The Trouble with Macro
By Arnold Kling
My earlier post suggesting a macro-less economics major drew some interesting comments. I agree with those who say that a student should choose courses on the basis of the professor rather than the topic–that was exactly the advice I gave to my daughter.
On the issue of dropping macro, I think it boils down to three questions.
1. Do you think that it undermines otherwise sound economics?
2. How useful and important is AS-AD?
3. How useful and important is IS-LM?In my view, macro seriously undermines sound economics. It treats work as scarce and consumer wants as insufficient, which is the opposite of what we teach in micro. Macro treats saving as contractionary and international trade deficits as contractionary, which is contrary to general equilibrium micro. Most people with no economics training intuitively believe that jobs are scarce, that they help the economy when they spend rather than save, and that trade deficits are bad. In general it is the job of economists to explain why those views are fallacies.
Many economists believe that the metaphor of aggregate demand and aggregate supply is very useful for explaining output and inflation. I am not so sure.
One nit to pick is that the aggregate demand curve has the price level on the Y-axis, while the aggregate supply curve has the rate of price change on the Y-axis. I won’t dwell on that issue.
My problem is that I think it is really off track to suggest that the economy produces a single good, and that employment variation is due to variation in the demand for that single good. Instead, I think of the economy as having many sectors with constant shifts of demand among sectors. Variation in aggregate employment reflects sluggishness in shifting across sectors. I admit that one must strain to tell this story for the Great Depression.
The IS-LM model of money demand, saving, and investment is an attempt to explain interest rates and aggregate demand. Since I already don’t like the concept of aggregate demand, I’m not so excited.
For interest rates, there is again a nit. The LM curve has the nominal interest rate on the Y-axis, and the IS curve has the real interest rate on the Y-axis.
I think that one of the most important elements of the capital market is the risk premium. In fact, there are many risk premia. As the risk premium changes, we see variations in the type of investment that is profitable to undertake.
(My story of the Great Depression would be that there were major shifts away from investments in electric power plants, housing construction, and other businesses, because the risk premium rose. Labor never got around to moving toward sectors that were less dependent on a low risk premium.)
The combination of IS-LM and AD-AS has so many degrees of freedom that one may tell just-so stories about any conceivable combination of macroeconomic variables. But most economists do not believe that the predictions from macro-econometric models based on those concepts have been sufficiently accurate to validate the models. To me, that suggests a scientific failure.