Tag Archives: macroeconomics

Educating economists

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How well are universities teaching their economics students? This is the question a number of academic and non-academic economists have been addressing since a conference this time last year held under the auspices of the Government Economic Service and Bank of England. The conference papers were published as [amazon_link id=”1907994041″ target=”_blank” ]What’s The Use of Economics: Teaching the Dismal Science After the Crisis[/amazon_link] – reviewed by Declan Jordan yesterday in the LSE Review of Books.

[amazon_image id=”1907994041″ link=”true” target=”_blank” size=”medium” ]What’s the Use of Economics?: Teaching the Dismal Science After the Crisis[/amazon_image]

The debate continued yesterday at a meeting of several dozen economists held at the Treasury, working towards a statement suggesting some directions for curriculum and teaching reform, although of course it will be for individual university departments to decide whether or not they think change is needed. The statement will be published after a bit of revision and discussion.

At the meeting Wendy Carlin presented an updated model from her [amazon_link id=”0198776225″ target=”_blank” ]macroeconomics text with David Soskice[/amazon_link], integrating a financial sector into the basic three equation model. Their new textbook will be published later this year and will obviously be well worth while. Wendy cited Claudio Borio’s excellent paper on what we’ve learnt about the financial cycle and macroeconomics, thanks to the crisis.

A book that will change your mind

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As an author, I’ve learned that most readers take out of a book what they bring to it. We all have our pre-existing worldview and it is rare for us to alter it. So I was struck by this comment by Ian Bright on a book I reviewed here last month, [amazon_link id=”0691158681″ target=”_blank” ]The Great Rebalancing: Trade, Conflict and the Perilous Road Ahead for the World Economy[/amazon_link] by Michael Pettis. Ian writes: “I have now read Pettis book. It is as good (even better) than you outlined….. the book challenges much of the way I think about things.”

[amazon_image id=”0691158681″ link=”true” target=”_blank” size=”medium” ]The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy[/amazon_image]

As his comment notes, the recent FT review of the book was somewhat unfair. It says the author ignores the importance of history, and gives the impression that this weakens the argument. I don’t agree. Anyway, it addresses the overall pattern of global imbalances so it would be a monster task to embed that in an informative history of the world’s major trading blocs.

If you are interested in the global economy and believe yourself to have an open mind, I urge you to read it. It’s ideal for students too because it sets out so clearly the operation of the accounting identities of the balance of payments.

The Assumptions Economists Make

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On my journeys to and from The Hague this week (one of the joys of travel – offline time when nobody can email, phone me or ask me what’s for dinner), I read Jonathan Schlefer’s enjoyable [amazon_link id=”0674052269″ target=”_blank” ]The Assumptions Economists Make[/amazon_link]. It’s a book of two halves: a combination of a critique of modern economic methodology in general and a polemic against actually existing neoclassical economics in particular. The former, the first half, is much stronger, although the latter is probably more populist. The two halves will also appeal to different audiences – to professional economists and other social scientists in the first case, and to more general readers who are inclined to blame economics for the mess we’re in in the second.

The author is a political scientist and writer who undertook the commendable task of learning economics and reading widely before embarking on a critique. This distinguishes him from almost all other non-economist critics and in itself means economists must offer him equal respect and take this book seriously. The book starts with a very clear description of general equilibrium theory and the microfoundations built on it. Schlefer makes some extremely interesting points about the theory, drawing on the literature – as he notes, there is a “breach between the subtle world of proper neoclassical theory, which faces quandaries head on, and the corrupt world of neoclassical practice, which just ignores those quandaries.” (p89) One point, for example, is why a stable equilibrium cannot exist in the imaginary general equilibrium economy. All students of economics learn about the impossibility theorem – and then motor on with the rest of their studies as if it were not true. Similar points have been made elsewhere, such as Steve Keen’s [amazon_link id=”1848139926″ target=”_blank” ]Debunking Economics[/amazon_link], but I found it to be much clearer in [amazon_link id=”0674052269″ target=”_blank” ]The Assumptions Economists Make[/amazon_link].

The first chapters set out the basics of economic theory through a history of thought progression from Adam Smith to the marginalists – Jevons stands out here – along with Walras and Menger –  as the driving force in turning economics into a purely deductive science concerned with (in his words) ‘the mechanics of self-interest and utility’. (p76) (I wanted to know more about Jevons, especially having seeing his Logic Machine (below) in a Science Museum exhibition.)

Jevons’ Logic Machine (‘The machine is capable of replacing for the most part the action of thought required in the performance of logical deduction’.)

The book then turns to the consequent flaws in basic microeconomics, especially the concept of the production function and the assumption of marginalism and competition in investment. It revisits the ‘Two Cambridges’ debate (which I was taught about in graduate school, but with the neoclassical side the unquestioned victor in the version I learned), and goes on to question the logical coherence of aggregation in the way it’s done in conventional macroeconomics. Well, I’m with that idea wholeheartedly; my own journey from macroeconomics to micro started with a PhD thesis that confronted macro labour market models with industry-level data, a very effective way of lifting the rock of aggregation to reveal the nasty creepy-crawlies underneath.

However, after that, the book becomes less compelling for me. Schlefer spends the remaining chapters discussion Keynesianism as the master intended it and as his neoclassical interpreters shaped it in the post-war years. This is well-written, and I enjoyed discovering, for example, that Paul Samuelson was almost regarded as a dangerous Commie for taking Keynes seriously, so paranoid was early Cold War America (p192). However, a turn to a discussion of macroeconomic aggregates not what I wanted to read as a follow-on to a persuasive argument about why macroeconomic aggregates are problematic. Schlefer, like Keen in his book, attacks the conventional three-equation DSGE models – quite right too – but seems to want to replace it with an alternative abstract macro framework. Keen’s is a Minsky-esque version of disequilbrium dynamics. Schlefer’s is a structuralist approach following his teachers, especially Lance Taylor. (No doubt he would approve of Justin Yifu Lin’s [amazon_link id=”0691155895″ target=”_blank” ]The Quest for Prosperity[/amazon_link], setting out a ‘new structural economics’, although he doesn’t cite it.) He also mentions favourably ecological models.

He writes: “It is legitimate to impose informed assumptions on macro data – profits, wages, consumption, investment and the rest – in order to build rough macroeconomic models of cause and effect. The role of models is to be sure that assumptions are consistent, to understand their implications as well as possible, and to frame a coherent view that you can compare with historical experience.”  (p267) The huge mistake in modern macro, he says, was introducing the illusory quest for ‘microfoundations’. I suppose it’s correct to say an assumed macro framework is necessary, but this leaves me with a question not answered here, which is how on earth we should choose between them. Schlefer obviously likes the look of ecological predator-prey models. Other critics of macroeconomics prefer agent-based modelling, or econo-physics-style empirical exploration of datasets to derive regularities. Steve Keen has his own Keynes-Minsky set of abstractions. Many mainstream macroeconomists are insistent on the relevance of New-Keynesian DSGE models with stickiness in wages and prices, and some finance added in, post-crisis. [amazon_link id=”0674052269″ target=”_blank” ]The Assumptions Economists Make[/amazon_link] raises important questions but doesn’t answer the one raised half way through the book: “Is macroeconomics possible? There are serious doubts.”

[amazon_image id=”0674052269″ link=”true” target=”_blank” size=”medium” ]Assumptions Economists Make[/amazon_image]

Unicorns, Higgs Bosons, and the state of macroeconomics

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In 2005 the UK Treasury sponsored a conference with the title [amazon_link id=”023001903X” target=”_blank” ]’Is There a New Consensus in Macroeconomics?[/amazon_link]’; a book of the conference was published in 2007. Its answer was ‘yes, but….’, the ‘but’ being – correctly, as it turned out in hindsight – the flagging up of some puzzles and controversies as well as shortcomings such as the absence of international flows and imbalances in the conventional model. At the time this sense of consensus was (by definition) widespread – Olivier Blanchard at the IMF famously wrote about it too, in The State of Macro.

[amazon_image id=”023001903X” link=”true” target=”_blank” size=”medium” ]Is there a New Consensus in Macroeconomics?[/amazon_image]

Earlier this week, the ESRC sponsored a symposium on macroeconomics hosted by the Oxford Martin School, with the aim of evaluating the state of macro now. As the ESRC’s Adrian Alsop put it in his introduction: “While in the economics profession, macro is but a sub-set of what we do, any perceived lack of vitality and strength in macro tarnishes economics as whole in the eyes of citizens and policy makers alike; and that in turn causes reputational damage for the whole of social science. So this is big stuff the profession, let alone the funding agencies.” Internationally, funding agencies are considering what kind of research in macro is needed – and particularly in the UK, where this is an area of economics in this country flagged up as weak by a 2008 benchmarking study (scroll down) for the ESRC, led by Elhanan Helpman.

My headline from the symposium is that macroeconomists are deeply divided, with any sense of consensus shattered. There is a division between those who regard increasing the sophistication and flexibility of existing models and approaches as an adequate response to the crisis, and those who believe a more far-reaching re-tooling is essential for both scientific and public policy credibility. This is more or less the same as the division between adherents to DSGE models, or more broadly a deductive equilibrium framework that uses a small number of aggregate variables to make analytical predictions; and those who believe macroeconomics must now become more inductive and data-based. As Professor Neil Ferguson, Professor of Mathematical Biology at Imperial College, put it in his comment on day 2 of the symposium, he was astounded by how little macroeconomists discussed data and the new techniques available for handling large amounts of data.

When this division between deductive and inductive approaches, between parsimonious analytical models and computer-based statistical techniques (agent-based modelling, econo-physics, statistical exploration of the data) surfaced, the discussion grew a little heated. This included the breaks: many of those who disagree with the prevailing, albeit broken, ex-consensus feel unable to bring about change even in their own research, and are not eager to speak out or change the nature of their work because it will harm their career prospects. To advance in UK economics departments requires publication of numerous articles in a small number of American journals which are firmly sticking to the conventional modelling approach.

My view is that if macroeconomics does not abandon its obsession with being able to write down analytical 3 equation models with maybe 12 or even 20 variables to explain and predict what is happening at large scale in the economy, it will lose all meaning and purpose. Below is a picture of my son burning his macroeconomics notes as soon as he’d taken his final exam – despite having an outstanding teacher, it seemed obvious to him that macroeconomics was a fairy tale, a fable. Yet many macroeconomists seem not to realise that they are dealing in metaphors, and that IS-LM curves are more like unicorns than Higgs bosons. Microeconomics suffers in the same way but not so badly and applied microeconomists are already a bit more flexible – more willing to use ad hoc rules of thumb derived from behavioural psychology, more willing to use qualitative evidence and business data, not just highly aggregated time series data.

Burning unicorns?

So I was wholly in agreement with Professor David Hendry, who in his presentation on statistical techniques for exploring data, said:

– all macroeconomic theories are incomplete, incorrect and changable

– all macroeconomic time series are aggregated, inaccurate and rrely match theoretical concepts

– all empirical macroeconometric models are aggregated, inaccurate and mis-specified in numerous ways

So why justify an empirical model by an invalid theory that will soon be altered? Why is internal model credibility considered more important than verisimilitude? “It’s why people think economists are daft,” he said. And, as he pointed out, DSGE models are not even logically internally consistent because they incorrectly regard agents’ expectations today of the future state of the world, conditioned on what they know today, as the same as their equivalent expectations tomorrow, bar for an unpredictable error – but this would only be true in a stationary world. When the state of the world can change in a non-stationary way between today and tomorrow, the kind of ‘model-consistent’ or rational expectations conventionally used are not possible.

I hope the ESRC and other social science funders will focus their efforts on enabling the reformist macroeconomists to pursue their alternative approaches. None of us knows what approach to macroeconomics will ultimately prove most fruitful, but at present given the institutional structures in academia, none of the alternatives are being pursued. Academic economists who have spent their careers doing everyday macroeconomics will need 2 or 3 years to change direction and learn new techniques and approaches to data. But if they want to keep their jobs, they will not get the space to do that – they will need to publish another tweak on a DSGE model in the American Economic Review.

Following the conference earlier this year that resulted in [amazon_link id=”1907994041″ target=”_blank” ]What’s The Use of Economics[/amazon_link], a working group hosted by the Government Economic Service has been considering the institutional barriers to reform of the undergraduate curriculum, and we will report next year. A parallel consideration is needed of barriers to reform in research, and I don’t excuse microeconomists from the need to think deeply about their subject, but it’s more urgent in macroeconomics because of the crisis.

 

Gold Medals and Macroeconomic Models

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There is an epidemic of Olympics-related cheerfulness in the UK, for obvious reasons. The Post Office is painting a post box gold for every Team GB gold medal, London is full of cheerful (mainly non-athletic) people in athletic clothes, and the vast majority of people are (literally) watching the sport and chatting about it. There has been quite a lot of discussion about whether the Olympics will be positive for the economy or not; the weight of opinion is leaning towards not, because normal tourist and retail spending is significantly down on normal levels, and because there is a lot of surreptitious Olympics-watching going on at work.

I read this morning a recent paper by Roger Farmer of UCLA, The Evolution of Endogenous Business Cycles, and it set me wondering if the psychology of Olympic success might actually have a lasting positive effect on the economy. The paper describes the evolution of the way business cycles have been modelled in modern economics. In the late 1970s/early 1980s the Real Business Cycle models dressed old classical, equilibrium models of cycles driven by exogenous supply shocks in new mathematical costume. The economy doesn’t behave like this, however, so nominal wage rigidities were added to give us the workhorse Dynamic Stochastic General Equilibrium models, enriched by a number of complications over time. Farmer writes that a DSGE model, “Loaded up with enough frictions and multiple shocks, does a credible job of replicating the dynamics of post-war U.S. business cycles.”

In the mid-90s, Farmer and his co-authors introduced “sunspot” dynamics, self-fulfilling changes in expectations that could account for business cycle departures from full employment that would last for a time before the economy returns to normal. However, the disequilibrium could not last all that long or have a high welfare cost. In two recent books, [amazon_link id=”0195397916″ target=”_blank” ]How The Economy Works: Confidence, Crashes and Self-fulfilling Prophecies[/amazon_link] and [amazon_link id=”0195397908″ target=”_blank” ]Expectations, Employment and Prices[/amazon_link], Farmer introduces a labour market that cannot readily match workers to jobs because of the costs of searching. The latest version of these endogenous business cycle models therefore features self-fulfilling dynamics and unemployment that persists and can be large scale. He presents a rigorous (‘micro-founded’) Keynesian model that seems to explain the post-crisis behaviour of the economy. Farmer points out that macroeconomic data demonstrate strong persistence over time, something many models gloss over by the way they filter the data, whereas his model describes it explicitly.

I find this very interesting (not least for the personal reason that in my 1985 PhD thesis I tried and very much failed to marry search and efficiency wage labour market models with Real Business Cycle thinking in a way that fit the data!) This paper is the most persuasive I’ve read on the continuing usefulness of technical micro-founded DSGE-type models – and after all, central banks and governments continue to need macro models and forecasts. However, the absence of financial institutions – and the specific characteristics of banks and financial markets that explain why normal transmission mechanisms are failing –  still seems to me a glaring gap, given the experience of the crisis. I’m also interested in the contribution network/epidemic models can have to understanding changes in expectations and behaviour.

But the important role of self-fulfilling changes in expectations – another Keynesian insight – did also strike me as I read the paper. Hence, perhaps, a little ray of hope shed in the UK by our Gold medals at the Olympics.

An economic as well as athletic triumph?