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Unlearning economic paradigms

What’s at stake: Both the crisis, its aftermath, and the empirical econ revolution have changed our understanding of economics. Conventional wisdoms about the supply side of the economy, the length of the short run, or the international adjustment process are all being challenged. Even conventional microeconomic wisdoms about the role of minimum wages and welfare programs are being challenged by new data raising questions about how economics should be taught and used to guide policymaking.

By: Date: November 30, 2015 European Macroeconomics & Governance Tags & Topics

Unlearning macroeconomics

Adam Posen writes that a lot of economists have spoken about the need to fundamentally rethink major parts of macroeconomics following the global financial crisis.

Paul Krugman writes that what hasn’t worked nearly as well is our understanding of aggregate supply. One big problem has been the absence of deflation. The “accelerationist” Phillips curve that used to be standard — inflation depends on unemployment and lagged inflation — seemed consistent with the experience from previous big slumps, which were associated with large declines in the rate of inflation. Specifically, we used to cite the “clockwise spirals” one saw in unemployment-inflation space as evidence for something like the Friedman-Phelps theory of the natural rate. The other big problem is the dramatic drop in estimates of potential output, which is clearly correlated with the depth of cyclical slumps.

Robert Waldmann writes that that the reason Krugman was surprised by the failure of the supply side is that he didn’t pay enough attention to the European unemployment problem. The natural unemployment rate hypothesis failed spectacularly in Europe in the 1980s. Extremely high unemployment did not lead to deflation — rather it coexisted with moderate inflation for a long time, then with low inflation. By 2008, the flat Phillips curve was already very clear to anyone who read Italian newspapers.

Brad DeLong writes that Hicksian-inclined economists misunderstood the length of the short run. It was supposed to be a small multiple of typical contract duration in the economy – perhaps six years in an economy characterized by three-year labor contracts, and perhaps three years in an economy in which workers and employers made decisions on an annual cycle. After that time, nominal prices and wages were supposed to have adjusted enough to nominal aggregates that the economy either would be at or would be well on the road to its long-run full-employment configuration.

Lawrence Summers writes that it is pretty hard indeed to escape the conclusion that – contrary to the implication of simple textbook macroeconomic models – when a recession happens in 2020, a sensible person’s view is the GDP in 2028 will be significantly lower than it would have been without that recession.

In a recent speech at the Clausen center, Benoit Coeure writes that recent theoretical and empirical research has started deconstructing three important assumptions about our understanding of the international macroeconomic adjustment process: that the reallocation of aggregate demand across economies would sustain an appropriate pace of global growth; that freely floating exchange rates would support such demand and act as shock absorbers; and that cross border capital flows make international adjustment smoother and improve the global allocation of capital.

Unlearning microeconomics

Noah Smith writes that again and again, standard ideas – the stuff that most of the undergrad kiddos learn in their Econ 101 classes – are being smacked down by the heavy hand of new data. A ton of standard, common theories are just not matching reality very well. For example:

  1. If you slap some quick supply-and-demand graphs on the board, it looks like minimum wages should harm employment in the short term. But the data shows that they probably don’t.
  2. If there’s any sort of limits to mobility, then simple labor demand theory says that a big influx of immigrants should depress the wages of native-born workers of comparable skill. But the data shows that in many cases, especially in the U.S., the effect is very small.
  3. A simple theory of labor-leisure choice predicts that welfare should make recipients work less. But a raft of new studies shows that in countries around the world, welfare programs barely reduce observable work effort.
  4. Most standard econ theory doesn’t assume the existence of social norms. But experiments consistently show that social norms (or morals, broadly conceived) matter to people.

Noah Smith writes that we shouldn’t train tomorrow’s business elite to have faith in theories that have only a small amount of empirical success. The simple theories we teach in Econ 101 classes (for example on the impact of minimum wage hikes and welfare policies) work once in a while, but in many important cases they fail. This is what we have learned from the empirical revolution in economics. We now have an academic economics profession focused on examining evidence and an Econ 101 curriculum that focuses on telling pleasant but often useless fables. This has big political implications. If economics majors leave their classes thinking that the theories they learned are mostly correct, they will make bad decisions in both business and politics.

Noah Smith writes that the problem is that by emphasizing theory so much, and by relegating evidence to some brief asides, Econ 101 textbooks (and classes) will tend to trick kids into thinking that the theories have better fit than they do. When you make people learn a theory in detail, I think they naturally tend to believe that the theory has strong empirical fit unless they see evidence to the contrary.


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The Italian referendum

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By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 28, 2016
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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
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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
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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
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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
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Brexit, the pound and the UK current account

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By: Silvia Merler Date: October 17, 2016
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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
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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
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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
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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
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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
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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
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