Arnold Kling  

Junk Macroeconomic Science

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Several days ago, Greg Mankiw linked to a list of top economists according to some objective criteria related to published work. I was familiar with most of the top 150, at least to the point of being able to identify their main field of contribution. In the top 25, there was only one economist with whom I was unfamiliar. His (I assume it's a he) name is Jordi Gali.

Coincidentally, the other day I received a review copy of a book by Gali, enthusiastically blurbed by Mankiw among others. I think that the book is junk.

It is a graduate textbook in New Keynesian economics. What that means in practice is a bunch of mathematical modeling utterly divorced from reality. As David Colander points out in his The Making of an Economist, Redux, contemporary graduate students are forced to suffer through this in spite of the fact that many of them, as well as many of their professors, suspect that it is worthless.

I will lay out my own views on macro now.

There are two essential features of macroeconomics.

1. Financial markets and investment depend on subjective perceptions of risks and opportunities.

I have talked about the risk disclosure problem, which is that financial intermediation works by disguising risks. When people perceive that it is working well, the cost of investment falls and we have a boom, or possibly even a bubble. When people lose faith in financial intermediation, we can have a crash.

Keynes spoke of "animal spirits" of entrepreneurs. He contrasted that with a propensity to hoard among those who are averse to risk. His story was of an excess desire to save among the hoarders relative to the animal spirits of the entrepreneurs. There is much about Keynes that I reject (the liquidity trap, for example), but I have always liked the "animal spirits" story. It is mostly overlooked in textbooks nowadays.

2. Labor markets adjust slowly to sudden shifts in demand.

There is a perpetual need for people to change jobs. Societies start out with the majority of workers in agriculture, and the trend is to migrate to jobs in cities. For the past fifty years in the United States, the share of manufacturing production work has declined. These gradual, normal adjustments in the labor market reflect the fact that demand grows faster than productivity in some sectors (health care, education) while productivity grows faster than demand in other sectors (foodstuffs, manufactured goods).

On the other hand, there can be sudden, unexpected shifts in labor demand. Think of the dotcom crash of 2000, which suddenly lowered the demand for web developers and "business development" shmoozers. In theory, wages for these occupations should have fallen and the relative wages of other occupations should have risen, with little or no net drop in employment.

In practice, relative wages adjust slowly. It may be possible for the monetary authorities to speed the process of relative wage adjustment by engineering an inflation surprise. That is, you increase the rate of money creation, leading to more inflation, causing real wages to fall where needed. Maybe. My confidence in that mechanism is actually pretty low.

3. "Fiscal policy" is an unfortunate excuse for vote-buying.

Running a government deficit means redistributing wealth away from future taxpayers toward current taxpayers. On net, this makes people feel wealthier. This would be a good thing if the economy were suffering from severe, protracted high unemployment. In practice, however, deficit spending is used as a cynical political tactic. It is a stain on macroeconomics that this crude vote-buying is dignified with the name "fiscal policy."

Having a large government sector helps to insulate the economy from macroeconomic fluctuations, primarily because government employment is not subject to sudden changes in market demand. But temporary increases in spending or cuts in taxes are exercises in politics, not in good economics.

4. The central bank matters more as a lender of last resort than as a monetary authority.

Financial markets are large and complex. There are many substitutes for money. When the financial markets are operating reasonably smoothly, the central bank has to work really hard to generate either high inflation or disinflation. Central banks certainly have done this. In the U.S., the central bank facilitated inflation in the 1970's. However, for most of the past twenty years, many central banks have kept inflation at modest levels.

When financial markets threaten to unravel, a lender of last resort may be able to mitigate the damage. This is the context in which I view recent moves by the Federal Reserve in the U.S. Only time will tell whether my support for these policies is warranted. But it is consistent with my view of macro.

5. Remember that much of macroeconomics is anti-economics.

In real economics, work is a "bad." There is no such thing as a shortage of jobs. Instead, there are unlimited wants. We should be rooting for high productivity that enables people to choose a mix of consumption goods and leisure that they prefer.

In real economics, saving does not hurt the economy. Saving allows individuals to smooth their consumption. It allows businesses to accumulate capital, raising worker productivity. We should be rooting for high saving, rather than worrying about consumers being in the mood to spend.

In real economics, government spending that is financed by borrowing is typically not a good thing. We should be rooting against deficit spending.

In real economics, borders and currencies do not matter. We should not be rooting for a weak dollar to give us a "trade surplus." Instead, we should be rooting for unimpeded trade, in order to gain from specialization and comparative advantage.


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CATEGORIES: Macroeconomics



COMMENTS (15 to date)
eric writes:

How does this comport with your co-blogger's desire to turn things over to the experts? They are wrong now, not on logic, but priorities, as always! Read Samuelson's Principles book from the 50's or 80's, and it's full of howlers, such as that nimble fiscal and monetary policy should be used to avert recessions, without which we will certainly have another Depression. And of course, budget deficits are good if we are below full employment (ie, always). Smart guy, but as always, the Harvard and MIT faculty are worse than the first 50 names in the Boston phone book for economic policy.

Garrett Schmitt writes:

I agree with this post entirely. I know other people that agree. I also know scads of other people, though, who disagree.

Why isn't Keynesianism dead and buried, or at least pushed to the fringes of polite discourse with dialectical materialism and dianetics? It still animates policy debates, business news, and the fundamental assumptions behind--dare I say--all of the economic statistics published today.

Trying to argue with the myriads of respectable people who accept Keynesianism lock, stock, and barrel as mainstream economic thought makes me feel like someone trying to sell flights to the Moon in a medieval monastary. I just can't even begin to ponder real questions without accomodating a host of basic fallacies.

Why isn't Keynesianism dead, and what can I do about it?

Radford Neal writes:

Nice post, but I'm not sure I agree with a couple points...

First, why does a central bank have to "work really hard" to generate high inflation? Won't printing up a sufficiently large quantity of dollar bills (more technically, increasing the monetary base) accomplish that easily, in a matter of weeks? Maybe you mean that it's unlikely that they will accidently produce high inflation as a result of policies motivated by some other goal? That's more plausible, though I'm not convinced.

Second, you say that in "real economics, saving does not hurt the economy", and that we "should be rooting for high savings". Aren't time preferences a matter of personal choice, outside the domain of real economics? Shouldn't we be rooting for people to save whatever is the right amount for them?

Fred Grunwald writes:

Agree with your post completely - very relevant to the times as we, like other Americans, just received our Publisher's Clearinghouse prize notification from the Treasury Department. All we have to do is file our 2007 tax return to claim the "prize".

It is disturbing to know that my children and grandchildren will be paying for my "prize" (rebate), long after any magazines I ever ordered stop coming.

Justin Ross writes:

When I teach Macro, I cut out the lectures on Keynesian Theory and instead make it part of a lecture(s) of macroecnomic fallacy. The simplest rebuttal to the theory for principles students is that nobody has ever heard of spending their way to prosperity, only savings can do that. It's the honest and true approach. It should be cast this way just as in biology you briefly cover spontaneous generation as the relevant previous misunderstanding.

BGC writes:

Well, you convince me (a non-economist).

This sounds like the mismatch you get in all large sciences between the kind of science that is useful to people outside the science, and the kind of science that is useful inside the science.

Inside the science usefulness is essentially a matter of whether something helps build careers.

An example from bioscience is brain imaging - which over the past generation has probably built more careers than anything except molecular biology - but its real-world, outside the science usefulness has been pretty close to zero.

Rob writes:

Ah, the debate between the classical and Keynesian models is perpetually unrelenting. With the current "crisis" it looks like the pendulum has swung back into the Keynesian camp, but our society has never really demonstrated any kind of conviction in one style of thought in macroeconomics. Maybe Keynes will die for good when we start paying off our national debt and the social security tax is at 20%.

jsalvati writes:

"Fiscal policy" is an unfortunate excuse for vote-buying.

This isn't a plausible explanation for "fiscal policy." Didn't Bryan demonstrate pretty well that voter material self-interest plays a pretty minor role in politics? You could explain this some other way, maybe voters are naturally biased towards things that are in their self interest. If you do this though, you shouldn't use the phrase "vote buying," you should give your explanation. The phrase "vote buying" is misleading.

Lord writes:

If there are 2 essential features why are 5 listed?

Over time the monetary authorities have quite a deal of control over the value of money and the value of money does matter. Collapsing the value of money by a third in three years at the beginning of the depression is rapid and sizable to me. The ability to lower real interests below zero is a great benefit to me. As you point out money is always elastic to some extent. Being able to control it to some extent is not only necessary but imperative. That is why macro will last forever.

Franklin Harris writes:

Marcoeconomics is to real economics as "Intellegent Design" is to biology. Except that there is a government (and macroeconomists) who think they can play God.

Matt writes:

Before I read Arnold's comments, let me make my quick IMHO.

Macroeconomics attempts to do on an aggregate scale what accountants do for net present value accounting.

Why bother. Economists study population behavior. They use units familiar to wealth units in a modern society, but economists could just as well use value units and construct their science on the basis of biological group behavior, or they could apply their science to particles in a fluid. What makes the science of economics so spectacular is that it is a bridge between what happens in biology or physics and what we perceive as value in our own relative terms.

In other words, the job of the economist is to apply force equations to our own behavior.

That somewhat to do with standard double accounting but economists should quit kowtowing to the business and accounting community and join the real scientists.

Now, let me get onto Arnold's essay.

Nick Firoozye writes:

Don't you think that this recent crisis and the responses by CBs will cause us all to chuck out the fixed lag-structure backward-looking Neo-Keynesian models (which were really just conveniences to fit data, but are not very realistic) and lead to a resurgence of rational expectations/neo-monetarist models? Clearly Money Supply Matters!!!!

Just look at how the Fed is now following in the ECB's footsteps. The ECB clearly states that they see liquidity and interest rates as being different tools. Address the banking crisis by money (and then prepare to face the inflationary consequences), but do not address it by lowering rates. A Neo-Keynesian (Phillips curve, IS curve and Taylor rule, a la Clarida-Gali-Gertler) doesn't have room for money, just for rates.

In fact the current rational expectations models themselves currently do not address the need to model inflation both through rates and monetary supply. The only one I know of is through segmented markets: Alvarez-Lucas-Weber http://citeseer.ist.psu.edu/416882.html

I anticipate an ebbing of interest in Neo-Keynesian models through time, and they, like the Keynesian models which were thrown out before them, will become New New Keynesian, incorporating more RE and now monetarist terms in them.

Ryan writes:

Although I like your comments on #3, I don't think it touches the real problem of Fiscal deficit spending. It is a fact that at any given point in time there is a finite supply of capital in the economy which no government can increase or decrease outright. However, what the government can do is, through fiscal spending, bid away these scare factors of production away from firms operating in the private sphere of the economy. As far as government is capable of effectively utilizing and managing resources, I think the view is nearly universal that government is more apt to squander and mismanage when compared to private enterprise. So under these circumstances the aggregate supply of finite capital is not being utilized in its most efficient uses. To the extent that Fiscal spending lends itself to capital consumption I'm unsure about, but regardless I think that the distortions that fiscal policies have on the utilization of capital is the most pernicious effect of those policies rather than mere vote-buying. Nice post.

Taxman writes:

Modern macroeconomics is just a mess. Keynesianism never had any serious intellectual foundation, except in Axel Leijonhufvud's formulation of it as only applicable in a deep, deep depression, such as the unique experience of the 1930s. Neither Keynes, Keynesians, or Leijonhufvud have had much empirical material to prove their presumptions, however. Milton Friedman's monetarism has virtually disappeared with the advent of all kinds of money-like substitutes, making the "money supply" a rather questionable concept. Rational expectations have proved pretty much a dead end.

But there is one surprisingly solid empirical result that overturns a lot of Arnold's argument: Ricardian equivalence holds, pretty much.

That is, federal deficits don't matter. Government bonds are not private wealth. Government borrowing is not shoving debt on our descendants in favor of spending by current generations. Interest rates and exchange rates have been shown to be invariant with deficit spending. Those empirical results are solid. We should all be Ricardians now. Throw out your textbooks if they don't say this.

And I also question Arnold's simplistic suggestion that we should "encourage savings". Sure, if we like growth. But the more correct statement should be that our savings, investments, and growth paths should be determined by our market-negotiated equilibria for time preference. That could be high or low growth, depending. Too much growth is not a good thing -- certainly it's not for those of us close to the edge of existence.

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