Macrocomplaining vs. macrosplaining

I don't blog much about macroeconomics methodology debates that much anymore, but every once in a while it's still fun to wade back in.

Mark Thoma wrote a column in the Fiscal Times in which he explained where he thought macroeconomics went wrong before the 2008 crisis. Some key excerpts:

There are good reasons to be critical of the rational expectations, dynamically optimizing, representative agent approach that underlies modern macroeconomic models. For example, the representative agent approach makes it difficult to study financial markets. At least two agents with different views about the future price of a financial asset are needed before we can even begin to model markets for financial assets, financial intermediation, and other key elements of the financial sector... 

[M]acroeconomists, for the most part, did not think questions about financial meltdowns were worth asking, so why bother with those theoretical complications? The financial collapse problem had been overcome, or so some macroeconomists thought. 

Nobel prize winning economist Robert Lucas, for example, in his 2003 presidential address to the American Economic Association famously claimed that the “central problem of depression-prevention has been solved.”

Josh Hendrickson, whose blog is called "The Everyday Economist" but whose Twitter handle is @RebelEconProf, decided not to be a rebel every day, and came to the defense of pre-crisis macro, Lucas, etc. Josh makes some good points and some unconvincing points.

Here is a really good point:

Suppose there is some exogenous shock to the economy. There are two possible scenarios. In Scenario 1, macroeconomists have models that describe how the shock will affect the economy and the proper policy response. In Scenario 2, macroeconomists have no such models. 

In Scenario 1, we avoid a severe recession. In Scenario 2, we could possibly have a severe recession...Given [macro critics'] logic, the only time that we would have a severe recession is when macroeconomists are ill-prepared to explain what is likely to happen and to provide a policy response.

In other words, our perceptions of the failures of macroeconomics are hugely influenced by selection bias. True! How many more crises would we have had without the models we have developed? Maybe none, or maybe some. How useless macro has or hasn't been depends on the crises we avoided, not just the ones we failed to avoid.

Here is a point that is somewhat less convincing:

Thoma argues that the reason that we lacked a proper policy response to severe recessions was because people like Robert Lucas thought we didn’t need to study such things. However, this is a very uncharitable view of what Lucas stated in his lecture (read it here)...when Lucas says that the depression-preventing policy problem has been solved, he actually provides examples of what he means by depression-prevention policies. According to Lucas preventing severe recessions occurs when policymakers stabilize the monetary aggregates and nominal spending. This is essentially the same depression-prevention policies advocated by Friedman and Schwartz. Given that view, he doesn’t think that trying to mitigate cyclical fluctuations will have as large of an effect on welfare as supply-side policies.

Lucas' speech, in other words, is a sort of old-monetarist variant of the Great Moderation hypothesis, which was very common among macroeconomists at the time. But the Great Moderation turned out to be illusionary, and that's Thoma's whole point. It may be unfair to single out Lucas for an idea that most macroeconomists shared at the time, but he is a very famous and influential guy, after all.

Josh then makes the odd point that since we didn't actually adopt the policy that Lucas claims we did adopt (stabilization of monetary aggregates), Lucas wasn't wrong. That's just too weird of a point, so I'll skip it.

Josh then makes another good point:

Thoma argues...that economists spent far too little time trying to explain the Great Moderation. This simply isn’t true. John Taylor, Richard Clarida, Mark Gertler, Jordi Gali, Ben Bernanke, and myself all argued that it was a change in monetary policy that caused the Great Moderation.

This is true. I think Mark probably misspoke; what he probably meant was not that economists didn't try to explain the Great Moderation, but that they didn't question the Moderation's stability as suspiciously as they might have.

Josh then makes another unconvincing point:

Similarly, his criticism that economists simply didn’t care enough about financial markets is unfounded. Townsend’s work on costly state verification and the follow-up work by Steve Williamson, Tim Fuerst, Charles Carlstrom, Ben Bernanke, Mark Gertler, Simon Gilchrist, and others represents a long line of research on the role of financial markets. Carlstrom and Fuerst and well as Bernanke, Gertler, and Gilchrist found that financial markets can serve as a propagation mechanism for other exogenous shocks. These frameworks were so important in the profession that if you pick up Carl Walsh’s textbook on monetary economics there is an entire chapter dedicated to this sort of thing. It is therefore hard to argue the profession didn’t take financial markets seriously.

This is the idea that "there exist papers on X" means "the profession took X seriously". But that doesn't seem right to me. After all, there is nothing limiting the topics on which macroeconomists write papers, and there is every incentive for them to write papers imagining any and every conceivable phenomenon. So there will, in general, be a macro paper on any topic. But it is impossible for the profession to simultaneously take every topic seriously, so we need a better criterion than the existence of papers.

In particular, the claim that macroeconomists thought enough about financial shocks and frictions before the crisis seems to conflict with the huge outpouring of work on financial shocks and frictions since the crisis. If macroeconomists were clued in to the dangers of financial stuff before the crisis, why all the new models?

Josh then misunderstands one of Thoma's criticisms:

The same thing can be said about representative agent models. Like Thoma, I share the opinion that progress means moving away from representative agents. However, the profession began this process long ago. While the basic real business cycle model and the New Keynesian model still have representative agents, there has been considerable attention paid to heterogeneous agent models.

But Thoma was talking about heterogeneous beliefs. The models Josh is talking about incorporate heterogeneous wealth, productivity, etc., but not heterogeneous beliefs. There are lots of heterogeneous-belief models in the finance literature (see here for some of them). But macro models mostly continue to adhere to the rational-expectations framework advocated by Lucas, or occasionally a representative-agent version of a learning model, neither of which incorporates heterogeneous beliefs. I say "mostly" because I haven't seen any recent macro models that include heterogeneous beliefs, but Rule 1 of macro is "There is a macro paper on any topic."

Anyway, Josh makes some good points, but he also goes pretty soft on the profession and its leading thinkers regarding the pre-crisis consensus, which really did downplay the importance of finance, and really did avoid thinking about heterogeneous beliefs.

Will lack of tax hikes crash the Japanese economy?

Adam Posen thinks that if Abe fails to follow through on his pledge to hike taxes, the Japanese stock market will crash:

Posen’s fear, outlined in an interview in his office last week, is that Abe reneges on a plan to raise Japan’s consumption tax to 10 percent, from the 8 percent level it was boosted to in April. If that happens, prepare for international investors to dump Japanese stocks and the yen, says the former U.K. central banker. 

“If Prime Minister Abe decides to postpone, let alone cancel, he runs a real risk of crashing the stock market,” said Posen... 

To Posen, delaying the tax measure would test the patience of international investors who have backed Abe’s efforts to both propel his economy from 15 years of deflation and restore fiscal order to a nation where government debt now tops 240 percent of gross domestic product.

This is interesting, because most people are saying the exact opposite. Most people are blaming the recent Japanese sales tax hike (from 5% to 8%) for the severe contraction of GDP in the second quarter.

I always thought that was a little weird. Why should a 3% tax hike crush Japanese GDP when a similar-sized tax hike in America a year earlier failed to put much of a dent in growth? Why is the Japanese economy so fragile to tax hikes? Neither Econ 101 theories of deadweight loss nor Econ 102 Keynesian theories have much insight, and the calibrated DSGE models I've seen don't predict an effect nearly so big.

OK, but now let's take Posen's totally opposite contention. Will delays in tax hikes really cause a collapse in investor confidence that crashes the Nikkei? It seems possible, certainly. After all, Japan can get rid of its debt in three ways - default, monetize, or consolidate. The more it starts to appear that consolidation is politically impossible, the more it starts to look like monetization is inevitable.

That could cause the marginal Nikkei investor (who is probably not Japanese) to bolt. But will monetization be bad for stocks? As interest rates go to zero, the present discounted value of stocks explodes. As long as inflation remains subdued, monetization is good for stocks, not bad.

So what Posen is saying is essentially that debt monetization will lead international investors to fear hyperinflation - which really does kill stocks. I'm very, very suspicious of this, because I think it's just a fact that no one really knows why or when hyperinflation happens. It's always possible that investors could get scared of hyperinflation and bolt.

But suppose Japan's debt were half of what it is. Wouldn't it still be the case that investors could get scared of monetization-induced hyperinflation and bolt at any moment? What level of debt and monetization is reassuring to investors, and what level is scary? Posen has no evidence to support his contention that Japan is near a tipping point. But does anyone have evidence? Can anyone?

Thursday Roundup, 9/18/2014

Do a Google Image search for "cowgirl", and you will learn something interesting about American culture. Anyway, here's Thursday Roundup:


Me on BV:

1. Lots of people use the word "Keynesian" as a synonym for "socialist" or "liberal". They should quit.

2. Sometimes you have to be a dick. But if you don't have to, don't.

3. What does "credit-fueled growth" even mean?

4. Government is an indispensable input into innovation.


From Around the Econ Blogosphere:

1. Matt Yglesias discusses Barack Obama's inscrutable, odd ideas about monetary policy. I keep telling people Obama is an Austrian, and no one listens.

2. If, like me, you are a really boring person, you can take a break from work by reading blog debates between New Keynesian mainstream people and Post-Keynesian heterodox people. Like this one. I mean, what else are you going to do with your free time? Tinder?

3. Matt Bruenig responds to my post about capitalist principles. He doesn't seem to quite get the idea of an ex ante reward or state-contingent assets, but overall, he's right - theories about what people "deserve" are utterly arbitrary. I'd like to see Bruenig debate Mankiw.

4. Ryan Avent, who always makes sure to write a post about anything I write a post about, on the exact same day, attempts to rebut Peter Thiel's techno-pessimism. I think Ryan is right.

5. People around the world are apparently much more pro-trade than we usually think.

6. Tim Taylor writes that we should have empathy for the poor, saying:

One could look across swathes of modern America and still write: "Whole sections of the working class who have been plundered of all they really need are being compensated, in part, by cheap luxuries which mitigate the surface of life." It is a failure of basic human empathy to blame the poor for behaviors that offer a way of mitigating the surface of difficult life circumstances.

What a commie. Go back to Cuba, you commie hippie. Greg Mankiw just flicked a gold doubloon into Tim Taylor's ear from the back of the class.

7. Christian Slater David Andolfatto interviews a scientician Mike Woodford about his views on Quantitative Easing.

8. Dean Baker has compressed his entire consciousness into a single blog post. There is no Great Stagnation.

9. In our age there seem to be very few truly original economic thinkers, going off the reservation the way that, say, Minsky did. But there is Michael Pettis.

10. Brad DeLong, Nick Rowe, and David Glasner ask: "What is a recession?"

11. I knew that eventually, someone would perceive a discrepancy between my endorsement of civility and my labeling of Austrian ideas as "brain worms", and would call me out on said discrepancy. I did not, however, expect that it would be Paul Krugman.

12. Speaking of Austrianism, it turns out that the Great Recession did not have a "cleansing" effect on the productivity of American businesses. It's almost as if...it's almost as if...things in the economy happen that are not the simple sum of optimal decisions by far-sighted actors operating in frictionless markets...but no, to quote Henry P., this question would carry us too far away...

13. T.P. Carney, whose name sounds more like a 19th Century circus promoter than any other I have encountered, makes a good point: Inflation allows employers to cut workers' real wages by stealth, simply by letting nominal wages stagnate. Actually, that's one of the reasons economists usually think that 2%, not 0, is the "right" target rate for inflation - in other words, economists like businesses to be able to cut real wages, so to them this is a feature, not a bug.

14. Mark Thoma launches a fusillade of shoulder-mounted heat-seeking missiles at Bob Lucas. Lucas, he says, by telling us to ignore recessions, stopped macroeconomists from thinking about the possibility of another Depression-like event in the years before 2008.

15. Matt Levine, the most entertaining finance journalist of whose existence I am aware, has a good run-down of the case against hedge funds as an asset class. See also Barry Ritholtz, who is the most entertaining-in-person finance journalist of whose existence I am aware.