Sunday, February 16, 2014

Is macro doomed to always fight the last war?



The eternally simmering blog debate over "microfoundations" has reached a sort of balance, with Simon Wren-Lewis and Paul Krugman on the skeptical side, and Chris House, Steve Williamson, and Tony Yates in support of the dominant paradigm. But "balance" doesn't mean "boring", so I encourage you to read the latest round, which is about the history of New Keynesian macro. Wren-Lewis and Krugman say that New Keynesians, by embracing the microfounded approach, gave up an important type of modeling tool unnecessarily; House and Williamson say that the thing that was given up was not useful at all, so it deserved to go. (Update: John Taylor also jumps in.)

Instead of repeating my thoughts on the matter, I want to ask a different question. In his post, Chris House writes:
The main thing New Keynesian research has been devoted to for the past 20 years is an exhaustive study of price rigidity. If anything was holding us back it was the extraordinary devotion of our energy and attention to the study of nominal rigidities. We now know more about the details of price setting than any other field in economics. As financial markets were melting down in 2008, many of us were regretting that allocation of our attention. We really needed a more refined empirical and theoretical understanding of how financial markets did or did not work.
And in this earlier post, he writes:
If there is a model that really got taken to the woodshed during the financial crisis it was the New Keynesian model which had, until then, occupied a clearly dominant position in policy discussions and academic research.
This seems to be the overwhelming consensus in academic macro these days. It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama's future socialist policies caused the recession, and that's just plain silly.

Before 2009 there was very little finance in mainstream macro models (the biggest exception being these models by Ben Bernanke and coauthors). In 2009 and after, lots of people outside the field noticed this fact and got angry at macro. But macro, to its credit, was not nearly as tone-deaf as its critics made it out to be - macroeconomists immediately started working on models of how the financial sector could wreck the real economy, and a couple years later, as far as I can tell, "financial friction macro" is almost the only game in town. (And it seems to be rapidly erasing the "freshwater/saltwater" divide.)

In other words, when macroeconomists saw something their models couldn't explain, they changed the models extremely quickly. Which was, of course, exactly the right thing to do.

But of course it would have been even nicer if macro had picked up on the finance thing more strongly before 2009. Then we might have been better prepared. Instead, macroeconomists in the 2000s and the 1990s were focused almost entirely on explaining the last big business-cycle events - the stagflation of the 70s (which seemed to fit with RBC models) and the Volcker Recessions of the early 80s (which seemed to fit with New Keynesian models).

Are macroeconomists doomed to always "fight the last war"? Are they doomed to always be explaining the last problem we had, even as a completely different problem is building on the horizon?

Well, maybe. But I think the hope is that microfoundations might prevent this. If you can really figure out some timeless rules that describe the behavior of consumers, firms, financial markets, governments, etc., then you might be able to predict problems before they happen. So far, that dream has not been realized. But maybe the current round of "financial friction macro" will produce something more timeless. I hope so.


Updates

Brad DeLong has a great (and long) post on the "microfoundations" debate, with which I agree pretty much completely.

76 comments:

  1. If the true-macro-is-micro zealots are looking for "timeless rules that describe the behavior of consumers" etc., they are looking in strange places. Honestly, I'd say David Attenborough would do a better job. (If you get a chance to hear him describing his observations of primate behaviour at BBC committee meetings, don't pass it up.)

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  2. It might be a very stupid comment, but what if the nature of macroeconomics it-self condamns macroeconomists to "fight the last war"?

    At the hear of every capitalist economy is innovation, as Schumpeter noticed. And with innovation comes uncertainity.

    In case of the dot-com bubble, well, how do we price something new? Information by definition does not exist... before it exists. In case of the subprimes bubble, one can think of securities introduced by the GSE as the innovation.

    Basically if we had a theory of bubbles before 2000 and 2007, arguably there would have been no bubbles. Thus, if there is a crisis it has to be something unexpected (a kind of "Black Swan", something we do not know, otherwise there should be no crisis at all (assuming good policies of course).

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    1. I don't think that's a stupid comment at all.

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  3. Reading your post, one would think that 2007 was the first banking crisis, the first housing bubble, that any country had ever faced.

    Bagehot seems to have had more useful insight 150 years ago than American economists have now.



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    1. Reading your post, one would think that 2007 was the first banking crisis, the first housing bubble, that any country had ever faced.

      Just the most recent. The Depression produced a flurry of thinking about finance and macro too - Keynes, Minsky, etc.

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    2. Noah - I think you missed my point. It sounds like economists suffer from collective ADD, constantly chasing squirrels and shiny objects.

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    3. No, I got that point, and it very well might be true.

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  4. Krugman had some recent claims in his blog posts about Tobin; he seems to think that macro basically forgot about what Tobin did on the fact of banks, financial firms and 'money' by the 1980's.

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  5. There are plenty of people who are looking towards the next big crisis. They're just wrong 99.9% of the time. So they're quite rightfully ignored. Hindsight is 20/20 as they say. If understanding the last crisis leads to insights into our economy then at least it can constrain the scope of can reasonably be asserted about the future, and cut down the huge amount of bullshit that does pass for economic forecasting.

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  6. This is good. I think you're figuring it out. This quote from House is important:

    "If there is a model that really got taken to the woodshed during the financial crisis it was the New Keynesian model which had, until then, occupied a clearly dominant position in policy discussions and academic research."

    I'd agree with regard to "policy discussions," but not the "academic research." There is and was so much going on in the field we want to call macro, that it's hard to say that NK was "dominant" in academic circles, even in, say, the period 1998-2008.

    NK was originally designed as a monetary policy tool. Among the people I see a lot - the New Monetarists (dumb name I know, but we're stuck with it now) - the view even before the shit hit the fan was that NK needlessly neglected a lot of things that were important for monetary policy. For example, the details involving the roles of asset exchange and financial intermediation. Woodford's position was essentially that there are so many frictions to worry about that he wanted to keep life simple by worrying only about the sticky price frictions.

    NM has had two problems. One is that people who work in that paradigm tended to be aloof from policy. Neil Wallace was famous for thinking that we had nothing to tell central bankers, and he still thinks that. I think he's wrong, and I've been trying to correct that impression. So have others - and some of them work as policymakers and are influential. Second is that NM has not attracted many quantitative people, so no one is taking the ideas and refining them in a way that confronts what is in the data, except informally. So, there's plenty of low-hanging fruit for young researchers to go after.

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    1. What do you see as being the other approach(es) that were on a level with NK in the 1998-2008 period? RBC?

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    2. Look at this 2004 program for SED:

      http://www.economicdynamics.org/SED2004.pdf

      You might argue that SED is centred around Minnesota macro, but I think they have taken pains to get a lot of different stuff in these programs. If you're in doubt, look at what is done at the NBER summer institute. I'd say the other areas that have attracted a lot of attention are:

      1. focus on search and labor markets.
      2. asset pricing.
      3. incomplete markets models applied in various contexts - optimal taxation, explaining the wealth distribution.
      4. household economics.
      5. I/O issues in macro.

      There are others too, but that's a start. Research in RBC was essentially dead by 1998. In fact, when I worked at the Minneapolis Fed, 1987-89, even Prescott's students were not working on RBC. They had moved on to other things, e.g. Victor Rios-Rull.

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    3. Thanks for the list!

      A lot of that stuff looks like "RBC plus" to me, since in a lot of labor search, asset pricing, and incomplete-markets models, TFP shocks are still the main or only driver of aggregate uncertainty. I always thought "RBC" meant "TFP shocks are the main thing".

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    4. No, RBC is Brock-Mirman with a labor/leisure choice and some bells and whistles, and is focused (or was focused originally) on explaining quantities. Asset pricing is about the prices, sometimes taking the quantities as given, Sometimes both are mixed up. Though some exercises in labor search, like Shimer's 2005 paper, focus on TFP shocks and the implications for labor market variables, the labor macro literature is concerned with a whole array of issues other than things that occur at business cycle frequencies. To say the macro literature is sticky wages and prices, and what is not that, is just not a useful description.

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    5. Forgot to mention growth. There are whole journals devoted to just that.

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    6. Cooley's book (1995) is a useful departure point:

      http://www.amazon.com/Frontiers-Business-Research-Thomas-Cooley/dp/069104323X

      You can see things moving on already in that volume, from standard RBC. Included is a Rotemberg and Woodford model that is one step removed (it only needs the Calvo pricing) from NK.

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  7. "If you can really figure out some timeless rules [through microfounded macro] that describe the behavior of consumers, firms, financial markets, governments, etc., then you might be able to predict problems before they happen."

    Another way to try and do this is assume ignorance about the microfoundations -- any microstate that is consistent with your macrostate is equally probable:

    http://informationtransfereconomics.blogspot.com/2014/02/ii-entropy-and-microfoundations.html

    (Not to say this is the only way ... both bottom up and top down approaches should be done together.)

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    1. If you can really figure out some timeless rules ... that describe the behavior of ... financial markets,

      Four timeless, universal truths:
      1) Leverage is risky;
      2) Financial risks are fat tailed;
      3) Bankers and politicians are only about half as smart as they think they are; and
      4) Bankers and politicians lie and cheat.

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    2. As Noah says below, if we were to take (1) as a postulate, we'd really only be able to derive that prices are random variables. Taking (2) as an additional postulate eliminates some forms of distributions of those random variables.

      (3) is some kind of behavioral Zeno's paradox, but (4) could likely be used as a basis for game-theoretic modeling.

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  8. I am not sure if Dean Baker would be considered a New Keynsian, but I think he would argue that it was not the "financial crisis" that caused the Great Recession of 2007-2009, but rather the other way around. His argument is that when the housing bubble finally started to burst in 2006:

    "...The basic story is actually quite simple. The housing bubble had been driving the economy prior to the recession. It created demand through several channels. A near-record pace of housing construction added about 2 percentage points of GDP to annual demand or more than $300 billion in the current economy.

    The $8 trillion in ephemeral housing wealth created by the bubble led to a huge surge in consumption. Tens of millions of people borrowed against bubble-generated equity or decided that they didn't need to save for retirement. When house prices were going up 15 percent-20 percent a year, the house was doing the saving. The result was a huge consumption boom on the order of 4 percent of GDP or $600 billion a year.

    In addition, there was a bubble in non-residential real estate that followed in the wake of the housing bubble. This raised non-residential construction above its normal levels by close to 1 percent of GDP, or $150 billion a year.

    A Bubble Generated

    Adding these sources of demand together, the bubble generated well over $1 trillion in annual demand at its peak in 2005-2007. When the bubble burst, this $1 trillion in annual demand vanished as well. That is the central story of the downturn." http://finance.yahoo.com/blogs/the-exchange/baker-story-housing-crash-recession-politicians-don-t-170039954.html;_ylt=A0LEV114HQFTIUAAEeZXNyoA;_ylu=X3oDMTExaDV1NTZmBHNlYwNzcgRwb3MDMwRjb2xvA2JmMQR2dGlkA1VJQzFfMQ--

    Admittedly, Baker is using basically arithmetic, and not a DSGE model (looking at total GDP, residential Housing Investment's share of GDP, and empirical studies of how consumers will boost consumption and reduce savings when housing equity rises. But someone finally did a DSGE model that shows the same thing with "microfoundations."

    http://ideas.repec.org/p/euf/ecopap/0505.html

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    1. Right. When Noah writes: "It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama's future socialist policies caused the recession, and that's just plain silly."

      ...that seems almost deliberately misleading. "socialist Obama" is the ONLY causal hypothesis Noah can think of, besides "the financial sector did it"?

      Surely, Noah, you are not wholly ignorant of the Market Monetarists (Scott Sumner, etc.), the proposal for NGDPLT, and the (well-supported!) claim that tight monetary policy caused BOTH the recession AND the financial crisis.

      You don't have to agree with the MMs, but to claim that the next-best theory to the financial crisis cause, is a wacko socialist Obama theory ... that is doing a severe disservice to your readers.

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    2. Don, this is a bit like saying "Guns don't kill people, people kill people". The MMs think the Fed could have prevented the Great Recession and didn't. That isn't inconsistent with the idea that the shock that the Fed should have responded to came from the financial sector.

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    3. OK, but then the whole tone of your post, that finance was a "missing" part of macro models, and that macro has now improved because lots of theorists have added finance to their models ... kind of falls apart.

      You've got a car driving down a road, with hills and valleys. You'd like to keep the car at constant speed. These new "finance" theorists show up, and say: look! We've done some research into geology, and we can make small progress into predicting future hills and valleys in the road. The MMs look at this, and respond: you do realize that the car driver has a gas pedal and a brake, right?

      Modelling the financial sector is not important, if monetary policy has the power to accommodate whatever happens to occur in that sector. All that work has no significant predictive power for the greater macro economy (outside of the financial sector itself), and hence is not particularly important. In contrast to the tone in your OP.

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    4. I'm sure both PK and Dean Baker have pointed out that part of the reason why there was a housing bubble was that Fed was forced to lower interest rates because of the lack of alternative domestic real investment opportunities, mainly due to the trade deficit and a consistently (from a trade point of view) overvalued USD. Any model that assumes that prices adjust to clear markets, must deal with generation long currency misalignments.

      A currency misalignments part of financial markets, or not?

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    5. Anonymous9:43 AM

      "if monetary policy has the power to accommodate whatever happens to occur in that sector."

      Which patently it does not. Apparently the finance sector can cause the car to run into a ditch.

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    6. @Anonymous: "patently DID not", I'd agree with. As to whether it could have, that's a whole different question. Market Monetarists have made a strong case that the Fed mismanaged the economy in 2007/8, and caused an unnecessary multiyear recession.

      You can't use recent history to distinguish between "it is not possible to control the car to stay out of the ditch", vs. "the driver fell asleep at the wheel, the car is easily capable of avoiding the ditch, all we need is a driver who is paying attention."

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    7. I'm not an MMist, but I have to agree with Don's broad point here: right or not the MMists do have an explanation for why the downturn in housing turned into a recession which I think qualifies as an alternative explanation more worth mentioning than fear of Obama's socialism.

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  9. Anonymous5:36 PM

    There is more insight about the Great Recession in Fisher 1933 and in Minsky's non-technical, 10 pages financial instability paper than in any mainstream macro done in the last two decades.
    People who take credit rationing, loan monitoring and incomplete financial markets (pretty hard to tell a bank that the collateral for your credit is the income you will make in five years) seriously and who read the micro literature know that incorporating this stuff into Arrow Debreu GE model is ridiculous and above all unnecessary.
    When we are in a balance sheet recessions so ample of consumers are liquidity constrained so fiscal multiplier are obviously large.

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  10. JSeydl5:42 PM

    Eh, I've always been skeptical of this turn toward incorporating finance into macro models. I don't think that's the lesson from the 2008 crash. The lesson, to me, seems to be that the collapse of bubbles driving real variables matters a lot. All the panic and contagion in 2008 was beside the point; the reason why the downturn was so deep is because the housing bubble collapsed, a bubble that was clearly driving the real economy in unsustainable ways - both through out-of-control construction spending and beyond-rational consumption. The economy was going down regardless of whether financial markets froze and contagion spread; we simply built too many homes, and that was the underlying problem.

    Now, you might make the argument that finance has changed in a way that inflated the bubble in the first place. But that's a different argument - and a more interesting one, in my opinion - than the one economists have put forward for incorporating financial frictions in macro models. Indeed, those frictions are all about how shutdowns in certain markets can affect bank lending (etc.) - they do not say anything about the period prior to the shutdowns when financial flows perhaps inflate bubbles that in turn affect real variables.

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    1. Well by historical standands we now have a shortage of houses. You really should think about the fact that when you buy a house, you buy the land with it, and land is part of your perceived wealth. And the reason that land prices ballooned has something to do with lending policies. Which is finance.

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  11. Balance we don't need no stinking balance. Look I'm not in their league or anything but I am very vigorously participating in the discussion and I don't find my view there at all. I disagree with Krugman and Wren-Lewis because I think the approach for which new-Keynesians abandoned the old approach is worthless.

    Now I guess my contribution to the debate hasn't gotten all that much attention, but I haven't gotten a one tenth of the way convincing answer to the question "what have microfoundations ever done for us." I am particularly pleased that you lumped Wren-Lewis and Krugman together because it gives me an excuse to embed this link (it really shows that their views are different -- it's here because it proves Krugman typed "Robert Waldmann" but it's relevant).

    http://krugman.blogs.nytimes.com/2012/03/13/microfoundations-micro-payoffs-wonkish/

    One would think that being accused of offering "very thin gruel" by Krugman would stimulate some further effort. I do think that. I am confident that Wren-Lewis has devoted considerable effort to the search for payoffs from the micro-foundations approach. I think he hasn't found any, because there aren't any to find.

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    1. Right, you and I are both kind of orthogonal to the debate.

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    2. I suspect that the problem with "micro-foundations" is not the idea of micro-foundations per se but rather linking it with inter-temporal optimization in a completely unrealistic way combined with the need to build over simplified models to make the models mathematically tractable.

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  12. 1) Leverage is risky

    This is trivially true in all cases where returns are stochastic.

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    1. And yet people seem to forget it over and over. :-)

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    2. No they don't! It's there.

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    3. Wall St's behavior could have fooled me. And how many economists were sounding the alarms before the Crash?

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  13. OK now I've read the post and have more nearly to the point rants.

    "We now know more about the details of price setting than any other field in economics. "--House
    I actually don't know if he meant "we macroeconomists know more than people in other fields" or "we macroeconomists know more about price setting than other things". It doesn't matter. I think new Keynesian models of price setting are total nonsense. I am not at all talking about Calvo alarm clocks. I am talking about the idea that price setting is rationally forward looking. I have 3 objections

    1) expected inflation is equal to the true expected value of inflation given the policy rule so it changes when the policy changes and not just because past inflation changes. If the models are taken literally, this happens instantly. Of course all assume that there is really some learning dynamics -- but that is enough to weaken the claim enough for it to be untestable given historical data. Now I don't think that anyone could doubt Volcker's resolve in 1982. Survey data (of experts even) from the trough of the ruthless Volcker recession show they expected inflation to increase. This can be explained if one assumes that Volcker hadn't demonstrated resolve or that the survey participants were distracted by flying unicorns. The second story is much more plausible.
    2) desired prices are a markup on marginal costs. This requires managers to have a firm opinion about what their marginal costs are and to believe that it is a useful concept. To believe that, you have to act as if "as if" were a convincing response to any fact. Notoriously managers either are not familiar with the concept or say they have no use for it. Micro foundations means ignoring what actual economic agents say about what they do. I have no idea (and have long wondered) how anyone can claim to believe in microfoundations and also use "as if" arguments. This is a plain obvious blatant contradiction.
    3) anticipated future marginal costs have to matter too. Brad asked "Thus your standard New Keynesian model will use Calvo pricing and model the current inflation rate as tightly coupled to the present value of expected future output gaps. Is this a requirement anyone really wants to put on the model intended to help us understand the world that actually exists out there? " He sure is insinuating nK models of price formation are nonsense, and I don't know of anyone answering the question.

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    1. A lot of this has to do with the assumption of risk-neutral firms. And of course the "Rational Expectations" assumption of common priors.

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    2. 1) True, which is why more complicated models usually include "hybrid" NK Phillips curve with both forward- and backward-looking inflation term. You can microfound that too somewhat (assume firms that don't reoptimize index they prices by past inflation), though it does feel bit ad-hoc.

      2) With constant returns (as usually assumed), marginal cost is the same as average cost, and surely managers care about at least one of those.

      3) Calvo pricing is used to capture the intuition - if firms adjust prices only rarely, they will care about future inflation in addition to current cost when choosing the new price. All the rest is just formal modelling that (just like any model) shouldn't be taken too literally.

      But I think the original point was that, in addition to numerous applications of NK models, economists have spent effort on studying sticky prices beyond Calvo, both empirically (looking at price changes in micro data) and theoretically (e.g. state-dependent pricing), compared to relatively small attention paid to financial frictions.

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  14. You wrote "And it seems to be rapidly erasing the "freshwater/saltwater" divide." You read Krugman. You know that the divide seemed to be rapidly vanishing way back in 2000-05. Then it reappeared with freshwater economists saying saltwater economists must be fools knaves or both because Calvo pricing was fine until models with it were used to justify Obama's fiscal policy and then it was known to be nonsense as it had been known for decades. If a macro consensus is patched up again, it will hold exactly until the next time there is a major partisan debate about macro policy.

    you wrote "the stagflation of the 70s (which seemed to fit with RBC models) and the Volcker Recessions of the early 80s (which seemed to fit with New Keynesian models)."

    Ah you are so young. I wish I was so young. The original RBC models didn't include a price level. They had nothing to do with inflation let alone stagflation. The model which seemed to fit the stagflation was, in fact, the Phillips curve as discussed by Samuelson and Solow in 1960. It was perceived to be the critique of a strawman made by Friedman and Phelps (who added nothing and subtracted hysteresis). Later it was thought that the stagflation era and earlier data might fit the Lucas supply function which was Huge for a while. Later it was noted that those data reject the Lucas supply function which was a clearly silly idea to begin with. As noted by Krugman, RBC emerged when freshwater economists had to come up with something new or admit that saltwater economists were right.

    New Keynesian economics does not fit data from the Volcker deflation except to the extent that it is identical to old Keynesian economics (see above). Also over here (in Europe) the last war was the huge unemployment problem of the late70s 80s and 90s which is radically inconsistent with new Keynesian models (as note by, among other, leading new Keynesian O.J. Blanchard).

    Macroeconomists are totally unprepared to fight the last war or the war before that.

    Your idea that macroeconomics always changes so that it wouldn't be defeated in the same way again assumes that old macroeconomics was defeated in battles which newere macroeconomics would win. My view is that this is totally false and that not only have macroeconomists not gained the ability to predict the future but they have lost ability to fit past data.

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    1. Just to defend Noah a bit, he may blog about macroeconomics, but he himself rejected macroeconomics as a lot of very inelegant mathematics where the models don't make predictions about real world events, but try to turn themselves into pretzels to explain such events (or if they can't, then pretend the real wold events don't exist since they "violate established scientific facts." ltabln'etheot of a pseudonb

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    2. Anonymous3:28 PM

      This is a good attempt to re-write history as you see fit Robert. Except history is written by the winners. Did you miss the debate between Friedman and Tobin on what is driving inflation in the 1970s?

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  15. Anonymous7:24 PM

    "...macroeconomists immediately started working on models of how the financial sector could wreck the real economy, and a couple years later, as far as I can tell, "financial friction macro" is almost the only game in town. "

    The models need to do a lot more than look at "frictions". Financial costs or borrower-lender matching problems don't begin to help understand the problem of unemployed people with no assets purchasing $500k homes. If anything , that indicates a too-well-lubricated financial system.

    Financial shocks are not necessarily exogenous. Most often , they arise because they're embedded in the production-consumption process - an integral part of it. I'm not so sure today's macro modelers , chastened though they may be , are looking at it this way.

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  16. Anonymous11:18 PM

    Noah -- Robert 6:20 is on to something. It was really Friedman who garnered the credit for predicting stagflation. But the Friedman monetarism was discarded after the Lucas critique. I think pretty much all the new microfoundation models are a methodological response to the Lucas critique by the profession as a whole. The problem for policy is that the "middlebrow" models and ad hoc models that had predicative power were pitched. The new models are so underdeveloped at this point that they can't predict/forecast and they're pretty crappy at even explaining the past. (kudos to Robert for saying that first and clearly.) Maybe these new models will improve their explanatory and predictive power but they currently suck. Unfortunately, some of the advocates of these models confuse their supposed methodological superiority with their predictive power. When I was in grad school one very wise prof prefaced his macro lecture by warning that no one on the faculty really believes this stuff and most undergrads didn't think it made much sense either -- only grad students fully buy into the bs. I'm afraid some of the current faculty, er Steve, hasn't received the message.

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    1. Anonymous7:37 AM

      It is very difficult to criticise DSGE openly, even though it is obviously farcical. Its total dominance as an unquestionable paradigm means you have to submit to it. Once you have tenure you can start looking at actually what goes on in the world, but by then you will be too busy and have too much sunk cost invested to start again.

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  17. Olli Ranta2:40 AM

    One factor causing bad predictions is the everlasting denial of the existence of endogenous money in the financial world. That money gets created in the bowels of double entry T accounts. Generally all people shy away from those considerations but in this case I claim that to be interesting and entertaining. For details see http://olliranta.wordpress.com/endogenousmoney/

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    1. I'm generally generally sympathetic to Post-Keynsian macro I don't think your point is very strong. Endogenous money is a result of interest rate targeting. But there will always be a cap on the amount of money created due to the amount of excess reserves. (although this mechanism may be altered by IOR).

      Ultimately, I don't think that NK and others necessarily ignore this fact as much as find it irrelevant. The important point is that the money supply is controlled through interest rate policy. The fact that banks usually create the money or the FED prints it is kinda besides the point.

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  18. Seems like a very basic problem with microfoundations that doesn't get much attention is essentially that people act differently in groups than they do individually. My behavioral finance/economics classes were always totally cordoned off from my macro-modeling ones. Is anyone working with dsge models that don't exactly use the classical assumptions?

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  19. I want to repeat a point, I've made elsewhere that seems to be forgotten. The problem in the DSGE methodoly is the GE. GE is the problem. There is no GE.

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    1. I think the following from Bruce Wilder is apposite here:

      http://crookedtimber.org/2014/02/10/macroeconomics-made-easy/comment-page-1/#comment-511985

      "When I was a young dinosaur, people looked at Arrow-Debreu-McKenzie (ADM) with awe and admiration, nodding sagely that it provided, not a model of the world as it was or could be, but, rather, a sharp contrast to the world, which could be used to discover the nature of our imperfect institutions. ADM had shown that the market economy as a system needed a lot of insurance to be efficient, and everyone recognized, by contrast, the actual world did not have that much insurance. It seemed to many to be a fatal blow to laissez faire liberalism, and a vote in favor of social democracy, since the latter promised public provision of cheap and efficient social insurance, now a formally proven necessity for an efficient market economy.

      The ideal of the market economy, coordinating and equilibrating itself, had been modified by the insight that lots of insurance was required to realize that ideal. The classic, siamese-twin handicaps on the competitive market provision of insurance — adverse selection and moral hazard — promised to be the keys to a new understanding of imperfect competition and hierarchy in the organization of the economy. The Phelps volume was greeted as the harbinger of a new era, a paradigm shift in the making."

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    2. The economy is not a calculator. If equilibrium emerges, it emerges as the result of lots of uncoordinated individual decisions, and these decisions take time, and may follow indirect paths. Same as in ecology.

      And the same as in ecology, systems are always subject to invasion and overshoot, and so never reach fully stable states.

      When macro-economics sees itself as a special case of ecology (rather than something completely different), it will be making progress.

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    3. Yep. I'd like any economist of any stripe to explain how her model addresses deterministic chaos and emergent properties, for starters.

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    4. The underlying assumption is that the markets are coordinating individuals through the vector of prices. Equilibrium is indeed a spontaneous phenomenum (Hayek), nothing new, it is taken into account in the models -- even if the adjustment of prices mecanism remains very abstract and unclear.

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    5. Andrew7:38 PM

      Equilibrium is a consistency requirement in economics, it is not a statement of stability. A system of over and undershooting can be an equilibrium outcome (for a nice example, see Kiyotaki and Moore 1997). Furthermore, general equilibrium effects are emergent properties (I just noticed Math. Bo. making this point) - though maybe these terms should be properly defined...

      Jargon is specific to the particular discipline it applies to. Terms are allowed to mean different things in different jargons.

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    6. Math Bo.
      "The underlying assumption is that the markets are coordinating individuals through the vector of prices. Equilibrium is indeed a spontaneous phenomenum (Hayek), "

      1. There is no empirical reason to believe that this actually works like that. And it certainly should not be an assumption built into the models. I simply do not believe that the economy tends to a GE (and if it is not stable - then how is it in any sense "Equilibrium" and how is it reachable?)

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    7. Math Bo. Andrew,
      you do realise of course the DSGE models are "solved". They don't actually model agents dynamic response to the current state as a proper dynamic system would. The Dynamic bit in DSGE is a bit of a pretend.

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    8. Andrew10:04 AM

      sorry, I don't understand. of course DSGE models are "solved". what else do you have in mind? also, the solution to an agent's problem (be it a firm, consumer etc.) in these models is exactly their response to the current state. so I'm not sure what you mean by that either. and of course they are dynamic models... individuals consider the future when making decisions, economic variables evolve over time... maybe i'm just missing something.

      also, equilibrium in economics is a solution concept - it is the final tie that bring everything else together consistently, so that quantities, prices and actions all line up. it doesn't really make much sense to talk about equilibrium outside the context of a model. you can talk about how a model is useful or not for describing a feature of the economy, but it doesn't really make much sense to talk about "tending to an equilibrium" or "out of equilibrium". again it does not mean "in balance" or "at rest" like it does in physics.

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    9. Excuse the butting-in, but there is another concept of equilibrium in physics that is based on entropy and information that has particular relevance to the microfoundations debate. One way to use "equilibrium" would be to say all microstates consistent with the macrostate are equally probable. Another way would be to say the EMH is the statement that price data is maximally uninformative in equilibrium. You can actually derive supply and demand diagrams from this:

      http://informationtransfereconomics.blogspot.com/2014/02/a-physicist-reads-economics-blogs.html

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    10. Andrew - I mean that this "solving" is nonsense. There are only limited interactions between (many and heterogenous agents) - solving is introducing a process that doesn't in reality exist. There is no walrasian auctioneer, there are not complete markets, there is not perfect knowledge and plans are contingent so that consistency is not a meaningful concept. Is that clear enough?

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    11. Andrew,
      think about it - what does this phrase "so that quantities, prices and actions all line up" - actually mean. What are they all lining up WITH? Are you saying that all markets are clearing (prices and quantities demanded and supplied lining up). In which case - what about the labour market - then unemployment (including frictional unemployment!) is impossible in equilibrium. But the Fed is explicitly targeting positive unemployment. And what about the process of price change - are prices determined by black box markets or do agents set them for strategic reasons? Do you understand how this might make a difference between a "solved" model and a proper dynamic model, where agents determine their offer price and produced quantity in ways that may be inconsistent with what other agents expect. If you think about competition and production lags, it should be clear that firms do not consider the entire demand for what they are producing, but their estimate of their own market share. And particularly with new entrants, the penalty for excessive pessimism is less than the penalty for excessive optimism (because competitors will fill demand that cannot be met on time). So really modelling the way agents think and act in a particular local situation, is quite different from "solving" models, and the dynamics will be significantly different, EVEN if the "equilibrium" market condition is unchanged.

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  20. "If you can really figure out some timeless rules that describe the behavior of consumers, firms, financial markets, governments, etc., "

    If you're looking for laws in social science....you're gonna have a bad time.

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    1. Not only that, but 'you' have to figure out these timeless rules given very limited data, in a world where many things are changing. Talk about the Lucas Critique!

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  21. I'm having a great deal of difficulty understanding what kind of macroeconomic model could possibly have predicted a financial crisis caused primarily by the opaque market for CDS derivatives. As these trades were OTC, conducted in the "shadow banking system" and therefore undisclosed... so the data was unobtainable! Doesn't the fact you economists are still finger pointing over your failed models expose your lack of understanding of financial markets?! The fact is the data just wasn't there to analyse and the little data we had ie. the MBS and CDOs that had been given the triple AAA stamp by corrupt or inept ratings agencies was clearly faulty. So even if we had the correct macro economic models they would have failed to predict the crisis as they would have been afflicted with the GIGO (garbage in garbage out) problem. I submit exhibit A:

    http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Greenberger.pdf


    Widespread Recognition That CDS Played Key Role in the Meltdown. It is now almost
    universally accepted that the unregulated multi-trillion dollar OTC CDS market helped foment a mortgage crisis, then a credit crisis, and finally a ―once-in-a-century‖ systemic financial crisis that, but for huge U.S. taxpayer interventions, would have in the fall of 2008 led the world economy into a devastating Depression.

    How CDS Worked. The CDS ―swap‖ was the exchange by one counterparty of a
    ―premium‖ for the other counterparty‘s ―guarantee‖ of the financial viability of a CDO. While CDSs have all the hallmarks of insurance, issuers of CDSs in the insurance industry, specially the bond insurers (―monolines‖) enticed into underwriting CDS, were urged by swaps dealers not to refer to it as ―insurance‖ out of a fear that CDSs would be subject to insurance regulation by state insurance commissioners, which would have included, inter alia, strict capital adequacy requirements.65
    By using the term ―swaps,‖ CDSs fell into the regulatory ―blackhole‖ afforded
    by the CFMA‘s ―swaps‖ exclusion (Section 2 (g)) because no federal agency had direct supervision over, or even advance knowledge of, what went on in the private, bilateral world of ―swaps

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    1. Doubtful that the previous financial crisis was caused by CDSs. CDOs certainly played a significant role.

      Economists know the size of the derivatives market and it is ten times the size of the global economy. They could certainly have asked themselves the question whether something which is opaque, ten times the size of the real economy and run by bankers was capable of causing a systemic problem. The derivatives market is still a huge risk hanging over all our heads.

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    2. And the big criticism is (from memory) that economists were in general saying that deregulating the financial markets would stabilize them.

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    3. The consensus of economist or politicians? I would suggest most economists wouldnt have advocated dismantling Glass-Steagle.

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  22. Anonymous10:36 AM

    is macro doomed to fight the last war ? Yes, because an economy is an open evolving system. you can't predict what will evolve.

    Minsky argued that institutions evolve in response to "the last econ war" (though he didnt use those words) so that any math model / econometric model will always fail.

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  23. Noah, I have to disagree with a major point of your post. Where are these economists who are getting busy on the new models?

    Right now, we see the usual suspects (Prescott, Mulligan, Mankiw, Cochrane, Williamson, House etc.) pointedly not 'marking their beliefs to market'.

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  24. Anonymous10:00 PM

    Which side is Macro on any way?

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  25. Anonymous10:03 PM

    Does macro refuse to venture out on the dynamic sea or stay in flat water?

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  26. Anonymous10:04 PM

    (Water in equilibrium.)

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  27. Anonymous10:07 PM

    If the ship is not built for the open (dynamic) sea. It is not sea worthy.

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  28. Credit market frictions is the "last war"? What do credit market frictions have to do with a credit bubble and bust? Seems more like people who have over-committed to exogenous money continuing to avoid the obvious credit cycle issues written about by Minsky, Fisher and the Austrians.

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  29. Anonymous1:26 PM

    Understanding how an economy works and the correct interventions is different than having the political will and consensus to do what needs to be done. Economic policy has been captured by Malefactors of Great Wealth who use their power to enrich themselves at the expense of the rest of us. We know that policies that would make the distribution of profits more equal and fair would increase demand by giving the poor more pocket money to spend. Since they poor spend everything they make, demand would increase. Those types of policies are blocked. They are fought tooth and nail by Malefactors of Great Wealth who want much more for themselves and even less for the poor. We can't even get an increase in the minimum wage. Another reason for less in equality: an economy with less inequality is more stable.

    Take the example of smoking. We know that smoking causes lung cancer, emphysema and other harmful effects. The solution is to quit smoking. If someone continues to smoke and gets cancer and emphysema, the solutions become far less clear.

    What has happened to economics is similar. We know that increasing inequality is bad for an economy and that it is self reinforcing. The wealthy use money to corrupt the rules and capture even more wealth. Now that we have entered territory where inequality has damaged demand, economic tools such as monetary policy become impotent; fiscal and regulatory policy have been captured and thus not effective. The economy becomes more difficult to fix.

    Economic models built during the Great Moderation may be useful under a narrow set of economic conditions. Now that we have strayed beyond the boundaries, these models are not much help until the economy returns to Great Moderation conditions. We need to reevaluate the policies of the Great Moderation that led to a stagnation in wages that led to this mess.

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  30. All macro economists need to know is that TOO MUCH DEBT AND TOO MUCH STATE SPONSERED RISK TAKING makes fat tails much more likely. That is all macro needs to know the rest is bullshit for academics to write papers about to get a paycheck

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