Noah Smith’s recent post on the state of macroeconomics has gotten a lot of attention. Paul Krugman criticizes Noah’s claim that the saltwater and freshwater schools of thought aren’t that far apart. I think Krugman’s right, and I also agree that the
freshwater saltwater school is basically correct on the key issue of demand shortfalls. But while Krugman might seem pessimistic about the state of macro, he’s a Pollyanna compared to me. I see the field of macro as being completely adrift.
Noah Smith asks some very good questions:
So if collegiality and similarity of technique are measures of a field’s health, then macro is doing quite well. But I feel like there’s a larger question: What has macro done for the human race in the last 40 years? How are we better off as a result of all this macro research effort?
(This is the more general version of the question asked by the Queen of England, when she asked why (macro)economists didn’t see the financial crisis coming. Sure, some people argue that “financial crises” are inherently unpredictable because of the EMH. But there’s no obvious reason why recessions shouldn’t be predictable in advance.)
Today, in 2012, do we know much more about the “shocks” that cause recessions than we knew in 1972? I’m not sure we do. The question of whether these shocks are mainly “real” or mainly “monetary” is not settled within the field (as Bob Lucas mentioned in a recent interview). Nor do we seem to know much about how the shocks actually work – usually, macroeconomists just assume the shocks follow a simple random process like an AR(1).
What this means is that the actual cause of recessions is basically still one huge mystery.
What about the question of how the economy responds to the shocks? Even if we don’t know much about the cause(s) of recessions, do we understand how recessions play out? I’m not sure we do. We have some empirical observations, of course – we know how much investment tends to vary with swings in GDP, etc. But in terms of impulse responses – i.e. the way the economy would move if all the noise were cleared out of the data – we have as many different guesses as we have macro theory papers. And macro theory papers are as numberless as the stars in the night sky.
What about the question of policy? Do we know how governments can damp out the swings in the business cycle? Here there seems to be very little agreement. Even if macro isn’t divided into warring camps shouting at each other, there is nevertheless a huge diversity of opinion on both the efficacy and the proper conduct of monetary policy, fiscal policy, and other recession-fighting measures. That there is no consensus means that the question is still unanswered. Useful technology has not been delivered. It doesn’t take an expert to realize that fact. (Update: Well, actually not quite. Constantine Alexandrakis comes up with a couple of important counterexamples; see below.)
So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them.
Actually mainstream macro does know what causes most recessions in big highly diversified economies—-aggregate demand shocks. And mainstream macro concluded years ago that it was the central bank’s job to steer AD. And mainstream macro has all sorts of ways of making monetary policy effective at the zero bound. Indeed all this stuff is taught to our undergraduates in mainstream textbooks like Mishkin’s money text.
The real problem with mainstream macroeconomists is that they are too influenced by “framing effects” and had a giant brain freeze in late 2008. Virtually the entire profession forgot that the central bank has the ability and responsibility to provide an adequate level of AD. Only a fringe group of Aspergy-types looked beyond the framing effects, saw the real problem, and saw what needed to be done. But the profession (freshwater and saltwater) failed us. The central banks do pretty much what a consensus of elite macroeconomists think they should be doing. The profession “owns” the Great Recession, or at least that portion of it caused by inadequate AD. The profession has had the tools all along, but doesn’t seem to know how or when to use them. Only 4 years later is it starting to wake up.
(As an aside, modern macro models – at least, the DSGE variety – are basically not regarded as useful by private industry, although time-series methods developed for macro, such as vector autoregressions, have seen wide application.)
Of course private industry doesn’t use DSGE models, they are useless. The macroeconomy is incredibly complex; I recall McCallum once listing 10 types of wage/price stickiness. Most models assume one type. And most models fail to incorporate AD/AS interaction, as when adverse demand shocks reduce AS by leading policy-makers to extend unemployment insurance from 26 weeks to 99 weeks. Most don’t know how to identify monetary policy shocks. The DSGE models are incredibly simplistic. I basically “retired” from mainstream macro several decades ago when I saw where things were going, and pursued my own research interests.
There are two possible uses for DSGE type models; identify the costs of macro instability, so that central banks can pick the optimal target, and identify the stance of monetary policy most likely to hit the policymaker’s target. But the DSGE models cannot do either. The optimal monetary policy stance is most efficiently resolved by targeting market forecasts of the goal variable. And given the complexity of the macroeconomy, any attempt to use DSGE models to identify the optimal monetary policy goal will depend entirely on what assumptions are built into the model.
All we really know is what Milton Friedman knew, with his partial equilibrium approach. Monetary policy drives nominal variables. And cyclical fluctuations caused by nominal shocks seem sub-optimal. Beyond that it’s all conjecture. The reason NGDPLT caught on recently is that in this recession (and many others I’d add) fluctuations in NGDP seemed to do better than inflation at identifying what most economists saw as suboptimal levels of demand.
Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren’t divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn’t giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe?
Not all fringe groups are created equal. Replace the establishment with the one fringe group that correctly anticipated where mainstream macro opinion would end up in December 2012 (i.e. NGDPLT, and “target the forecast”), and did so in late 2008 and early 2009. Replace Ben Bernanke with David Beckworth.
PS. My nightmare scenario is nicely described by a recently commenter named John Brown:
I am an 18 year old college student with a strong interest in economics. With regret, I have to say that, based on what I’ve seen, you are totally correct in your assessment of our generation.
When I talk to other people in my age group about economics, there seem to be two groups. One group sees easy money as the root of all economic problems. These are the Ron Paul supporters who talk about gold all the time. They read Mises on a regular basis and constantly use the world “fallacy” (usually accompanied with something about a broken window).
The other group reads Krugman on a daily basis. In their view, the ultimate problem with our economy is that the government isn’t running large enough deficits and that underregulation of the banking industry was the only major cause of the financial troubles in 2008. On top of this, this group scoffs at the thought that high marginal tax rates, overregulation, and even trade protectionism have any negative effect on long term GDP. According to them, the large tax/transfer systems and tightly regulated labor markets had nothing to do with the relative decline of GDP in Western Europe.
There are very few, if you will, centre-right or centre-left economists. I would consider myself centre to centre-right, all things considered. I am a staunch believer in free trade and free markets, but I also support NGDP targeting. Like you, Mr. Sumner, I am of the view that we should have the fed boost AD while we continue to partake in pro growth, neoliberal reforms in the rest of our economy.
Unfortunately, if nothing changes, I would predict we will have a generation of economic policy managed by goldbugs who want to abolish the fed (or peg it to gold) and hard left statists who think 90% tax rates are good and free trade is bad.
But perhaps I should be optimistic that there are people like Brown and Soltas and Wang coming along.