Another chapter on “What´s wrong with economics”

Wolfgang Munchau has an interesting piece on the FT: “Macroeconomists need new tools to challenge consensus”:

Macroeconomists are once again caught up in a discussion about the future of their profession. An example has been the recent debate between Lawrence Summers and Ben Bernanke about the deep causes of the economic slowdown. The former US Treasury secretary has defended the case of a “secular stagnation” while the former chairman of the Federal Reserve sees an excess of savings over investment.

It is an enlightened debate, but it also masks a much deeper problem within macroeconomics. Secular stagnation — a sharp fall in growth rates lasting a very long time — is not something that you can easily square with the current generation of macroeconomic theories and models.

Part of this debate reminds me of a discourse among mathematicians at the end of the 19th century. At the time, mathematicians — and physicists too — thought they had solved most problems, just as economists did until 2008.

The advent of chronic instability is the equivalent challenge for macroeconomics today. The present tools used by mainstream macroeconomists cannot deal with this adequately. New ones are needed. They exist in other disciplines, but to macroeconomists they look as weird today as the abstract stuff looked to mathematicians of the 19th century.

Some comments (with reference to the US):

1 I don´t think there is chronic instability. There was a spate of instability in 2008-09, that configured the crisis. For the past five years what we´ve had is a “great stability” at the “wrong level”.

2 The 1970s was a decade of “Great Instability” (“Great Inflation”) in real growth, unemployment and inflation; but that was followed by more than 20 years of “Great Stability” (“Great Moderation”) in real output, unemployment and inflation.

3 The “Great Disturbance” derived from the fact that policymakers, in particular the ones responsible for monetary policy, came to believe that the source of the “Great Stability” was having kept inflation low and stable (or on target). So when inflation got a direct hit from oil prices they “tightened the monetary screws” and reaped a “Great Instability” followed by an “Inadequate Stability”, also dubbed “Secular Stagnation”!

The necessary tools are certainly there. What´s needed is a revision of the mainstream views on the source of the “Great Stability”!

Nick Rowe has a discussion and suggestion:

Fluctuations in inflation are a noisy signal of monetary disequilibrium, because the firms that do change prices are not always representative of the firms that don’t. And by targeting inflation the central bank makes inflation stickier, and this reduces inflation’s signal/noise ratio. Fluctuations in output are also a noisy signal of monetary disequilibrium. NGDP targeting means targeting the sum of two noisy signals. NGDP targeting is unlikely to be exactly optimal, but may well be better than inflation targeting, which puts all the weight on one noisy signal and ignores the other.

The big puzzle of the recent recession is why the inflation guard dogs failed to bark, to warn central banks of recession. Even in those countries where inflation did fall, it only fell a little. In others it stayed on target, or even rose above target. The NGDP guard dogs barked loud and clear, giving a consistent and correct signal. That is what we need to model. And if we can model that, we may also have a model in which targeting NGDP can do better than targeting inflation.


5 thoughts on “Another chapter on “What´s wrong with economics”

  1. Marcus, I think you are right on target. If you take P=MV/Q, under inflation target one is trying to stabilize growth rate of P, by gauging changes in Q (using potential RGDP and NAIRU) and adjusting M hoping that V does not screw up the entire thing. The thing is the indicators that should help to estimate Q have a poor history of success, and V changes abruptly anyway. Surprisingly, PQ, on the other hand shows much less volatility than V, therefore, NGDP is well suited as an indicator to help estabilize AD. Now, what about the supply side? Does MM offer an answer as to how to model supply ? or more important, is it enough to model potential growth as exogenous stochastic shocks around a fixed trend growth?

  2. My take is that most economists roughly agree on the supply side—of course, taxes and regulations should be kept at the minimum. You have some political disagreements, on who should pay taxes, and whether environmental regs are worth it, etc. But broad agreement.

    On monetary policy, it is a no-holds-barred wrestling match, WWF-style.

    And what macroeconomists should be studying is QE.

    Look at Japan. look at Europe. They can’t lower interest rates much more (yes, they went negative but there is a limit to that).

    QE is the only real tool left. And it will take years, perhaps decades, to supply-side our way to adequate aggregate demand, if ever. QE is the tool on the table.

    Sadly, many economists do not even understand how QE works. They talk about swaps for reserves. They chatter that the Fed must reduce its balance sheet, as if it is a physical weight on the Fed building roof, or a keg of dynamite. They say QE is inert, or hyperinflationary.

    The real story is that QE may have to become a conventional tool, as it already has in Japan.

    That’s what macroeconomists need to study.

  3. Marcus and Cole,
    I am not an economist, but I am a fund manager and the 2008 crisis affected my beliefs in many ways. I “was sold” in business school (2000-2001) on the thesis that we had achieved such a knowledge of the economic system that we had conquered the “great moderation”. Since then, and since it is obvious that something is wrong, I study things that people point me to. I read this paper, and from what I read, it looks to me that productivity growth is modeled in new neoclassical synthesis as exogenous random shocks around a trend. The trend line is taken from a (long?) history of growth data. But, what is this is too simplistic? What if trend growth is not exogenous, and inflation and / or money growth somehow affect it?

    • JRB, That´s basically the RBC view of business cycles. The trend (level and growth rate) is determined by the principles of growth theory (institutions, innovation, productivity, etc). There´s no place for stabilization policy. Some shocks are real, but there are also the nominal (monetary) shocks, mostly induced by monetary policy errors.

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