Tuesday, June 17, 2014

Big Ideas in Macroeconomics book review, Part 4: Macro and the Crisis

(This is Part 4 of my ongoing review of Big Ideas in Macroeconomics, by Kartik Athreya. Part 1 is herePart 2 is here, and Part 3 is here.)

Why did Kartik Athreya decide that now is the time to write a book defending macroeconomics from its many public critics? Probably because there are many public critics. And why are there so many? Probably because of the 2008 financial crisis and subsequent deep, prolonged recession. So it makes sense that a large part of Athreya's apologia would be about "Macroeconomic Theory and Recent Events" - as Chapter 6 of Big Ideas in Macroeconomics is titled.

But let's back up a bit, to Chapter 2, where Athreya writes:
[T]he overall conclusion one gets from the vast literature on industrial organization is that, with two exceptions, pervasive and important degrees of monopoly or oligopoly power do not play a dominant role in most modern economies most of the time... 
The latter [exception] arises from the ability of financial "intermediaries" such as banks, insurance companies, and hedge funds, among others, to become considered "too big to fail" (TBTF). In this case, a very poisonous dynamic arises...Preventing TBTF and the corrosive effects on behavior that it generates are big pieces of unfinished business[.]
Hmm. Monopoly power isn't important in modern economies, except for TBTF? Where did the idea for that exception come from? I'm guessing it didn't come from a formal mathematical model with highly persuasive assumptions, written down by an academic macroeconomist before 2008 and published in a reputable journal. I'm guessing, instead, that it came from Athreya reading news and blogs.

When Kartik Athreya sticks "poisonous" and "corrosive" exceptions into his grand sweeping statements about the smooth workings of markets, you know something must have spooked him.

That something is the financial crisis of 2008. You'd have to be criminally insane not to be spooked by it. The wider world instinctively saw that the macro theories that they had been served up prior to 2008 - which said either that business cycles weren't bad at all, or that the Fed could handle them - were sorely lacking. The force of that realization, more than anything, is behind the proliferation of public macro critiques. 

(Except for Yours Truly, of course. Yours Truly is merely venting his anger over having to get up at 7:00 in the morning and trudge through the snow to take Chris House's macro class back in 2007. 7:00 IN THE MORNING, DAMMIT. But I digress.)

In Chapter 6 of Big Ideas, Kartik Athreya explains and defends macroeconomists' response to the Crisis. He describes how, with amazing speed, macroeconomists started building models of how institutional problems in the finance industry could cause a crash. This really is The Hot Thing in macro these days, along with labor search models (Athreya also goes over both of these in Chapter 5). The sheer speed with which these models have been developed is a testament to the skill and intelligence of macroeconomists, the responsiveness of the macro community to real-world events, and the flexibility of the general equilibrium framework.

Athreya doesn't address the question of why these models weren't The Hot Thing in 2007. 

Chapter 6 takes a detour into financial econ, including asset pricing, corporate finance, and banking. Athreya discusses heterogeneous beliefs and the limits of Rational Expectations, and whether it might be possible to detect and curb the growth of asset bubbles. He talks a little bit about debt vs. equity financing, and about banks and bank runs. This is all very good stuff, although these topics could (and do) fill many books each.

After that, Chapter 6 sort of disintegrates into a bunch of random stuff - unconnected, brief glosses over topics that Athreya probably couldn't figure out where to put. Actually, much of Big Ideas is arranged a bit haphazardly (much like this book review, actually, since I should have pointed this out in Part 1).

If you're searching Big Ideas for clues to Athreya's political outlook, it's in the jumbled Chapter 6 that you might find them. He takes one section to explain that modern macroeconomics is not inherently laissez-faire (and he's right), but he spends a lot of time cautioning against government intervention in the economy. Maybe that's because he himself is a laissez-faire sort of guy, or maybe it's because he thinks the critics of macro are mostly on the political left. In any case, that's about the extent of the book's political content.

The end of Chapter 6 - which is also the end of the book - is very revealing. Section 6.7.2 is titled "Where Did We Fail?", and Section 6.8 is titled "What Should Macroeconomists Be Doing?" These plaintive questions - which Athreya answers only tentatively - show that macroeconomists feel a bit under siege as a result of the crisis. Overall, Big Ideas can be viewed as a bunch of defensive rhetorical cannon, firing in all directions from the walls of the besieged fortress. Some of the cannonballs hit their mark; others don't. But Big Ideas shows that the castle is still being vigorously defended; the garrison is not yet ready to abandon the fortress.

But in those final sections, Athreya strikes a more hesitant tone. He writes:
Do macroeconomists have models that would produce a forecast for the likelihood of a huge downturn if they could clearly observe the full structure of IOUs across financial intermediaries and households? No. Could our models speak to the possibility that more relaxed underwriting standards would coincide with a period of extremely high price appreciation in real estate? No. Did our benchmark models suggest that, in the absence of any change in fundamentals, real estate prices could drop nationwide by 20% or more? No... 
Macroeconomics, therefore, has a good deal of unfinished business, and so has failed, in recent years, to be useful in a variety of ways. 
I suspect that the median macroeconomist can accept what I have just said. Nonetheless, I suspect that they think, for reasons I have laid out all along, that these reasons do not make a wholesale revamping of macroeconomics a good idea. A more measured response is the one that is already happening: the crisis and the slow recovery have yielded a sensible shift in priorities toward understanding the role of household finance (e.g., mortgage and student loans) and financial contracting between firms (e.g., repos) as sources of macroeconomic fluctuations.
This, I think, is the main message of Big Ideas: Outside critics, be quiet and let macroeconomists handle our own problems. We've got things under control. Our basic paradigm is sound; we'll fix things by evolution, not revolution, and we don't need you guys beating down our door with poorly informed criticism in the meantime.

Anyway, in Part 5, I'll wrap up and talk about what I think of the book as a whole. Stay tuned for the exciting conclusion!


  1. Anonymous9:43 PM

    I do IO and I don' t think it is even remotely accurate to say that `[T]he overall conclusion one gets from the vast literature on industrial organization is that, with two exceptions, pervasive and important degrees of monopoly or oligopoly power do not play a dominant role in most modern economies most of the time...'

    Every paper I've ever seen in an IO seminar features `monopoly or oligopoly power'. Some of those industries are quite big.

    1. What's insane is that it's not even a shallow reading of the IO lit--if you think about the one paper that one might read on market power (Nevo's "Measuring Market Power in the Ready-to-Eat Cereal Industry") you find a lot of market power.

    2. Yeah, I had a feeling IO people might not agree on that one... ;-)