Macroeconomics In The Era Edward Hugh Of The Internet London: February 2011

Why Didn’t Mainstream Economists See The Crisis Coming?

Three Hypotheses

•Over-reliance on consensus

•Excessive Belief That Markets Can Never Fail

•They Were Mesmerised By Their Own Models

The Case Of The IMF

For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time however, largely because facts do not go away, 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 and herding. None of this deadly however. The state of macro is good............ there has been broad convergence in vision.

Oliver Blanchard , Chief Economist at the IMF

"Part of the problem was the similar mindset of many mainstream economists working at the Fund, with similar background and training and who were not open to dissenting views. Both in and outside the Fund, there were other economists and policy makers with contrarian views. But their views were not encouraged or closely examined within the Fund.“

 IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07Background Paper: Summary of Views of the Advisory Group

The IEO View(IMF Independent Evaluation Office)

The Heart of the Problem

Excess of Confidence – “Feel-good” Effect

Too Much Consensus – Inability To Listen

The “Storks on the Wire” – false correlation – effect, years of apparent economic stability and a new generation of macro theories (the era of the so-called Great Moderation) lead to the idea that sound application of consenually grounded theory had had something to do with the apparent stability. This later turned out to have been a mistake.

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.Paul Krugman

This is a widely shared view, and is certainly the case. But Krugman goes further, the world of economics as he sees it is divided between those who believe the economic system regulates itself, and those that don’t. In Krugman’s terminology, freshwater economists are, essentially, market purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work. My question is: are these very strong, and scarcely credible, assumptions really needed to get the game of doing useful macroeconomics started?

The Freshwater and Saltwater Approach

On the other hand there are those who believe economic systems don’t run smoothly on their own: “Where the freshwater economists were purists, saltwater economists were pragmatists. ... they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable”.

Demand Driven Recessions

This argument seems more plausible , since levels of consumer and investment demand do fluctuate, but it still leaves us with the underlying issue as to why such shifts in demand occur. In other words, what drives these movements in demand. Is there any identifiable underlying process?

"What does concern me about my discipline, however, is that its current core —by which I mainly mean the so-called dynamic stochastic general equilibrium approach — has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one”.

Ricardo Cabellero - Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome

The “Core” Versus “Periphery” Argument

At this level Caballero’s approach seems similar to Krugman’s statement above, but rather than put the line in the sand between “laissez-faire” and interventionist economists, he tries to differentiate between an increasingly unreal (he uses the word “surreal”) core and a series of “real-world” plug-ins which have been created to in an make the models work by making their assumptions more realistic. As Caballero notes, in fact integration of the plug-ins increasingly poses a threat to the coherence of the models they were meant to rescue.

Realism vs Coherence?

But Before Going Further: What Was The Last Crisis About?

The recent financial crisis was basically about debt, and about how heavily indebted societies were going to claw their way back to economic growth.

In fact mainstream neo-classical economists have often found it extremely difficult to incorporate this deep structural component into their cyclically based models.

But Then: Just Why Was There So Much Debt?

This is a key part of the puzzle. One of the key parts of the problem is to explain why some societies got into debt, while others didn’t. Spain’s households, for example, contracted a lot of debt. German households didn’t.

Why the difference? One theory is that a failure of single-size monetary policy. But is that enough to explain such massive structural divergence?

Then There Were Those Famous “Global Imbalances” – But Just Why Did The Imbalances Build Up?

Japan, Germany and China – the usual suspects – had their massive current account surpluses.

While that other group - the debtors, like the UK, the US and Spain – ran substantial deficits.

So with such mundane macro processes like these as the backdrop, do we really need to start by talking about rare phenomena and “fat tail” events here?

So What Really Are The Problems With Macroeconomics?

Surely comprehensive macro theory should be able to handle and explain such general global phenomena. Ricardo Caballero in his paper “Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome” makes some strong assertions, which I think macroeconomics needs to challenge and give a response to.

• Complexity Implies Uncertainty

• Events Cannot Be Foreseen

• Something Is Rotten In The Core of Neo- Classical Theory

"The idea is to place at the center of the analysis the fact that the complexity of macroeconomic interactions limits the knowledge we can ever attain. In thinking about analytical tools and macroeconomic policies, we should seek those that are robust to the enormous uncertainty to which we are confined, and we should consider what this complexity does to the actions and reactions of the economic agents whose behaviour we are supposed to be capturing".

Does Complexity Really Imply Uncertainty?

Really there is uncertainty, and uncertainty. I may be able to identify a housing bubble, but I cannot tell when exactly it will burst (although “x” months after the central bank starts raising interest rates would be a good rule-of-thumb approach - think China now).

Multi year GDP forecasts may be the next best thing to useless, but is it completely impossible to identify the level of trend growth for an economy at any given moment in time.

Spain’s economy was growing at about 4% a year for the best part of a decade, but would anyone like to bet me we will see average growth rates of over 1% annually between now and 2020?

Is The World Really So Uncertain As Caballero Claims?

Really there is uncertainty, and uncertainty. I may be able to identify a housing bubble, but I cannot tell when exactly it will burst (although “x” months after the central bank starts raising interest rates would be a good rule-of-thumb approach - think China now).

Multi year GDP forecasts may be the next best thing to useless, but is it completely impossible to identify the level of trend growth for an economy at any given moment in time.

Spain’s economy was growing at about 4% a year for the best part of a decade, but would anyone like to bet me we will see average growth rates of over 1% annually between now and 2020?

Is The World Really So Uncertain As Caballero Claims?

"In my view, the conviction that one can foretell a severe crisis in advance is mostly a manifestation of pareidolia—the psychological phenomenon. That makes people see faces and animals in clouds and the like.“Ricardo Caballero

Knowing What You Might Know, And What You Almost Certainly Don’t Know

In a manner which is extraordinarily reminiscent of the way scholastics treated the move from the closed to the infinite universe, Caballero ridicules attempts to give a predictive edge to economic theory. In Newton’s day appeal to non material forces of attraction (like gravity) was ridiculed as being no better than mere astrological quackery. Today we are faced with a transition in the way we think about things which is every bit as profound as the shift from Newtonian to Einsteinian physics.

But Then What Really Is The Problems With ModernMacroeconomics?

"The core approach to macroeconomics, as it is taught in most graduate programs and as it appears in leading journals, begins with a neoclassical growth model. This model is then developed into a stochastic form....“Ricardo Caballero

The Neo-Classical Core

So at the heart of modern macroeconomics lies the neo-classical growth model, and the assumption of some form or other of – hard to define – steady state growth. Some notion of this kind has to lie behind all those weird and wonderful RBC models, or the game could never commence. But just how reasonable are the premises which lie behind this assumption?

"All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.“

Solow, R. M. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics 70(February):65-94.

Solow’s Simplifying Assumption

Now one of those simplifying assumptions for Solow, and the whole neo classical growth approach is based on this is that POPULATION IS AN EXOGENOUS VARIABLE.Just how realistic is this assumption?

What Happens If We Make Population Endogenous?

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

Solow: Homogenisis & Steady State Dynamics

What Happens If We Make Population Endogenous?

Instead of treating the relative rate of population increase as a constant, we can more classically make it an endogenous variable of the system. Suppose, for example, that for very low levels of income per head or the real wage population tends to decrease; for higher levels of income it begins to increase; and that for still higher levels of income the rate of population growth levels off and starts to decline.

Solow: Homogenisis & Steady State Dynamics

But Do We Really See Homogenisis In Reality?

Is there a self correcting “”hiddenhand” type mechanism at work here?

Do societies converge towards a common steady state income per capita growth rate as they age?

One Size To Fit Them All – Median Population Age

Could it really all be as simple as this?

A Simple Model Of Current Account Dynamics Using Demography and Median Age

Claus Vistesen

If Lions Could Speak, Would We Really Be Able To Understand Them?

The Role Of The Internet I – The Arrival of the Sell Side Analyst

Nikkei Peak, and Japan Dependents RatiosFrom The Golden To The Grey Age, Deutsche Bank Special Report.

Can Greece Really Pay All That Debt?

The Role Of The Internet II – New Media

Universities won't survive. The future is outside the traditional campus, outside the traditional classroom.

Distance learning is coming on fastPeter Drucker - I got my degree though e-mail

The Role Of The Internet III – Social Networks

The Role Of The Internet IV – Access To High Volume Data

The Role Of The Internet V – Qualitatative Data

Despite the obsession with building robust quantitative models.

In real world economics,at the empirical level, Quantitative data – like PMI & Labour Force Surveys – ProvesTo Be Incredibly Useful.

The Role Of The Internet VI – Sharing Information & Perspectives

The new information technology.. Internet and e-mail.. have practically eliminated the physical costs of communications.Peter Drucker

Are There Positive Externalities Associated With Sharing Information?

So What Does The Future Look Like?

I’ve seen it, but does it work? The Japanese Case

And What About Spain?

And That “Horrid”European Sovereign Debt Crisis?

According to the World Bank, the nine countries that have been attracting the bulk of capital flows since the crisis are Brazil, China, India, Indonesia, Malaysia, Mexico, South Africa, Thailand and Turkey. - World Bank‘: Global Economic Prospects 2011.

Can We Really See Nothing In Advance?

Monetary Policy In the Age of A Global Economy

Ben Bernanke’s Latest Statement

“With regards to commodities inflation in developing economies, Ben Bernanke asserted that central banks there were equipped to deal with it. They could raise interest to quash price pressures and also allow the exchange rates of their currencies to appreciate to counter imported inflation””.

Globalization is an ecosystem in which economic potential is no longer defined or contained by political and geographic boundaries. Economic activity knows no bounds in a globalized economy. A globalized world is one where goods, services, financial capital,machinery, money, workers and ideas migrate to wherever they are most valued and can work together most efficiently,flexibly and securely.Richard Fisher , President of the Federal Reserve Bank of Dallas

Thank You Very Much For Your Attention

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again.John Maynard Keynes