplines have already successfully addressed many of the problems that economists face. ...

I added:

...I am torn between the first two options -- fixing the existing model and building a new one -- but fortunately work on the two options is not mutually exclusive. There's no reason why one group of researchers can't try to fix the model we are using now while another group works on a much different theoretical structure. Presumably, in the end, the better model will win out.

Many people are working on fixing the existing structure -- macroeconomists are already tooled up for this, so it's a natural progression -- what is needed is more acceptance within the profession (at journals in particular) for alternative theoretical models and different approaches to economic modeling (one thing that come up at the conference is if there any role for articles without math in top journals).

Outside of the work on fixing the existing DSGE model (where I think developing better connections between real sector and financial intermediation, and endogenous leverage cycles are the first things to do), my first choice of where to go next would be to investigate network models. There is already progress in this direction, and I think these models have a lot of potential for characterizing the risk within financial networks in a way that would be helpful for regulators. But while these models look promising in some areas, it's hard for me to see how network models could constitute a brand new macroeconomics more generally (they seem more of a complement than a substitute for existing models). So there's a lot more work than that to be done.

Most of the current work is focused, as expected, on whether the existing sturcture can be fixed. Thus, while "the crisis has opened the ground for alternative frameworks as well as tweaks of the existing one," work on fixing the existing framework is dominant for now.