Edward Luce has a very misleading piece in the Financial Times. Here’s an excerpt:
Why do economists continue to get it so wrong? One answer is that not all of them do. David Blanchflower, who was on the Bank of England’s monetary policy committee during the 2008 crash, insists that evidence of an impending crash was hidden in plain view long before it happened. Blanchflower, whose book Not Working: Where Have all the Good Jobs Gone? is a stinging rebuke to his profession, was consistently outvoted eight to one on the MPC, which sets UK interest rates. Unlike his colleagues, who were using models based on a 1970s-style economy, Blanchflower went out and talked to people. He calls this “the economics of walking about”.
His peers, meanwhile, were relying on “largely untested theoretical models that amounted to little more than mathematical mind games”. Paul Romer, the former World Bank chief economist, calls this “mathiness” — playing with regression to give a false sense of precision. Others might call it alchemy. Lucas, whose Chicago School housed the high priesthood of mathiness, won a Nobel Prize for his rational expectations theory. It demonstrated that the market was always right.
Central bankers do tend to rely on 1970s-style Keynesian models of the economy. But almost everything else is wrong. Paul Romer was criticizing an entirely different set of models, often called “new classical” or “real business cycle” models. These models certainly have flaws, and indeed they may be as useless as Romer claims. But policymakers do not rely upon them. Robert Lucas‘s rational expectations work can be viewed as a critique of 1970s-style Keynesian economics. And by the way, rational expectations most certainly does not suggest that “the market is always right”. The financial system is saturated with moral hazard, a phenomenon long understood and critiqued by “mathiness” economists.
It’s also not clear how “playing with regression to give a false sense of precision” fits in here. That is certainly a problem in economics, but it has nothing to do with the other issues discussed in these two paragraphs. Nor does it have anything to do with the recent policy failures leading up to the 2008 crisis.
In my view, almost all of the top economics programs have too much “mathiness”, not just the University of Chicago. BTW, when I was in grad school, MIT was far more mathematical than Chicago, although that may no longer be true. I went to Chicago precisely because in the 1970s it was more focused on the real world than most other programs.
Most importantly, rational expectations theory is not the problem; it’s the solution. The recession of 2008 occurred precisely because monetary policymakers at the Fed ignored market signals and relied on 1970s-style Keynesian models. The Fed focused on backward looking indicators showing high inflation in 2008, and ignored market signals that growth was slowing dangerously. It was like driving a car while looking in the rear view mirror.
The Fed is now beginning to take market signals more seriously, and that is one reason why monetary policymakers decided to cut rates this year. Older Phillips curve models would have called for a rate increase, and if we had followed them we would already be in recession.
READER COMMENTS
Mark J Brophy
Oct 12 2019 at 6:54pm
Wouldn’t it be better to have a recession than avoid it? When the world is so crazy that investors buy century bonds from Argentina and negative interest rate bonds from Greece, something is terribly wrong. A recession might return sanity to financial markets.
Lorenzo from Oz
Oct 12 2019 at 7:41pm
It is amazing how many “business” and “economic” journalists do not understand what they do not understand. So to speak.
Mark Brady
Oct 12 2019 at 10:04pm
FWIW, Edward Luce is neither a “business” nor an “economics” journalist. He is the Washington columnist and commentator for the Financial Times. As such, from time to time he ventures into economics commentary. I read him each week, and I think he’s one of the better journalists on their staff. On occasions, he is, of course, wrong. Aren’t we all?
Scott Sumner
Oct 13 2019 at 1:44am
That’s right. Of course it’s easy to find wrong analysis in the media. I try to focus on examples that are representative of fairly widely held misunderstanding.
Thomas Hutcheson
Oct 13 2019 at 6:50am
Looking backward may explain Fed policy mistakes up to Aug 2008 (although just how much above 2% trend line had the price level moved?), but not thereafter. Thereafter it was just sheer reluctance to “do what it takes” to comply with its mandate. For me the question still is, why? Did it in fact have competing targets — “stability” of short-term interest rates, inflation rate ceiling — or self imposed constraints on use of instruments — no negative short term interest rates, not “too much” QE? What was it?
This s not to say that using information from existing futures markets or creating new ones like a NGDP futures market would not be useful.
Scott Sumner
Oct 14 2019 at 12:03pm
Good point. Part of the problem was overly optimistic forecasts of how quickly the economy would recover, or overly pessimistic forecasts of the natural rate of unemployment (assumed to be 5% to 6% until the recent decline.)
Alan Goldhammer
Oct 13 2019 at 8:17am
Most of what economists have gotten wrong is amply documented in Binyamin Applebaum’s fine book, “The Economists’ Hour: False Prophets, Free Markets, and the Fracture of Society” that I recently finished reading. Applebaum is one of the principal economic writers for the NY Times and the books is thoroughly researched and annotated. It covers many of the prediction errors that economists have made over the years. Sebastian Mallaby, a fine econ writer, reviews this and Nicholas Lemann’s book (which I have just finished reading as well) in The Atlantic.
Scott Sumner
Oct 14 2019 at 12:04pm
The Luce article was (in part) a review of that book.
Michael Rulle
Oct 14 2019 at 1:46pm
Very clear and you hit all the right notes. Also agree that Powell, at least, has shown a willingness to care about the market’s expectations (and not because he is afraid of Mean Mr. Mustard). Your point of the Fed either causing problems, or making them worse, by tightening, and using the right definition of tightening (misreading the supply and demand for money) is neither well accepted nor easy to read in real time when accepted. The Fed used to run a model of M1 versus employment–from the early/mid-50s-to around 1990 (circa). Each year it would be “tweaked” so history matched the model. Give them credit for patience—and more importantly —-for finally ditching it.
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