Blog Post

The critique of modern macro

What’s at stake: This week’s conversation on the blogosphere focused on whether the modern macroeconomic tools developed in the stable macroeconomic environment of the Great Moderation actually failed us when we entered the Great Recession.

By: Date: April 20, 2015 European Macroeconomics & Governance Tags & Topics

What’s at stake: This week’s conversation on the blogosphere focused on whether the modern macroeconomic tools developed in the stable macroeconomic environment of the Great Moderation actually failed us when we entered the Great Recession.

The state of macro redux

Olivier Blanchard writes that the techniques we use affect our thinking in deep and not always conscious ways. This was very much the case in macroeconomics in the decades preceding the crisis. The techniques were best suited to a worldview in which economic fluctuations occurred but were regular, and essentially self-correcting. The problem is that we came to believe that this was indeed the way the world worked. These techniques however made sense only under a vision in which economic fluctuations were regular enough.

Olivier Blanchard writes that we thought of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. The notion that small shocks could have large adverse effects, or could result in long and persistent slumps, was not perceived as a major issue.

the modern models have at least two questionable features.

Wolfgang Munchau  writes that the modern models have at least two questionable features. The first is the assumption of a single macroeconomic equilibrium — the notion that the economy reverts to its previous position or path after a shock. The second is linearity — the idea of a straight-line relationship between events. But if you want to understand why the economy did well before 2007, why there was a break in 2008 and why the path of economic output never returned to its previous trajectory, one would require models that incorporate the notion of non-linearity, and even chaos.

David Andolfatto writes that the dynamic general equilibrium (DGE) approach is the dominant methodology in macro today 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. The DGE approach 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. It provides an explicit description of government policy. 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.

Non-linearity and multiplicity

Maybe the complaint is simply that economists don’t do enough nonlinear analysis

Paul Krugman writes that ranting about the need for new models is not helpful. First, claims that mainstream economists never think about, and/or lack the tools to consider, nonlinear stuff and multiple equilibria and all that are just wrong. Maybe the complaint is simply that economists don’t do enough nonlinear analysis. Bu the problem with nonlinear models is that it’s quite easy, if you’re moderately good at pushing symbols around, to write down models where nonlinearity leads to funny stuff. Showing that this bears any relationship to things that happen in the real world is, however, a lot harder, so nonlinear modeling all too easily turns into a game with no rules — tennis without a net.

Tony Yates writes that the 2000 Benhabib and Schmitt-Grohe’s paper on the ‘perils of Taylor rules’ is one example of a paper [but there are hundreds] that embraced both nonlinearity and multiplicity.  This is solved non-linearly, in the presence of the zero bound.  And it explains how there are 2 steady states.  One with inflation at target.  And one with nominal interest rates perpetually trapped at the zero bound.

Financial intermediation in macro models

Noah Smith writes that the favorite macro models didn’t have any finance in them, with the possible lone exception of the Bernanke-Gertler “financial accelerator” models. That was a big mistake, especially since the Great Depression and crises in other countries (e.g. Japan) should have suggested that financial crashes were a big deal. To their credit, though, mainstream macroeconomists have been hastening to correct the mistake.

Frances Coppola writes that central banks are now “adding” the financial sector to existing DSGE models: but this does not begin to address the essential non-linearity of a monetary economy whose heart is a financial system that is not occasionally but NORMALLY far from equilibrium.

David Andolfatto writes that while one might legitimately observe that New Keynesian DSGE models or RBC 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. A large and lively literature on financial crises existed well before 2007. 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.

Asking the right questions and discrimination against alternative models

Olivier Blanchard writes that we all knew that there were “dark corners”—situations in which the economy could badly malfunction. But we thought we were far away from those corners, and could for the most part ignore them. We now know that we were much closer to those dark corners than we thought—and the corners were even darker than we had thought too.

The major debates in macroeconomics had nothing to do with the possibility of bubbles causing a financial system meltdown

Mark Thoma writes that all the tools in the world are useless if we lack the imagination needed to build the right models. Models are built to answer specific questions. The problem wasn’t the tools that macroeconomists use, it was the questions that we asked. The major debates in macroeconomics had nothing to do with the possibility of bubbles causing a financial system meltdown. That’s not to say that there weren’t models here and there that touched upon these questions, but the main focus of macroeconomic research was elsewhere.

Noah Smith writes that if you have models for everything, you don’t actually have any models at all. Without a way of choosing between models, your near-infinite stable of models turns into one big giant mega-model that can give anyone any results he wants.  Now, technically, you could choose between models based on the plausibility of the assumptions. But three things make this impossible in practice. First, the need for tractability means that the assumptions in almost any modern macro model will be utterly implausible to anyone who has not spent decades in a monastery high in the Himalayas training himself in the art of self-deception. Second, the assumptions are so stylized that it takes a huge amount of talent just to figure out what they are. And third, with a near-infinite catalog of models to comb through, there’s just no way to compare any significant number of them all at once.

The US-Europe divergence in thinking after 2010

In Europe, by contrast, policy makers were ready and eager to throw textbook economics out the window

Paul Krugman writes that it’s wrong to claim, as many do, that policy failed because economic theory didn’t provide the guidance policy makers needed. In reality, theory provided excellent guidance, if only policy makers had been willing to listen. What stands out from around 2010 onward is the huge divergence in thinking that emerged between the United States and Europe. In America, the White House and the Federal Reserve mainly stayed faithful to standard Keynesian economics. In Europe, by contrast, policy makers were ready and eager to throw textbook economics out the window in favor of new approaches that were innovative, exciting and completely wrong.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Italian referendum

What’s at stake: on 4 December, Italy will hold a referendum on a proposed constitutional reform approved by Parliament in April. The reform, which was designed in tandem with a new electoral law, aims to overcome Italy’s “perfect bicameralism” by changing the structure and role of the Italian Senate. It also changes the distribution of competences between the state and regions. After the shocks of Brexit and the US election, polls are now drifting towards a defeat of the government’s position in Italy.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 28, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Trumpocalypse now: first reactions

What’s at stake: this question should probably be re-formulated as “what’s NOT at stake?” On Tuesday 8 November, the US elected Donald Trump as its next President. Several aspects of Trump’s political and economic agenda appear extreme (we have previously focused on his stance on trade). After the initial shock, we review economists’ opinions on what has happened and what may happen. We will be coming back to this topic regularly.

By: Silvia Merler Topic: Global Economics & Governance Date: November 21, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Brexit and the law

What’s at stake: last week, the UK High Court ruled that the triggering of Article 50 - and therefore the Brexit process - should involve the UK Parliament. The Government will appeal the decision but this has created a new wave of uncertainty about the timing of Brexit, and on what this involvement can mean in practice. We review the different opinions.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 14, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Monetary policy at the time of elections

What’s at stake: At this week’s meeting, the Federal Reserve left interest rates unchanged. While this was largely expected, the economic blogosphere has been discussing whether and to what extent this is linked to the election, and what can be expected for the future.

By: Silvia Merler Topic: Global Economics & Governance Date: November 7, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Should we rethink fiscal policy?

What’s at stake: there has been quite some discussion recently on whether we should rethink the framework of fiscal policy in order to make it more appropriate and effective in a world where demand seems to be chronically anemic, inflation is low and the interest rates are likely to stay close to zero (if not negative) for a long time. According to some of the authors, in the Eurozone these concerns are particularly pressing.

By: Silvia Merler Topic: Global Economics & Governance Date: October 24, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Brexit, the pound and the UK current account

What’s at stake: UK PM Theresa May announced the intention to trigger article 50 by March 2017, the Pound Sterling crashed, and a dispute among Tesco and Unilever has resulted in Marmite shortage. Brexit means Brexit, and it continues to be highly discussed. It would be impossible to summarise all the economic blogosphere on Brexit. Our aim is to periodically update our readers on selected important aspects of what promises to be a long-lived topic of discussion. This time we are looking at economists’ view on the Pound crash and the UK current account.

By: Silvia Merler Date: October 17, 2016
Read article More by this author

Blog Post

Silvia Merler

The Deutsche Bank Frenzy and what it says about European banks

What’s at stake: The IMF recently published its Fall Global Financial Stability Report, which points to a decrease in short-term risk but building of medium-term ones. At the same time, European market has been nervous last week on the news that Deutsche Bank (Germany’s biggest bank) has been demanded USD14bn by the US Department of Justice to settle allegations that the bank mis-sold mortgage-backed securities before the financial crisis. While reports point to a possible USD5.4bn settlement, this turmoil raises a question of whether the European financial system is still weak, eight years since the crisis. We try to summarize the reactions in the blogosphere.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 10, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Trumping Trade

What’s at stake: Trade is a central topic in the US presidential campaign, with both candidates expressing some degree of criticism about past trade policy. But while Hillary Clinton’s position could be described as a cautious scepticism, Donald Trump’s trade plans are more openly protectionist. His proposals include high tariffs on imports, renegotiating trade agreements and possibly US withdrawal from the WTO. After the first presidential debate, we review economists’ reactions and their assessment of Trumps trade policies.

By: Silvia Merler Topic: Global Economics & Governance Date: October 3, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Big in Japan

What’s at stake: This week saw two important Central Banks’ meetings, whose outcomes could hardly be more different. While the U.S. Federal Reserve left interest rates unchanged, the Bank of Japan introduced a big shift in its easing framework. BOJ committed itself to overshoot its inflation target of 2 percent, and introduced a targeting of the yield on ten-year Japanese government debt, initially at about zero percent. We review the economic blogosphere reaction to this latest monetary policy action.

By: Silvia Merler Topic: Global Economics & Governance Date: September 26, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The US infrastructure investment debate

What’s at stake: Infrastructure investment has been and will continue to be a prominent campaign theme in the run up to the US elections. Both Hillary Clinton and Donald Trump have promised significant public investment in infrastructure. For some time, the discussion has revolved around the opportunities and costs of increased government infrastructure spending.

By: Silvia Merler Topic: Global Economics & Governance Date: September 19, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Apple of Discord

What’s at stake: On August 30th, following the results of an in-depth state aid investigation started in 2014, the European Commission concluded that Ireland granted undue tax benefits of up to €13 billion to Apple. The decision is based on state aid grounds: the Commission argues that two tax rulings issued by Ireland effectively granted Apple preferential treatment, which amounted to state aid. The Commission ordered Ireland to recover up to €13 billion (plus interest) from Apple, but the decision is controversial and opinion differ as to the effects it will have. We summarize reactions.

By: Silvia Merler Topic: Innovation & Competition Policy Date: September 12, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Post-Jackson Hole low morale

What’s at stake: this year’s edition of the Jackson Hole symposium was awaited as an occasion to discuss how to redesign monetary policy for the future. We documented the state of academic and policymaking discussion on the topic in a previous review. But it seems the meeting has left many with the impression the Fed is not yet ready to start “rethinking normality”.

By: Silvia Merler Topic: Global Economics & Governance Date: September 5, 2016
Load more posts