The State of Modern Cutting Edge Macro: Narayana Kocherlakota Leaves Me Puzzled
The very sharp Narayana Kocherlakota http://www.econ.umn.edu/~nkocher/ on the state of "modern cutting-edge macroeconomics":
Why do we have business cycles? Why do asset prices move around so much? At this stage, macroeconomics has little to offer by way of answer to these questions. The difficulty in macroeconomics is that virtually every variable is endogenous – but the macro-economy has to be hit by some kind of exogenously specified shocks if the endogenous variables are to move. The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic. Perhaps most famously, most models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities). None of these disturbances seem compelling, to put it mildly. Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables....
It is not true that all macroeconomic models assume complete financial markets--quite the contrary.... However, few macroeconomic models capture an intermediate messy reality in which markets are incomplete but there are nonetheless many assets and/or asset trade is conducted through intermediaries. As a consequence, we don’t understand the sources (or costs/benefits) of large-scale daily (or even quarterly) financial asset re-allocation. In part, this omission reflects a belief among macroeconomists that this level of institutional detail was not essential for questions of interest. In part, it reflects the extreme difficulty in handling mathematical formalizations of these features of reality.... Again, recent events may well lead to a re-ordering of priorities...
Note: Narayana Kocherlakota is a defender of the enterprise. He thinks that everything is more-or-less fine.
But, he says, if you ask a modern cutting-edge macroeconomist why we are currently in a deep recession, he will say that he does not know:
Why do we have business cycles? Why do asset prices move around so much?... [M]acroeconomics has little to offer by way of answer to these questions...
He will say that that modern cutting-edge macro builds models that do attribute economic downturns to various causes:
[M]ost models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)...
The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.
But, Kocherlakota says, all of these causes that modern cutting-edge macro models investigate strike him as implausible just-so stories that do not illuminate--simply not to be taken seriously:
The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic.... None of these disturbances seem compelling, to put it mildly...
And so, Kocherlakota says, nobody really believes them:
Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables...
This seems to me to be wrong. It does not seem to me that it really is the case that nobody really believes these just-so stories.
Ed Prescott of Arizona State University really does believe that large-scale recessions are caused by economy-wide episodes of the forgetting of the technological and organizational knowledge that underpins total factor productivity--with the exception of episodes like the Great Depression, which Prescott says was caused by the extraordinary pro-labor pro-union policies of that left-winger Herbert Hoover that pushed real wages far above equilibrium values.
Casey Mulligan of the University of Chicago really does appear to believe that large declines in the employment-to- population ratio are best seen as “great vacations”--when they are not the side-effects of destructive government policies, like those in place today which are leading workers to quit their jobs so they can get higher government subsidies to refinance their mortgages. (Yes, I know, I know.)
And Robert Lucas of the University of Chicago said in his Nobel Prize lecture that his:
discovery of the central role of the distinction between anticipated and unanticipated money shocks... [did not lead to] a satisfactory theory of business cycles. Perhaps in part as a response to the difficulties with the monetary-based business cycle models of the 1970s, much recent research has followed the lead of Kydland and Prescott (1982) and emphasized the effects of purely real forces on employment and production.12 This research has shown how general equilibrium reasoning can add discipline to the study of an economy’s distributed lag response to shocks, as well as to the study of the nature of the shocks themselves.... All one can be sure of is that progress will result from the continued effort to formulate explicit theories that fit the facts, and that the best and most practical macroeconomics will make use of developments in basic economic theory.
Things that strike Kocherlakota as “patently unrealistic” are not viewed as such by many of his modern cutting0-edge macroeconomic peers and colleagues, but rather as essential for "the best" and for "the most practical" macroeconomics.
Why are Kocherlakota's peers and colleagues so much more optimistic than he is? Why do they find these just-so stories in any way satisfactory?
