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Unicorns, Higgs Bosons, and the state of macroeconomics

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In 2005 the UK Treasury sponsored a conference with the title [amazon_link id=”023001903X” target=”_blank” ]’Is There a New Consensus in Macroeconomics?[/amazon_link]’; a book of the conference was published in 2007. Its answer was ‘yes, but….’, the ‘but’ being – correctly, as it turned out in hindsight – the flagging up of some puzzles and controversies as well as shortcomings such as the absence of international flows and imbalances in the conventional model. At the time this sense of consensus was (by definition) widespread – Olivier Blanchard at the IMF famously wrote about it too, in The State of Macro.

[amazon_image id=”023001903X” link=”true” target=”_blank” size=”medium” ]Is there a New Consensus in Macroeconomics?[/amazon_image]

Earlier this week, the ESRC sponsored a symposium on macroeconomics hosted by the Oxford Martin School, with the aim of evaluating the state of macro now. As the ESRC’s Adrian Alsop put it in his introduction: “While in the economics profession, macro is but a sub-set of what we do, any perceived lack of vitality and strength in macro tarnishes economics as whole in the eyes of citizens and policy makers alike; and that in turn causes reputational damage for the whole of social science. So this is big stuff the profession, let alone the funding agencies.” Internationally, funding agencies are considering what kind of research in macro is needed – and particularly in the UK, where this is an area of economics in this country flagged up as weak by a 2008 benchmarking study (scroll down) for the ESRC, led by Elhanan Helpman.

My headline from the symposium is that macroeconomists are deeply divided, with any sense of consensus shattered. There is a division between those who regard increasing the sophistication and flexibility of existing models and approaches as an adequate response to the crisis, and those who believe a more far-reaching re-tooling is essential for both scientific and public policy credibility. This is more or less the same as the division between adherents to DSGE models, or more broadly a deductive equilibrium framework that uses a small number of aggregate variables to make analytical predictions; and those who believe macroeconomics must now become more inductive and data-based. As Professor Neil Ferguson, Professor of Mathematical Biology at Imperial College, put it in his comment on day 2 of the symposium, he was astounded by how little macroeconomists discussed data and the new techniques available for handling large amounts of data.

When this division between deductive and inductive approaches, between parsimonious analytical models and computer-based statistical techniques (agent-based modelling, econo-physics, statistical exploration of the data) surfaced, the discussion grew a little heated. This included the breaks: many of those who disagree with the prevailing, albeit broken, ex-consensus feel unable to bring about change even in their own research, and are not eager to speak out or change the nature of their work because it will harm their career prospects. To advance in UK economics departments requires publication of numerous articles in a small number of American journals which are firmly sticking to the conventional modelling approach.

My view is that if macroeconomics does not abandon its obsession with being able to write down analytical 3 equation models with maybe 12 or even 20 variables to explain and predict what is happening at large scale in the economy, it will lose all meaning and purpose. Below is a picture of my son burning his macroeconomics notes as soon as he’d taken his final exam – despite having an outstanding teacher, it seemed obvious to him that macroeconomics was a fairy tale, a fable. Yet many macroeconomists seem not to realise that they are dealing in metaphors, and that IS-LM curves are more like unicorns than Higgs bosons. Microeconomics suffers in the same way but not so badly and applied microeconomists are already a bit more flexible – more willing to use ad hoc rules of thumb derived from behavioural psychology, more willing to use qualitative evidence and business data, not just highly aggregated time series data.

Burning unicorns?

So I was wholly in agreement with Professor David Hendry, who in his presentation on statistical techniques for exploring data, said:

– all macroeconomic theories are incomplete, incorrect and changable

– all macroeconomic time series are aggregated, inaccurate and rrely match theoretical concepts

– all empirical macroeconometric models are aggregated, inaccurate and mis-specified in numerous ways

So why justify an empirical model by an invalid theory that will soon be altered? Why is internal model credibility considered more important than verisimilitude? “It’s why people think economists are daft,” he said. And, as he pointed out, DSGE models are not even logically internally consistent because they incorrectly regard agents’ expectations today of the future state of the world, conditioned on what they know today, as the same as their equivalent expectations tomorrow, bar for an unpredictable error – but this would only be true in a stationary world. When the state of the world can change in a non-stationary way between today and tomorrow, the kind of ‘model-consistent’ or rational expectations conventionally used are not possible.

I hope the ESRC and other social science funders will focus their efforts on enabling the reformist macroeconomists to pursue their alternative approaches. None of us knows what approach to macroeconomics will ultimately prove most fruitful, but at present given the institutional structures in academia, none of the alternatives are being pursued. Academic economists who have spent their careers doing everyday macroeconomics will need 2 or 3 years to change direction and learn new techniques and approaches to data. But if they want to keep their jobs, they will not get the space to do that – they will need to publish another tweak on a DSGE model in the American Economic Review.

Following the conference earlier this year that resulted in [amazon_link id=”1907994041″ target=”_blank” ]What’s The Use of Economics[/amazon_link], a working group hosted by the Government Economic Service has been considering the institutional barriers to reform of the undergraduate curriculum, and we will report next year. A parallel consideration is needed of barriers to reform in research, and I don’t excuse microeconomists from the need to think deeply about their subject, but it’s more urgent in macroeconomics because of the crisis.

 

Better than fiction

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On the train to Oxford yesterday, I did something unusual for me, namely read an e-book. It was a new publication from the Financial Times, [amazon_link id=”B009D04RF2″ target=”_blank” ]The Bo Xilai scandal[/amazon_link] by Jamil Anderlini. This is an extended version of an article in the FT magazine some weeks ago, and well worth the 99p it costs to have all the additional detail from a superb reporter. I’ve been gripped by this story from the start, for the light it casts on Chinese politics and society, but also because it is just an absolutely amazing saga. Highly commended, and the perfect length for a journey, at a fraction of the price of a magazine.

[amazon_image id=”B009D04RF2″ link=”true” target=”_blank” size=”medium” ]The Bo Xilai Scandal: Power, Death, and Politics in China[/amazon_image]

 

A mess beyond fixing?

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I’ve thoroughly enjoyed reading Robert Peston’s [amazon_link id=”1444757091″ target=”_blank” ]How Do We Fix This Mess?[/amazon_link] Its author is so famous, as the BBC’s Business Editor, that his photo is on the front cover. Yet he’s modest enough to start the book with: “I don’t know. But don’t stop reading now.” Indeed, the title is misleading because he sensibly does not try to dole out generalised policy prescriptions. (Oh and – note to publishers – that’s enough long and chatty subtitles, thank you. They’re becoming annoying.)

[amazon_image id=”1444757091″ link=”true” target=”_blank” size=”medium” ]How Do We Fix This Mess?: The Economic Price of Having it All, and the Route to Lasting Prosperity[/amazon_image]

The book draws on Robert’s long experience as a journalist covering the banking industry. (I should say that I’ve known him for years and followed, albeit far less successfully, in his footsteps at The Investors Chronicle and then a national newspaper, The Independent in my case, the FT and Sunday Telegraph in his.) As he says, it must seem to others to have been a boring reporting beat, but it has paid off handsomely in equipping him with the knowledge and the contacts to report superbly on the financial crisis to UK and worldwide audiences.

How Do We Fix This Mess combines chapters giving the context for the crisis, and – the heart of the book – chapters describing what happened in the course of the crucial events starting in late 2007. Scene-setting chapters describe the process of innovation and growth in financial markets and the creation of new kinds of derivatives; the inadequacy of the regulatory regime, and how it came to be so feeble; and the globalisation of the world economy and rise of China. These are all excellent overviews, although some readers will find this familiar territory.

I found the chapters on the early days of the unfolding crisis the most interesting, from the warning signs about Northern Rock through 2007 and the extraordinary run on the Rock in September that year. As Robert points out, the fact that Northern Rock’s business model involved online banking, with very few branches, meant that even a small proportion of depositors wanting to withdraw their money (my sister was one of them) translated into a big queue outside the branch. Some people accused him of causing the crisis, as if the drying up of credit markets and an unsustainable business model were somehow caused by the reporting of it. He is also very interesting on the part played by the Bank of England, much criticised for its handling. As Robert says, Mervyn King was right to say bailing out the banks would contribute to moral hazard – look at where we are now, still hostage to these titanic, toxic institutions – but the book criticises the Bank of England for not raising interest rates or taking other actions in the years before 2007 to puncture the evident bubble in asset markets. MPC minutes from 2005 and 2006 show little concern with its unsustainability or the need to raise interest rates: they were reduced once in 2005, and raised twice in 2006, but by just 0,25% points each time.

The book then turns to the Euro crisis and ends with the Libor scandal, and, rather than a list of things governments and regulators must do, Robert writes: “Perhaps the most important [cause of sluggish growth] is that there is a growing realisation that we have to take steps to live within our means, over the longer term….  The innocent pay a price for the national indebtedness that they did not cause or choose.” He professes himself optimistic:

“The clean up will take years. And there is no quick fix, so you need to brace yourself for perhaps a decade of economic stagnation. As it happens, I don’t think that is reason to weep. We are a very rich country. And we can be a very happy country if we learn how to make the most of what we have got.”

I must say, I’m far less optimistic about the way the economics and politics of the coming lost decade will play into each other. Let’s hope I’m wrong and the mess is fixable. Either way, this is a terrifically interesting and well-written book, which benefits greatly from its author’s detailed knowledge of the banking industry that is at the heart of this crisis.

Oh no, not happiness again!

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There are some things some people so fervently want to believe that no amount of evidence or logic will persuade them otherwise, no matter how brilliant they are. Adair Turner’s book [amazon_link id=”026201744X” target=”_blank” ]Economics After the Crisis[/amazon_link] is a good book, and I’m a great admirer of his. But my heart sank when I read this new review of it in the TLS by Robert Skidelsky. Lord S writes:

“The case against making increased GDP per capita the overriding policy objective is that it doesn’t deliver the increased happiness or welfare if promises. In 1974, the economist Richard Easterlin published a famous paper, “Does Economic Growth Improve the Human Lot?”. The answer, he concluded, after correlating per capita incomes and self-reported happiness levels across a number of countries is probably “no”. In a refinement dating from 1995, Easterlin found no relationship between income and happiness above an average per capita income level of between $15,000 and $20,000. Other findings confirm Easterlin. Data from the UK show that from 1973 to 2009, there was a continuous rise in GDP per head, but no increase in reported life-satisfaction.”

Er, no. The error of logic is that if you compare a stationary (reported life-satisfaction) and non-stationary (level of GDP) time series via a chart or regression, they will as a matter of construction not be correlated with each other. And the evidence has recently flowed in that GDP growth and reported happiness are positively and strongly correlated with each other – for example, Stevenson and Wolfers. Finally, common sense should tell everyone that abandoning economic growth as a policy objective is a political and practical no-hoper: we have that now and it’s called recession. It cements current inequalities, reduced job opportunities, and voters just hate it. So actually, the task of achieving satisfying and sustainable growth is a pretty difficult one (it’s why I wrote the [amazon_link id=”0691145180″ target=”_blank” ]Economics of Enough[/amazon_link]…).

[amazon_image id=”026201744X” link=”true” target=”_blank” size=”medium” ]Economics After the Crisis: Objectives and Means (Lionel Robbins Lectures)[/amazon_image]

Update: broken link replaced 5/11/14