Without a QTM anchor, macro is nothing more than undergrad BS

If you’ve ever taught intro to macro, you know that undergrads like to use “self-fulfilling prophesy” arguments for things they don’t understand.  Thus I am somewhat dismayed to see Robert Shiller use the same basic argument to explain why the economy has started to recover.  And yet, despite the derisive title of this post, I am also a bit sympathetic to Shiller’s recent NYT piece:

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again “” in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession began in December 2007, according to the National Bureau of Economic Research, so it is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

.   .   .

President Roosevelt is widely remembered for saying, in 1933, that “the only thing we have to fear is fear itself.” But he was only repeating an oft-told message.

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article in The Antioch Review titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase, but by the 1930s the idea was already as commonplace as the breakfast toast made with modern electric toasters. (Interestingly, the same Robert Merton documented the tendency for important ideas to be falsely attributed to celebrities.)

Like Shiller, I think that shifts in expectations are the driving force in business cycles.  But what bothers me about the self-fulfilling prophesy approach is that it treats expectations as sort of a free-floating concept, not anchored to fundamental determinants of long-run AD growth.  And I think there is a reason for this.  In some of my early posts I talked about how deflation always leads to a sort of dark ages of macro.  The problem is that economists use the wrong indicators for the stance of monetary policy; focusing on interest rates and the monetary base.  Both of these indicators tend to behave “perversely” during deflation.  Interest rates fall to low levels, and the public and banks tend to hoard base money.  So it looks like monetary policy is easy.  Once monetary policy is viewed as irrelevant, macroeconomics loses the only variable capable of anchoring long run expected NGDP growth.  And without the anchor provided by the Quantity Theory of Money, it’s all just undergraduate BS.  (No disrespect to any undergrads reading this, I am directing the same complaint against an outstanding Yale economist.)

Shiller is hardly the only economist who has written off monetary policy once rates hit zero.  And I give him credit for intuiting that expectations may be a more important driver of AD than fiscal policy.  But in the end, if macro can’t rely on certain basic principles, such as the long run relation between monetary policy and expected NGDP growth, then we really don’t have anything even worth calling a “social science.”

In the Great Depression many economists reverted to the crude prejudices of the man on the street.  It’s happening again.



5 Responses to “Without a QTM anchor, macro is nothing more than undergrad BS”

  1. Gravatar of StatsGuy StatsGuy
    28. November 2009 at 09:16

    The ideas underlying Shiller’s comment are not too far from those underlying Nick Rowe’s argument on sociological equillibria.

  2. Gravatar of marcus nunes marcus nunes
    28. November 2009 at 09:52

    Expectations is certainly THE DRIVER of AD. More so in an age of enhanced central Bank credibility. I´m reminded of a piece that came out in Business Week (Greenspan´s Dilema,April 3rd 2000 pages 36-38) that argued that the high credibility enjoyed by the Fed could be harmful! According to the article: “investors have so much confidence that Greenspan could keep the economy growing robustly without inflation that they ignored Greenspan´s warnings that growth has to be reduced”. Last year everyone was confident that the Fed would keep inflation in check following the oil and commodity shocks and that do do so it would restrain AD. Naturally, AD contracted. The fact that there was a financial crisis going on only worsened the fall in AD.

  3. Gravatar of ssumner ssumner
    28. November 2009 at 12:53

    statsguy, I see why you say that, but I don’t completely agree. I think in Nick’s case the public accurately figured out that once rates hit zero, the Fed didn’t have a backup plan. But the lack of a back-up plan is a fundamental reality, not just a self-fulfilling prophesy. The similarity is that once the public believes that, it makes it harder for the Fed to use its traditional tools. So that part does seem a bit self-fulfilling. But there are some fundamentals in Nick’s model. Shiller doesn’t seem to have any.

    marcus, But I still say that level targeting (of prices or NGDP) would have stabilized expectations. And the central bank can always control the long run path of nominal aggregates

  4. Gravatar of Doc Merlin Doc Merlin
    29. November 2009 at 20:55

    ” I think in Nick’s case the public accurately figured out that once rates hit zero, the Fed didn’t have a backup plan.”
    Yes, they did, Scott. Their plan has been to buy assets above market prices. The Bank of Japan on the other hand has been talking about the idea of negative interest rates.

    Also, just as a side note, per capita NGDP would be a better target than NGDP.

  5. Gravatar of Scott Sumner Scott Sumner
    1. December 2009 at 06:41

    Doc Merlin. I meant they didn’t have an effective backup plan.

    I agree that per capita income would be better. I tend to gloss over that because population growth is a fairly steady 0.9% per year, so the the two targets have similar implications, and it’s easier to just say NGDP. But that’s a good point.

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