A Pat on the Back for Macro
It comes from Olivier Blanchard.
a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good.
Thanks to Paul Walker for the pointer. I’ll excerpt more below, and try not to get personal about an economist who for thirty years has embodied everything I despise about macro. Back then, he was insufferably smug and I was childishly rebellious. Not much has changed.Blanchard depicts mainstream macro thusly:
a specfic model, the so-called new-Keynesian (or NK) model, has emerged and become a workhorse for policy and welfare analysis …The model starts from the RBC (real business cycle) model without capital, and, in its basic incarnation, adds only two imperfections. It introduces monopolistic competition in the goods market. ..It then introduces discrete nominal price setting, using a formulation introduced by Calvo, and which turns out to be the most analytically convenient.
Blanchard lavishes praise on this model. Of course, without capital or investment, it has no financial sector to speak of.
The current financial crisis makes it clear that the arbitrage approach to the determination of the term structure of interest rates and asset prices implicit in the basic NK model falls short of the mark: Financial institutions matter, and shocks to their capital or liquidity position appear to have potentially large macroeconomic effects.
The main imperfection around which thinking about credit markets is built is asymmetric information.
This has two direct implications for macro fluctuations. First, these constraints are likely to amplify the effects of other shocks on activity. To the extent that adverse shocks decrease profits, and thus reduce the funds available to the entrepreneurs as well as the value of the collateral they can put up, they are likely to lead to a sharper drop in investment than would happen under competitive markets. Second, shifts in the constraints can themselves be sources of shocks. For example, changes in perceived uncertainty which lead outside investors to ask for more guarantees may lead entrepreneurs to reduce their investment plans, leading to lower demand in the short run, and lower supply in the medium run
to the extent that investment projects have horizons longer than those of the ultimate investors, financial intermediaries may hold assets of a longer maturity than their liabilities. Because financial intermediaries are likely to have specific expertise about the loans they have made and the assets they hold, they may find it difficult or even impossible to sell these assets to third parties. This in turn opens the scope for liquidity problems: A desire by the ultimate investors to receive funds before the assets mature may force the intermediaries to sell assets at depressed prices, to cut lending, or even to go bankrupt|all possibilities the current financial crisis has made vivid. (The standard non-macro reference here is Diamond and Dybvig (1983), which has triggered a large literature.)
Discussing empirical factor analysis undertaken by Stock and Watson, Blanchard writes,
There is a tempting but slightly worrisome interpretation for these results: That shocks to aggregate demand, which indeed move most quantities in the same direction, have little effect on prices, and thus on inflation. That shocks to prices or wages, and thus to inflation, explain most of the movements in inflation, with little relation to or effect on output. And that asset prices largely have a life of their own, with limited effects on activity.
Blanchard proceeds to discuss methodology.
A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, ¯rms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.
So, the state of macro is this:
1. We have a workhorse model, with no capital or financial markets.
2. We have some work on asymmetric information and financial markets that is not really integrated into the workhorse model, but which suggests that when “shocks” occur, their effects may be amplified relative to the workhorse model.
3. Real-world data have interesting patterns that either are unexplained by or contradict the most widely-used models.
4. Papers follow a “haiku-like” ritual in order to be published.
And this is “good.” I agree with all four propositions, but I disagree with the conclusion.
For example, Washington is currently discussing an economic stimulus package. This sounds like an issue on which macroeconomists ought to have an informed opinion. How large should it be? Should it be enacted at all? In all of the haikus that have been published over the past thirty years, is there one that offers a clue to the answer?
With regard to the bailout, I don’t see macro doing much better. We have theoretical models that tell us that financial sector losses can “amplify shocks.” On the other hand, we have an empirical study that says that asset price movements don’t have big effects on employment and output. If we believe the empirical work, then the likelihood of another Great Depression resulting from recent financial turmoil is actually pretty low.
Even in the theoretical models, we have no idea what sort of financial sector distress could lead to a quantitatively large effect on the real economy. We have no idea whether, taking opportunity cost into account, injecting capital into banks is a net plus or a net minus for the overall economy. Remember that Ken Rogoff, correctly in my opinion, describes the financial sector as bloated. That means that the financial sector might be the last place where we should be injecting capital.
There may very well be adverse macro effects to follow from the loss of confidence in the way that financial institutions handle risk. But isn’t that loss of confidence justified? Didn’t financial institutions in fact do a lousy job of managing risk?
Common sense would suggest that injecting capital into banks will not restore confidence if nobody believes that the banks know what they are doing. In that case, the capital injection could turn out to be a waste of resources, keeping financial institutions going when the market is screaming at them to shut down.
Neither I nor anyone else knows what the macroeconomic consequences will be of the various rescue plans and stimulus proposals. At best, these moves can be justified as sheer panic. At worst, they reflect a long-term agenda of the Left, which is using the financial crisis as cover for looting corporate America, just as thieves use an urban riot as a cover for looting televisions.
Macroeconomics can tell us nothing useful about the current policy environment. All we know for sure about what is taking place is that there has been a massive shift of power to Washington, with much more likely ahead.