Wednesday, February 12, 2014

Damned with faint praise

I posted yesterday on the new book by Kartik Athreya, Big ideas in Macroeconomics: a non-technical view. There's a blurb on the back by Herb Gintis, who I think is a very smart guy and worth listening to. I noticed he also has written a review on Amazon, which is titled: At Last! A Serious Presentation and Defense of Modern Macroeconomic Theory. That sounds really positive, doesn't it? I thought, wow, Gintis thinks the theory is in great shape? I'm shocked, and I have to think hard about what he says. The review starts out saying nice things about the book. But then look at the parts I've highlighted below:

It is easy to find excellent, accurate, accessible, and entertaining books that present the current theories and ideas in many fields, including law, physics, and biology. It is virtually impossible to find such books in economics. Sadly, when someone writes a book about economics, it almost always is an attempt to convince the reader that some politically motivated partial truth is the whole truth.

There are some books that present basic economic theory in an unbiased manner, and I review the ones I have found in an entry on my web site ( Click on You Must Read This! and look for "Books on Economics for Serious Beginners: Very Introductory Readings."

But for the sort of advanced macroeconomic that guided policy makers and central bankers leading up to the financial meltdown of 2008, there has been virtually no serious accessible exposition without a political bone to pick. I love this book because it treats the reader as intelligent and discerning, presents the theory ably and in great detail, but avoids the mathematical detail that makes the material quite impenetrable to all but the expert who spends the bulk of his time devoted to the subject.

The reader who even cursorily inspects this book might consider me a biased observer because I contributed a blurb to the book jacket and the author graciously thanks me for my support in the introductory pages. The fact is that I consider this an exemplary exposition of modern macroeconomics, and I think his defense of the theory is as good as one can find anywhere, the theory is in fact so weak that nothing can save it. People continue doing it not because it is good theory, but because it is the only game in town. I believe a complete revolution in macroeconomic theory is in the process of being born, although it will take some years to take over as the mainstream theory.

Change in macroeconomic theory can be extremely rapid. Keynesianism displaced classical macroeconomics in just a few years after the end of WWII, and the reigning "rational expectations" macro displaced Keynesianism in just a few breathtaking years. This is a credit to economics as a discipline--given new evidence and given new economic conditions, young Ph.D. economists are quite willing to throw over the past, and in the best graduate schools, hiring of new faculty is based on how productive they are as researchers, not whether or not they agree with the reigning orthodoxy.

Macroeconomics has always been deeply political. After WWII in Europe and the US, the growth in organized labor led to cost-push inflation (higher wages --> higher prices) and unemployment caused by wages above the market-clearing level. Keynesianism blamed the unemployment on the market system itself and suggested deficit spending as the way to restore full employment and accommodating higher prices by increasing the money supply. Of course, this is a stupid theory because it leads to chronic deficit spending and chronic inflation. With the decline in the power of organized labor (caused mainly by increased international competition eliminating domestic monopolies in internationally traded goods such as steel, mining, and automobiles), a resurgent right-wing macroeconomics, called rational expectations theory, displaced Keynesian macro by recognizing the fatal flaws in its reasoning, which contradicted economic rationality. Keynesianism remains today in an attenuated form that recognizes coordination failures and price inertia, but is mainly a liberal profession of faith.

The only virtue of rational expectations macro (RA macro), which Athreya explains so nicely in this book, is that it killed Keynesian macro. The theory itself is nothing but smoke and mirrors. It purports to be solidly based on widely-accepted microeconomic principles that accurately describe the market economy (the "rational" in rational expectations), but this is simply false. The market economy is in fact a complex dynamic system whose behavior can be simulated, much as the weather is simulated by supercomputers, but cannot be captured in a few recursive equations, as the RA macro supporters claim. Instead of a large number of economic actors, RA macro assumes there is one "representative agent," and instead of large numbers of firms and industries, RA macro assumes there is one "production function." The only source of volatility in such a world is technology shocks and the vagaries of "expectations" (which of course cannot be measured, because they don't really exist). All we end up with is smoke and mirrors, plus lots of abstruse equations.

Among the more bizarre modeling choices of RA macro is to assume that all markets clear instantaneously. This of course assumes away the coordination failures that really underlie macroeconomic fluctuations. Especially exotic is the assumption that there is always full employment! "Unemployed" workers are simply people who temporarily prefer not to work (they prefer "leisure," in the parlance of macro theory). In fact what happens in a recession is that millions of jobs disappear. The displaced workers prefer their old or equivalent jobs at their accustomed wages, but these are gone. Of course, many could find work at a lower wage, but that is not always the rational thing to do because the worker may get locked into the lower wage occupational level.

This absurd sort of macro modeling would be okay if the resulting models predicted well, but they do not. RA macro long ago gave up econometric testing their equations in favor of "calibrating" them, which means just get the best fit you can, however poor. An poor they are.

Of course, prediction is not everything. Engineers cannot predict when a car will go over a bump, but they can model the effects of such a shock on the car and proposed mechanisms (shock absorbers) that allow the system (the car) to survive the shock with minimal damage. The same is true, to a much more limited extent in macroeconomics, where "automatic stabilizers" can lessen the effects of shocks to the economy.

The real problem with RA macro (and similarly of Keynesian macro) is the theory cannot deal with finance at all, and financial markets lie at the heart of contemporary economic instability. The Walrasian micro model on which RA macro is built simply has no place for money or finance. Graduate students in economics do not even study finance---that is left to the business schools.

Of course, all of that is now changing. Economists around the world are revamping their theories and developing the empirical data on finance so that a more useful theory is likely to be forthcoming. It is a very exciting time for macroeconomics. Athreya's defense of the current theory is quite brilliant and I urge the reader to learn from him. However, we all know the story of the silk purse and the sow's ear.

In short, nice attempt on an impossible task: giving a coherent defense of modern rational expectations macroeconomics.


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