Friday, April 11, 2014

Macroeconomists make a great advance -- or maybe not

By way of Unlearning Economics, who has made the effort of plowing through the details of the paper, read below and see if you've ever had a similar experience while reading some new and allegedly exciting "advance" in macroeconomic theory:
How Not to Do Macroeconomics

A frustrating recurrence for critics of ‘mainstream’ economics is the assertion that they are criticising the economics of bygone days: that those phenomena which they assert economists do not consider are, in fact, at the forefront of economics research, and that the critics’ ignorance demonstrates that they are out of touch with modern economics – and therefore not fit to criticise it at all.

Nowhere is this more apparent than with macroeconomics. Macroeconomists are commonly accused of failing to incorporate dynamics in the financial sector such as debt, bubbles and even banks themselves, but while this was true pre-crisis, many contemporary macroeconomic models do attempt to include such things. Indeed, reputed economist Thomas Sargent charged that such criticisms “reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished.” So what has it accomplished? One attempt to model the ongoing crisis using modern macro is this recent paper by Gauti Eggertsson & Neil Mehrotra, which tries to understand secular stagnation within a typical ‘overlapping generations’ framework. It’s quite a simple model, deliberately so, but it helps to illustrate the troubles faced by contemporary macroeconomics.

The model

The model has only 3 types of agents: young, middle-aged and old. The young borrow from the middle, who receive an income, some of which they save for old age. Predictably, the model employs all the standard techniques that heterodox economists love to hate, such as utility maximisation and perfect foresight. However, the interesting mechanics here are not in these; instead, what concerns me is the way ‘secular stagnation’ itself is introduced. In the model, the limit to how much young agents are allowed to borrow is exogenously imposed, and deleveraging/a financial crisis begins when this amount falls for unspecified reasons. In other words, in order to analyse deleveraging, Eggertson & Mehrotra simply assume that it happens, without asking why. As David Beckworth noted on twitter, this is simply assuming what you want to prove. (They go on to show similar effects can occur due to a fall in population growth or an increase in inequality, but again, these changes are modelled as exogenous).

It gets worse. Recall that the idea of secular stagnation is, at heart, a story about how over the last few decades we have not been able to create enough demand with ‘real’ investment, and have subsequently relied on speculative bubbles to push demand to an acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one financial instrument: a risk-less bond that agents use to transfer wealth between generations. What’s more, as the authors state, “no aggregate savings is possible (i.e. there is no capital)”. Yes, you read that right. How on earth can our model understand why there is not enough ‘traditional’ investment (i.e. capital formation), and why we need bubbles to fill that gap, if we can have neither investment nor bubbles?

Naturally, none of these shortcomings stop Eggertson & Mehrotra from proceeding, and ending the paper in economists’ favourite way…policy prescriptions! Yes, despite the fact that this model is not only unrealistic but quite clearly unfit for purpose on its own terms, and despite the fact that it has yielded no falsifiable predictions (?), the authors go on give policy advice about redistribution, monetary and fiscal policy. Considering this paper is incomprehensible to most of the public, one is forced to wonder to whom this policy advice is accountable. Note that I am not implying policymakers are puppets on the strings of macroeconomists, but things like this definitely contribute to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.

8 comments:

  1. thanks for sharing this, nice information have a nice day youcandoit

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  2. Any rates increase should be determined by social level rise. And it doesn’t matter if it would be average prices, loans for emergency costs, or stock quotes. Society’s wealth is the main reason of economic and political functioning.

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  3. Fine piece of writing. This quote is one I need to take with me, something to recite to others over and over again:

    "What’s important is how money and resources move around: where they come from, and how they are split – on aggregate – between investment, consumption, financial speculation and so forth. This type of methodology can help understand how the financial sector might create bubbles; or why deficits grow and shrink; or how government expenditure impacts investment."

    The most resilient things we build as humans are not our physical structures, but our social structures. Those structures start as habit, they become ritual and, oh so gradually that it rarely touches on human perception, they take on the trappings of full blown religious dogma complete with a rich set of rituals.

    Macroeconomic theory is just such a social structure. It long ago attained religious status. It comes complete with an academic priesthood and, as detailed in the article's critique of the tautological assumptions that find their way into so much of that priesthood's arguments, a rich set of ritualistic incantations.

    Digital technology and the sort of agent modelling it allows will, of course, sweep much of this away. Resistance will be futile. It will be good fun, however, watching those who've tried to ignore that incoming wave try to ride it as it blows past them.

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  5. As I suppose macro economist do have great advance now and will be in near future also for Commodity Tips, although I haven't seen the model yet.

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