Tom Sargent Interview

Tom Sargent is interviewed by Art Rolnick on the state of modern macro. Very nice read. But the best part is this exchange:

Rolnick: I’ll come back to that in a second, but you haven’t said anything yet about what is to be gained in terms of understanding financial crises from importing insights of behavioral economics into macroeconomics.

Sargent: No, I haven’t.

Read the whole thing.

A New Macroeconomics Paradigm

Joseph Stiglitz calls for a paradigm shift in macroeconomics:

The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Today, not only is our economy in a shambles but so too is the economic paradigm that predominated in the years before the crisis – or at least it should be.

There follows the typical litany of complaints against modern macroeconomics: equilibrium assumptions, representative agent models, no room for finance. Some of these points make some sense, but there is no alternative approach that shows the way to go. Stiglitz talks about success in economic theory that has not gotten into macroeconomics.

Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient.

The problem is not to recognize that a model is just a model, but how to incorporate frictions into usable models. This is really hard. The most likely reason it has not been done yet is that nobody has figured it out, not that economists are ostriches.

Stiglitz also takes the typical potshot at market efficiency. Economists assumed markets were efficient so nobody stopped people from taking too much risk. I just don't get this argument. If people thought markets were efficient they would not have believed that extra return could arise with extra risk. The problem is that too many in the financial world, including regulators, did not really believe in efficient markets. Otherwise, they would have known that risks were being seriously piled up.

What's Wrong with Macro

Mark Thoma has collected as many links on this as anybody.

Predictability of the Crisis

Alex Tabarrok weighs in on the argument that no macro model could predict the crisis.

...the word timing is misleading. Let's accept that a crisis cannot be predicted to the day or even to the year. Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis.

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur. If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets. Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms. It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet. It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense--even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models.

It seems to me, however, that once you define the problem as one of predicting increased risk of a crisis then the charge against macroeconomics is lessened. Many economists argued that the risk of a crisis had increased after 2006.

The notion that economists should be able to isolate periods of increased risk is a good one. The IMF has tried to do that with early warning indicators. The BIS was warning of increased risks from at least 2006.

Macro and Finance

I keep arguing that macroeconomics needs to incorporate finance more fully. I think this is the major criticism that is made of macro models that actually holds up to scrutiny. People nonetheless ask me what I mean. Here is an article by BIS Chief Economist Steve Cecchetti and colleagues on precisely this subject.

Economics and the Crisis

Paul Krugman has a long article discussing the role of economists in the crisis. Krugman argues that macroeconomics has gotten it very wrong. His basic indictment:

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, thatstocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

The explanation is becoming fairly conventional. The problem is that mathematization of the field.

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.

The article is worth reading in full, but Krugman's attack lacks focus I think. His attack is too broad, and thus the worthy parts are offset by the desire to blame everything he does not like.

For example, it is just not fair to argue that economists accepted the efficient markets hypothesis or the belief in market efficiency for personal gain:

The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

What about the evidence from financial markets that demonstrates the difficulty of beating the market? Most empirical studies, especially the early ones, were quite clear on this (see, for example, here). This is especially true for the weak form of the hypothesis that says that asset prices incorporate all publicly available information.

Krugman also mis-characterizes why fresh-water and salt-water economists reconciliated. He writes:

Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.

This misses the story. What happened is that fresh-water economists started to incorporate market frictions in their models, especially those that come from search. Meanwhile, salt-water economists adopted the methodology, using dynamic models with optimizing agents to study economies with other types of market frictions. An agreement to study the quantitative effects of policies made it easier for macroeconomists to talk. This is much closer to what happened.

How about Krugman's claim that macroeconomists should have predicted the crisis?

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst.

Of course it is not really clear that Shiller actually predicted that housing prices would decline nationally, as Falkenblog has noted. Moreover, a bubble continues precisely because the belief that asset prices follow a bubble is not common knowledge. Once it becomes common knowledge traders sell against the bubble. The bubble continues precisely because nobody knows when enough agents realize this. This is the important lesson from Abreu and Brunnermaier (the latter is Krugman's colleague, so he should be aware of this). Now suppose that there is a difference of opinion concerning the likelihood we are on a bubble path. What are policymakers to do? If they try to prick the bubble they will be blamed for the consequences. There is a political agency problem here.

The person who gets the most credit for predicting the crisis is Nouriel Roubini. He did predict crisis, the one that many economists did expect. But that was a currency crisis due to our excessive current account deficits. This was quite a rational fear. As for the excessive risk in the banking system, it seems that Raghuram Rajan was the only major economist who talked about this (there was some very good work at the BIS that was also ignored). And as Krugman notes in his article, when Rajan made these warnings even Larry Summers belittled him. Why was this the case? I suspect that most economists understood the basics of securitization, but could not believe how much of the CDO's banks were keeping on their books or in special investment vehicles they were responsible for. Since the latter are off-balance sheet, they are precisely organized to fool analysts.

What economists did miss is an important point made by Posner in his book, A Failure of Capitalism. Suppose we have regulations that prevent some type of crisis. Over time, if the policies are successful, the likelihood of seeing a crisis will recede. So the benefits of the regulations will be less apparent. But the costs of the regulation will not be reduced. So a cost-benefit analysis of beneficial regulations will seem to signal inefficiency. This increases the political support for eliminating the beneficial regulations. And this will make a crisis more likely.

This leads to another interesting point about economics. Normally economics works through negative feedback loops. When demand for a good falls so does its price. The fall in the price reduces the extent of the fall in sales and signals producers to produce other things. Negative feedback is what makes the equilibrium hypothesis useful. But what happens when the economy is so far out of kilter that we have positive feedback loops? This is what happened when the housing bubble burst. The fall in asset prices led to a deterioration of bank balance sheets and less lending. This hurt investment and production and incomes declined. So people could not purchase homes that were much cheaper. This is positive feedback, and it is what turned the asset bubble into the great recession.

Notice that after many asset bubbles burst negative feedback loops operated. Think of the 1987 crash or the end of the tech bubble. These had little economy-wide effects because of negative feedback. But in rare cases we do get positive feedback. Yet if these cases are so rare most of the data we operate with will not display it. So most of our experience, and most of our analysis will be conducted using data generated by negative feedback behavior. It is not surprising that we are not well-prepared for positive feedback loops. If we were it would mean we had experienced many more crises.

One could then blame economists for focusing so much on normal times and ignoring how the economy works outside the corridor (see my previous post on the Corridor hypothesis). But given how rare depressions have been was this such an unwise strategy?

Another important point Krugman makes is that macro failed to incorporate finance sufficiently. This is an important criticism, but I doubt the reason is the efficient markets hypothesis. It stems much more from the use of representative agent models. These make it hard to model finance. I think it is the complexity rather than the obtuseness of economists that led to this result.

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.