Arnold Kling  

Macroeconomics, Circa 1970

PRINT
Betting Stakes and Julian Simo... David Friedman on TSA...

According to Prad Krulong, macroeconomists had it and then lost it. They lost it some time after 1970. We had this magic formula, call it M70, and somehow we let it slip from our collective memory.

But what was M70? It was multi-equation computer models that embodied a set of beliefs about macroeconomics. These models said that inflation was determined as follows:

1. Nominal wage growth is an inverse function of the unemployment rate (this is the infamous Phillips Curve).

2. Real wages are determined by the price-markup equation.

Because of (2), the attempt by workers to raise wages when unemployment is low is an exercise in futility. They can raise nominal wages, but never real wages. In a sense, workers trying to get higher wages are causing an externality. They are creating inflation that hurts everyone and helps no one. Given this externality, the logical policy response is to impose wage and price controls.

Oops.

One reason that macroeconomics as of 1970 is not still around today is that the macroeconomics of 1970 was tried in 1971-1973, with adverse consequences.

If we were to go back to thinking in terms of M70, sooner or later we would again come around to the point of view that inflation is a silly result of market failure. We would once again try to use wage and price controls.

I think that the computer models suffer from a k>n problem. That is, the number of plausible right-hand-side variables exceeds the number of observations. Other people have other issues with the computer models. In any event, the models are a vehicle for articulating a set of beliefs, but they do not provide evidence about the validity of those beliefs.

I think we are left with a much more casually empirical approach to evaluating countercyclical policy. How often has it worked? How often has it failed?

What I suggest is that, without any prejudice, look at the instances over the past 50 years in which countries tried countercylical fiscal policy. What were the successes? What were the failures? My impression is that there were many more of the latter than the former.

Look, I take second place to no one in my dislike for representative-agent, rational-expectations macroeconomics. But I think that the failure of M70 was not just that it lost favor with people who were obsessed with microfoundations and fascinated by math. Much of the failure of M70 was and remains empirical.


Comments and Sharing





COMMENTS (13 to date)
Jacob Oost writes:

Who the heck is Prad Krulong? I thought you were making some spooneristic joke about Paul Krugman at first.

GU writes:

"Prad Krulong" = Paul Krugman + Brad DeLong.

Noah Yetter writes:

Any economist or theory that recommends price controls should be summarily drummed out of the profession. The effects of such policies are so well understood and well documented, with evidence going back literally to the beginning of human history, that endorsing them cannot be regarded as anything other than willful stupidity.

Jacob Oost writes:

Amen Noah. An economist doesn't have to be a Friedman or Hayek clone to earn my respect, and I try my best, but it is darn hard to maintain respect for economists who advocate certain policies that are obviously counterproductive. Price and wage controls, and fiscal stimulus to get out of a recession spring to mind.

Robert Solow and Alan Blinder are two economists who I've heard admit that they believe in policies which do not make economic sense (government administration of schools and minimum wage, respectively). What is one to say?

If a physicist said "sure all of the evidence says gravity bends light waves, but I prefer to believe in a society that does not allow light waves to bend," they'd be dismissed as a quack.

Doc Merlin writes:

" were the successes? What were the failures? "
How do you even define success and failures of it? What annoys me about large parts of macro is that they aren't even wrong. Macroeconomists are notoriously reluctant to actually make hard testable public predictions.

FC writes:

Prad Krulong earned his PhD at the age of 12 under the direction of Joan Robinson, then returned to his native India to become Finance Minister...

George J. Georganas writes:

The intitial post is a very cheap shot on Prad Krulong. They are not going back to the M70.
But suppose everybody, from Wall Street giants to the mom-and-pop corner store, want out of their risky assets and into "safe" cash at the same time. Should the government accommodate all that perfectly "market" demand ? Simple question, really, for our macroeconomics experts. Should the Fed continue buying risky assets against cash ? The "market" demands it. Who knows, capitalism may have decided it wants to commit suicide. Or just take a few years off. Should the government assist it ? And what would the Fed do with all those corner stores it would end up with ? Will we not end up with a Soviet-type economy, except that it would be by consent ? Assuming that foray into a Soviet economy is only temporary and only partial, would its costs be lower than waiting out the current slump ? These are, in my view, tough questions for Prad Krulong. But their opponents have to answer them, too. If "the market" wants massively out of risky and productive assets, is the government to sit and watch ? How much damage should the government let the people do to themselves ? Do not tell me they are rational representative agents. They are human and panic. Otherwise we wouldn't have fire drills.

Tom Grey writes:

I was alive in 1970, I knew 1970;
and this is no 1970.

There's a book about the US winning the Tet Offensive, this time, as was the historical reality (in '68). I don't know if it equates the anti-draft, anti-Vietnam protesters to the anti-capitalist pro-communists, but I do. And when the commies won in Vietnam, then in Cambodia, there were bloodbath murders as the pro-victory in Vietnam group had predicted.

But most folks, probably like Prad, seem to think supporting commie victory & genocide is the more moral choice.

If we can't even get this big army- war history and results analysis correct, with pretty clear body count tests, it's no surprise that actual macro results seem unable to falsify any theories.

The usefulness of economics is in making predictions, not to understand, but to control. And/or to profit. But any predictions economics makes that produces profit-making results, like some "US real estate always goes up! (20 years of model data proves it!)", such economics induces behavior changes (buy more; borrow more to buy more) that, at some point, invalidate that rule.

This is not a problem of k>n.
It's a problem that all economic relations are based on behavior. And any relation that's usable for making greater profits will, when used, change behavior to invalidate that relation. In the long, if not mid or short term. This isn't quite efficient markets, but is related.

John dalman writes:

George - why would the government control people moving out of risky investments into cash? By cash do you mean physical cash? People leaving one investment (sellers) require buyers with either cash or other liquid assets.
As some people leave risky investments (corner stores), supply shrinks and returns for remaining corner stores may rise making the risk acceptable for some people. Government intervention only defeats this marketplace adjustment and prevents the flow of capital to more useful places.
The Fed/Govt should never have started buying risky investments of any kind. In fact their interference is prolonging the misery if for no other reason than people who chose wisely are paying to bail out the greedy. Now people are reluctant to take risk and our economy is burdened with huge debt.

George J. Georganas writes:

@John dalman
The question is how long do we have to wait until that adjustment takes place. Sure, I would like to buy all the corner stores (and Wall Street giants' stocks) that come to market at a low price. But how much money would the bank lend me for my brilliant project ? And would the bank not get nervous as the value of hundreds of my newly-acquired corner stores keeps falling ? Is that not what we see happening before our very eyes? It looks like a variation of the plot of "Atlas Shrugged" with capitalism going Galt, not because of state interevention and envy, but because of fatigue ! To be sure, some day values will recover. But how many bank depositors are willing to wait for their money till that day ?
I believe the normal scenario is the one you outline. But these are abnormal times and call for abnormal responses.

Miguel Madeira writes:

"They are creating inflation that hurts everyone and helps no one. Given this externality, the logical policy response is to impose wage and price controls."

No - it is to increase unemplyment (usually rising interst rates).

At least, this is the traditional answer of the trditional macroeconomics

nb writes:

Oh yawn! You're slipping in your morbid old age, Kling, my dear depressing old thing! Delong and Krugman are winning the intellectual game hands down. Grin-and-bear-it Depression Economics is just so dashed unattractive, not to mention untrue!

salamancan writes:

Nb doesn't explain how Krulong are "winning", but just indulges in name calling, which it is clear he mistakes for argument.

Comments for this entry have been closed
Return to top