What's wrong with macro?
By Scott Sumner
I see at least three problems with macro, as practiced at the elite level:
1. Academics who don’t know the stylized facts of macro over the past 100 years. (Fifty years is not enough, as most of the great natural policy experiments occurred between the wars.)
2. Academics who don’t know the history of thought in macro, and hence who keep re-inventing the wheel, or invent false doctrines which were considered and discarded decades ago.
3. Academics who rely on abstract mathematical models that are built on assumptions wildly at variance with the real world.
Let’s think about the third problem. I recently spoke with someone who had mentioned NGDP targeting at a discussion involving elite macroeconomists. Several acted as if they had never even heard of the idea. Why might that be?
One possibility is that macro models are generally structured in such as way as to generate useful policy advice, and economists often assume that inflation variability and output gaps are the relevant problems. So P and Y appear in the models, but not NGDP. It is certainly true that nominal instability is a problem, but why assume that nominal instability is better proxied by inflation than NGDP? In other words, very few elite macroeconomists seem to have read George Selgin.
I’ve recently been corresponding by email with a very bright UC student named Basil Halperin. One issue that keeps coming up is the fact that NGDP targeting might result in inflation instability, and/or changes in the trend rate of inflation. It’s not easy to explain why this doesn’t matter to someone that has been trained to assume that the costs of nominal instability are best proxied by inflation. If you ask a typical economist why, they might mumble something about relative price distortions and/or menu costs, as if these are major economic problems at low inflation rates. Consider the following:
1. Suppose oil prices suddenly double due to less supply. In that case, under inflation targeting you’d have to suddenly reduce all non-oil prices by a small amount. Imagine the menu costs if they did so, and imagine the relative price distortions if they changed at uneven rates! Even under NGDP targeting one might have to reduce non-oil prices, but not as many and not by as much. (BTW, this is one reason why targeting total nominal labor compensation is probably better than NGDP targeting.) You might object that this example assumes a supply shock. Yes, but in the face of demand shocks inflation and NGDP targeting are exactly the same.
2. It seems likely to me that the preceding costs of inflation are utterly trivial compared to some of the other costs of excess/volatile nominal growth, such as excessive taxes on nominal income, or unfair redistribution between lenders or borrowers, or excessive risk in credit markets, or financial turmoil/banking crises. And yet in all those cases nominal GDP growth is a much better proxy for the harmful nominal instability than is inflation. Even “shoe leather costs” are better proxied by NGDP.
Of course I might be wrong, but where is the empirical evidence either way?
The elite macroeconomists will try to tell you that only complex mathematical models count. That those of us trying to figure out relevant characteristics of the real world that actually need to be modeled are not doing “real science.”
I’m not opposed to mathematical models, and of course some of the market monetarists are much more technical than I am. I want people to develop good technical models of NGDPLT. I took a stab at it over at TheMoneyIllusion. But there’s also a need to check out the underlying assumptions of these highly technical models.
It must be a major embarrassment to the profession that us lowly MMs turned out to be more correct during the crisis than any other major group (New Keynesians, New Classical, RBC-types, etc.) and indeed more accurate than other groups on the fringes (old Keynesians, old monetarists, Austrians, MMTers, etc.):
1. It’s now obvious that Fed, ECB, and BOJ policy was far too tight in late 2008 and early 2009, but MMs were just about the only people saying so at the time.
2. We correctly pointed out that fiscal austerity in 2013 would not slow growth in the US because of monetary offset, whereas in a poll of 50 elite economists by the University of Chicago, all but one gave answers implying it would slow growth.
3. We pointed out that massive QE would not lead to high inflation, while many other economists on the right said it would.
4. We correctly predicted that the BOJ and Swiss National Bank could depreciate their currency at the zero bound, while many on the left said monetary policy was pushing on a string at the zero bound.
5. We pointed out that the ECB’s tightening of policy in 2011 was a huge mistake, which now almost everyone recognizes.
6. We advocated NGDPLT before it was cool (i.e. before Woodford.)
And yet because we don’t always express our ideas in the language of math, we are not doing “serious science.”
PS. I’d like to thank Basil for correcting an earlier version of this post, which mischaracterized the standard model. All remaining mistakes are my own.