Thursday, September 17, 2009

Macroeconomist Says Macroeconomics Really Successful

Narayana Kocherlakota writes a concise defense of modern macroeconomics, and basically says 'it's all good'.

I'm not so sure. I got my PhD in econ because I wanted to be a macroeconomist, but after a year of introductory macro, and having one quarter with models from a Keynesian, another quarter with models from a supply-sider (eg, Kydland & Prescott), it was clear to me they were overfitting the data, and reconciliation was not in the cards. They simply did not have enough business cycles to distinguish between very different theories, and it was too easy to fix models after every new decade's surprise.

For example, the main data is post World War 2 US data, and there have been about 10 recessions. There are hundreds of time series (consumption, consumption per capita, non-durable consumption per capita) where one can derive a model that explains things. Given the failure of economists to forsee the stagflation of the 1970s, the disinflation of the 1980s, the fall in velocity in the 1980s, the growth of the Asian Tigers, the relative productive power of capitalist economies (most thought the Soviet Union's savings rate would necessarily generate higher productivity in a generation circa 1960), it is difficult to see what what else is needed to be discouraged. I've made several strategic errors in my career; leaving macroeconomics was not one of them.

But, if you're a 50 year old macroeconomist, the cognitive dissonance in admitting this is too great. Thus, Kocherlakota notes:
The work of the people on this list is pretty technical. Most are very gifted intuitive economists. But intuition necessarily plays a limited role in macroeconomics. There are just too many things going on in a macroeconomic model of any interest to rely on intuition alone. ... The good news is that, thanks in part to the people on this list [top macroeconomists mentioned earlier], we’ve made enormous progress in the kind of realistic complications that we can usefully model.
An example would really help, because I'm at a loss. It reminds me of John Campbell's Asset Pricing at the Millenium, where he noted:
the period 1979 to 1999 has also been a highly productive one. Precisely because the conditions for the existence of a stochastic discount factor are so general, they place almost no restrictions on financial data
Yup. Progress is generalization, a la String Theory, because explaining things with complicated yet elegant mathematics is progress, right?

The main issues in economics are explaining
  • what determines economic growth over long time horizons
  • what determines business cycles
  • what are the essential characteristics of an optimal fiscal policy
  • that are the essential characteristics of an optimal monetary policy
I think to the degree we know anything about these key questions, we have learned via experience. In a productive scientific area, like solid state physics, experts are much better than non-experts at knowing essential truths, but macroeconomists are as divergent on the big issues as anyone. That is, they cannot explain, let alone predict, recessions, just like journalists. Look at the divergent explanations for 2008: the Fed, too much regulation, too little regulation. Which is it? Who knows. They are still arguing about the causes of the Great Depression, and why we got out of it. I have my beliefs, but I realize I can't prove them true.

The most successful macroeconomic policy is perhaps the the Taylor Rule (see here, page 202), which basically was derived by explaining how the actually Fed Funds rate related to inflation and GDP growth in the decade prior to its proposal in 1992. There are lots of dense books on theory that should have been helpful here, and one can retrospectively look in the macro literature to derive this rule, but lets be honest, high-brow theory was pretty irrelevant in the discovery of this useful rule.

Macroeconomics is the triumph of hope over experience, and has been no more successful than sociology. I think it's great that some people are working on this, but let's not kid ourselves that there has been any progress. It is easy to think that merely because a lot of intelligent people have published peer reviewed articles, knowledge must be increasing. The bottom line is the data, and real time experience with macroeconomic models has been horrible as always. It is nice that some of the bad models of the past are now known to be wrong, but the set of wrong models is infinite, so that does not imply we are getting closer to the correct model merely by excluding more bad ones.

Around 1840, Macaulay wrote a grand history of England, and noted that doctors had historically recounted their field’s successes with an obvious lack of detachment:
The history of our country during the last hundred and sixty years is eminently the history of physical, moral, and intellectual improvement. And this is the way the history of medicine used to be written, principally by doctors in their retirement, as a form of ancestor-worship (no doubt in the hope that they, too, would become ancestors worthy of worship). In this version, the history of medicine was that of the smooth and triumphant ascent of knowledge and technique, to our current state of unprecedented enlightenment. . . . [but] it is clear that for centuries it possessed no knowledge or skill that could have helped its patients, rather the reverse.

This was before anesthesia and the theory of germs, a time when visiting a medical doctor was about as useful as visiting a witch doctor.

Macro was created by John Maynard Keynes, before then it was just 'economics'. The simultaneous creation of a model that applied to aggregate variables (eg, aggregate demand) and national income accounting, created what Keynes thought would be the new era of the 'joy of statistics'. It hasn't turned out that way.

Paul Samuelson’s first paper in 1939 was to apply mathematics to the new theory of macroeconomic dynamics, in this case a second-order difference equation. Hyman Minsky's most prominent refereed journal article was a second order difference equation applied to the macroeconomy because that was top line macroeconomics in the 1960s. No one thinks those models work now, they were doomed. Do we really think today's tools are any less futile?

The key indicator of scientific progress is not the opinion of a seasoned practitioner (with their clear bias), but rather, do large financial institutions, who would really benefit from being able to forecast the economy, have thriving economics departments, with the best macroeconomists moving in and out as Chief Economist of Citigroup, to Harvard, and back? No.

In the 1980s, I worked with economists who worked for the Bank of America in the mid-1970s, and they talked of a whole floor of economists, forecasting at various industry and regional growth rates, the things one expects macroeconmists to know. When I got back into banking after graduate school around 1994, the large regional bank I worked for had over 10,000 employees and 1 economist, whose main job was public relations, not advising internal decision making, and this was a typical use for an economist. A few years later, they got rid of him. Macroeconomists are demonstrably not helpful to those institutions that could use economic expertise. Macroeconomists know a lot of stuff, just not anything useful.


Anonymous said...

the macroeconomists who know 'anything useful' may be out of the public eye (e.g. i would guess brevan howard has a few, and i doubt they're doing pr there).

i thought the long-term drivers of growth were productivity and labor force growth?

tesla said...

I'm of the opinion that economics is not a true science because you can't do controlled experiments. You can't ever falsify economic theories no matter how crappy they are, which is why socialism refuses to die.

Economics is certainly a field worth studying but since you can never demonstrate cause and effect the best you can do is show correlations and trends. I think it should be an empirical science first and foremost with statistics as its main embodiment. For that matter I never understood why economists were so obsessed with formal mathematics- it all seems like so much mental masturbation.

Pete Murphy said...

My biggest concern with macroeconomics is that anything that tends to drive it higher is considered good. That's not the case with population growth. As population density rises beyond some optimum level, over-crowding begins to drive down per capita consumption, giving rise to higher unemployment and poverty. But, since any per capita consumption at all contributes to macroeconomic growth, further population growth is pursued as a cure for a flagging economy.

Here's an example: In Japan, a nation ten times as densely populated as the U.S., the per capita dwelling space is less than a third that of Americans, not because the Japanese like living in cramped quarters, but because there is no room for anything larger. Now consider the effect upon sales of products used in the manufacture and furnishing of their housing. Since their homes are one third the size of Americans', but there are ten times as many Japanese as there would have been if they had leveled off at our population density, sales of these products (for manufacture and furnishing of housing) is three times higher as a result of their population growth. So, in the end, such population growth has been great economic policy for Japanese businesses, but has been very bad policy for Japanese citizens, who now find themselves stuffed into cramped quarters as a result.

It gets worse. Per capita employment in these industries is also less than a third of per capita employment in these same industries in the U.S. The problem is that the per capita consumption of virtually everything, to a greater or lesser extent, is similarly affected by over-crowding. It is this effect of extreme population densities - a reduction in per capita consumption - that makes such economies utterly dependent on manufacturing for export in order to gainfully employ the excess labor force that results from low domestic per capita consumption.

Pete Murphy
Author, "Five Short Blasts"

Mike LeGower said...

@tesla - I think insofar as you're referring to Macroeconomics, you are probably correct. Attempting to use manageable mathematical models to analyze something as complex and interdependent as the U.S. economy is intellectually arrogant. The models used for growth and business cycle analysis, although complex to some degree, can not hope to capture the multitude of factors that impact the macroeconomy. They always have a feel of fitting the model to the data, which works great until the data changes.

However, mathematical models in game theory applications have their usefulness. They have even been co-opted by computer scientists and biologists. Also, there are economists out there who are attempting to conduct controlled experiments to analyze small questions particularly in game theory that, if answered, could be generalized to larger questions.

At any rate, the criticism of macro in the OP is something I think most younger economists have echoed for awhile now. There just doesn't seem to be any consistent predictive power in these models. They work for a while, while the paradigm that generated the data on which they are based is still in place, but when something fundamental shifts, the models fall apart. Maybe in another 100 years, we'll have seen enough of these sea changes to construct a model that can account for them, but after only 50 or so, we seem to be tilting at windmills.

Anonymous said...

Hi, Eric --

I'll assume that Mike's observation that

> There just doesn't seem to be any consistent predictive power in these models.

accurately summarizes your dismissal or macroeconomics, or to narrow it down even further, macro is useless because it can't tell us:

> what determines business cycles

But I think you're asking too much. The prediction business is tough or impossible, but maybe we'd have better luck cleaning up the mess after our predictions have gone wrong. Has macro nothing to tell us here?


Unknown said...

Your post expresses my own sentiments on macroeconomics. I was trained as a physicist, and if nothing else developed a healthy respect for the complex and often unexpected behavior of even the simples systems - systems where we actually have a reasonable model, can study it in great detail, can make testable predictions, and can run repeated experiments under different conditions.

A few years ago, I had an exchange with the economist blogger Mark Thoma expressing doubt that macro-economists had a good handle on their subject, given the complexity of the world economy and the numerous and mostly poorly understood non-linear interactions between the various parts, human psychology included. I pointed out that non-linear systems can exhibit radically different behaviors with just small changes in the parameters. He assured me that non-linearity was not important in economics ... which judging from the events of the last few years, appears laughable.

But you make your point well - if the experts cannot agree not only on what will happen, but even on the causes of what has happened, the subject is not useful.

Christian Gormsen said...

I can only think of one example where mathematics in macroeconomics has advanced our knowledge in one of the four areas that you put forward:
Oded Galor's theory of unified growth.
The model describes the transition from a Malthusian world, to an industrial society to a knowledge economy. Although I have not dug into the equations, it seems like a step forward to me.

Generally this critique (which is the harshest I have seen to date) is spot on. Is their any hope for change in the field? It appears that at least some economists agree that the course is wrong.

Anonymous said...

yes but ... the concerted action of western governments based on recommendations of macroeconomists appears to have averted depression. Am I missing something?

But What do I Know? said...

**Macroeconomists know a lot of stuff, just not anything useful**


I think your observation that we just don't have enough data to construct useful models is apt (if I'm interpreting you correctly.) It's similar to people pulling "lessons" from history--oftentimes things might have turned out very differently but for some lucky breaks and the actions of a few well-placed men and women. The same is true of our economics history. The paradigm of the business cycle is so compelling and "natural" that it clouds our thinking in much the same way as an Elliot Waver will rudely force his model on defenseless price data.

Anonymous said...

You might have just as well just described modern theoretical linguistics, a field I know way too much about at this point. Looking under your favorite lamppost is a common, perhaps preferred activity in academia - an argument against tenure if I ever heard one.

Anonymous said...

Two things: First, you equate success in macro with the ability to forecast ("The key indicator of scientific progress large financial institutions, who would really benefit from being able to forecast the economy, have thriving economics departments..."). Understanding (if only ex post) macroeconomic problems and constructing ways of preventing them do not imply any ability to forecast, but it's hard to believe that this would not constitute progress. Second, you are mischaracterizing Kocherlakota's short paper, and badly. He said, we have made progress in what complications WE CAN MODEL, not in matching the models to the real world. In fact, he explicitly states that most of the driving shocks in macro models are patently fantastic, and admits that at least one complication (large-scale, frequent reallocations of wealth) is almost completely unmodeled and perhaps crucial.

If you truly believe that no progress whatsoever has been made in modeling, then you haven't been paying attention. If you merely want a strawman, you should make up your own instead of trashing one of the few thoughtful (and truly critical, if still optimistic) pieces to come out of all this meta-macro debating.

Anonymous said...

Some people would look at "the Great Moderation" period from the 1980s to now as a period of relative success for macroeconomics. Numerous countries adopted inflation targeting and succeeded in keeping inflation low and stable, in part due to their ability to forecast output and inflation. To some extent, we have succeeded in preventing accelerating inflation by anchoring expectations.

The biggest problem macroeconomics has always faced is the financial side. (Consumer) price stability seems to work fine, it's the output stability and its relation to rapidly falling asset prices that is still causing the problems.

If you want to dump on macro, by all means you should, but you should equally dump on finance. Your point about the financial sector not hiring macroeconomists is a good one, but I also take it to imply that most of the math and theory behind finance is also wrong
since the lack of macroeconomists didn't really help Lehman, Bear Stearns, etc. Perhaps the biggest mistake of macro in the last few decades was to assume that the financial guys had the right models and that therefore policy could focus on consumer price inflation and ignore leverage, tail-risk, financial innovation, runaway asset price growth, etc.

Anonymous said...

"Perhaps the biggest mistake of macro in the last few decades was to assume that the financial guys had the right models"

The banks that went bust in the UK - B&B, HBOS, NRock, all went because of their leverage and exposure to the housing market, not because of their use of derivatives.

Unknown said...

Banks don't hire macroeconomists, but the massive quantities of quants we see in finance are economists. Financial economists just turn out to be far more practical and useful than macro economists.

Really, I given the limited utility of macro, you would think these people would make a rational decision to move to a different

Anonymous said...

It is a good thing you left macroeconomics behind. We're much better off than if your nonsense was allowed to pollute things. Leave it to people who know what they're doing.