I am keenly aware that since, say, 1997 one disagrees with Paul Krugman at one's grave intellectual peril. But I am not as confident as Paul Krugman is that "the past decade has been a huge validation for textbook macroeconomics". A large component of what Krugman calls "good old-fashioned macro" was that expectations were, if not rational, adaptive. Keynes's "speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done..." had no place in "old-fashioned macro". And it is not as though this was a flaw and could be quickly, coherently, and satisfactorily patched. The integration of behavioral finance and macro is still not done—which is why I am such a booster of Nicola Gennaioli and Andrei Shleifer (2018): A Crisis of Beliefs: Investor Psychology and Financial Fragility https://books.google.com/books?isbn=0691184925. (That, and Andrei is my friend.) They are at least looking in the right direction: Paul Krugman: What Do We Actually Know About the Economy?: "Among macroeconomists, the self-criticism seems to me to be mainly too narrow: people berate themselves for, say, not giving financial markets a bigger role in their models, but few have done what they should, which is to question the whole direction macroeconomics has gone these past four decades or so...
...Among economists more generally, a lot of the criticism seems to amount to the view that macroeconomics is bunk, and that we should stick to microeconomics.... [But] in an important sense the past decade has been a huge validation for textbook macroeconomics; meanwhile, the exaltation of micro as the only “real” economics both gives microeconomics too much credit and is largely responsible for the ways macroeconomic theory has gone wrong.... So let me talk about... the unsung success of macroeconomics, the excessive prestige of microeconomics, [and] the limits of empiricism, vital though it is....
IS-LM... is the simplest model you can write down of how interest rates and output are jointly determined, and is how most practicing macroeconomists actually think about short-run economic fluctuations.... The overall story... is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn’t fail in the crisis–it worked extremely well. In fact, it’s hard to think of any other example of economic models working this well–making predictions that most non-economists (and some economists) refused to believe, indeed found implausible, but which came true. Where, for example, can you find any comparable successes in microeconomics?
But, you say, we didn’t see the Great Recession coming.... What happened was that economists refused to believe that home prices could be that out of touch with reality. That’s... a problem with financial economics... the general unwillingness of human beings... to believe that so many people can be so wrong about something so big. The bottom line: the past decade has been a vindication, not a refutation, of good old-fashioned macro....
Trade people tended to consider international macro people semi-charlatans, doing ad hoc stuff devoid of rigor. International macro people considered trade people boring, obsessed with proving theorems and offering little of real-world use. Both sides were, of course, right.... Does microeconomics really deserve its reputation of moral and intellectual superiority? No. Even before the rise of behavioral economics, any halfway self-aware economist realized that utility maximization–indeed, the very concept of utility—wasn’t a fact about the world; it was more of a thought experiment, whose conclusions should always have been stated in the subjunctive.... Here’s my question: where are the examples of microeconomic theory providing strong, counterintuitive, successful predictions on the same order as the success of IS-LM macroeconomics after 2008? Maybe there are some, but I can’t come up with any. Just to be clear: there’s plenty of excellent micro work, both theory and empirical. What I’m talking about, however, is the kind of mind-altering, the-world-doesn’t-work-the-way-you-think-it-does stuff macro has achieved. When I look at the American Economic Review’s list of its top 20 papers, I think I may see one micro paper like that – Kenneth Arrow on health care. Other candidates?...
Meanwhile, the demand that macro become ever more rigorous in the narrow, misguided sense that it look like micro led to useful approaches being locked up in Schwinger’s back room, and in all too many cases forgotten. When the crisis struck, it was amazing how many successful academics turned out not to know things every economist would have known in 1970, and indeed resurrected 1930-vintage fallacies in the belief that they were profound insights....
Economists do turn out to know quite a lot: they do have some extremely useful models, usually pretty simple ones, that have stood up well in the face of evidence and events. And they definitely shouldn’t defer to important and/or rich people on policy: compare Janet Yellen’s macroeconomic track record with that of the multiple billionaires who warned that Bernanke would debase the dollar. Or take my favorite Business Week headline from 2010: “Krugman or [John] Paulson: Who You Gonna Bet On?” Um. The important thing is to be aware of what we do know, and why...
#shouldread
#economicsgonewrong
#monetaryeconomics
#finance
#economicsgoneright
