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.

Originally published at the Economist’s View and reproduced here with the author’s permission.

8 Responses to "Macroeconomic Meltdown?"

  1. Dr. Mitry   April 11, 2009 at 2:57 pm

    I agree that these econometric models and overly stretched theoretical nuances are the wrong direction for the profession. However, the idea that economics has lost its power is curious to me. As an economist, I have been using the economic principles to forecast the direction of the markets and economy for years, and quite successfully. For example, I sold my real estate holdings at the very peak of prices. I sold all my common stocks before the descent of securities markets, and I went to holding cash. It is quite obvious if you simply use the principles and you do not stretch for elegant but false assumptions or overly quantitative approximations. The simple principles of Economics tell us that what transpired was completely predictable. The much ballyhooed concept of globalization with persistent trade imbalances was unsustainable. A nation cannot continue to run chronic current account deficits without eventually paying the unpleasant price. Financial chicanery will not avoid reality in the long run, not even if the nation’s currency has been considered the world reserve currency. Absolutely everything that has happened was predictable with the wisdom of the simple economic models that are taught in the university principle classes. As for timing the economy, in the medium and long term, you do not need to know much more than the signals for reversals. Indeed, as you say, the “old fashioned” theoretical principles suffice, and the practice of attempting to apply modeling practices akin to Physics is more than unnecessary, it is dangerous and damaging to the profession.

    • Guest   April 11, 2009 at 7:43 pm

      Yes globalization made every player more vunlerable. Trade imbalances could only be maintained on large scale only by the US as we could settle accounts for now,with a plainload of our own dollar notes. The real problem was the repeal of Glass Steagal, and the Fed which kept on rolling over the bubbles from one into another. Our trade imbalance is small potato compared to what we owe to the newly born “investment banks” and their owners (some 300 to 30,000 fellow Americans) whom we are rescuing, by courtesy of the Government. These folks have,a stranglehold on our economy and our very existence, because we let them. It is rather pathetic to assign high minded economic theories to what has been obvously going on for the past 20 years or so, and its’ all too obvious end. There is nothing wrong with capitalism,if there are what is called in other areas “checks and balances” are in place. No need to hide behind a cloud of “high economic” theories. The going has just been too good for some, they just could not get off the train. We allowed our government become and remain corrupted in the process.So good luck to us on the road to recovery.

  2. Guest   April 11, 2009 at 7:44 pm

    IF you read Sraffa–and knew even his background, and the orientation of P of C–is constructivist mathematics, it would come as no surprise that there is no logical content in “economics.” It is phrenology.Ban housing evictions now.John Ryskamp

  3. G Kaiser   April 11, 2009 at 8:33 pm

    Until we have a better mousetrap, the simple, old fashioned one will have to suffice.I’m afraid that this is going to be of no use, if you are trying to catch rats!What we are seeing here is in essence a class war, where parts of the world are held hostage by criminals. We do have the right weapons to treat the problem, jail, repayment, confiscation, insolvency and bankruptcy, but we have no more legitimate governments to enforce them!The world has become corrupt to such an extent that Orwell’s visions of 1984 are close to being fulfilled.This will end in tears.

  4. Guest   April 12, 2009 at 7:51 am

    You guys don’t know your butts from holes in the ground. Get your nose out of the book, look at reality, and get to work.Why that field should still be around when it is obviously irrelevant and completely useless because it couldnt grasp this current crisis, is beyond those of us with pitchforks.

  5. Anonymous   May 11, 2009 at 2:24 am

    Crises bring many things into the open. For the economist profession its the truth that the positivist muddle of Keynesianism and Neo-Classical thought in which we have been educated is disturbingly inadequate. Luckily, economics is not confined to the mainstream, (the Krugmans, DeLongs or Mankiws), which I think have contributed not only to leading the subject astray, but also have to share some blame for the current crisis. There are others, such as the Austrian School economists, who predicted this crisis years before it happened (Read Antony P. Mueller, “Financial Cycles, Business Activity, and the Stock Market, 2001). What is more the Austrian School economists not only predicted the crisis, they also advocate the right kind of policies to rid the economy off these detrimental credit expansions.