Must-Read: Paul Romer: The Trouble with Macroeconomics

Must-Read: Paul Romer observes–I believe indisputably–that the now 40-year tool-building exercise creating Dynamic Stochastic General Equilibrium models based on representative agents and rational expectations has produced neither estimates nor insights. He further ventures the guess–which I believe is correct–that it never will.

As Paul Krugman observes, the fact that he was one of the last students to learn macroeconomics under the old Keynesian regime of Jim Tobin and then escaped the gravitational attraction of DSGE and RBC entirely by wandering off into international trade meant that, when the —- started to hit the fan internationally in the later 1990s and did hit the fan for real in 2008, he was vastly better prepared to understand the world than virtually any of his colleagues who had felt, to any degree, the gravitational attraction of DSGE and RBC:

Paul Romer: The Trouble with Macroeconomics:

In the last three decades, the methods and conclusions of macroeconomics have deteriorated…

…to the point that much of the work in this area no longer qualifies as scientific research. The treatment of identification in macroeconomic models is no more credible than in the first generation large Keynesian models, and is worse because it is far more opaque. On simple questions of fact, such as whether the Fed can influence the real fed funds rate, the answers verge on the absurd. The evolution of macroeconomics mirrors developments in string theory from physics, which suggests that they are examples of a general failure mode of for fields of science that rely on mathematical theory in which facts can end up being subordinated to the theoretical preferences of revered leaders. The larger concern is that macroeconomic pseudoscience is undermining the norms of science throughout economics. If so, all of the policy domains that economics touches could lose the accumulation of useful knowledge that characteristic of true science, the greatest human invention….

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As Canova and Sala (2009) signal with the title of a recent paper, we are now “Back to Square One.” Macro models now use incredible assumptions to reach absurd conclusions. To appreciate how far backwards our conclusions have gone, consider this observation, from a paper published in 2010, by a leading macroeconomist:

…although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations.

If you want a clean test of the claim that monetary policy does not matter, the Volcker deflation is the episode to consider…. If the Fed can cause a 500 basis point change in interest rates, it is truly absurd to wonder if monetary policy is important. Faced with the data… the only way to remain faithful to dogma that it is not important is to argue that despite what people at the Fed thought, it was actually an imaginary shock that increased real fed funds rate….

The real business cycle model explains recessions as exogenous decreases in phlogiston. Given output Y , the only effect of a change in the monetary monetary aggregate M is a proportional change in the price level P. In this model, the effects of monetary policy are so insignificant that, as Prescott taught graduate students at the University of Minnesota “postal economics is more central to understanding the economy than monetary economics” (Chong, La Porta, Lopez-de-Silanes, Shliefer, 2014).

Proponents of the RBC model cite as one of its main advantages its microeconomic foundation. This posed a problem because there is no microeconomic evidence for the negative phlogiston shocks that the model invokes nor any sensible theoretical interpretation of what a negative phlogiston shock would mean.
In private correspondence, someone who overlapped with Prescott at the University of Minnesota sent me an account that reminded me of what it was like to encounter “negative technology shocks” before we became numb to them:

I was invited by Ed Prescott to serve as a second examiner at one of his student’s preliminary oral…. I had not seen or suspected the existence of anything like the sort of calibration exercise the student was working on. There were lots of reasons I thought it didn’t have much, if any, scientific value, but as the presentation went on I made some effort to sort them out, and when it came time for me to ask a question, I said (not even imagining that the concept wasn’t specific to this particular piece of thesis research) “What are these technology shocks?”

Ed tensed up physically like he had just taken a bullet. After a very awkward four or five seconds he growled “They’re that traffic out there.” (We were in a room with a view of some afternoon congestion on a bridge that collapsed a couple decades later.) Obviously, if he had what he sincerely thought was a valid justification of the concept, I would have been listening to it…

In response to the observation that the shocks are imaginary, a standard defense invokes Milton Friedman’s (1953) methodological assertion from unnamed authority that “the more significant the theory, the more unrealistic the assumptions.” More recently, “all models are false” seems to have become the universal hand-wave for dismissing any fact that does not conform to a favorite model. The noncommittal relationship with the truth revealed by these methodological evasions and the “less than totally convinced …” dismissal of fact goes so far beyond post-modern irony that it deserves its own label. I suggest “post-real”…