Macroeconomics, Fantasy, Reality, and Intellectual Utility…

A very nice overview piece this morning from smart young whippersnapper Noah Smith:

Noah Smith: Economics Struggles to Cope With Reality: “Four different activities… go by the name of macroeconomics. But they actually have relatively little to do with each other….

1. ‘coffee-house macro,’ and it’s what you hear in a lot of casual discussions. It often revolves around the ideas of dead sages–Friedrich Hayek, Hyman Minsky and John Maynard Keynes. It doesn’t involve formal models, but it does usually contain a hefty dose of political ideology.

2. Finance macro. This consists of private-sector economists and consultants who try to read the tea leaves on interest rates, unemployment, inflation and other indicators in order to predict the future of asset prices (usually bond prices). It mostly uses simple math, though advanced forecasting models are sometimes employed. It always includes a hefty dose of personal guesswork.

3. Academic macro. This traditionally involves professors making toy models of the economy–since the early ’80s, these have almost exclusively been DSGE models (if you must ask, DSGE stands for dynamic stochastic general equilibrium). Though academics soberly insist that the models describe the deep structure of the economy, based on the behavior of individual consumers and businesses, most people outside the discipline who take one look at these models immediately think they’re kind of a joke. They contain so many unrealistic assumptions that they probably have little chance of capturing reality. Their forecasting performance is abysmal. Some of their core elements are clearly broken. Any rigorous statistical tests tend to reject these models instantly, because they always include a hefty dose of fantasy….

4. Fed macro. The Federal Reserve uses an eclectic approach, involving both data and models. Sometimes the models are of the DSGE type, sometimes not. Fed macro involves taking data from many different sources, instead of the few familiar numbers like unemployment and inflation, and analyzing the information in a bunch of different ways. And it inevitably contains a hefty dose of judgment, because the Fed is responsible for making policy.

However, I think he has picked the wrong four.

Let’s start with Noah’s second: finance macro. It needs to be divided: One of its pieces–call that the second of our four components of macro–is grifter-finance macro: essentially affinity fraud to terrify rich people and get them to let you overcharge them to manage your money or simply to sell some snake oil you have to offer. I think it should come first:

1. Grifter macro

The other piece of Noah’s second–call that the useful finance-forecasting macro–is really the same thing as Fed-technocratic macro: the flow of ideas and people is large, and convergence not to a consensus model or approach but to a near-consensus distribution of models and approaches is relatively rapid. But let’s postpone that.

Instead, turn to Noah’s third, academic macro. It too needs to be divided: One of its pieces–DSGE macro–has indeed proven a degenerating research program and a catastrophic failure: thirty years of work have produced no tools for useful forecasting or policy analysis. As Noah puts it:

Academic macro has basically failed the other three…. Because academic macro is so useless for forecasting–including predicting the results of policy changes–the financial industry can’t use it for practical purposes. I’ve talked to dozens of people in finance about why they don’t use DSGE models, and some have indeed tried to use them–but they always dropped the models after poor performance.

Hence Noah’s first two need to be:

1. Grifter macro
2. Pointless (academic DSGE) macro

The other piece of Noah’s third is composed of that part of the academic community that is in dialogue with both finance-forecasting and Fed-technocratic macro. Noah says:

My view is that academic macro has basically failed the other three…. The Fed has had to go it alone when studying how the macroeconomy really works. Regional Fed banks and the Federal Reserve Board function as macroeconomic think tanks, hiring top-level researchers to do the grubby data work and broad thinking that academia has decided is beneath it. But that leaves many of the field’s brightest minds locked in the ivory tower, playing with their toys…

I think this is wrong. Academics are not locked in the ivory tower. Rather, some academics–unfortunately, many academics–lock themselves in their own ivory tower. And I question Noah’s description of the people as “brightest”. If you insist on trying to understand business cycles by requiring a single consumption Euler equation (rather than, say, risk-averse rich 70-somethings with short horizons; myopic middle-class 40-somethings, and the liquidity constrained); if you insist on trying to understand business cycles by requiring that firms engage in Calvo pricing; If you insist on trying to understand business cycles by requiring rational expectations (rather than anchored, adaptive, extrapolative, perfect-foresight, and Panglossian)–well, then you really aren’t very bright at all, are you?

In fact, there is a dialogue between Fed-technocratic, finance-forecasting, and what we might call useful-academic. This dialogue is strong enough that they are pretty much the same thing: the flow of ideas and people is large, and convergence not to a consensus model or approach but to a near-consensus distribution of models and approaches is relatively rapid. Thus Noah’s first three should be:

1. Grifter macro
2. Pointless (academic DSGE) macro
3. Useful (Fed-technocratic, finance-forecasting) macro

And then there is Noah’s first, coffee-house macro:

Because academic macro models are so out of touch with reality, people in causal coffee-house discussions can’t refer to academic research to help make their points. Instead, they have to turn back to the old masters, who if vague and wordy were at least describing a world that had some passing resemblance to the economy we observe in our daily lives…

What this leaves out, I think, is that there is substantial idea-flow from coffee-house macro into useful Fed and forecasting macro. The useful macro community has spent the last decade realizing that there is a lot more to be learned from Keynes and Minsky than it had thought, and has been busily revising how and what it thinks under pressure of events. In some sense this was or ought to have been obvious. As Larry Summers said to me back in 1983: “There ought to be an awful lot of excellent careers to be made in macro by mathing-up more pieces of Keynes”. (There is also, alas!, substantial idea-flow from coffee-house macro into grifter macro–Hayek, von Mises, etc.)

Thus if I were to write down a quadriad, I would modify Noah’s into:

1. Grifter macro
2. Pointless (academic DSGE) macro
3. Useful (Fed-technocratic, finance-forecasting) macro
4. Coffee-house macro

I would say that (2) is in dialogue with nobody and nothing. I would say that (1) is in dialogue with the wing nuttier parts of (4). And I would say that (3) and (4) are in useful dialogue–albeit one-way dialogue, so far at least, as useful macro is a recipient of big ideas from coffee-house macro rather than a generator of new and different big ideas for coffee-house macro.

And I would add a fifth:

1. Grifter macro
2. Pointless (academic DSGE) macro
3. Useful (Fed-technocratic, finance-forecasting) macro
4. Coffee-house macro
5. Policy macro

Policy macro is the intellectual framework that underpins the policies that the North Atlantic has followed since the start off 2010.

It is not in close dialogue with any of the others.

It has been, on the fiscal side, a complete disaster. It has been, on the regulatory side, a mixed bag. And it has been, on the monetary side, a very partial success.

Noah concludes with optimism:

Justin Wolfers… a conference celebrating the career of MIT economist Olivier Blanchard…. Wolfers suggested abandoning DSGE models, saying that they ‘haven’t worked’… suggests that the new macroeconomics will focus on empirics and falsification… fertilized by other disciplines… will incorporate elements of behavioral economics….

I think the new macroeconomics… will redefine what ‘macroeconomics’ even means…. ‘Macro-focused micro’–studies of businesses, competition, markets and individual behavior that have relevance for macro… business dynamism, price adjustment, financial bubbles and differences between workers. Let’s hope more and more macroeconomists focus on these things, instead of trying to make big, grandiose, but ultimately vacuous models of booms and recessions. When we understand the pieces of the economy better, we’ll have a much better chance of grasping the whole…

I am not sure. Macroeconomics needs, desperately, better and real behavioral microfoundations at the sector and the market level. But it also needs much better approaches to aggregation–to understanding how macroeconomic phenomena emerge out of real microfoundations.