This post was motivated by the following comment in a recent Paul Krugman post:
By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote. So you could do exchange rate models that actually had realistic assumptions about prices and employment, but put the focus on rational expectations in the currency market, so that people really didn’t notice. Or you could model optimal investment choices, with the underlying framework fairly Keynesian, but hidden in the background. And so on.
I can’t quite tell whether Krugman thinks “rational expectations and intertemporal stuff” are counterproductive, so the following isn’t really aimed at Krugman, but rather the many economists who I am quite certain do regret the influence of ratex and the efficient markets hypothesis.
The most important macro event of my lifetime was the precipitous drop in inflation and NGDP growth expectations during the late summer and early fall of 2008. Because inflation had been running around 5% over the previous year, antique macro models based on adaptive expectations were completely useless during this period. Indeed, I’m guessing that one of the reasons why the Fed was behind the curve in the fall of 2008 was precisely because their models were far too backward-looking. During the financial crisis Fed policy got effectively tighter and tighter, and as a result there was a whole lotta “rational expectations and intertemporal stuff” going on.
Here’s what I find so ironic. Everyone talks about how the profession became obsessed with ratex and the EMH after 1980, but from my perspective most economists still seem stuck in the adaptive expectations era. If you really believed in ratex and the EMH, wouldn’t you be really, really interested in market forecasts of the policy goal variable? I would be. Yet instead of trying to infer market forecasts, they built elaborate structural models to try to forecast the goal variables. In the 1980s when I tried to peddle my futures targeting approach, no one seemed interested. I presented papers at the AEA meetings, the NY Fed, the Philly Fed, and everyone just yawned. So from my perspective we face exactly the opposite problem; the profession doesn’t take ratex and the EMH seriously enough. If the Fed really believed in ratex and efficient markets, they would have put the pedal to the metal in the infamous September 16, 2008 meeting. Instead they yawned, and left rates unchanged at 2%.
PS. Perhaps me and the other futures targeting proponents were just ahead of our time. One famous macroeconomist endorsed futures targeting just recently. A sign of things to come?
PPS. Yes, the Fed did use the EMH as an excuse not to intervene in the housing bubble. But that’s exactly where it was not appropriate. The existence of FDIC and TBTF means the EMH provides no justification for not regulating bank risk-taking.