The (failed) state of macroeconomics (crosspost from Crooked Timber)

When econbloggers aren’t arguing about cyborgs, they spend a fair bit of time arguing about the state of macroeconomics[1], that is, the analysis of aggregate employment and unemployment, inflation and economic growth. Noah Smith has a summary of what’s been said, which I won’t recapitulate. Instead, I’ll give my take on some of the issues that have been raised (what follows is inevitably monkish wonkish)

The main issues at stake are
* Is there a consensus ? [1a]
* If not, what are the main points of disagreement ?
* What, if anything, has macroeconomics achieved in the last 40 years
* Where should we go next?

I’ll post today on the first of these, then come back for more later

Is there a consensus?

– Clearly there was a consensus as of early 2008. The differences between “saltwater” (former New Keynesian) and “freshwater” (former New Classical/Real Business Cycle) economists had blurred to the point of invisibility. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets. In the background, central banks were assumed to use a Taylor rule to keep both inflation rates and the growth rate of output near their target levels[2]. There was no role for active fiscal policy such as stimulus to counter recessions, but it was generally assumed that, with stable policy settings, fiscal policy would have some automatic stabilizing effects (for example, by paying out more in unemployment insurance, and taking less in taxes, during recessions). It was generally agreed that this approach to macroeconomic policy, combined with financial deregulation had produced a ‘Great Moderation’ in the volatility of economic activity, as well as sustainably low and stable inflation. In the academic macro literature, this convergence was represented by Dynamic Stochastic General Equilibrium models, constructed with all the rigor and elegance of a haiku as Olivier Blanchard observed at the time

– This broad consensus was destroyed by the Global Financial Crisis and the Great Recession, but it wasn’t replaced by anything resembling a real debate. Rather, different groups have gone off in different directions

Academic macro went on more or less as before, except that the inclusion of financial sector shocks in DSGE models has now become a hot topic. So, from the viewpoint of someone like Stephen Williamson, everything in the garden is rosy.

This is actually a relatively tranquil time in the field of macroeconomics. Most of us now speak the same language, and communication is good. I don’t see the kind of animosity in the profession that existed, for example, between James Tobin and Milton Friedman in the 1960s, or between the Minnesota school and everyone else in the 1970s and early 1980s. People disagree about issues and science, of course, and they spend their time in seminar rooms and at conferences getting pretty heated about economics. But I think the level of mutual respect is actually relatively high.

As you might expect from someone who thinks that economic theory has no implications, and that this is a good thing, Williamson doesn’t even raise the issue of whether this internal tranquillity is problematic given the chaos in the actual macroeconomy and the absence of any agreement on how to respond to it.

Central banks have, in effect, treated the entire period since 2008 as a Schmittian “state of exception”[3], during which normal rules cease to apply. They have used the crisis to push governments to adopt “reforms” favored by the financial sector, such as cutting welfare benefits and other areas of public expenditure. But their central concern has been to restore the status quo ante, and the exclusive primacy of monetary policy, as soon as possible. From the central bank viewpoint, the restoration of low and stable inflation after the shocks of the 1970s is their crowning achievement and one to be maintained at any cost.

So, there is virtually no debate going on in academic macroeconomics, or in the circles where policy is actually being made. What debate is happening largely involves people like Krugman (and, much less notably, me) arguing against his Chicago opponents (Cochrane, Fama, Mulligan) who are mostly not macro specialists and therefore (as Williamson points out in his piece) “not really up on what is going on in macroeconomic research” but who do have something to say about macro-economic policy. Although most of the participants are academics, and both sides can boast Nobel prizewinners[4], this argument is, just like most things in the US today, part of the general war between parallel left and right universes, encompassing issues like climate change, tobacco, gun control and so on. There’s no way in which New Classical or RBC models can explain a sustained depression occurring in many countries at once, and they don’t even try. Instead we get absurdities like Casey Mulligan’s claim that the Great Recession is caused by easier access to food stamps in the US (or, as one commenter put it, “Soup kitchens caused the Great Depression”). Note that Mulligan doesn’t even attempt to explain how food stamps in the US could cause a deep depression in, for example, the UK, where welfare benefits have been sliced by the Tories.

fn1. Broadly speaking, there’s a generally positive view among mainstream economists about the state of microeconomics. The general view is that the inadequacies of the Econ 101 model of competitive markets are being addressed by developments in behavioral economics, theory of asymmetric information, game theory and so on.

fn1a I thought it was obvious from the context but I’ll add that I’m referring to mainstream economists in this post, and that the 2008 consensus I describe was shared by policymakers and mainstream academic macroeconomists but not by all economists, or even all mainstream economists. In particular, I didn’t agree with it, and was writing about Minsky and asset bubbles in 2006, but that kind of work did not (and does not) get into mainstream macro journals.

fn2. The underlying assumption was that low and stable inflation is consistent with broadly stable output growth. Because it was presented first as a description of actual central bank behavior and then as a rule of thumb, it was acceptable to both saltwater and freshwater economists, and helped to blur the differences Saltwater types interpreted the Taylor rule as a mandate to pursue both objectives. In the freshwater view, central banks were supposed to focus only on price stability, but output fluctuations might provide information about future inflation, and could therefore be taken into account in setting policy.

fn3. I get this terminology at second-hand, so apologies if I’m misusing it, but it seems apposite to me.

fn4. Yes, yes, I know.

23 thoughts on “The (failed) state of macroeconomics (crosspost from Crooked Timber)

  1. In Katoomba at the Edge Cinema there is a flight simulator based on the Boeing 737 aircraft. The cockpit is an exact replica. “Flying” this simulator is an experience every economist should partake of. The reason is that controlling this process has a very similar feeling to controlling an economy. Maintaining control requires the smallest and smoothest of movements of the control column. Arriving at a prescribed destination requires forethought, planning, and concentration. However when the controls are over used the performance of the aircraft becomes wild and erratic. Handling the vehicle when external forces are applied becomes difficult and dangerous.

    Managing an economy in a macroeconomic manner with just a small selection of control mechanisms is similarly reliant upon fine control and near ideal conditions to be successful. The reality in the economic field is that many of the controls are either missing or do not function properly, and economists accept that a periodic “crash and burn” is a natural part of the cycle. So with that degree of freedom from responsibility it is no wonder that Williamson is complacent, he is clearly living in a fools paradise.

    Of course the application of macro economics is in the hands of politicians and “others”, and is subject to interpretation. But in my opinion the economic machinery is incomplete. Even though externalities are recognised in the theory they do not command a central role in economic planning. The free trade model is similarly flawed. The main theory does not offer a mechanism to balance distortions in labour markets to cater for the steady erosion of worker/consumer status where production is substantially moved offshore. The core notion that wages and prices are the “only” motivations within an economy is now being recognised to be fallacious.

    If macro economics were to be judged by engineering standards it would be given a fail as a science. It would be given an “average effort must try harder”, and if peoples lives were on the line the science would grounded.

  2. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets.


    “state of exception”

    The general view is that the inadequacies of the Econ 101 model of competitive markets are being addressed by developments in behavioral economics, theory of asymmetric information, game theory and so on.

    This is certainly the (unpleasent) state of things. The supposed general consensus appears to be (in effect) – “But for minor glitches (shocks, exceptions, games, asymetric information and so on) the underlying economic platform (competitive markets, circular flow, IS-LM) is sound and unobjectionable.”

    However, what if the deep problem is that using interest rate adjustments for anything is an, or the, original (economic) sin?

    In fact, if real wages are constant and wages = final consumption, and savings = investment, how can interest ever exist?

    A wiser view is that – capital stays constant and needs only to receive the value necessary to match depreciation.

    If additional claims are made (rent, interest) they must come out of funds that should have appeared as wages. The dollars or pounds they represent should have fed into final consumption expenditures. Having this flow into interest and rents only leads finally to a GFC when it compounds over a series of cycles undisrupted by world wars.

    The problem with interest rates is that if you get a certain rate today, you cannot get the same rate next year (and into the future) on an expanding quantity of capital – without skullduggery. The reason is clear – it is because wages are the only real source of final consumption expenditure in a closed economy.

  3. It seems that only a minority of heterodox economists can perceive the reality. The odd thing is how most people, even apparently intelligent people, are completely susceptible to ideological groupthink and denial of the empirical realities. The reality is that orthodox macro is in a shambles and the world economy is in dire trouble.

    The last 40 years has been a developing disaster with high unemployment and poverty at the low end of town juxtaposed with over-rewarding and over-consumption at the middle and high end of town. A good proportion of the so-called “wealth creation” has been generated by catabolising the public sector. Much of the other growth has been fed by debt creation which has taken the place of public funding as the driver of aggregate demand. All of this has been taking place in a totally unsustainable manner, ecologically speaking.

    Unfortunately, it appears it will take much larger crash (making 2008 look tame) to force people to confront the reality. It’s difficult to predict the precise year but I see a major crash (great depression) happening before 2021. Many countries will never climb out of this crash IMO. Their environment will be too trashed to permit recovery.* It will be a crisis of indefinite duration.

    * Thought experiment. Imagine life in the middle and north of the Indian sub-continent when the glaciers are gone (major rivers drying up) and the monsoon suffers permenant disruption and almost yearly failure.

  4. John

    The mainstream economic schools will continue to flounder as long as they fail to understand the dynamics of a fiat money system where banks create money basically backed by debt.

    Your own book neglected to address the institutional arrangements of a modern monetary system. And no I am not an MMTer.

  5. The general view is that the inadequacies of the Econ 101 model of competitive markets are being addressed by developments in behavioral economics, theory of asymmetric information, game theory and so on.

    Does this point to possibility of economics imposing its mistaken assumptions onto developements in behavioral economics, theory of asymetric information, game theory, group thinking.. or that knowled from those developements will crush economic mistaken assumptions?

  6. Yes SDFC it is a moot point.

    Keynes recognised this and therefore favoured using fiscal policy in only a number of conditional circumstances.

    Where these did not occur he actually agreed with Hawtrey and Cassell that monetary policy could be effective when deflation was conquered .
    The great Depression proved Keynes right and Hawtrey right on recovery though.

    In terms of Saltwater V Freshwater I think it is more Republican apologists v realists.

    Once a Republican is in the Whitehouse they will change their tune as we have seen from Reagan to Bush Jnr

  7. I was also worried at the perceived “tranquil state” of the macroeconomic debate. Over the decades of the so called “debate”, the New Classical side have never changed their views on the economy. They still believe fiscal multiplier is 0, they still believe changing the money base will cause the exact change in inflation (hence the QE = hyperinflation prediction) etc. It is, in fact, that the mainstream Keynesians have assimilated and adopted ideas of the New Classical Sides; and worst of all the New Classical side is failing miserably in the real world ( most obvious of all, austerity).

    P.S. I cbf dragging privatisation, deregulation, cuts in tax rates and the “only” use fiscal policy when the economy enters zero or lower bound crap into my comment

  8. When sitting in a shabby carriage, one can actually put on such airs that the whole carriage looks good, and the horse too.

    — Georg Christoph Lichtenberg

    It should be possible to apply scientific methods to economics but the prerequisite of admitting to complexity and uncertainty seems to be too much for a lot of people who imagine themselves to be economists. If you talk to a biologist or physician, unresolved questions are everywhere; economic research appears to have been completed.

  9. As said above, in the years prior to 2008 governments were all moving away from active to passive fiscal policy as a means of economic stabilisation. When the GFC hit, and the deficit from the passive policy was increasing, certain economic illiterates threw their toys out of the pram and undermined the system of automatic stabilisers as well! And then they have the cheek to complain that recovery from the depression is taking so long.

  10. @Jim Birch

    In my point of view, economics can never be hard science.

    There are several reasons for that, one of the most decisive reason is that humans are in fact, illogical, irrational and inconsistent, so any economic models should to take those into account if it were to model economic agent behaviour (hence ‘subjective expectations’ by Post Keynesians). This is simply too chaotic, and to add more difficulty to it, the human physiological behaviour changes (although not exactly dramatic) over time.

    From the above reason, the fiscal multiplier (which is one of the major issue in dispute with the Keynesians and the New Classicals) will change over time, state of the business cycle and the phycological state of economic agents (saving for a rainy day in recession vs reckless credit binge in boom etc).

    Other factors such as the activities in the financial market and its ‘innovations’ are also important but difficult. Although the deregulation and the repeal of Glass-Steagall Act have major contribution to the GFC, the financial market and its products do evolve (for good or bad) over time and this is also difficult to model.

    Then there is the change in technology, scarity of resources, changes in the climate, asymmetrical information, and the competitiveness of the market (by that I mean if monopoly or oligopoly exists).

    While scientific laws (biology, chemistry etc.) never change, the economy always do and therefore in my opinion, it is not possible to do hard science with economy. However, this does not excuse the failures of the New Classicals nor does it excuse their behavior to ignore evidence.

  11. “saving for a rainy day in recession”

    I should elaborate on this. In my opinion this most probably will apply to households which have a job with incomes exceeding expenditure. When people lost their job and have negative saving rate is obviously different, so the design of the fiscal policy is also quite important.

  12. Moving to a passive policy was Keynesian a monetary policy was more than adequate however once the GFc came upon and credit market froze then active fiscal policy was the Keynesian solution

  13. @nottrampis

    If you’re talking about interest rate at zero or lower bound then its arguable. I do not support the idea to only using fiscal policy when monetary policy had been exhausted. It takes a fair while for the Central Bank to lower interest rate to near zero, depending on how reactive the Central Bank is and the interest rate before it started dropping.

    The risk this pose is that, during this period, other than the economic damage (firms lowering their investments, banks tighten their lending, increase in unemployment), it makes people pessimistic which will lower the spending for people who still have income, cause social damage (disrupts household spending plan or destorys people’s lives sometimes), and worst, it will need a larger and more short term stimulus because the output gap is larger the longer the recession. Short term stimulus also usually have a lower multiplier and have less if no effects on long term gains (as opposed to long term stimulus like infrastructure).

    A quick strike of fiscal stimulus when the signs of recession is coming can be cheaper and will stabilise the economy (stabilising demand thus investment and stabilising consumption as a % of income) much more effectively than holding out until monetary policy enters zero or lower bound (Australia is one of such example).

  14. Monetary policy approaches ZLB only under extreme conditions. That is one of the times you use fiscal policy directly.

    Under most but not all other conditions you only use fiscal policy indirectly through automatic stabilisers. Monetary policy is the key policy lever.

    In Australia since the war the only time Fiscal policy should have been used was when the GFC approached as monetary policy was clearly impotent (Banks couldn’t get funding).

  15. @nottrampis

    Indeed, Monetary policy hardly ever reach zero or lower bound since WWII. However, neo-liberalism haven’t began until the early 80s, which introduced deregulation, privatisation, and cutting automatic stabilisers. However, fiscal stimulus through government investment (infrastructure etc) as a % of GDP was much higher than it is now, itself was a form of direct fiscal stimulus.

  16. @Tim Peterson

    yes there is that complication, dealing with which usually exceeds most peoples attention span.

    Also for a rigorous approach it is best to start with a simple case.

    You can only pay retirees, and rentiers, from surplus produced by other people. In effect they take over this portion of final consumption. This is a social contract.

    In the final analysis, for a stable economy, the only final consumption is, and must remain, wages and salaries (but these can be shared by social contract to various individuals, children, sick, handicapped, aged, etc).

    Normal pensions and rents are is not particularly relevant – provided the rentiers and retirees do not seek to re-invest their income to earn a capitalist profit.

  17. “But I think the level of mutual respect is actually relatively high.” [Stephen Williamson, quoted above]. This proves nothing.

    There are many conceivable conditions consistent with 2 or more parties acting in a manner consistent with an ostensibly high level mutual respect (eg all parties realise they are wrong, or all parties have taken training in mediation offered in human resource management courses, ….).

  18. @Chris Warren

    This talk of surplus seems to imply the labour theory of value, which is egregiously wrong. In reality, capital generates a surplus just as labour does.

  19. @Tim Peterson

    Capital generates no surplus. When it receives a premium, this consists only of a temporary competitive advantage.

    If all producers of a certain commodity all had the same capital, the market would drive the price down to cover only the socially necessary wage of producers, plus maintenance and replacement of capital goods. Any producer charging more would be outcompeted. Any producer charging less would go out of business.

    Most profits in today’s reality result from politics, not economics.

  20. @Chris Warren

    Are you seriously suggesting that the labour saved by mowing a lawn with a lawn mower instead of shears _exactly_ equals the total amount of labour used to manufacture the lawnmower (minus the cost of the shears)?

  21. In a society where the socially necessary amount of labour is determined by shears, then someone who has a lawnmower saves labour that bears no relation to the total amount of labour used to manufacture the lawnmower (minus the cost of the shears).

    However when all of society uses lawnmowers, the fee charged by lawnmower owners, per hr, is practically the same it was when shears were used (plus extra or less depreciation).

    Hopefully the new technology will save work hours – which then belong to workers, and that can go into leisure or additional productive activity.

  22. @Chris Warren

    In which case the investment in lawnmowers generates a surplus of output over the depreciation rate of the lawnmowers.

    Bear in mind that capital is costly, so the lawnmower owners need to charge more than the depreciation rate to brfeak even.

    If capital didn’t generate a surplus of output then the optimal capital stock would be zero.

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