Monday, November 25, 2013

New Quartz article: A battle for the soul of macroeconomics

Miles and I have a new article in Quartz, about the shakeup at the Minneapolis Fed, the ongoing battle between Freshwater and Saltwater macro (which Saltwater appears to be winning), and the history of modern (read: DSGE) macro.

It was very tricky to write this column, since A) we really don't know if the Minneapolis thing is part of the Saltwater/Freshwater battle, or whether it was just a personality conflict, and B) we wanted to take sides in the Saltwater/Freshwater battle without either endorsing or criticizing Kocherlakota's personnel decision. That is a tricky tightrope to walk, but I think we did a decent job.

Excerpts from the article:
Two of the Minneapolis Fed’s most eminent and long-serving economists, Patrick Kehoe and Ellen McGrattan, have been fired...[A]lthough the Minneapolis Fed shakeup could be due to any number of reasons—a personality conflict, a disagreement over the Fed bank’s mission, etc.–one possibility is that the personnel changes are related to Fed officials’ changing attitude toward business cycles... 
Patrick Kehoe, one of the economists dismissed from the Fed, is a key figure in a school of economics called “Freshwater Macroeconomics” (the other, Ellen McGrattan, is his frequent co-author)...If the Fed prints money to try to stimulate demand, [the Freshwater people] say, it will only succeed in creating inflation rather than reviving the economy... 
The Freshwater school gained enormous clout in the ‘80s. But in the ‘90s, there was a counterattack from the coast. The Saltwater macroeconomists believed that recessions were economic failures, and that monetary policy was important in fighting them...But one bastion of hard-line freshwater thinking held firm: “Minnesota macro.” The researchers at the University of Minnesota and the Minneapolis Fed have largely hung onto the belief that monetary policy can affect inflation, but can’t fight recessions. 
But there is good reason to think that this view is losing credibility at the Fed. 
Narayana Kocherlakota important bellwether of Fed thinking. His views have shifted decisively toward believing that monetary policy can stabilize the economy. What changed his mind? The answer is obvious: the Great Recession, and the failure of large purchases of long-term government bonds and mortgage-backed assets—QE—to create inflation. It makes all the difference in the world when the No. 1 event shaping the questions macroeconomists ask is no longer the Great Inflation of the 1970s, but the Great Recession that still casts its shadow over the world. 
Nor is Kocherlakota the only Fed official to change his mind. So even if the Minneapolis Fed shakeup wasn’t caused by a clash of ideas, the Fed’s shift toward Saltwater macro is a real phenomenon... 
As QE ramped up, disputes broke out among Fed economists. Some, like Philadelphia Fed president Charles Plosser (himself a noted Freshwater researcher) and Minneapolis Fed president Narayana Kocherlakota, argued that QE would put us in danger of inflation. But as the Fed’s printing presses rattled on and inflation failed to materialize, some “hard money” advocates had second thoughts. Last year, Kocherlakota declared that he had changed his mind, and now supported QE... 
Kehoe and McGrattan’s dismissal drew loud protests from other members of the Freshwater school...Steve Williamson, a Freshwater economist at Washington University, blogged that Kocherlakota “seems intent on destroying the [Minneapolis Fed] as a research institution.” So whether or not the firings had anything to do with economic theories, Freshwater folks are concerned, and with good reason. A key part of the genesis of Freshwater macro was a desire to say something about monetary policy (i.e., why not to use it). If the Fed refuses to listen to leading Freshwater voices, then a big chunk of the real-world influence of this school of thought will be gone.
There's much more in the article (Miles' first draft was over 3000 words!), so read it all here.

Another difficult thing about writing this column was that it comes off sounding like we're critical of Kehoe's ideas, but I personally really like both of the Kehoe papers I've read! And one of those two papers is the paper where he criticizes New Keynesian (Saltwater) economics! In that paper, Kehoe acts as the "microfoundation police," pulling micro evidence to show that some of the assumptions in the most popular New Keynesian models don't add up. Since bad microfoundations really annoy me, I enjoyed that paper quite a lot, and it's one reason I'm a lot less sanguine about New Keynesian models than Miles!

(FYI, the other Kehoe paper I've read is this excellent paper on herd behavior.)

So the article ended up containing more pro-Saltwater boosterism than I would have included had I written it alone, but that's fine with me, because most of the Freshwater RBC-type models I've seen just assume away any role for monetary policy, so it doesn't make a lot of sense for the Fed to be using these. (Note that the "New Monetarist" models made by people like Steve Williamson don't make this assumption, and they're considered Freshwater too, so there's a distinction between "Minnesota macro" and "St. Louis macro" that was too subtle to put in the column.) Plus Freshwater microfoundations are probably even less realistic than Saltwater ones.

But anyway, I think the article turned out OK. I'd love to hear any feedback that people have.


Mark Thoma thinks the shakeup was probably due to personality conflicts, not differences in economic theory. Brad DeLong also suspects this is the case.

Nick Rowe, on his blog and in the comment section, has some very harsh and disapproving things to say about both Narayana Kocherlakota and his erstwhile advisors. He might want to take this up by Steve Williamson, who has some equally harsh things to say on the opposite side of the issue.

Paul Krugman takes the opportunity to criticize Minnesota macro.

Philly Fed economist Makoto Nakajima tweets (in Japanese!) that Miles and my analysis is "shallow", and suggests we have better ways to spend our time.

A couple people have written to me with thoughts about the Fed firings. One alternative hypothesis I had not considered: It's all about money. Economists who hold university professorships and also do work at the Fed are paid full-time salaries by their universities and full-time salaries by the Fed (I had not known this fact). But working at the Fed probably doesn't make those joint economists put out much more research than they would if they just worked at their university. So the $$$ that the Fed is paying to those economists might be mostly waste, especially if the researchers in question are not doing much in the way of direct advising on policy matters. So it could be all about budget cuts.


  1. Anonymous1:31 PM

    TravisV from TheMoneyIllusion comments section here.

    I think there are HUGE problems with the article. Very misguided and confusing. It overcomplicates matters.

    It’s not that the EMH is wrong, it’s that humans are irrationally hostile to nominal wage cut……

    1. It is a bit like saying: "It is not that the flat Earth theory is wrong. It's that planets are irrationally hostile to being flat disks...".

      Sorry, couldn't help myself.

    2. The idea that the only real problem is that workers irrationally refuse to accept lower wages has to be one of the most barren, idiotic, and ideological 'theories' ever concocted. I find it absolutely amazing that anyone is stupid enough to actually believe it.

    3. Wonks Anonymous3:40 PM

      EMH and wages are entirely different things. Noah was writing about macro, not finance.

    4. Anonymous5:10 PM

      TravisV here.


      Why is it idiotic? If national income is growing 0% or 1% a year, individual firms that need to cut back are unwilling to cut the wages of workers. Instead, they reduce the average wage by firing lots of people. The economy suffers depression, mass unemployment and reduced wealth creation.

      In contrast, if national income is growing 5% a year, individual firms that need to cut back will hold the workers of some wages flat. With that approach, everyone is still working. Hooray, problem solved!

      There's tons of evidence for irrational downward nominal wage rigidity, such as the following:

    5. Wonks Anonymous6:06 PM

      I think some "New Monetarists" (or other midwestern types) have suggested that wage norms are the outcome of some rational process, so sticky wages are not evidence of worker irrationality and trying to undo that through monetary policy is not obviously utility-increasing. I'm too lazy to google someone making that argument now though.

    6. The Koch-funded Bryan Caplan is a ridiculous and purely ideologically motivated hack.

    7. I am NOT a Caplan fan. You can find me critical of him online easily. But I would bet a lot of money that "Joe" has never accomplished anything at all in economics: kind of like someone who can't hit a layup saying "Carmello Anthony can't play ball!"

    8. What are you, an 'austrian'? That's more a form of mental disease than any sort of accomplishment.

    9. Cutting wages really doesn't solve the business man's problem of lower demand. What is he going to say: "Here, we've cut your wages 50%, do a half assed job." Now he's got the same staff sitting around half idle.

      Lowering wages makes things a lot worse for the worker too. They are still stuck at work full time and can't look for a side job to try and make enough money so they can eat, sleep indoors and other fantastic luxuries.

      When an economist starts going on about sticky wages being a thing, it makes the Kepler exoplanet mission look worthwhile. Think of it as our search for the economists home world.

  2. Saltwater vs Freshwater? Typical propagandistic approach: narrow the debate to where it becomes meaningless. Both saltwater and freshwater utterly failed before the crisis, both pushed policies that helped usher it (heap more debt on the middle class while draining it from income by pursuing balanced budgets and deregulating everything in sight). And now they debate fiercely which one is more useless.

    1. +1

      And now they debate fiercely which one is more useless.

      They are both right: each is even more useless than the other. :-)

    2. Anonymous6:31 PM


      And let's avoid specifics so we don't expose ourselves.

    3. Anonymous11:05 AM


      "Both saltwater and freshwater utterly failed before the crisis" Proof please. Bias and preconceptions not accepted.

      The only thing more useless than economists, it seems, is you.

    4. "Proof please"

      Res ipsa loquitur

  3. Thanks to you and Miles for this. I had basically assumed that the split you hypothesize was behind the shakeup on Hennepin avenue, so it's nice to know that some folks who are better informed than me think it might be the case as well.

  4. Noah, but Pat Kehoe isn't at all such a pure monetary neutrality type at all (unlike Macgrattan)! Recent papers have included one of the better New Keynesian DSGE models including both sales and regular prices, and showing how sales may be irrelevant for judging the level of price stickiness. He's also a key contributor to modeling market segmentation leading to monetary non neutrality even with flexible prices (see e.g his ideas page). And Minnesota macro in recent iterations has been at the forefront of modeling financial market problems, and non Walrasian markets with search frictions-things that can fundamentally screw up the economy even without the Calvo fairy of New Keynesian models (and things that can justify all sorts of corrective government policies, but not the "increase G, reduce interest rates" you learn in macro 101). Finally, RBC models don't imply that QE must cause inflation, because unlike many monetarist models they don't assume constant velocity/quantity theory of money (no need to go to a Minnesota economist to see this point, just look up the flex price version of the models of people like Woodford, e.g in the beginning of his monetary policy text). In the RBC model expanding the supply of reserves at the zero lower bound is noninflationnary because reserves and very short run debt are perfect substitutes in that case.
    Oh, and the business cycle accounting framework developed by Kehoe and Macgrattan among others has been a key influence on the BoE's new forecasting framework in terms of how to handle model misspecification,

  5. Anonymous5:04 PM

    TravisV from TheMoneyIllusion comments section here.

    Remember: deep down, Noah Smith is a liberal partisan. So the column distinguishes between naive freshwater types who believe in the EMH and “sophisticated” saltwater types who reject the EMH.

    Except……..both groups of people are wrong. Freshwater types are wrong about easy / tight money and saltwater types are wrong about the EMH. The correct view is that tight money combined with downward nominal wage rigidity are the root cause of high unemployment. That doesn’t refute the EMH. In fact, the stock market and TIPS markets anticipated the severity of this recession far more quickly than academics ever did.

  6. Oops. typo.

    1. "The researchers at the University of Minnesota and the Minneapolis Fed have largely hung onto the belief that monetary policy can affect inflation, but can’t fight recessions." You seem to want to characterize Minneapolis as some monolithic place. It isn't, and it never was. You can take any two people associated with that operation and get them to disagree about something. Sometimes one of them can disagree with him/herself. Prescott wrote down some models where money didn't matter, but there's another tradition which comes out of the place. Neil Wallace is all about how and why money matters. Larry Christiano is a one-time employee of the Minneapolis Fed, and he's now a prominent New Keynesian, but Minneapolis permeates his work. He's all about preferences, endowments, and technology, apparently.

    2. "But there is good reason to think that this view is losing credibility at the Fed." Keynes has always had a tight hold on the Fed. It's not like there was some big swing from Keynes to something else, and then back again. What was Greenspan? Certainly not a modern macroeconomist in the Minnesota mold. The big story at the Fed is the increasing prominence of discussion of the second part of the dual mandate (emphasis on unemployment, for example).

    3. You have to stop with this freshwater/saltwater talk. That's so old.

    4. "Note that the "New Monetarist" models made by people like Steve Williamson don't make this assumption, and they're considered Freshwater too..." Considered by who? I'm wondering now what you think you mean when you say "freshwater." Maybe that's anything not New Keynesian.

    5. "Plus Freshwater microfoundations are probably even less realistic than Saltwater ones." Holy cow. What could that mean?

    1. You seem to want to characterize Minneapolis as some monolithic place. It isn't, and it never was.

      Well, this is going to sound like a lame excuse, but Miles wrote that part. I don't even all the people who work at Minnesota! But sure, I signed my name on it, because I trust Miles to characterize these things accurately.

      The big story at the Fed is the increasing prominence of discussion of the second part of the dual mandate (emphasis on unemployment, for example)

      That sounds like 6 of one, 1/2 dozen of the other to me...

      You have to stop with this freshwater/saltwater talk. That's so old.

      Well, yeah, it's probably a bit out of date, but note that there's a huge lag between when people make models and when those models become widely accepted.

      Also, Kehoe's 2008 paper is not that old.

      Considered by who?


      Maybe that's anything not New Keynesian.

      Probably. More like anything where monetary easing doesn't boost output.

      "Plus Freshwater microfoundations are probably even less realistic than Saltwater ones." Holy cow. What could that mean?

      A topic for another day...or several other days. ;-)

    2. "That sounds like 6 of one, 1/2 dozen of the other to me..."

      No no. It's much more subtle than that.

      "Well, yeah, it's probably a bit out of date, but note that there's a huge lag between when people make models and when those models become widely accepted."

      No, you haven't got it. When I'm saying "old" I mean 1975. First, geographically, it no longer makes sense, and you can't so easily separate the ideas anymore. At one time it was easy to characterize these separate schools of thought. Use the biological analogy. Maybe we start with two living things, and their genes are spread around, mutate, etc. The living beings we have now can't be separated into these two types.

      "Probably. More like anything where monetary easing doesn't boost output."

      Got you there. In 1972, Lucas wrote down a model in which monetary easing does indeed boost output. Freshwater or saltwater?

    3. Anonymous9:11 PM

      " Lucas wrote down a model in which monetary easing does indeed boost output. Freshwater or saltwater?"

      Who care? Lucas and RBC followers' models just do not hold water. What they claim to be microfoundations are nothig but arbitrary mathematical assumptions. What are the biological and social foundations of utility maximization and expectation formation in their models? Any serious microfoundations must be based on human decision-making process, social psychology and their intercations with institutions etc. New Keynesian models are no better in terms of microfoundations. They somehow show how ridiculous Lucas and RBC models can be.

    4. At one time it was easy to characterize these separate schools of thought. Use the biological analogy. Maybe we start with two living things, and their genes are spread around, mutate, etc. The living beings we have now can't be separated into these two types.

      I know that's what some people say, and I've seen many models that can't easily be classified. But the dispute seems like it's still there. At the AEA last year (at the reception you didn't come to!), Randy Wright started going off about "Why do we have to include these frictions in our models, what happened to preferences and technology?", etc. etc. And of course there was Kehoe's paper.

      In 1972, Lucas wrote down a model in which monetary easing does indeed boost output. Freshwater or saltwater?

      I always thought the "water" labels only applied to DSGE models, and I thought the key difference was whether or not a model had the assumption of sticky prices.

    5. Steve, here are some blog posts of yours that I think pretty well explain the freshwater/saltwater distinction:

    6. Stephen, words can evolve, and can take on more than one meaning, as you see constantly in a dictionary. Saltwater and Freshwater may have meant one thing in the 70s, but their meanings can evolve up to today, and influential people, like Krugman certainly is, can coin new meanings. Look at the word "conservative" today compared to what it meant in the Nixon or Eisenhower days; it's like night and day. A typical "conservative" in Eisenhower's day is to the left of Elizabeth Warren.

      The key point is that there certainly seem to be two camps here (yes with some grey area and exceptions, as is usually the case in our complicated world). And given how human communication works, it's pretty useful to have names for these two camps. Saltwater and Freshwater look like good names, because one camp agrees a lot more with the Freshwater of yore, and largely descends from it, and another agrees a lot more with the Saltwater of yore.

      I think you may get too hung up on the names, it's not hard to guess pretty well what ideas and people Krugman and others mean when they say freshwater, and it’s obviously helpful to give some names to the two camps, which are usually very opposing on very important questions and issues.

      Of course, you may think "Freshwater" and "Saltwater" are misleading, because many people in the "Saltwater" group, like Woodford, use a lot of the techniques and ideas of the "Freshwater" group. So, then, what names would you give to the two camps?

    7. FYI

      From Stephen Williamson:

      Miles Kimball may have been the first New Monetarist (actually, if you read the paper, he may have been the first New-Keynesian; he's basically outlining the basic NK model in 1995). Fortunately for us, Miles wants to blog, which is guaranteed to increase the average quality of discourse in the medium.


      I like seeing this, because one of the things Stephen and others will say or imply is that Krugman, and other critics, just don't know the models and literature of their macro (which is thee macro). They don't know what they're talking about. And I often wonder myself, could there be a there there in their literature that I don't know (and no one seems to be able to make clear to non-specialists in blogs and articles). It's what drove me to go through Walace's 1981 AER with a fine tooth comb thinking about each equation. Unfortunately, while that helped a lot, it was just the beginning for this stuff.

      In any case, it's great to see critiques from people who really do know this literature like specialists, and this may include Simon Wren Lewis.

  7. Noah: don't be too quick to assume that NY has seen the light. Because in June 2013 he presented a model in which "Excess labor supply pushes up nominal wage growth.", and so a decrease in AD, which causes unemployment in the short run when nominal wages are sticky (OK so far) causes ***higher*** inflation in the long run when nominal wages are flexible.

    His model is here:

    My critique of that model is here:

    On the other hand, he might have fired his advisers for letting him say something so totally and obviously daft in public.

    "I thank participants in a FRB-Minneapolis bag lunch for comments."

    He shouldn't be thanking them. He should be cursing them, for not pointing out the massive and obvious flaw in his model, and letting him make a fool of himself in public (again).

    This whole thing is really sad. Because he's clearly a really bright guy, who is really trying to do the right thing. But nobody ever taught him basic macro, and his advisers have been totally useless.

    1. OK. Maybe that was a little strong. I think he has sort of seen the light, but as late as June 2013 he still wasn't getting it. But maybe he is starting to get it now, and that's why he is firing his useless advisers.

    2. that's why he is firing his useless advisers

      Dear lord, that's by far the strongest language I've ever heard you use!!

    3. Well, they are very smart and not useless *people* (or even useless *economists*), but they are useless *as advisers to NK*, if they can't spot his mistakes.

  8. I sense a creep - slow, but nevertheless encouraging - in the thought process of our Minnesota-Chicago friends (including Steve Williamson at ustl). All this talk about DNA and genes are analogies (so disliked by Steve Williamson, by is own pronouncement!) crafted to slowly change an indefensible position. It good, since horseshit slowy finds its natural place.

    In listening to this debate from a 30k feet view, I am reminded of Paul Samuelson's comment on the usefulness of the latter-day-Chicago/strong form EMH for monetary policy. Here is what Samuelson said:

    "....But Milton Friedman had a big influence on the profession -- much greater than, say, the influence of Friedrich Hayek or Von Mises. Friedman really changed the environment. I don't know whether you read the newspapers, but there's almost an apology from Ben Bernanke that we didn't listen more to Milton Friedman.

    But anyway. The craze that really succeeded the Keynesian policy craze was not the monetarist, Friedman view, but the [Robert] Lucas and [Thomas] Sargent new-classical view. And this particular group just said, in effect, that the system will self regulate because the market is all a big rational system.

    Those guys were useless at Federal Reserve meetings. Each time stuff broke out, I would take an informal poll of them. If they had wisdom, they were silent. My profession was not well prepared to act."

    Read the whole interview here. Its a peek into the beautiful mind of the foremost mind in economics since Keynes.

  9. Anonymous9:50 AM

    One criticism I would add is that many people you would call "saltwater" make policy arguments along lines which are not at all present in New Keynesian models. In particular, in the baseline NK model Inflation more or less only plays a role because it increases firms discount of future deviations from their optimal price and thus induces them to set prices that are better today. Most policy saltwater people make completely different arguments as to why inflation should be higher in a recession but refer to NK models as a justification.

    1. That kind of thing happens a lot, but which specific arguments are you referring to?

  10. Anonymous11:09 AM

    While I agree that Real Analysis is probably not so critical as to be a prerequisite for certain graduate economics study, it is certainly useful in its own way and should at least be a strong suggestion.

    In any event, it was the first math course that challenged me to any degree at all. It was really useful to finally be challenged, as it got me to think more deeply about mathematics and proofs and *how to think*.

    1. I agree...I love real analysis. It's probably the most fun math out there (or maybe differential geometry).

  11. Anonymous2:10 PM

    I read the paper that Professor Krugman linked to on his post. My god. What a naïve and silly interpretation of cataclysmic events in 2008. Can you imagine Chari/Kehoe running the Fed instead of Bernanke in 2008. Makes me thankful for having Bernanke. And trust me, I am no Bernanke fan. I think he helped created the bubbles to start with. But at least he has learned. These people should not be in policy circles. They deserve to be fired from the Fed.

  12. Hey Noah
    You should write a column on the tradition of tenure in colleges and universities. As I see it, its somewhat unnecessary, and leads to adverse selection. The good ones do not need it - especially today, when a bright researcher is recognized without being shackled by the chin-strokers, looking to maintain status quo-. Kocherlakota has started a trend I think.

  13. From a distance this all sounds like it comes down to something pretty simple. Some economists had models that forecast huge inflation would result from the FED policy following the financial crisis. The huge inflation didn't happen. Some other economists think those economists haven't properly examined their models to see why they were wrong.

    I say this resolves itself. it takes time to work out the kinks in a model. There's no way these smart people won't make some changes to their models in good time. And they will make changes they think make sense, not those proposed by their critics. Therefore the underlying problem will happen again - someone's models will be wrong and blah blah blah...

    It all seems a little too inside baseball and hard to see how its more than much to-do about nothin'.

    They were wrong - happens all the time. It's not like there's a great alternative. No one has the perfect model yet. The one thing we know for sure is that all the models are far short of complete.

    1. Some people predicted high inflation, some predicted low inflation. The people who predicted low inflation were predicted correct. Those who predicted high inflation pretend like they were never wrong. That's very dishonest.

      Kocherlakota was one of the few who changed his mind in the face of new evidence, so good for him.

  14. Anonymous9:34 PM

    Here's how this shit went down: K fired these economists because they were two-timing the Fed with other gigs in the UK. Normally such stuff is overlooked or politely turned down but K chose to fire there ass because of personal reasons. The reason why Andolfatto and Williamson take up their case is no surprise either. They are doing their bit for their employer JBullard. You see, sooner or later some DSGE honcho is going to take up the mantle of the Fed chair. A & W are just making sure that Bullard and not Kocherlakota is the most eligible bachelor. Someone please call it for what it is...

    1. "K fired these economists because they were two-timing the Fed with other gigs in the UK."

      I don't think that's correct. Ellen is not two-timing anyone, and with Pat I don't think his job with UCL was an issue for the Bank.

      "The reason why Andolfatto and Williamson take up their case is no surprise either. They are doing their bit for their employer JBullard."

      I can't speak for David, but in my case that's B.S.

    2. Anonymous5:20 PM

      B.S. ...Really??? You get paid by one president and you criticize the other...even suggest that he has an ulterior motive behind his change of views! So, explain to us how others have ulterior motives and you don't ... and please save the DSGE model to explain this for another top-tier academic journal publication.

  15. Given Minnesota Macro is such a hotbed of Hallucinogenic Business Cycle Theory (HBC) I thought this might be a good time to review the Wikipedia entry on HBC:

    “Hallucinogenic Business Cycle Theory (or HBC Theory) is a class of psychedelic macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by imaginary (in contrast to reality based) shocks. (The four primary economic fluctuations are the gold rush, the bubble (deviation from trend), the counterintuitive movement, and mass hysteria (also known as “the panic” in classic terminology).) Unlike other leading theories of the business cycle, it sees recessions and periods of economic growth as an artificial response to illusory changes in the hallucinatory economic environment. That is, the level of national output necessarily minimizes the irrationally expected utility, and government should therefore concentrate on pretending to make short-run policy changes and intervene through random statements of make-believe fiscal or monetary policy designed to actively and whimsically whip the general public into a false sense of security.

    According to HBC theory, business cycles are therefore “hallucinogenic” in that they are based on complete fantasy, and are the most inefficient possible operation of the economy, even given its seemingly perpetually unviable nature. It differs in this way from other theories of the business cycle, like Keynesian economics and Monetarism, which see asset bubbles as being untenable, and recessions as having tangible causes, which lead to what are known as “real-world repercussions.”

    An important principle underlying HBC Theory is the principle of irrational expectations. Irrational expectations theory defines this kind of expectations as being identical to a wild guess about the future (a preposterous forecast) that systematically ignores, or thoroughly misinterprets, all of the available information. However, even with an unlimited number of additional assumptions, this theory of expectations indetermination still makes the prediction that human behavior will still be completely capricious and herd like. Thus, it is assumed that outcomes that are being forecast differ arbitrarily or unpredictably from the market disequilibrium results. As a result, irrational expectations differ substantially from disequilibrium results. That is, it assumes that people systematically make errors when predicting the future, and deviations from common sense happen consistently. In an economic model, this is typically modeled by assuming that the expected value of a variable is equal to a spontaneous error term representing the role of ignorance and mistakes plus the value of some completely irrelevant piece of information (such as the price of tea in China).”

  16. Ecomedian12:34 AM

    Great Moments in Academic History:

    5th century BC: Greek mathematician Hippasus is drowned at sea by fellow Pythagoreans for proving that the square root of 2 is an irrational number, thus averting a theoretical crisis

    2013: The failure of Fed policy to reduce unemployment according to academic macro models was solved by firing the Minnie Fed researchers who pointed this out

  17. "Scientifically, Freshwater macroeconomics plays an important role in laying out how the world should be if everyone thought like an economist."

    I know the article is already long, and there's a desire to not make it too detailed and unflowing for laypeople, but it's so much more than this. More like, thinks like an economist-superman-cyborg from the future – 100% of all public knowledge in their brains, 100% expertise in every area and sub area known to man, and the ability and willingness to do any analysis, no matter how extensive and difficult, perfectly with zero time and effort.

    Here's Paul Krugman, from his 1994 book, Peddling Prosperity, page 208:

    Does this argument sound convincing? It did (and still does) to many economists. Akerloff pointed out, however, that it depends critically on the assumption that people do something that they are unlikely to do in real life: take account of the implications of current government spending for their future tax liabilities. That is, the claim that deficits don't matter implicitly assumes that ordinary families sit around the dinner table and say, "I read in the paper that President Clinton plans to spend $150 billion on infrastructure over the next five years; he's going to have to raise taxes to pay for that, even though he says he won't, so we're going to have to reduce our monthly budget by $12.36."

    ...the truth is that even families of brilliant economists don't have conversations like this. No, the point is that the effort isn't worth it. If a family has arrived at a sensible rule of thumb for deciding how much to spend, trying to improve on that rule by making sophisticated predictions about the future implications of government spending will improve the families decisions so little that it isn't worth the investment of time and attention.