“When the facts change, I change my mind.” The crash of 2008 has brought Keynes’ famous line back into popular use. But should it have done so? Here’s my claim:
Nothing that happened in the last two years should have significantly revised the general macroeconomic views of anyone who is (a) familiar with the last two centuries of global economic history, and (b) reasonable.
The most someone could reasonably claim to have learned since last year
is that the “Great Moderation” has been oversold. After all, a
generalization about the last two decades is a lot easier to
unseat with one big event than a generalization about the last two
centuries.
This may seem like libertarian dogmatism, but I insist that it’s just good Bayesianism. Financial crises happen all the time. Disastrous global crises are rarer, but the Great Depression was vastly worse than anything we’ve seen or are likely to see, and there have been plenty of scary shocks before and since. And before we follow Arnold and deny the powerful effect of monetary policy on nominal variables, we’ve got to remember that monetary policy has always been subject to Friedman’s “long and variable lags.”
Admittedly, you could look at this history and say, “2008 is just another in an endless series of macro disasters caused by capitalism.” If that’s your position, then at least you’re updating correctly. But if you claim that 2008 overthrew everything you thought you knew about economics, I’ve got to wonder what you knew in the first place.
READER COMMENTS
Lee Kelly
May 11 2009 at 11:37am
There is no such thing as good Bayesianism.
ThomasL
May 11 2009 at 11:37am
Hear, hear.
Greg Ransom
May 11 2009 at 11:43am
What MOST tenured economists thought they knew was that all of the math and econometrics produced by the top 10 economics departments of great “science” that really did let us know what was going in on the macroeconomics. Most of that “knowledge” has explodes.
Yes, you should really wonder whether most tenured economists really have sound and reliable knowledge about how global economic order and disorder works.
Bryan wrote:
“But if you claim that 2008 overthrew everything you thought you knew about economics, I’ve got to wonder what you knew in the first place.”
ThomasL
May 11 2009 at 11:53am
I should have been clearer on my subject. In this case, I was attempting to express agreement with Bryan.
Elvin
May 11 2009 at 12:10pm
Agreed.
If you look at the VIX index, you can see that the price of risk got ridicuously low by 2006. This means that it was cheap to take risk; thus, everybody–households, financial sector, governments–levered up. Basic finance–a subsector of economics–says that in cases of extreme leverage, a shock can be a very, very bad event. Hoocodanode?
Now why risk got so cheap is another question. It clearly involves “animal spirits”. With no major financial bankruptcy since the S&L’s, no decline in housing in the wimpy 2001 recession, consumers and investors were lulled into the belief that risk was very managable. Again, no violation of basic economics in my opinion; they were wrong about the measurement of risk.
kebko
May 11 2009 at 12:38pm
The criticisms of the Greenspan Fed seem to me to be saying that, basically, he was a failure because the economy was so successful when he was at the Fed that now that it is almost as bas as it was for the decade that preceded his tenure, it’s a major catastrophe for us.
Unfortunately, it seems that human expectations correlate to human experience at a greater than 1 to 1 rate, so that as things get better, we expect them to be even better than they are, and we interpret this as failure.
Comparing the conditions of today’s worker with the worker of 100 years ago, how can large numbers of people see capitalism as a problem that needs to be solved and not be laughed out of the public conversation?
El Presidente
May 11 2009 at 1:04pm
Well said.
Sebastian
May 11 2009 at 5:08pm
I’m not sure if this is what triggered your post. But, it is exactly on point. Quiggin seems to be suggesting that we return to the happy days of Bretton Woods (while avoiding its excess) but I don’t really see how that is different than wishing for the great moderation of the 1990s (while avoiding its excess).
William Newman
May 11 2009 at 7:20pm
Good point, but note that 200 years doesn’t seem to be the right baseline for everything. How about a baseline of 100 years for (most of our data on) the risk structure and public choice effects of government insuring away the risks of private parties? Or a baseline of less than 100 years of fiat money (plus a few adventurous years earlier, but in nonmodern economies)? Or a baseline of 50 years for financial models complicated enough that many of the executives, regulators, voters, legislators, etc. couldn’t do the calculations without going back to school? (and resulting principal-agent and other issues)
Also, as you recognize, for big blowups we get only a few events over those years. When we only had one or two events before, I think a single new event can add significantly to the old knowledge. E.g., a few years ago, one could ask a fan of government insurance whether the taxpayer losses in the FSLIC adventures in the 1980s were a larger or smaller fraction of GNP than the deposit losses in the Great Depression before federal insurance. But it can be iffy drawing statistical inferences from a single event. Now we have two big events, and one can ask about the 1980s and the current mess together. Yesterday, an anecdote; today, *two* anecdotes; perhaps tomorrow, data…
Jacob Oost
May 12 2009 at 4:00am
Bryan’s right, and Greg’s right. I’ve heard some questionable economic pundits say that this current recession, for whatever reason, changes their opinion on markets. Bull pats. They confused rock-solid market economics with their fancy mathematical models.
I don’t get it. Were these people who wanted to be physicists, weren’t smart enough, but could do math so they shoe-horned this model crap onto economics?
Carl The EconGuy
May 12 2009 at 8:20am
In macroeconomics, it seems the questions endure, but the answers always change. Remember the line, about 40 years old, “We’re All Keynesians Now!” At the time, that meant simple multiplier Keynesians and all could be fixed with deficit spending and active government intervention. Then came the monetarist revolution, and all was havoc. Along came rational expectations, and it got worse. Then it all seems to have settled down on DSGE modeling, which includes elements of everything inside a mostly Keynesian framework of 500 equations, and now that’s broken apart. Throughout all of this, people still debate the meaning of “Keynesianism” and “what did Keynes really say.” Sad, that. Meanwhile, on the sidelines, there have always been naysayers, esp. the Austrians. There seems to be no macro *theory*, only macro *mythologies*.
My Bayesian priors tell me that we’re unlikely to get a settled macrotheory ever. Ever. The reason is that asset pricing is too volatile and fundamentally indeterminate, depending as it does on guesses about other people’s guesses about values, and on market overreactions to both good and bad news. Just look at the annual percentage variation in stock market pricing over the years, and ask whether that bears any relation to changes in real underlying values, and you see the point. If both C and I depend on perceived wealth, rather than real, then macro will always be at sea. In a little boat. On a big ocean. With no navigational equipment. And a lousy rudder. The limited successes of DSGE modeling means that we can find our way on a calm sea, with land in sight, but if the fog sets in or we get blown over the horizon, we’re lost. In other words, equilibrium macro works fine, but real disequilibrium macro never will. So, what good is it then?
Garett Jones
May 13 2009 at 12:56am
@Greg Ransom
I don’t see how this crisis debunks the major macro innovations of the last few decades. In fact, it seems like the crisis–at least the magnitude of the crisis–comes from ignoring some recent big lessons of mainstream macroeconomics.
Examples:
1. We ignored the Taylor Rule and kept interest rates way too low for a few years, so it’s no surprise we got a bad result. Lots of mainstream macro folks said this at the time. The Taylor rule was invented in ’92, and was mainstream by ’97: And it’s largely a reinvigoration of Friedman’s money growth rule…
2. We failed to reform our bankruptcy laws, even though the Asian Financial Crisis of ’97 created massive calls from guys like Stiglitz for “Super Chapter 11.” Such a “speed bankruptcy” reform would help avoid debt-deflation-type scenarios like the one we’re living through now in the mortgage market and the banking sector. So by ignoring the lessons of Stiglitz and other corporate finance/macro guys, we made it much easier for politicians to insist on massive government purchases of bank equity, rather than pushing for the theoretically better policy: the massive debt-to-equity swaps that would be normal in a “speed bankruptcy.” I learned all this stuff in grad school in the late ’90’s.
3. Markets and government participants downplayed the reality of bubbles, whether rational, near-rational, or behavioral. But mainstream economists have taught about the possibility of bubbles for decades. In 2005, for instance, the thoroughly mainstream Journal of Economic Perspectives had a mini-symposium on housing bubbles. Can’t say we missed that one….
So on interest rate policy, the benefits of bankruptcy over bailouts, and the possibility of bubbles, the mainstream of macro was right.
Where is the failure of mainstream academics, qua academics? Individual economists had terrible ideas, and the mainstream has never been unanimous, but you can find all of these ideas in the typical syllabi of most top 20 econ departments…..
Of course, I should close with one of the great ideas of modern macro: The idea that business cycles are a natural part of capitalism (whether you’re a real business cycle theorist or a monetarist/New Keynesian), and that business cycles don’t hurt the typical person’s well being that much (one of Lucas’s great insights).
So for people in the rich countries, even complaining loudly about recessions qua recessions is itself a sign of intellectual weakness. Yes, recessions are bad: Largely because they lead to bad government policy responses. But the Lucas insight that we’re probably just fluctuating around a trend means that the only real choice is big volatility vs. small volatility: And for rich countries like us with decent safety nets, not much harm comes from big volatility….
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