Must-Read: Paul Krugman: Good enough for government work? Macroeconomics since the crisis

Must-Read: But who is this “we”, Kemosabe? Paul Krugman believes that “saltwater” economists have little to learn, theoretically, from the financial crisis. I think that is wrong. I think what “saltwater” economists have to learn is that it was a huge mistake to engage with rather than ignore—”freshwater” economists. People interested in understanding the world and guiding policy should always have been focused on the world outside, rather than on RE and DSGE and RBC and other pointless alphabet soup: Paul Krugman: Good enough for government work? Macroeconomics since the crisis: “hen the financial crisis came policy-makers relied on some version of the Hicksian sticky-price IS-LM as their default model; these models were ‘good enough for government work’…

…While there have been many incremental changes suggested to the DSGE model, there has been no single ‘big new idea’ because the even simpler IS-LM type models were what worked well. In particular, the policy responses based on IS-LM were appropriate. Specifically, these models generated the insights that large budget deficits would not drive up interest rates and, while the economy remained at the zero lower bound, that very large increases in monetary base wouldn’t be inflationary, and that the multiplier on government spending was greater than 1. The one big exception to this satisfactory understanding was in price behaviour. A large output gap was expected to lead to a large fall in inflation, but did not. If new research is necessary, it is on pricing behaviour. While there was a failure to forecast the crisis, it did not come down to a lack of understanding of possible mechanisms, or of a lack of data, but rather through a lack of attention to the right data….

The intellectual impact of the crisis just seems far more muted than the scale of crisis might have led one to expect. Why?… Macroeconomics hasn’t changed that much because it was, in two senses, what my father’s generation used to call ‘good enough for government work’. On one side, the basic models used by macroeconomists who either practise or comment frequently on policy have actually worked quite well, indeed remarkably well. On the other, the policy response to the crisis, while severely lacking in many ways, was sufficient to avert utter disaster, which in turn allowed the more inflexible members of our profession to ignore events in a way they couldn’t in past episodes….

The DSGE models that occupied a lot of shelf space in journals really had no room for anything like this crisis. But macroeconomists focused on international experience—one of the hats I personally wear—were very aware that crises triggered by loss of financial confidence do happen, and can be very severe…. Did economists ignore warning signs they should have heeded? Yes…. But did this failure of observation indicate the need for a fundamental revision of how we do macroeconomics? That’s much less clear…. Was the failure of prediction a consequence of failures in the economic framework that can be fixed by adopting a radically different framework?… A significant wing of both macroeconomists and financial economists were in the thrall of the efficient markets hypothesis, believing that financial overreach simply cannot happen—or at any rate that it can only be discovered after the fact, because markets know what they are doing better than any observer. But many… knew better… especially those who had studied or been involved with the Asian crisis of the 1990s. Yet they (we) also missed some or all of the signs of overreach. Why?…

My bottom line is that the failure of nearly all macroeconomists, even of the saltwater camp, to predict the 2008 crisis was similar in type to the Met Office failure in 1987, a failure of observation rather than a fundamental failure of concept. Neither the financial crisis nor the Great Recession that followed required a rethinking of basic ideas…