We all have our own pet peeves with the way macroeconomic theorizing has progressed over the last few decades. My own is with the the so-called "New-Keynesian" paradigm (Woodford); which is clearly the "mainstream" view adopted by most policymakers (until recently, that is).
My beef with the NK paradigm is this in a nutshell. It is a model that ignores money and typically, financial markets too. It embeds unexplained "frictions," like sticky prices. It embeds conceptually vacuous "shocks" like "mark-up shocks" or "inflation shocks." It focusses on the policy problem of "stabilizing" the economy in the face of these little itty-bitty shocks. It is not a model designed to understand financial crisis. It is a model designed to legitimize what central bankers always believed they should be doing in the first place: adjust the short-term interest rate to stablize the economy around a predetermined long-run trend. This is why the NK model is the dominant paradigm; and this is why those that promote this view land all the cushy consulting jobs. Among those that promote this view include our very own Herr Buiter. Here are some links to the courses he teaches on the subjects: see here. Good job, Willem. One can easily see how your students (and yourself) were well-prepared to deal with the current financial market crisis with your "very useful ad hoc models" of the economy.
Of course, most economists who have worked to develop the NK paradigm are honest researchers with a sincere desire to understand how the economy works and how policy might be designed to meet worthy social objectives. Evidently, Herr Buiter has a different view:
Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.I presume that he is talking about himself here; he should not attribute his own objectives to others in this manner.
Let's see what else he has to say...
The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’.
This is clearly evidence that he has no idea of what he is talking about. The complete markets paradigm is the Arrow-Debreu model; and this is patently not what "New Classical" and "New Keynesian" theories assume.
In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.
No, Mr. Buiter, the irony of modeling liquidity by imposing money as a constraint was not lost on the profession (see the work of Neil Wallace and Randall Wright, for example); it was lost on a subset of the profession of which you belonged.
It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’, that is, autarky or no trade, is a much better one than that of ‘complete markets’.Oh thank you Professor Buiter; thank you for this. Let us begin by modeling exchange by assuming an economy populated by a single Robinson Crusoe. Yes, this should help. And let us model the exchange process as "involuntary" exchange instead of voluntary exchange. Perhaps we will get somewhere this time indeed. Good luck. I'm sure that you will lead the way.
The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.
Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction.And so where is Herr Buiter's theory that would replace the EMH? I am very much looking forward to my de-programming from such an enlightened and worldly individual.
The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc.
Clearly, he does not understand the EMH. We probably do have some things to learn from behavioral approaches; but I would not want this ignoramus to lead the charge.
I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.
I too hope that central banks are now led to place less weight on the "conventional wisdom" expoused by Buiter and others. It is indeed a good thing to be humbled by the realization of the limits of our theorizing. But to expouse a program of ignorance "without firm theoretical foundations" is going too far. Too far that is, unless you are Willem Buiter, economicus-ignoramus ready for hire.