Mark Thoma recently wrote a piece on the failures of macroeconomics and the need for new thinking in macroeconomics. His main criticisms are as follows:
- Existing macroeconomic models failed to give warning about the financial crisis.
- The models failed to give us policy guidance.
- There is too much emphasis on representative agents.
- Macroeconomists did not think questions about financial markets were worth asking.
- During the Great Moderation, economists didn’t spend enough time thinking about why things were going well.
- In 2003, Robert Lucas proclaimed that depression-prevention policy had been solved and this sentiment was shared by others of importance within the profession thereby making it more difficult to get work on such topics published.
I should note that Thoma also criticizes the critics. He argues that the scorn leveled at dynamic stochastic general equilibrium models is misplaced. These models and techniques were developed to answer specific questions. Thus, we should expect them to answer the questions they ask, but we shouldn’t necessarily expect more than that.
Nonetheless, I would like to consider his criticisms point-by-point.
- Points 1 and 2 above are not (necessarily) fair criticisms of macroeconomics.
- While I agree that there is too much emphasis on representative agents in RBC models and New Keynesian models, there is considerable work in macroeconomics involving heterogeneous agents.
- Economists were actually thinking quite a bit about financial markets.
- Economists were actually thinking quite a bit about the Great Moderation (including yours truly).
- This discussion of Robert Lucas and his 2003 lecture is unfair to Lucas.
In his first two points, Thoma makes two distinct statements. First, he argues that modern macroeconomics does not equip us with models to explain the financial crisis and recession. Second, he argues that because of these models, economists were able to provide zero guidance to policymakers.
Macroeconomists think about recessions as coming from some exogenous shock. By definition, a shock is unknown and unpredictable. According to Thoma, a successful macroeconomic program would be one that provides models that explain what happens after the shock and provides policy guidance in the event that the policy. The implication thus seems to be that if we economists had the right models, we would know what was going to happen and could prevent the recession from being severe by enacting the necessary policy response.
This certainly sounds reasonable. Nonetheless, I actually think that this is a high bar for what we should expect from macroeconomics and macroeconomists. To understand why, consider the following example. Suppose there is some exogenous shock to the economy. There are two possible scenarios. In Scenario 1, macroeconomists have models that describe how the shock will affect the economy and the proper policy response. In Scenario 2, macroeconomists have no such models.
In Scenario 1, we avoid a severe recession. In Scenario 2, we could possibly have a severe recession. However, note something very important about our example. Given this logic, the only time that we would have a severe recession is when macroeconomists are ill-prepared to explain what is likely to happen and to provide a policy response. Thus, given Thoma’s expectations about macroeconomics, we should conclude that macroeconomics has failed every single time there is a severe recession. This seems like a very high bar.
As a result, I do not think that this is a fair criticism of macroeconomics. No matter how much we know, our knowledge will be imperfect and so long as our knowledge is imperfect we are going to have severe recessions.
This point is important because Thoma argues that the reason that we lacked a proper policy response to severe recessions was because people like Robert Lucas thought we didn’t need to study such things. However, this is a very uncharitable view of what Lucas stated in his lecture (read it here). Thoma quotes Krugman who quotes Lucas as saying “depression prevention has been solved.” Sure enough, the quote is there in the introduction. Lucas said it. Lucas then spends the rest of the paper comparing the welfare costs of business cycles to the welfare benefits of supply-side policies. However, if you read all the way through to the conclusion, you will note that Lucas actually has something to say about macroeconomic stabilization policies:
If business cycles were simply efficient responses of quantities and prices to unpredictable shifts in technology and preferences, there would be no need for distinct stabilization or demand management policies and certainly no point to such legislation as the Employment Act of 1946. If, on the other hand, rigidities of some kind prevent the economy from reacting efficient to nominal or real shocks, or both, there is a need to design suitable policies and to assess their performance. In my opinion, this is the case: I think that the stability of monetary aggregates and nominal spending in the postwar United States is a major reason for the stability of aggregate production and consumption during these years, relative to the experience of the interwar period and the contemporary experience of other economies. If so, this stability must be seen in part as an achievement of the economists, Keynesian and monetarist, who guided economic policy over these years.
The question I have addressed in this lecture is whether stabilization policies that go beyond the general stabilization of spending that characterizes the last 50 years, whatever form they might take, promise important increase in welfare. The answer to this question is no.
So when Lucas says that the depression-preventing policy problem has been solved, he actually provides examples of what he means by depression-prevention policies. According to Lucas preventing severe recessions occurs when policymakers stabilize the monetary aggregates and nominal spending. This is essentially the same depression-prevention policies advocated by Friedman and Schwartz. Given that view, he doesn’t think that trying to mitigate cyclical fluctuations will have as large of an effect on welfare as supply-side policies.
Nonetheless, Thoma’s quote and his remark imply that Lucas was wrong (i.e. that we haven’t actually solved depression-prevention). Of course, in order for Lucas to be wrong the following would have to be true: (1) Lucas says policy X prevents severe recessions, (2) We enacted policy X and still had a severe recession. In reality, however, we never got anything that looked like Lucas’s policy. The growth in monetary aggregates did not remain stable. In fact, broad money growth was negative. In addition, nominal spending did not remain stable. In fact, nominal spending declined for the first time since the Great Depression. We cannot conclude that Lucas was wrong about policy because we didn’t actually use the policies he advocates.
This brings me to a broader point. Thoma argues that Lucas’s thinking was indicative of the profession as a whole (or at least the gatekeepers of the profession). This ties directly into his argument that economists spent far too little time trying to explain the Great Moderation. This simply isn’t true. John Taylor, Richard Clarida, Mark Gertler, Jordi Gali, Ben Bernanke, and myself all argued that it was a change in monetary policy that caused the Great Moderation. Others, like Jonathan McCarthy and Egon Zakrajsek argued that improvements in inventory management due to innovations in information technology were a source of the Great Moderation. James Stock and Mark Watson argued that the Great Moderation was mostly result of good luck. Thus, to say that people didn’t care about understanding the Great Moderation is unfair.
Similarly, his criticism that economists simply didn’t care enough about financial markets is unfounded. Townsend’s work on costly state verification and the follow-up work by Steve Williamson, Tim Fuerst, Charles Carlstrom, Ben Bernanke, Mark Gertler, Simon Gilchrist, and others represents a long line of research on the role of financial markets. Carlstrom and Fuerst and well as Bernanke, Gertler, and Gilchrist found that financial markets can serve as a propagation mechanism for other exogenous shocks. These frameworks were so important in the profession that if you pick up Carl Walsh’s textbook on monetary economics there is an entire chapter dedicated to this sort of thing. It is therefore hard to argue the profession didn’t take financial markets seriously.
The same thing can be said about representative agent models. Like Thoma, I share the opinion that progress means moving away from representative agents. However, the profession began this process long ago. While the basic real business cycle model and the New Keynesian model still have representative agents, there has been considerable attention paid to heterogeneous agent models. Labor market and monetary search models contain heterogenous agents and not only get away from a representative agent framework, but also dispense with Walrasian market clearing.
But perhaps more important for this discussion is the work of the late Bruce Smith. Throughout his career, Smith was trying to integrate monetary models in which money and banking were actually essential to the model with growth and business cycle models. Look at a list of Smith’s work, which encompasses over 20 years of thinking about money, banking, and business cycles in frameworks with heterogeneous agents and in which money and banks are essential for trade to take place. It is hard to argue that the profession doesn’t take these issues seriously when one can establish such a long, quality research record doing so.
I agree with Thoma that we need to make progress in macroeconomics. We live in a complex and uncertain world and are tasked with trying to understand how millions of individual decisions produce equilibrium outcomes. It is a complex task and we do need to ask the right questions and develop frameworks to answer these questions. Nonetheless, to argue that macroeconomists aren’t already asking these questions and working on these tools does a disservice to macroeconomists and macroeconomics more generally.