Wednesday, July 22, 2009

Macroeconomics in Crisis

Paul De Grauwe argues in the Financial Times that macroeconomics is in crisis. There is much to agree with.

The science of macroeconomics is in deep trouble. The best and the brightest in the field fight over the most basic problems. Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp of macroeconomists claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment. Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation. Wrong, says the other camp. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits would intensify the deflationary forces in the economy and would lead to a new and more intense recession.

De Grauwe argues that finance must be re-integrated into macroeconomics, a position I would agree with for sure. He also argues that there is a deeper problem:

This is the underlying paradigm of macroeconomic models. Mainstream models take the view that economic agents are superbly informed and understand the deep
complexities of the world. In the jargon, they have “rational expectations”. Not only that. Since they all understand the same “truth”, they all act in the same way. Thus modelling the behaviour of just one agent (the “representative” consumer and the “representative” producer) is all one has to do to fully describe the intricacies of the world. Rarely has such a ludicrous idea been taken so seriously by so many academics. (Other fields of economics have not been deluded by this implausible idea and therefore do not face the same criticism.)
This is a common criticism but I would distinguish between the rational expectations assumption, which is a modelling convention that is useful in revealing what models are about, and the representative agent assumption. It is the latter that has gotten macroeconomics in trouble. This is what makes it hard to get finance into the models. It is the interaction of different agents that makes macroeconomics interesting, and the representative agent paradigm deflects attention from many problems. But rational expectations is a discipline device. It is a way of showing that one has nothing up his sleeve.

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