I’ve begun reading a very interesting book by the brilliant Steven Landsburg, entitled The Big Questions. I find that we share a taste for contrarian opinions. Of course Steven is much more skilled at defending his views. Here’s something that caught my eye:
I sometimes hear economists defend the unrealism of their models thusly: “Economics is an infant science. Today our models are unrealistic; a decade from now, they’ll be a little so, in a decade from then little less. Eventually we’ll have realistic models that make accurate predictions.”
That, I think, is pure poppycock. Our predictions are not, and never will be, based on models; they’re based on informal reasoning. We study models because they own our reasoning skills. We can figure out what happens in these models and thereby develop a good intuitive feeling for what sorts of reasoning are likely to be productive.
In this we are no different from, say, physicists.
. . .
When economists can’t do is tell you what interest rates will be eighteen months from now. Neither can the physicists. You could, I suppose, point to that as a failure of modern physics. After all, interest rates are determined by physical processes in the brains of bond traders; isn’t that the stuff of physics? The answer, of course, is that physical (or economic) models are not designed to make precise predictions of complicated phenomena outside the laboratory. They are designed to hone the intuition.
Great stuff. I used to complain that physicists were horrible at predicting earthquakes, or the weather next month. Steven has the courage of his convictions, and finds even deeper flaws. :)
So I decided to sit down and try to make a list of my money/macro toolkit. Here’s what I came up with off the top of my head:
1. The hot potato effect (AKA Quantity Theory of Money.)
2. The interest elasticity of money demand
3. Value of money = 1/P (or 1/NGDP, or 1/forex prices)
4. Money neutrality
5. The liquidity effect
6. The income effect
7. The price level effect
8. The Fisher effect
9. Money superneutrality
10. The Natural Rate Hypothesis (Exp. augmented Phillips Curve.)
11. Sticky wages and prices.
12. Nominal debt contracts
13. Non-indexed capital income taxes
14. Money illusion
15. Purchasing power parity
16. Interest parity theorem
17. current account deficit = capital account surplus
18. Consumption smoothing
19. Okun’s law
20. Wage tax = consumption tax = universal 401(k)
21. Exchange-rate overshooting
22. Balassa-Samuelson effect
23. Optimum quantity of money
24. Efficient markets hypothesis
26. Asset purchases = asset sales
27. Ricardian equivalence
28. Crowding out
29. Monetary offset of fiscal policy
30. Policy impotence under fixed rates
31. Temporary versus permanent monetary injections
32. Downward-sloping labor demand schedule
33. Expectations hypothesis of the term structure
34. Liquidity premium hypothesis of the term structure
35. Laffer curve effect
36. Solow growth model
38. Tax equivalence: consumer and producer taxes
39. Tax equivalence: import and export taxes
40. Export subsidies neutralize import taxes
41. Zero bound on nominal interest rates
42. Wicksellian equilibrium interest rate
43. Identification problem
44. Lucas critique
45. Rational expectations
46. AS/AD model
47. Policy credibility
(I’m sure there are dozens I’ve forgotten)
Some of these tools are based on more basic tools. Thus Dornbusch’s overshooting model relies on the QTM, PPP, liquidity effect, price level effect, ratex, and IPT.
Some economists are really good at zeroing in the the proper tool to employ in a given situation. Paul Krugman is perhaps the best in the macro blogosphere. Among academics, Bennett McCallum is excellent. Keep in mind that this is just one skill among many. Thus about 90% of the time I would agree with John Cochrane on policy issues more than with Paul Krugman, and yet on methodological issues I’m far closer to Krugman. I tend to think the profession overrates the importance of things like micro foundations and general equilibrium, although for certain problems a GE model is appropriate.
Regarding Landsburg’s opening remarks about progress in economics, I can’t help thinking of Milton Friedman’s claim (made in the 1970s) that in the past 200 years macroeconomics had merely gone one derivative beyond Hume. Today I can proudly say we are ahead of Hume in three areas, monetary superneutrality (the extra derivative), rational expectations, and the EMH. The latter two also represent advances over Friedman. Unfortunately, on the liquidity trap the profession still lags behind John Locke. (Yes, Landsburg’s point was slightly different.)
Over at Econlog I repeat the Landsburg quotation, and apply it to a specific example.
Update: In this op ed, John Cochrane shows off one of his best skills, brutally skewering Keynesianism.