Macroeconomics without the blinkers

Why was the 2008 Global Financial Crisis such a surprise to a surprising number of economists? A new book,  by Assaf Razin, suggests one reason is the mental blinkers imposed by the real business cycle worldview, whereby productivity shocks and nominal wage stickiness accounted for most cyclical fluctuations – as long as monetary policy was sensibly guided by a rule that avoided policy shocks. That complacency (as it turned out) has of course evaporated, leaving instead agreement about some aspects of the macroeconomic problem – the zero lower bound problem and role of “unconventional” QE – and wild disagreement about fiscal policy.

[amazon_image id=”026202859X” link=”true” target=”_blank” size=”medium” ]Understanding Global Crises: An Emerging Paradigm[/amazon_image]

The book starts with a history of the financial crises of the 1990s and 2000s – and you only have to see that history (the Asian crisis, LTCM, the dot com bubble) to be puzzled anew by the widespread belief in permanent stability by the mid-2000s. The second part looks at the various sources of financial fragility: asymmetric information, risk-shifting and risk-taking, excessive optimism, and co-ordination failures. This section presents a model of the optimal amount of insurance against risk-taking financial institutions, taking account of the moral hazard and adverse selection problems. The third section turns to currency and balance of payments crises, and the Eurozone’s unpalatable choices. It is a relatively short book covering in a very elegant way a lot of theoretical and historical territory.

The book concludes that some vital questions remain unanswered by the latest dynamic general equilbrium models it presents – including the most bitterly-disputed policy questions: when should fiscal austerity be implemented to reduce debt levels and unfunded demographic liabilities; when should monetary policy start to be tightened; when does the need to stabilise the financial system outweigh the risks of moral hazard.; and how should monetary policy take account of asset price bubbles during the zero/low interest rate period? These seem pretty fundamental, which I suppose will keep macroeconomists busy for some time.

The book is based on courses Prof Azin has taught since the crisis, and is geared towards a graduate student audience, so it is not one for the general reader interested in the sorry state of the global economy and financial markets, post-2008. It looks like a must-read for relevant courses, however. To me – with a foot in the academic camp but not remotely expert in global macro or finance – it also looks like it’s retrofitting economic theory to events. It is good to have it demonstrated so clearly, as many macroeconomists have assured me, that macro models can accommodate the kinds of event we have experienced in life. But it leaves unanswered the original puzzle – why did so many macroeconomists wear the real business cycle blinkers in the first place?


Modern macro

Although I don’t teach or practice macroeconomics, if I did I’d certainly be thinking of using the new textbook from Wendy Carlin and David Soskice, . As the subtitle so clearly indicates, this book does absolutely engage with the messiness of the post-crisis real world. Its aim is to stay simple enough for undergraduate use while also realistic enough to empower its readers to understand the why and how of the financial crisis and to evaluate macroeconomic policy. For graduate students or practising economists wanting a reference book, this offers a tractable, intuitive model that combines the standard 3-equation approach with the insights of Hyman Minsky (mentioned in the Preface) and institutional realism.

[amazon_image id=”0199655790″ link=”true” target=”_blank” size=”medium” ]Macroeconomics: Institutions, Instability, and the Financial System[/amazon_image]

The first chapters set out the standard 3-equation model, and chapters on expectations and money & banking follow. The latter includes a description of how a modern banking system works (no whiff of a money multiplier!). Two chapters on the financial sector and the crisis follow – including topics like balance sheet recessions, QE, and a discussion of austerity policies. There is a chapter on innovation, growth and fluctuations – Solow, endogenous growth and Schumpeterian growth. Next comes a section on the open economy, with separate chapters on oil shocks/commodity prices and  the Eurozone.

The final chapters cover monetary and fiscal policies, supply side policies and the labour market, and a final chapter on real business cycles and the New Keynesian approach.

This is certainly the first textbook I’ve spotted to have incorporated the lessons of the crisis, and it does so very elegantly, keeping the modelling framework reasonably simple. The book also weaves in the events of recent economic history, and applies the models it develops to actual events, so students do not have the dispiriting experience of being taught an economics in the classroom divorced from the kind of economics they hear about in the news.

I’m a big fan of Wendy’s already, having had the pleasure of working with her on the CORE curriculum and e-book; and this new textbook confirms my opinion. I’ve dipped in to specific chapters that I can evaluate properly, such as the one on growth and the supply side and labour market sections  – perhaps if I read the whole book properly it will cure me of my ingrained macro-scepticism……


Macroeconomics and aliens

Over a few weeks, I’ve been reading by Kartik Athreya, an economist at the Richmond Fed. I’ve found it very interesting and illuminating, but what it has illuminated has tended to confirm my scepticism about much conventional macroeconomics.

[amazon_image id=”0262019736″ link=”true” target=”_blank” size=”medium” ]Big Ideas in Macroeconomics: A Nontechnical View[/amazon_image]

The kind of macroeconomic debate that most people are familiar with from the blogs (see Simon Wren-Lewis, the National Institute blog, Noahpion etc) and the economics journalists – discussing why GDP growth is what it is, the effects of fiscal policy, how long interest rates need to stay so low, what is the risk of deflation in the Eurozone etc – is wholly absent from this book.

It is instead about macroeconomic theory. It seeks to explain without equations the deep theoretical foundations of macroeconomic models, the models later used in central banks and elsewhere to inform the practical policy discussion. Although billed as ‘non-technical’, and hence the absence of equations, it is still pretty tough going. Athreya’s starting point is general equilibrium theory derived from Walras in its modern Arrow-Debreu-McKenzie (ADM) manifestation. The first four chapters cover this theory, other theoretical foundations in the form of game theory and overlapping generations models, and the use of four often-criticised techniques or assumptions: aggregation, rationality, equilibrium and mathematics. Chapter 5 turns to policy advice, and chapter 6 to “recent events”. Even these, though, are discussions of the theoretical models.

The book is therefore an excellent guide to macroeconomic theorising – although too hard for a general audience, useful for students of macroeconomics, probably at the graduate level. However, I was genuinely startled by its implicit claim that the ADM model is both the right approach to practical macroeconomic policy and the approach in use in the policy world. This is not because I have any doubts at all about the usefulness of some mathematics, nor of the modelling assumptions of rationality and equilibrium in many contexts. I am a huge fan of markets as a process of information-discovery and co-ordination. But I’d imagined the insistence on the abstraction of the general equilibrium approach to macro was in retreat and now dug deep into in its bunkers in university departments and academic journals.

There is a telling passage in Chapter 2 where Arthreya writes of “the pervasive orderliness of the world in the absence of any central co-ordinator.” Many economists have noted this – Paul Seabright’s  is one wonderful, accessible example. But many have also, I would say, pointed out the frequent disorderliness of the world at the aggregate, macro level. ” ‘ADM minus some markets’ seems like a useful description of the real world,” the book claims – just before noting that the ‘minus some markets’ strikes out financial markets subject to asymmetric information, those with too-big-to-fail entities, and markets characterised by externalities. Then it claims that there are no other important areas of oligopoly power – oh, except for those where innovation is important. I can think of a few other areas of market power too! When ‘minus some markets’ ends up being a very large chunk of the aggregate economy, there is a lot of wishful thinking going on here about the practical relevance of the general equilibrium model.

What about the crisis? Athreya concludes that: “Macroeconomists lack models that can fully account quantitatively for the use of various contracts….Macroeconomics therefore has a good deal of unfinished business.” The crisis has led to a sensible shift in modelling priorities towards including some financial contracts, he says – and the book rightly notes that Keynesian or Minskian models would not have included relevant types of financial contracting for predicting the crisis either. Athreya thinks these evolutionary, internally-driven reforms are all that macro needs. I find this dispiriting.

After reading the book, I read some other reviews and found that John Quiggin had more or less the same reaction as me. I’m not all that persuaded by the revamped Keynesian non-DGSE versions of macro either (unlike Quiggin, I think); for me, we’re simply back to the drawing board on macro, and the most interesting starting points would be something like the Moore/Kiyataki models with credit cycle and labour market interactions at their heart, plus on long-term technology and financial cycles. The former seem to me like heirs of the much-underrated  approach.

[amazon_image id=”063117690X” link=”true” target=”_blank” size=”medium” ]Theory of Unemployment Reconsidered: Lectures[/amazon_image]

Still, as Quiggin says, the DSGE cult prevails still in academic economics – and, it seems, in the policy world too. Which means  is worth reading to understand how they think, alien as it may be.


Macroeconomics – a pile of tsundoku?

The in-pile is suddenly teeteringly large  – thanks to Bookshelf Porn, I now have the japanese word tsundoku:

Thank goodness for a lot of travel coming up.

One that just arrived and is very tantalising is , by Kartik Athreay, flagged up to me by a comment on this blog. Regular readers will know that I’m a macro-sceptic, so it will do me good to read what looks like a sympathetic account of modern macro. Noah Smith has blogged about the book already, and my prior is that I’ll agree with him, although Herb Gintis has a friendly quote on the back cover. Naturally I’ll keep an open mind!

[amazon_image id=”0262019736″ link=”true” target=”_blank” size=”medium” ]Big Ideas in Macroeconomics: A Nontechnical View[/amazon_image]


Macroeconomic regimes

As regular readers of this blog will know, macroeconomics isn’t my thing. Although unimpressed by the state of knowledge in macro, I’m even less impressed by my own expertise in it, and so avoid commenting on it.

Still, I try to keep up with the debates, and was reading the recent posts by Simon Wren-Lewis and follow-up by Paul Krugman on exactly this question of the state of macroeconomics and the various divisions. Broadly speaking, the former argues that looking to base macroeconomics on micro-foundations is an essential research strategy, while the latter says that insisting on microfoundations (“the insistence that everything involve intertemporal optimization”) excludes useful approaches to thinking about economic policy on the grounds that they are ‘ad hoc’.

With great diffidence, it seems to me that what you might or might not build micro-foundations for matters more. Whenever I think about the macroeconomy I turn back to a small book I read as an undergraduate, rarely cited these days, Edmond Malinvaud’s .

[amazon_image id=”063117690X” link=”true” target=”_blank” size=”medium” ]Theory of Unemployment Reconsidered: Lectures[/amazon_image]

He begins by pointing out that the classical theory of unemployment (and its descendants) make the mistake of looking at each market as a partial equilibrium – so the labour market would clear, and unemployment would fall, if only the real wage fell. For macroeconomics, though, general equilibrium analysis is needed. That was the important step contributed by Keynes in . Rationing in the labour market is closely linked to rationing in the goods market.

Malinvaud goes on to describe different ‘regimes’, depending on whether rationing prevails on the buy-side or sell-side of the labour and goods market at any moment – he labels them classical unemployment, Keynesian unemployment and repressed inflation. One would now surely add financial markets too, and a ‘debt hangover’, credit rationed state of the world. Policy prescriptions vary a good deal depending on which regime applies.

That’s as far as I’m going, the conclusion that the connections between markets can tip the economy into different rationed equilibria. When those connections and dynamics are clear, we could worry about how well microfounded the model is. Malinvaud also echoes another of my views: “The level of aggregation may hide some important complications.” Yup. This boils down to saying macroeconomics is fiendishly complicated, and after this brief excursion, I’m going back to avoiding it.