ROBERT LUCAS, one of the greatest macroeconomists of his generation,
and his followers are “making ancient and basic analytical errors all
over the place”. Harvard's Robert Barro, another towering figure in the
discipline, is “making truly boneheaded arguments”. The past 30 years of
macroeconomics training at American and British universities were a
“costly waste of time”.
To the uninitiated, economics has always been a dismal science. But
all these attacks come from within the guild: from Brad DeLong of the
University of California, Berkeley; Paul Krugman of Princeton and the
New York Times;
and Willem Buiter of the London School of Economics (LSE),
respectively. The macroeconomic crisis of the past two years is also
provoking a crisis of confidence in macroeconomics. In the last of his
Lionel Robbins lectures at the LSE on June 10th 2009, Mr Krugman feared that
most macroeconomics of the past 30 years was “spectacularly useless at
best, and positively harmful at worst”.
These internal critics argue that economists missed the origins of
the crisis; failed to appreciate its worst symptoms; and cannot now
agree about the cure. In other words, economists misread the economy on
the way up, misread it on the way down and now mistake the right way
out.
On the way up, macroeconomists were not wholly complacent. Many of
them thought the housing bubble would pop or the dollar would fall. But
they did not expect the financial system to break. Even after the
seizure in interbank markets in August 2007, macroeconomists misread the
danger. Most were quite sanguine about the prospect of Lehman Brothers
going bust in September 2008.
Nor can economists now agree on the best way to resolve the crisis.
They mostly overestimated the power of routine monetary policy (ie,
central-bank purchases of government bills) to restore prosperity. Some
now dismiss the power of fiscal policy (ie, government sales of its
securities) to do the same. Others advocate it with passionate
intensity.
Among the passionate are Mr DeLong and Mr Krugman. They turn for
inspiration to Depression-era texts, especially the writings of John
Maynard Keynes, and forgotten mavericks, such as Hyman Minsky. In the
humanities this would count as routine scholarship. But to many
high-tech economists it is a bit undignified. Real scientists, after
all, do not leaf through Newton's “Principia Mathematica” to solve
contemporary problems in physics.
They accuse economists like Mr DeLong and Mr Krugman of falling back
on antiquated Keynesian doctrines—as if nothing had been learned in the
past 70 years. Messrs DeLong and Krugman, in turn, accuse economists
like Mr Lucas of not falling back on Keynesian economics—as if
everything had been forgotten over the past 70 years. For Mr Krugman, we
are living through a “Dark Age of macroeconomics”, in which the wisdom
of the ancients has been lost.
What was this wisdom, and how was it forgotten? The history of
macroeconomics begins in intellectual struggle. Keynes wrote the
“General Theory of Employment, Interest and Money”, which was published
in 1936, in an “unnecessarily controversial tone”, according to some
readers. But it was a controversy the author had waged in his own mind.
He saw the book as a “struggle of escape from habitual modes of thought”
he had inherited from his classical predecessors.
That classical mode of thought held that full employment would
prevail, because supply created its own demand. In a classical economy,
whatever people earn is either spent or saved; and whatever is saved is
invested in capital projects. Nothing is hoarded, nothing lies idle.
Keynes appreciated the classical model's elegance and consistency,
virtues economists still crave. But that did not stop him demolishing
it. In his scheme, investment was governed by the animal spirits of
entrepreneurs, facing an imponderable future. The same uncertainty gave
savers a reason to hoard their wealth in liquid assets, like money,
rather than committing it to new capital projects. This
liquidity-preference, as Keynes called it, governed the price of
financial securities and hence the rate of interest. If animal spirits
flagged or liquidity-preference surged, the pace of investment would
falter, with no obvious market force to restore it. Demand would fall
short of supply, leaving willing workers on the shelf. It fell to
governments to revive demand, by cutting interest rates if possible or
by public works if necessary.
The Keynesian task of “demand management” outlived the Depression,
becoming a routine duty of governments. They were aided by economic
advisers, who built working models of the economy, quantifying the key
relationships. For almost three decades after the second world war these
advisers seemed to know what they were doing, guided by an apparent
trade-off between inflation and unemployment. But their credibility did
not survive the oil-price shocks of the 1970s. These condemned Western
economies to “stagflation”, a baffling combination of unemployment and
inflation, which the Keynesian consensus grasped poorly and failed to
prevent.
The Federal Reserve, led by Paul Volcker, eventually defeated
American inflation in the early 1980s, albeit at a grievous cost to
employment. But victory did not restore the intellectual peace.
Macroeconomists split into two camps, drawing opposite lessons from the
episode.
The purists, known as “freshwater” economists because of the lakeside
universities where they happened to congregate, blamed stagflation on
restless central bankers trying to do too much. They started from the
classical assumption that markets cleared, leaving no unsold goods or
unemployed workers. Efforts by policymakers to smooth the economy's
natural ups and downs did more harm than good.
America's coastal universities housed most of the other lot,
“saltwater” pragmatists. To them, the double-digit unemployment that
accompanied Mr Volcker's assault on inflation was proof enough that
markets could malfunction. Wages might fail to adjust, and prices might
stick. This grit in the economic machine justified some meddling by
policymakers.
Mr Volcker's recession bottomed out in 1982. Nothing like it was seen
again until last year. In the intervening quarter-century of
tranquillity, macroeconomics also recovered its composure. The opposing
schools of thought converged. The freshwater economists accepted a
saltier view of policymaking. Their opponents adopted a more freshwater
style of modelmaking. You might call the new synthesis brackish
macroeconomics.
Pinches of salt
Brackish macroeconomics flowed from universities into central banks.
It underlay the doctrine of inflation-targeting embraced in New Zealand,
Canada, Britain, Sweden and several emerging markets, such as Turkey.
Ben Bernanke, chairman of the Fed since 2006, is a renowned contributor
to brackish economics.
For about a decade before the crisis, macroeconomists once again
appeared to know what they were doing. Their thinking was embodied in a
new genre of working models of the economy, called “dynamic stochastic
general equilibrium” (DSGE) models. These helped guide deliberations at
several central banks.
Mr Buiter, who helped set interest rates at the Bank of England from
1997 to 2000, believes the latest academic theories had a profound
influence there. He now thinks this influence was baleful. On his blog,
Mr Buiter argues that a training in modern macroeconomics was a “severe
handicap” at the onset of the financial crisis, when the central bank
had to “switch gears” from preserving price stability to safeguarding
financial stability.
Modern macroeconomists worried about the prices of goods and
services, but neglected the prices of assets. This was partly because
they had too much faith in financial markets. If asset prices reflect
economic fundamentals, why not just model the fundamentals, ignoring the
shadow they cast on Wall Street?
It was also because they had too little interest in the inner
workings of the financial system. “Philosophically speaking,” writes
Perry Mehrling of Barnard College, Columbia University, economists are
“materialists” for whom “bags of wheat are more important than stacks of
bonds.” Finance is a veil, obscuring what really matters. As a poet
once said, “promises of payment/Are neither food nor raiment”.
In many macroeconomic models, therefore, insolvencies cannot occur.
Financial intermediaries, like banks, often don't exist. And whether
firms finance themselves with equity or debt is a matter of
indifference. The Bank of England's DSGE model, for example, does not
even try to incorporate financial middlemen, such as banks. “The model
is not, therefore, directly useful for issues where financial
intermediation is of first-order importance,” its designers admit. The
present crisis is, unfortunately, one of those issues.
The bank's modellers go on to say that they prefer to study finance
with specialised models designed for that purpose. One of the most
prominent was, in fact, pioneered by Mr Bernanke, with Mark Gertler of
New York University. Unfortunately, models that include such
financial-market complications “can be very difficult to handle,”
according to Markus Brunnermeier of Princeton, who has handled more of
these difficulties than most. Convenience, not conviction, often
dictates the choices economists make.
Convenience, however, is addictive. Economists can become seduced by
their models, fooling themselves that what the model leaves out does not
matter. It is, for example, often convenient to assume that markets are
“complete”—that a price exists today, for every good, at every date, in
every contingency. In this world, you can always borrow as much as you
want at the going rate, and you can always sell as much as you want at
the going rate.
Before the crisis, many banks and shadow banks made similar
assumptions. They believed they could always roll over their short-term
debts or sell their mortgage-backed securities, if the need arose. The
financial crisis made a mockery of both assumptions. Funds dried up, and
markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows
how both of these constraints fed on each other, producing a “liquidity
spiral”.
What followed was a furious dash for cash, as investment banks sold
whatever they could, commercial banks hoarded reserves and firms drew on
lines of credit. Keynes would have interpreted this as an extreme
outbreak of liquidity-preference, says Paul Davidson, whose biography of
the master has just been republished with a new afterword. But
contemporary economics had all but forgotten the term.
Fiscal fisticuffs
The mainstream macroeconomics embodied in DSGE models was a poor
guide to the origins of the financial crisis, and left its followers
unprepared for the symptoms. Does it offer any insight into the best
means of recovery?
In the first months of the crisis, macroeconomists reposed great
faith in the powers of the Fed and other central banks. In the summer of
2007, a few weeks after the August liquidity crisis began, Frederic
Mishkin, a distinguished academic economist and then a governor of the
Fed, gave a reassuring talk at the Federal Reserve Bank of Kansas City's
annual symposium in Jackson Hole, Wyoming. He presented the results of
simulations from the Fed's FRB/US model. Even if house prices fell by a
fifth in the next two years, the slump would knock only 0.25% off GDP,
according to his benchmark model, and add only a tenth of a percentage
point to the unemployment rate. The reason was that the Fed would
respond “aggressively”, by which he meant a cut in the federal funds
rate of just one percentage point. He concluded that the central bank
had the tools to contain the damage at a “manageable level”.
Since his presentation, the Fed has cut its key rate by five
percentage points to a mere 0-0.25%. Its conventional weapons have
proved insufficient to the task. This has shaken economists' faith in
monetary policy. Unfortunately, they are also horribly divided about
what comes next.
Mr Krugman and others advocate a bold fiscal expansion, borrowing
their logic from Keynes and his contemporary, Richard Kahn. Kahn pointed
out that a dollar spent on public works might generate more than a
dollar of output if the spending circulated repeatedly through the
economy, stimulating resources that might otherwise have lain idle.
Today's economists disagree over the size of this multiplier. Mr
Barro thinks the estimates of Barack Obama's Council of Economic
Advisors are absurdly large. Mr Lucas calls them “schlock economics”,
contrived to justify Mr Obama's projections for the budget deficit. But
economists are not exactly drowning in research on this question. Mr
Krugman calculates that of the 7,000 or so papers published by the
National Bureau of Economic Research between 1985 and 2000, only five
mentioned fiscal policy in their title or abstract.
Do these public spats damage macroeconomics? Greg Mankiw, of Harvard,
recalls the angry exchanges in the 1980s between Robert Solow and Mr
Lucas—both eminent economists who could not take each other seriously.
This vitriol, he writes, attracted attention, much like a bar-room
fist-fight. But he thinks it also dismayed younger scholars, who gave
these macroeconomic disputes a wide berth.
By this account, the period of intellectual peace that followed in
the 1990s should have been a golden age for macroeconomics. But the
brackish consensus also seems to leave students cold. According to David
Colander, who has twice surveyed the opinions of economists in the best
American PhD programmes, macroeconomics is often the least popular
class. “What did you learn in macro?” Mr Colander asked a group of
Chicago students. “Did you do the dynamic stochastic general equilibrium
model?” “We learned a lot of junk like that,” one replied.
It takes a model to beat a model
The benchmark macroeconomic model, though not junk, suffers from some
obvious flaws, such as the assumption of complete markets or
frictionless finance. Indeed, because these flaws are obvious,
economists are well aware of them. Critics like Mr Buiter are not
telling them anything new. Economists can and do depart from the
benchmark. That, indeed, is how they get published. Thus a growing
number of cutting-edge models incorporate one or two financial
frictions. And economists like Mr Brunnermeier are trying to fit their
small, “blackboard” models of the crisis into a larger macroeconomic
frame.
But the benchmark still matters. It formalises economists' gut
instincts about where the best analytical cuts lie. It is the starting
point to which the theorist returns after every ingenious excursion. Few
economists really believe all its assumptions, but few would rather
start anywhere else.
Unfortunately, it is these primitive models, rather than their
sophisticated descendants, that often exert the most influence over the
world of policy and practice. This is partly because these first
principles endure long enough to find their way from academia into
policymaking circles. As Keynes pointed out, the economists who most
influence practical men of action are the defunct ones whose scribblings
have had time to percolate from the seminar room to wider
conversations.
These basic models are also influential because of their simplicity.
Faced with the “blooming, buzzing confusion” of the real world,
policymakers often fall back on the highest-order principles and the
broadest presumptions. More specific, nuanced theories are often less
versatile. They shed light on whatever they were designed to explain,
but little beyond.
Would economists be better off starting from somewhere else? Some
think so. They draw inspiration from neglected prophets, like Minsky,
who recognised that the “real” economy was inseparable from the
financial. Such prophets were neglected not for what they said, but for
the way they said it. Today's economists tend to be open-minded about
content, but doctrinaire about form. They are more wedded to their
techniques than to their theories. They will believe something when they
can model it.
Mr Colander, therefore, thinks economics requires a revolution in
technique. Instead of solving models “by hand”, using economists' powers
of deduction, he proposes simulating economies on the computer. In this
line of research, the economist specifies simple rules of thumb by
which agents interact with each other, and then lets the computer go to
work, grinding out repeated simulations to reveal what kind of
unforeseen patterns might emerge. If he is right, then macroeconomists,
like zombie banks, must write off many of their past intellectual
investments before they can make progress again.
Mr Krugman, by contrast, thinks reform is more likely to come from
within. Keynes, he observes, was a “consummate insider”, who understood
the theory he was demolishing precisely because he was once convinced by
it. In the meantime, he says, macroeconomists should turn to patient
empirical spadework, documenting crises past and present, in the hope
that a fresh theory might later make sense of it all.
Macroeconomics began with Keynes, but the word did not appear in the
journals until 1945, in an article by Jacob Marschak. He reviewed the
profession's growing understanding of the business cycle, making an
analogy with other sciences. Seismology, for example, makes progress
through better instruments, improved theories or more frequent
earthquakes. In the case of economics, Marschak concluded, “the
earthquakes did most of the job.”
Economists were deprived of earthquakes for a quarter of a century.
The Great Moderation, as this period was called, was not conducive to
great macroeconomics. Thanks to the seismic events of the past two
years, the prestige of macroeconomists is low, but the potential of
their subject is much greater. The furious rows that divide them are a
blow to their credibility, but may prove to be a spur to creativity.
