Blog Post

Macroeconomics in the crossfire (again)

What’s at stake: After a first go at macroeconomics and its flaws a year ago, Paul Romer kicked off the debate again with a recent essay on how macroeconomics has gone backwards. The way that this debate, along with the debate of the role of economics in general, feeds into today's election woes, has also attracted attention in the blogosphere.

By: Date: December 5, 2016 Topic: European Macroeconomics & Governance

The macro debate between past beliefs and the lack of data

Romer kicked off the debate in an essay, stating that for more than three decades, macroeconomics has gone backwards. He finds that the treatment of identification now is no more credible than in the early 1970s, but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” For Romer, the Nobel Prize-winning crop of macroeconomic theorists who transformed the field in the late 1970s and 1980s — Robert Lucas, Edward Prescott and Thomas Sargent –  are the main people to be held responsible for this this development. Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by  actions that any person takes. Especially when it comes to monetary policy, the belief that it has no or little effect on the economy is disturbing, or as Romer puts it:

“The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.”

While Noah Smith agrees with Romer’s general message, he points to the fact that most of the profession does believe in the power of monetary policy by now. The dominant form of macroeconomic models for at least a decade has been the so-called New Keynesian models, which say that interest rates play a very large role in stabilizing the economy. These are also the dominant form of the modern macro model in use in  central banks. New Keynesian theorists such as Greg Mankiw, Michael Woodford and Olivier Blanchard have not yet received Nobel prizes, but their views and ideas are thriving in the marketplace of ideas. Noah Smith identifies the lack of good evidence as the real fundamental problem with macroeconomics. Because data is sparser and weaker in macro, theorists have a natural incentive to rely on their own pre-existing beliefs, on generally accepted practice and on the wisdom of authorities.

Nick Bunker points out that in a recent speech, the Federal Reserve Chair Janet Yellen raised important questions about  macroeconomic research in the wake of the Great Recession. The first area of interest is the influence of aggregate demand on aggregate supply. Yellen points to research that increasingly finds so-called hysteresis effects in the macroeconomy. Hysteresis, a term borrowed from physics, is the idea that short-run shocks to the economy can alter its long-term trend. One example of hysteresis is workers who lose jobs in recessions and then are not drawn back into the labour market but rather permanently locked out, therefore increasing the long-term unemployment rate. Another open research question that Yellen raises is the influence of “heterogeneity” on aggregate demand. Ignoring this heterogeneity in the housing market and its effects on economic inequality seems like something modern macroeconomics needs to resolve. Yellen raises other areas of inquiry in her speech, including better understanding how the financial system is linked to the real economy and how the dynamics of inflation are determined. Nick Bunker concludes by stating that perhaps it is time for each of these questions to rise on the collective research list so that policymakers have better vantage points as they assess the effect of inequality on economic growth and stability.

Simon Wren-Lewis identifies yet another factor which lies at the heart of macroeconomic criticism: ideology. As an example he quotes Real Business Cycle (RBC) research from a few decades ago. That was only made possible because economists chose to ignore evidence about the nature of unemployment in recessions. There is overwhelming evidence that employment declines in a recession because workers are fired rather than choosing not to work, and that the resulting increase in unemployment is involuntary (those fired would have rather retained their job at their previous wage). Both facts are incompatible with the RBC model. Why would researchers try to build models of business cycles where these cycles require no policy intervention, and ignore key evidence in doing so? The obvious explanation is ideological. While Simon Wren Lewis cannot prove it was ideological, it is difficult to understand why one would choose to develop theories that ignore some of the existing evidence, in an area that lacks data. There is reluctance among the majority of economists to admit that some among them may not be following the scientific method but may instead be making choices on ideological grounds. This is the essence of Romer’s critique.

The ideology in economics and today’s woes

Over at critical macro finance, Jo Michell disagrees with Wren-Lewis when he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. Simon Wren-Lewis suggests that the beliefs of the latter group are ideological, while those of the former group are based on ideology-free science. This strikes Jo Michell as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable. Instead, both have an ideological bias – the reason being that the standard New Keynesian model is not a Keynesian model at all – it is a monetarist model. Aside from the mathematical sophistication, it is all but indistinguishable from Milton Friedman’s ideologically-driven description of the macroeconomy. In particular, Milton Friedman’s prohibition of fiscal policy is retained with a caveat about the zero-lower bound in recent years. To argue otherwise is to deny Keynes’ dictum that ‘the ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood.’

Ann Pettifor reflects more generally on the fact that the Brexit vote is but the latest manifestation of popular dissatisfaction with the utopian ideal of autonomous markets beyond the reach of regulatory democracy. Brexit represented the collective, if (to her mind) often misguided efforts of those ‘left behind’ in Britain to protect themselves from the predatory nature of market fundamentalism. In a Polanyian sense, it is a form of social self-protection from self-regulating markets in money, trade and labour. In her opinion, with the historic Brexit vote, the British people rejected this flawed brand of economics — and in particular the dominant liberal finance narrative. And they did so because the hardship they are experiencing — repressed wages, diminished public services, rising housing costs and shortages, and insecure employment — is indirectly a consequence of the theories and policies of the mainstream economics profession.

This gets backing from other economists, among them Kevin O’Rourke, who argues that after the Brexit vote, it is obvious to many that globalisation in general, and European integration in particular, can leave people behind – and that ignoring this for long enough can have severe political consequences. He argues in a recent  piece that this fact has long been obvious. As the historical record demonstrates plainly and repeatedly, too much market and too little state invites a backlash. Markets and states are political complements, not substitutes.


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

The United States-Mexico-Canada free trade agreement (USMCA)

While final ratification of the USMCA (also known as Nafta 2.0) is pending, we review economists’ assessment of the agreement.

By: Silvia Merler Topic: Global Economics & Governance Date: October 22, 2018
Read article More on this topic More by this author

Blog Post

The 2018 Nobel Prize: Growth and the environment

The 2018 Nobel Prize in Economic Sciences has been awarded jointly to William Nordhaus and Paul Romer for integrating respectively climate change and technological innovation into long-run macroeconomic analysis. We review how economists reacted to the announcement.

By: Silvia Merler Topic: Energy & Climate Date: October 15, 2018
Read article More on this topic More by this author

Blog Post

Inequality in China

After amply discussing income inequality in Europe and the US, economists are now looking at the magnitude, implications and possible remedies for this phenomenon in the context of the Chinese economy.

By: Silvia Merler Topic: Global Economics & Governance Date: September 24, 2018
Read article More on this topic More by this author

Blog Post

Reforming the EU fiscal framework

Researchers have often highlighted the problematic nature of the currently very complex EU fiscal framework. Here we review economists’ views on how it should be changed.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: September 17, 2018
Read article More on this topic More by this author

Blog Post

Lehman Brothers: 10 Years After

Ten years after the bankruptcy that shook the world, we review economists’ take on the lessons learned from the global financial crisis.

By: Silvia Merler Topic: Finance & Financial Regulation Date: September 10, 2018
Read article More on this topic More by this author

Blog Post

Monetary policy and superstar firms

The yearly Jackson Hole gathering of central bankers has focused this year on the topic of changing market structure, the rise of superstar firms, and the implications of the way they compete for central banks.

By: Silvia Merler Topic: Global Economics & Governance Date: September 4, 2018
Read article More on this topic More by this author

Blog Post

The Turkish Crisis

Financial markets have been very nervous about Turkey for the past few weeks. We review economists’ opinions about the economic, political and geopolitical risks and opportunities of this situation.

By: Silvia Merler Topic: Global Economics & Governance Date: August 27, 2018
Read article More on this topic More by this author

Blog Post

Italy's "Dignity Decree"

The new Italian government pushed through its first legislative act including elements of labour market reform. Presented as an overturn of the previous government’s “Jobs Act”, the estimated effects of the decree are controversial. We review Italian economists’ view on the matter.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 23, 2018
Read article More on this topic More by this author

Blog Post

Economy of Intangibles

Economists have been discussing the implications of the rise of the intangible economy in relation to the secular stagnation hypothesis, and looking more generally into the policy implications it has for taxation. We review some recent contributions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: July 16, 2018
Read article More on this topic More by this author

Blog Post

World Cup Economics

As we approach the final rounds of the tournament, here are some recent contributions about the economics and economic impact of the World Cup.

By: Silvia Merler Topic: Global Economics & Governance Date: July 9, 2018
Read article More on this topic More by this author

Blog Post

US tariffs and China's holding of Treasuries

China has the biggest bilateral trade surplus vis-à-vis the US but is also a top holder of US government bonds. While China has started to counteract US trade tariffs, economists have been discussing the case of China acting on its holdings of US Treasuries. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: July 2, 2018
Read article More on this topic More by this author

Blog Post

The Meseberg declaration and euro-zone reform

The recent Franco-German Meseberg declaration will set the scene for next week’s summit. We review opinions on this important agreement.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 25, 2018
Load more posts