Sunday, May 01, 2011

Macroeconomists Lament Sterile Methods

Brad DeLong argues that macro needs an overhaul:

We need more Eichengreens, Shillers, Akerlofs, Reinharts, and Rogoffs – not to mention a Kindleberger, Minsky, or Bagehot...perhaps economics will remain a discipline that forgets most of what it once knew and allows itself to be continually distracted, confused, and in denial.

Now, Rogoff has created some conventional macro models, but presumably is mentioned here because of his recent economic history book 'This Time It's Different' with Carmen Reinhart. Shiller's on the list presumably because he doesn't believe in the caricature of efficient markets, though no one believes in that caricature so I'm not sure what the alternative is. Akerloff's theory also highlights limits of efficient markets because of asymmetric information, though it should be mentioned that without the efficient markets benchmark, his result would be ambiguous, highlighting the usefulness of the benchmark.

It's easy to criticize straw men, but even one who tries to make money must realize the value of assuming that markets efficient is useful because otherwise it would be too easy to generate alpha, and any thoughtful person should recognize this is difficult, or at least, rare.

As to Kindleberger, Minsky, Bagehot, and Eichengreen, they tell stories. While these are very interesting, they aren't concise stories, and the older ones were especially vague and inconsistent. What is the essence of Bagehot's worldview? If these are the key writers, macro would have to admit it's best viewed like the field of history as opposed to physics.

Noahpinion makes a common complaint of macroeconomics:

When we learned [Real Business Cycle theory], we were told that the measure of its success in explaining the data was - get this - that if you tweaked the parameters just right, you could get the theory to produce economic fluctuations of about the same size as the ones we see in real life... The editors of Econometrica, the American Economic Review, the Quarterly Journal of Economics, and the other top journals are the ones who publish paper after paper on these subjects, who accept "moment matching" as a standard of empirical verification, who approve of pages upon pages of math that tells "stories" instead of making quantitative predictions

It would be interesting if macro moved away from its emphasis on Dynamic Stochastic General Equilibrium modeling. This toolset takes a major intellectual investment which makes one loathe to dismiss it, just as few who have read the Bible really carefully would admit it is insignificant, but clearly macro hasn't proved useful in explaining the big problems such as why Haiti is poor or what causes business cycles. After a couple decades I think it's fair to say this has been a dead end.

Robert Merton once wrote about finance that

As recently as a generation ago, finance theory was still little more than a collection of anecdotes, rules of thumb, and manipulation of accounting data...The subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to scientific empirical examination was, of course, the work of many, but most observers would agree that Arrow, Debreu, Lintner, Markowitz, Miller, Modigliani, Samuelson, Sharpe and Tobin were the early pioneers in this transformation.'

And this is the way the history of any field is written, principally by esteemed academics as a form of ancestor-worship, no doubt in the hope that they, too, will become ancestors worthy of worship. In this version, the history of finance, or macro, is that of the smooth and triumphant ascent of knowledge and technique, to our current state of unprecedented enlightenment. Yet it is clear that the big issues of macro and finance, which are closely related, have generated little knowledge or skill that could have helped practitioners about expected returns and economic growth relative to that acquired by economic historians.

The essence of Macro was to leave the methodological individualism that is the essence of economics, and look instead at macro aggregates following laws of motion loosely motivated to look like supply and demand curves. One of the best decisions I ever made was to leave this field, because like being a learned Marxist or sociologist (same thing?), this may get you tenure, but you still don't understand anything.

It's important to know when a paradigm is not working, and clearly macro is just as unhelpful today as it was in the Great Depression in terms of focusing the debate, eliminating irrelevant distractions. The same arguments are being made for more or less government. I don't have the answers, but I do know that full-time macroeconomists are like active mutual fund managers: articulate, hard working, and basically worthless.

1 comment:

Kevin said...

I think the relatively recent surge in passive index funds and the focus on small/large/value/growth stocks in industry has largely been a direct result of research in finance. It seems like the investment industry markets products that are rooted in current finance research. As for macro, I guess most central banks use DSGE models, which is some sort of affirmation.