Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, April 12, 2015

In defense of modern macro theory

The first economist
The 2008 financial crisis was a traumatic event. Like all social trauma, it invoked a variety of emotional responses, including the natural (if unbecoming) human desire to find someone or something to blame. Some of the blame has been directed at segments of the economic profession. It is the nature of some of these criticisms that I'd like to talk about today.

One of the first questions macroeconomists get asked is: How could you possibly not have predicted the crisis? We all remember when the Queen of England asked this (supposedly embarrassing) question. Put on the spot, I might have replied that the same question could have been asked of her ancestor(*) predecessor King Charles I, whose death in 1649 also came about under rather unexpected circumstances. Or, I might have replied that many economists did in fact predict this crisis...along with the many other crises that failed to materialize (recall the old joke about the economist who successfully predicted 10 out of the past 2 recessions).

But seriously, the delivery of precise time-dated forecasts of events is a mug's game. If this is your goal, then you probably can't beat theory-free statistical forecasting techniques. But this is not what economics is about. The goal, instead, is to develop theories that can be used to organize our thinking about various aspects of the way an economy functions. Most of these theories are "partial" in nature, designed to address a specific set of phenomena (there is no "grand unifying theory" so many theories coexist). These theories can also be used to make conditional forecasts: IF a set of circumstances hold, THEN a number of events are likely to follow. The models based on these theories can be used as laboratories to test and measure the effect, and desirability, of alternative hypothetical policy interventions (something not possible with purely statistical forecasting models).

There is a sense in which making predictions is very easy. Here's one for you: Mt. Vesuvius will experience another major eruption on the scale of AD 79, when it buried the city of Pompeii, tragically killing thousands of people (among them, the famous naturalist Pliny the Elder). While volcanologists are getting progressively better at predicting eruptions, it remains very difficult to forecast their size. So when an event like this arrives, it always comes as a bit of a shock. In any case, like I said, making predictions (unconditional forecasts) that will eventually come true is easy. There are thousands of people predicting that the world will end in 2015, 2016, 2016, etc. Some of these prognosticators will one day be proven correct. Those making predictions that fail to come true hide in the shadows for a while, but then re-emerge bolder than ever. I don't blame these soothsayers: there seems to be an insatiable demand for the likes of Nostradamus, and this is clearly a case of demand creating its own supply. In this spirit then, permit me to deliver my own forecast (remember, you heard it here first): there will be another major financial crisis on the scale experienced in 2008.

While we can't predict when the next major crisis will occur (I hope the Queen can forgive us), it is reasonable to expect experts to make good conditional forecasts. IF Vesuvius blows, THEN a lot of people are going to die. This type of conditional forecast should lead policymakers to think of ways in which the potential death toll can be avoided or reduced. Perhaps citizens should be prohibited from inhabiting dangerous areas. At the very least, an emergency evacuation procedure should be put in place. The same is true for financial crises. Perhaps restrictions should be placed on the exchange of some types of financial products. At the very least, an emergency response strategy should be put in place. Actually, there is an emergency response strategy--the Fed's emergency lending facility--which essentially worked according to plan in 2008-09. Now, maybe you don't like various aspects of the Fed's liquidity facility and that's fine (even if it did make a healthy profit for the U.S. taxpayer). But you can't say that economists hadn't predicted the possible need for such a facility. Indeed, the Fed was set up on the premise that financial crises would continue to afflict modern economies (by the way, financial crises were a common part of the economic landscape well before the founding of the Fed in 1913, so think carefully before you accuse the Fed as the source of market instability).

Alright, so much for blaming economists and their less-than-crystal balls (hmm, a part of me says I should have edited that last sentence.) What else? Well, I notice a lot of blame also being heaped on modern macroeconomic theory and the professors of such theory. "What's Wrong With Macro?" the headlines wail (roll eyes here). Things have become so bad that we now see students telling professors how macro should be taught. Next we'll have teenagers telling their parents how to raise children. Well, we already have that of course. But the point is that while parents patiently hear out these protestations (having been young for much longer than the youth in question), they do not generally capitulate to them. I'm sorry, but you're only 16, I love you, and no, you can't have the keys to the car!

And yet, amazingly, we have to read things like this (source):
Wendy Carlin, professor of economics at University College London, who is directing a project at the Institute for New Economics Thinking, a think-tank set up by billionaire financier George Soros, said at a conference last year that students had become “disenchanted” and lecturers “embarrassed” by the way economics is taught.
Lecturers at UCL are "embarrassed" by the way economics is taught? What does this mean? Are they embarrassed about the way they personally teach their economics classes? Then they should be fired for incompetence. Are they embarrassed by the current state of macroeconomic theory? Then they should be fired and sent back to grad school (or the Russian front, if you're a Hogan's Heroes fan).

The dynamic general equilibrium (DGE) approach is the dominant methodology in macro today. I think this is so because of its power to organize thinking in a logically consistent manner, its ability to generate reasonable conditional forecasts, as well as its great flexibility--a property that permits economists of all political persuasions to make use of the apparatus.

For the uninitiated, let me describe in words what the DGE approach entails. First, it provides an explicit description of what motivates and constrains individual actors. This property of the model reflects a belief that individuals are incentivized--in particular, they are likely to respond in more or less predictable ways to changes in the economic environment to protect or further their interests. Second, it provides an explicit description of government policy. While this latter property sounds straightforward, it is in fact a rather delicate and important exercise. To begin, in a dynamic model, a "policy" does not correspond to a given action at a point in time. Rather, it corresponds to a full specification of (possibly state-contingent) actions over time. Moreover, there is no logical way in which to separate (say) "monetary" policy from "fiscal" policy. The policies of different government agencies are inextricably linked through a consolidated government budget constraint (see A Dirty Little Secret).  Thus, any statement concerning (say) the conduct of monetary policy must explicitly (or implicitly) contain a statement stipulating a consistent fiscal policy. The exercise is delicate in the sense that model predictions can depend sensitively on the exact details of how policies are designed and how they interact with each other. The exercise is important because the aforementioned sensitivity is quite likely present in real-world policy environments. Finally, the DGE approach insists that the policies adopted by private and public sector actors are in some sense "consistent" with each other. Notions of consistency are imposed through the use of solution concepts, like competitive equilibrium, Nash equilibrium, search and bargaining equilibrium, etc. Among other things, consistency requires that economic outcomes respect resource feasibility and budget constraints.

Now, what part of the above manifesto do you not like? The idea that people respond to incentives? Fine, go ahead and toss that assumption away. What do you replace it with? People behave like robots? Fine, go ahead and build your theory. What else? Are you going to argue against having to describe the exact nature of government policy? Do you want to do away with consistency requirements, like the respect for resource feasibility. Sure, go ahead. Maybe your theory explains some things a lot better than mine when you dispense with resource constraints. But do you really want to hang your hat on that interpretation of the world? An internally inconsistent theory that happens to be consistent with some properties of the data is not what I would call deep understanding. (Nor is an internally consistent theory inconsistent with the data something to be happy about, but that's the purpose of continued research.)

The point I want to make here is not that the DGE approach is the only way to go. I am not saying this at all. In fact, I personally believe in the coexistence of many different methodologies. The science of economics is not settled, after all. The point I am trying to make is that the DGE approach is not insensible (despite the claims of many critics who, I think, are sometimes driven by non-scientific concerns).

I should make clear too that by "the DGE approach," I do not limit the phrase to New Keynesian DGSE models or RBC models. The approach is much more general. While one might legitimately observe that these latter sets of models largely downplay the role of financial frictions and that practioners should therefore not have relied so heavily on them, it would not be correct to say that DGE theory cannot account for financial crises. If you don't believe me, go read this (free) book by Franklin Allen and Douglas Gale: Understanding Financial Crises. While this book was published in 2007, it reflects a lifetime of work on the part of the authors. And if you take a look at the references, you'll discover a large and lively literature on financial crises well before 2007. In my view, this constitutes evidence that "mainstream" economists were thinking about episodes like 2008-09. If central bank economists were not paying too much attention to that branch of the literature, it is at most an indictment on them and not on the body of tools that were available to address the questions that needed to be answered. (In any case, as I mentioned above, I think the Fed did act according to the way theory generally suggests during the crisis).

Once again (lest I be misunderstood, which I'm afraid seems unavoidable these days) I am not claiming that DGE is the be-all and end-all of macroeconomic theory. There is still a lot we do not know and I think it would be a good thing to draw on the insights offered by alternative approaches. I do not, however, buy into the accusation that there "too much math" in modern theory. Math is just a language. Most people do not understand this language and so they have a natural distrust of arguments written in it. Different languages can be used and abused. But this goes as much, if not more, for the vernacular as it does for specialized languages. Complaining that there is "too much math" in a particular theoretical exposition is like complaining that there is too much Hiragana in a haiku poem. Before criticizing, either learn the language or appeal to reliable translations (in the case of haiku poetry, you would not want to rely solely on translations hostile to Japanese culture...would you?).

As for the teaching of macroeconomics, if the crisis has led more professors to pay more attention to financial market frictions, then this is a welcome development. I also fall in the camp that stresses the desirability of teaching more economic history and placing greater emphasis on matching theory with data. However, it's often very hard, if not impossible, to fit everything into a one-semester course. Invariably, a professor must pick and choose. But while a particular course is necessarily limited in what can be presented, the constraint binds less tightly for a program as a whole. Thus, one could reasonably expect a curriculum to be modified to include more history, history of thought, heterodox approaches, etc. But this is a far cry from calling for the abandonment of DGE theory. Do not blame the tools for how they were (or were not) used.

(*) My colleague Doug Allen points out that Elizabeth II did not descend from Charles I. The Stuart line dies out with Queen Anne, at which point George I is brought over from Germany. EII is a member of the house of Hanover/Windsor, and not a Stuart. Many also think that EII is a descendant of Elizabeth I, but of course she had no children, and ended the Tudor line.