Modern macroeconomics finally rears its head

Via Greg Mankiw, here’s a good article on the state of modern macroeconomic modeling by the frequently-interesting Kocherlakota. There is a lot of nuance and detail in here that is missing from the conversations one usually hears about modern macroeconomics. I think it would be worthwhile to go through some of the references at some point, too.

The switch to modern macro models led to a fierce controversy within the field in the 1980s. Users of the new models (called “freshwater” economists because their universities were located on lakes and rivers) brought a new methodology. But they also had a surprising substantive finding to offer. They argued that a large fraction of aggregate fluctuations could be understood as an efficient response to shocks that affected the entire economy. As such, most, if not all, government stabilization policy was inefficient….Scholars in the opposing (“saltwater”) camp argued that in a large economy like the United States, it is implausible for the fluctuations in the efficient level of aggregate output to be as large as the fluctuations in the observed level of output. They pointed especially to downturns like the Great Depression as being obvious counterexamples.

…With the advent of better computers, better theory, and better programming, it is possible to solve a much wider class of modern macro models. As a result, the freshwater-saltwater divide has disappeared. Both camps have won (and I guess lost). On the one hand, the freshwater camp won in terms of its modeling methodology. Substantively, too, there is a general recognition that some nontrivial fraction of aggregate fluctuations is actually efficient in nature. On the other hand, the saltwater camp has also won, because it is generally agreed that some forms of stabilization policy are useful. As I will show, though, these stabilization policies take a different form from that implied by the older models (from the 1960s and 1970s).

…However, the models with asset market frictions (combined with the right kind of measurement from microeconomic data) make clear why the above analysis [of frictionless financial markets] is incomplete. During downturns, the loss of income is not spread evenly across all households, because some people lose their jobs and others don’t. Because of financial market frictions, the insurance against these outcomes is far from perfect (despite the presence of government-provided unemployment insurance). As a result, the fall in GDP from June 2008 to June 2009 does not represent a 4 percent loss of income for everyone. Instead, the aggregate downturn confronts many people with a disturbing game of chance that offers them some probability of losing an enormous amount of income (as much as 50 percent or more). It is this extra risk that makes aggregate downturns so troubling to people, not the average loss.

This way of thinking about recessions changes one’s views about the appropriate policy responses. Good social insurance (like extended unemployment benefits) becomes essential. Using GDP growth rates as a way to measure recession or recovery seems strained. Instead, unemployment rates become a useful (albeit imperfect) way to measure the concentration of aggregate shocks.

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Macroeconomists, again

economics

Unsurprisingly, a lot of people are interested in rebutting Paul Krugman’s essay in the NYT magazine, which I discussed earlier. There are two rebuttals in particular which I think are of note: David Levine’s and Narayana Kocherlakota’s.

Kocherlakota’s is more intellectually interesting, or at least useful. He lists all the young tenured faculty at the top fifteen economics departments in the US, and then gives ten conclusions about them. They are:

1. Macroneconomists don’t ignore heterogeneity
2. Macroeconomists don’t ignore frictions
3. Macroeconomic modeling doesn’t ignore bounded rationality
4. Macroeconomic models do incorporate a role for government interventions
5. Macroeconomists use both calibration and econometrics
6. There is no freshwater/saltwater divide – now
7. These researchers have been much more interested in the consequences of shocks than their sources
8. The modeling of financial markets and banks in macroeconomic models is stark
9. Macroeconomics is mostly math and little talk
10. The macro-principles textbooks don’t represent our field well

I would say that most of these are not the impression one would get from the Krugman’s article. Indeed, I can’t believe this whole freshwater/saltwater divide thing is being brought up as so important. Chicago is where some of the most important behavioral research is being done – not a very “freshwater” thing to do.

Levine’s article, on the other hand, is illuminating for what I think is being gotten wrong about the whole argument. Yes, he was wrong or misleading about a lot of things that macroeconomics is doing wrong. But the important point of the article is the institutional biases against that kind of economics being brought into policy debates. Now I have no idea whether that is true or not: but I don’t see any articles arguing against that point. It’s great to say that you have much better models than Krugman suggests – but why aren’t they being used in policy discussions? (Answer: probably because they’re harder to talk about.) I think this goes to point number 7 above, too. I also think there’s a difference in how academic economists see themselves and how the rest of the world sees them – which Levine alludes to – in that academic economists are interested in how the economy functions while the public wants them to be predicting rare events (major recessions).

On a slightly different topic, Matt Yglesias has a strange post against micro foundations in macroeconomics, and I gather he gets the idea from here. He first brings up the ‘metaphysical issue about whether or not it’s the case that macroeconomic propositions are ultimately reducible to microeconomic phenomena’, which is valid but beside the point. Obviously it would be nice to know but I fail to see how one can conclude that without doing the research in the first place. Further, if one cannot predict macro phenomena from micro phenomena, it says one or the other theory is wrong. But that’s great information to know, so I don’t see why there would be hostility to studying it.

He then asks the ‘methodological question about whether it really makes sense to demand that macroeconomists produce microfoundations for their theories’ which is ill-informed. Not every macroeconomist produces microfoundations. Instead, those searching for a rigorous basis to macroeconomics try to do this while those content with modeling qualitative macro phenomena do that! And that’s what they do in plenty of other fields too, and it’s very successful. The rest of his post is fairly misinformed, too, so I won’t say anything more about it. To get a decent rebuttal, one should read this article by Dasgupta from 1996 from page 13 on (“critiques of modern economics”). [Note to self: interesting note about herd behavior in citation 36).

[Update: A list.]