Does modern macro rely too much on Ratex and EMH?
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.
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10. October 2010 at 19:23
Once I divined the meaning of “ratex,” I found this a trenchant and informative post.
No, Wikipedia has no “ratex,” and googling it does not turn up much.
Oh, “ratex” must mean “rational expectations.” That has to be one of the ugliest bastard words yet.
TBTF?
It will be interesting to watch the EP (economic profession) in the years ahead. I think there is a chance that GCG (global capital gluts) will bring many countries near the ZB (zero bound). Japan has been in zero bound for years, a situation known as RSZB (Rising Sun Zero Bound,) or a bit light-heartedly, as the “Japanese Zeroes.”
Thus, the EP will have to open up to new MP (monetary polic(ies), in light of chronic ZB.
Egads, I keep trying to tell you monetary bulls how to frame and argument to win friends and influence people…..and you keep talking about ratex.
10. October 2010 at 23:46
Benjamin Cole: well said. I know what FDIC is, but TBTF?
10. October 2010 at 23:49
to big to fail
11. October 2010 at 01:13
To be cynical, the people pushing the EMH the hardest are the RBC types, especially post-1980s when Chicago became less monetarist and more RBC. And they dislike the notion of monetary policy being effective at all – or any government policy being effective at all – so of course they reject futures targeting. Or any targeting!
Invoking the EMH for non-RBC ideas is like being the one guy in the room to quietly argue (to right-wingers) that the Coase theorem implies the harmlessness of all sorts of liberal rights reassignments, or to note (to left-wingers) that the in-optimality of monopoly goes away under sufficient price discrimination… which may be true and consistent and all that, but that isn’t why those schools keep yelling about those concepts to begin with.
For good or for ill, most economists on both sides of the fence start from politically-desired policy conclusions and work backwards, not from fundamental ideas like the EMH and working forwards. If the EMH then clashes with their desired policy conclusions, then so much the worse for the EMH. And that dismissal is probably what your proposal ran into.
11. October 2010 at 02:40
I don’t understand why inflation having run 5% over the past year means that models based on adaptive expectations are useless.
What are useless is market clearing models that have changes in inflation disrupting output and employment due to changes in quantity supplied.
Whether rational expectations makes such disruptions impossible, or policy irrelevant, _is_ irrelevant.
The problem isn’t that inflation changes and this disrupts output. The problem is that money expenditures change and inflation fails to change enough to avoid disruption of output.
If some prices change and others don’t (say wages,) then the problem isn’t that some prices changed or that everything would be fine if those prices didn’t change. The more fundamental problem is money expenditures changing, and the secondary problem is that some prices failed to change enough.
In other words. the “too little inflation” approach is wrong, wrong, wrong.
11. October 2010 at 04:15
Prof. Sumner, I agree with your post; people who had a true interest in Rational Expectations and EMH would have behaved as you say.
I’m just going to toss my own crazy theory into the mix… Could it be that economists formulate their ideas as a way to confirm what they already believe about the market?
Here’s something Robert Lucas said in 1993: “What troubles me about neo-Keynesians is not so much that they have a definite clear-cut ideology that I dislike, but that they have too little ideology. They’re too good at rationalizing anything…. These guys have enough talent to put a kind of semi-respectable economic rationale on whatever the hell the politicians come up with. I don’t see a neo-Keynesian agenda on policy issues.”
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3727
Say what you want about Lucas and others, I think what the above quote demonstrates is that there is a lot empty rationalization in economics. From Lucas’ side, there is an ideology driving his modelling (at least according to that quote). From the “neo-Keynesian” side, there is a handy ability to justify anything with a model.
For what it’s worth, I think the real shortcoming of economics for the last couple of decades has been a virtual absence of theory and an overabundance of models.
11. October 2010 at 04:54
I think it’s obvious in “complex” sciences, e.g., economics, climatology etc., that
– the descriptive is not easily constrained by Occam’s razor (when all theories are very complicated, with multiple equilibria, and allow for ad hoc rationalizations, you can’t tell which one is “simplest” and therefore probably true). As a result, the prescriptive (personal likes) determines the descriptive (scientific result you will believe).
– the descriptive is then routinely entangled with the prescriptive and most bystanders don’t notice it.
As a friend of mine succinctly put it, in those situations you win if you own the null hypothesis. So the gamble becomes to put your pet interpretation of the world as the consensus (norm) than has to be disproved. It can’t usually be easily disproved, hence you are at a draw with the descriptive and you win the prescriptive.
11. October 2010 at 04:54
And he has written the “n volume” history of the Federal Reserve!
http://online.wsj.com/article/SB10001424052748704696304575538532260290528.html?mod=WSJ_Opinion_LEFTTopOpinion
11. October 2010 at 05:19
Benjamin and Lorenzo, Sorry for all the abbreviations. TBTF is Too big to fail.
David, You said;
“And they dislike the notion of monetary policy being effective at all – or any government policy being effective at all – so of course they reject futures targeting. Or any targeting!”
I don’t agree. If they truly believe nominal shocks don’t matter, they usually favor inflation targeting. In that case a CPI futures approach would be a natural way to go. But most are more like Cochrane and Lucas–they do think nominal shocks matter. Lucas is a big fan of Milton Friedman’s explanation for the Great Depression.
You said;
“Coase theorem implies the harmlessness of all sorts of liberal rights reassignments”
This always frustrated Coase, as people often misunderstood his theory. He was not saying the assignment of rights doesn’t matter, he argued that what mattered were transactions costs.
I’m not as cynical as you seem to assume other economists are. I follow the logic of arguments. Monetary policy is primarily a technical issue, and left/right disputes have no bearing on which monetary policy is best. That’s why i often agree with left winger son the need for monetary stimulus. All Fed monetary policies involve a roughly equal amount of government involvement in the economy.
Bill, You asked;
“I don’t understand why inflation having run 5% over the past year means that models based on adaptive expectations are useless.”
Because if people have adaptive expectations then they forecast future inflation by looking at past inflation. So they should have forecast high inflation during late 2008, as inflation had recently been high. Only forward-looking models can explain the sharp fall in inflation expectations.
I agree with the rest of your comment, but don’t think it conflicts with anything I said. Any time I talk about the Fed boosting inflation, I implicitly mean via the transmission mechanism of higher NGDP growth. That’s a given.
Ryan, Those are interesting points, but the term ‘ideology’ is hard to define.
mbk, Good points. But how do you get in the position of owning the null?
Marcus, Yes, he’s been arguing money is too easy all along, and he’s been wrong.
11. October 2010 at 05:40
This very much deserves your comment:
http://economistsview.typepad.com/timduy/2010/10/the-final-end-of-bretton-woods-2.html
11. October 2010 at 07:49
Scott,
“But how do you get in the position of owning the null?”
Marketing, reframing, repetition, ad hominem… Chomsky’s manufactured consent might fall in here (did not bother to read him on this but it sounds like it). Basically own the floor space of people’s brains, what everybody takes for self evident. The null is the prevailing paradigm. When the paradigm develops too many inconsistencies it eventually topples over (see Kuhn).
You might have opened a window where soon you may be owning the monetary null hypothesis. But it’s not a given – right now there’s a battle for the new null since the consensus opinion has so clearly failed.
11. October 2010 at 08:14
The “ad hominem” and Chomsky’s mention should be taken as sarcasm of course.
11. October 2010 at 13:24
Yellen joins the “opposition”!!!
“Federal Reserve Vice Chairman Janet Yellen, one of the U.S. central bank’s key defenders of low interest rates to support a weak economy, warned on Monday there may be dangers to an overly easy monetary policy”.
http://blogs.wsj.com/economics/2010/10/11/feds-yellen-acknowledges-risks-to-low-rates/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+wsj%2Feconomics%2Ffeed+%28WSJ.com%3A+Real+Time+Economics+Blog%29
11. October 2010 at 15:31
Dude,
You know there are many meanings associated with Rational Expectations.
Most of the people that believe in RE believe in the Policy Ineffectiveness Proposition – these guys think that most monetary and fiscal policy can only hurt and never help. As a result, you’ll have guys like Tyler Cowen – who as far as I can tell, kinda thinks that policy could help, but refrains from talking about specifically he thinks would help.
So when you talk about people not believing in RE, I think you mean RE as you understand it, not how the guys that walk the halls of Chicago understand it.
You are very different than these guys.
11. October 2010 at 15:37
James Hamilton says that via rational expectations the effects of QE2 have already occurred.
If so, the Fed had better not back out now.
(I’d post a link but multiple attempts have been blocked already, for some reason. Visit Econbrowser dot com.
11. October 2010 at 16:41
‘So when you talk about people not believing in RE, I think you mean RE as you understand it, not how the guys that walk the halls of Chicago understand it.’
Scott’s a U of Chicago Phd himself.
11. October 2010 at 17:44
Woodford on QE2 and a price level target.
http://www.ft.com/cms/s/0/4d54e574-d57a-11df-8e86-00144feabdc0.html
Effective communication is the key – as he says.
11. October 2010 at 20:37
Marcos Nunes-
Yellen may be just trying to establish cred. As in lecturing about the perils of inflation, but doing some QE. Anyway, when was the last time a central banker said, “You know, growth is the key, if inflation rides a little high, so what?”
Worse was the antique arguments posited by Allen Meltzer in today’s paper WSJ.
I just don;t get it. The CPI is at 1.1 percent for the last 12 months (and Boskin says the CPI measures 1 percent too high), we have massive unemployment and weak demand, and there are central bankers out there pettifogging about inflation.
I guess zero inflation is not low enough. I guess 10 percent unemployment is just a number. I guess unused capacity is an side artifact of the glorious war on inflation. I guess weak sales are just one of those things,
You know how in “primitive” societies people worship totems and practice rituals even when such traditions become self-destructive?
Usually the rituals had value at one point, a way of making a tradition something that was necessary (as in not eating pork and shellfish, which could be poisonous). But as time goes by, the rituals lose value–now we have central bankers piously sermonizing about inflation.
Go tell the Japanese about the dangers of inflation.
12. October 2010 at 04:07
It’s very possible for the academic economics profession to be obsessed with ratex and EMH, while monetary policymakers including the Fed have an adaptive expectations view.
Some thoughtful comments from a Bank of England MPC member, about inflation and how markets perceive central banks, quoted at the end of this David Smith posting: http://www.economicsuk.com/blog/001251.html
12. October 2010 at 04:38
Marcus, What exactly is Bretton Woods 2?
mbk, In a sense I am promoting the monetary null circa 2006:
1. Fiscal stimulus is useless.
2. Low rates don’t mean easy money
3. Monetary policy still highly effective at zero rates.
4. It’s future expected path of policy that matters.
It’s other economists who seem to have forgotten this set of givens.
Marcus, Yes, and they are attributing the weak open on Wall Street this morning to her statement.
Mr. E, No, rational expectations mean consistent expectations. You are confusing ratex with RBC models, which is a completely different idea. Lucas certainly doesn’t believe money doesn’t matter, he thinks tight money caused the Great Depression!
Jim Glass, Yes, I left a short comment on that post. The market has incorporated the expected easing, which means they need to do much more than expected.
Patrick, Yes, and Lucas and Barro were my advisers.
JimP, Yes, I plan a post on that.
Benjamin, That was my initial reaction, but given the stock market response, I’d say she made a mistake.
Leigh, I think that is exactly the problem. Adaptive expectations is precisely what led the Fed astray in 2008. They were looking back toward the high inflation of the first half of the year, instead of forward as the TIPS were showing a dangerous fall in inflation expectations. We need our policymakers to become obsessed with ratex and the EMH.
12. October 2010 at 06:35
Scott
David Beckworth has commented:
http://macromarketmusings.blogspot.com/2010/10/bretton-woods-2-vs-qe-2-smackdown-of.html
BWII in fact became the “way-ouy” for asian countries after the asian crisis of 1997-98. Make a graph of the US current account and house prices. You will see that house prices strat rising strongly after mid 1997 at the same time that the current account deficit begins to increase sharply. That´s how excess asian house stocks were “exported” to the US. In Asia resources were directed from nontradables (housing, for ex.) to tradables. In the US there was the opposite move.
12. October 2010 at 06:38
PS In the graph you will also notice that house prices reversal began the moment the CA deficit retrenched in mid 2006.
13. October 2010 at 23:19
@Scott
‘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.’
I will go one step further than that. The existence of a central bank and central planned money means EMH does not fully apply in money.
13. October 2010 at 23:38
‘Most of the people that believe in RE believe in the Policy Ineffectiveness Proposition – these guys think that most monetary and fiscal policy can only hurt and never help.’
That makes no sense. Removing bad policy is itself policy. This explanation of Policy Ineffectiveness is incoherent.
A better wording is “government actions cannot fix any economic problems that government itself hasn’t created.”
@Bill Woosley
‘In other words. the “too little inflation” approach is wrong, wrong, wrong.’
I couldn’t agree more. Monetary inflation doesn’t necessarily directly mean price inflation right away, it first means more price inflation dispersion among goods. Its only when the quantity supplied for financial goods catches up with the monetary shock (and gets us back to the equilibrium relationships between MC price and marginal revenue), that we get the price inflation in the more commonly used price indexes.
15. October 2010 at 14:57
Marcus, I’m working on a post on that, but haven’t had much time recently.
Doc Merlin, I’d be horrified if most ratex believers also believe in policy ineffectiveness. Even Robert Lucas doesn’t believe in policy ineffectiveness. And there are far more new Keynesians than extreme RBC-types.