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_link id=”063117690X” target=”_blank” ]Theory of Unemployment Reconsidered[/amazon_link].

[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 [amazon_link id=”9650060251″ target=”_blank” ]The General Theory[/amazon_link]. 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.

Economic forecasts, fortune telling and sunspots

An enticing looking book has arrived in the post. It’s [amazon_link id=”0691159114″ target=”_blank” ]Fortune Tellers: The story of America’s first economic forecasters[/amazon_link], by Walter Friedman.

[amazon_image id=”0691159114″ link=”true” target=”_blank” size=”medium” ]Fortune Tellers: The Story of America’s First Economic Forecasters[/amazon_image]

It’s easy to make fun of economic forecasts, which are always wrong. Nate Silver’s [amazon_link id=”0141975652″ target=”_blank” ]The Signal and the Noise[/amazon_link] has a chapter explaining with care why this is so, without bothering to score the cheap shots many critics resort to. Essentially, he points out that the macroeconomy is a large complex system with many feedbacks, about which we have very little data. Economic forecasting lags well behind weather forecasting in its gathering and use of statistics. David Hendry and Mike Clements have written, for my money, the best book on how to do time series forecasting given our current data and knowledge, [amazon_link id=”0521634806″ target=”_blank” ]Forecasting Economic Time Series[/amazon_link].

There has been progress. W Stanley Jevons famously correlated economic activity with sunspots. The theoretical basis for this might in fact have grown stronger now there is so much electronic communication for solar storms to disrupt. Fans of Kondratiev cycle-type analysis sometimes stretch the insight that applying disruptive technology can require generational change to trying to forecast the cycles.

I’m sympathetic to macro forecasters as I used to be one myself for a couple of years. It was an eyeopener to me, a relatively freshly minted, idealistic PhD, to realise how much fiddling there is to make any forecast look even plausible – they all require it –  and therefore how strong the herding instinct among forecasters. It took me another giant stride on my journey from macro to micro. I was working for Data Resources Inc, founded by the eminent US macroeconomist Otto Eckstein in 1969 (now part of Global insight).

[amazon_link id=”0691159114″ target=”_blank” ]Fortune Tellers[/amazon_link] stops before the Second World War, however – that is, before modern macro models. It looks great fun.

Undercover, bigtime

I think everybody should read Tim Harford’s new book, [amazon_link id=”1408704242″ target=”_blank” ]The Undercover Economist Strikes Back[/amazon_link]. This includes (a) everybody who has no idea what to make of the conflicting arguments about fiscal and monetary policy, whether the austerians or the stimulards are right; (b) everybody who thinks they know exactly what fiscal and monetary policy ought to be; (c) all economics students; (d) anybody not in the first three categories.

[amazon_image id=”1408704242″ link=”true” target=”_blank” size=”medium” ]The Undercover Economist Strikes Back: How to Run or Ruin an Economy[/amazon_image]

The subtitle is ‘How to Run – or Ruin – an Economy’. The Undercover Economist has decided to tackle macroeconomics. That this is so successful a book – clear, balanced but not indecisive, readable – is praise indeed, from someone like me who thinks macroeconomics is in a pretty sorry state. There is an absolutely terrific introduction about Bill Phillips (of the machine and the curve). The first batch of chapters cover: what do we mean by macroeconomics, what can cause recessions, what is money, how money and inflation are related, different policy prescriptions for different types of recession, output gaps and unemployment. Later chapters look at management and productivity, the concept of GNP, demolish the idea that ‘happiness’ can/should replace growth, discuss whether there are physical limits to growth, look at inequality, and the book ends with an agnostic view about the future of macroeconomics.

The book would be worth reading for the first half alone; it is such a public service to explain why macroeconomists are arguing about how policy should respond to the post-crisis recession, and to do it with such clarity that you can be utterly confident the author understands his subject. (I do not get this sense of confidence from a lot of people writing about the economy.)

I would have liked the Undercover Economist to tackle some areas of macroeconomics omitted from the book: financial markets and asset prices; and exchange rates and the balance of payments. Both are important to understand recent economic history and the financial crisis. So the book is not a complete guide. It would be churlish, too, to point out that a couple of the chapters are really more microeconomics than macro (job matching and efficiency wage models of the labour market, and management). And I personally don’t like the Q & A format of the book, but that’s seemingly a minority view. I still enjoyed reading it. It is definitely one for my list of economics books for beginners.


Positive, normative and provocative economics

Last night it was my privilege to give the annual Pro Bono Economics lecture. I’d be delighted to hear people’s comments on it. (It would be even more pleasing if you’d look at the website and consider making a donation to their work.)

Many people in the audience have been enthusiastic, but one macroeconomist has taken great offence at my criticism of macro. I daresay I was too provocative – Dave Ramsden of the Treasury, chairing the evening, diplomatically described it as ‘challenging’ – but it does simply amaze me that so many (but not all) macroeconomists don’t think anything much needs to change in their area. Anyway, views welcome.

In the chat afterwards, somebody recommended to me [amazon_link id=”0521033888″ target=”_blank” ]Rational Economic Man[/amazon_link] by Martin Hollis and Edward Nell. The blurb says:

“Economics is probably the most subtle, precise and powerful of the social sciences and its theories have deep philosophical import. Yet the dominant alliance between economics and philosophy has long been cheerfully simple. This is the textbook alliance of neo-Classicism and Positivism, so crucial to the defence of orthodox economics against by now familiar objections. This is an unusual book and a deliberately controversial one. The authors cast doubt on assumptions which neo-Classicists often find too obvious to defend or, indeed, to mention. They set out to disturb an influential consensus and to champion an unpopular cause. Although they go deeper into both philosophy and economics than is usual in interdisciplinary works, they start from first principles and the text is provokingly clear. This will be a stimulating book for all economic theorists and philosophers interested in the philosophy of science and social science.”

[amazon_image id=”0521033888″ link=”true” target=”_blank” size=”medium” ]Rational Economic Man[/amazon_image]

I’d like it to have been a bit more specific about the authors’ doubts, but it sounds intriguing.

Richard Davies of The Economist (@RD_Economist on Twitter) has recommended [amazon_link id=”0631194355″ target=”_blank” ]Three Methods of Ethics[/amazon_link] by Marcia Baron et al.

[amazon_image id=”0631194355″ link=”true” target=”_blank” size=”medium” ]Three Methods of Ethics: A Debate (Great Debates in Philosophy)[/amazon_image]

I can see I’m going to have to improve my philosophy to continue in the vein of the Pro Bono lecture.

UPDATE: Paul Kelleher (@kelleher_) recommends [amazon_link id=”041588117X” target=”_blank” ]Philosophy of Economics[/amazon_link] by Julian Reiss

[amazon_image id=”041588117X” link=”true” target=”_blank” size=”medium” ]Philosophy of Economics: A Contemporary Introduction (Routledge Contemporary Introductions to Philosophy)[/amazon_image]

The Scarlet Letter for economists

An econometrics paper that can make you laugh? Yes, Ed Leamer, famously the author of a 1983 paper, Let’s Take the Con Out of Econometrics (pdf), has a superb 2010 article in the Journal of Economic Perspectives, Tantalus on the Road to Asymptopia – it’s free access,  only moderately technical, and brilliant.

Leamer’s theme is the same in the more recent paper as in the earlier one, the need for a profound culture change in empirical economics:

“Can we economists agree that it is extremely hard work to squeeze truths from our data sets and what we genuinely understand will remain uncomfortably limited? We need words in our methodological vocabulary to express the limits. We need sensitivity analyses to make those limits transparent. Those who think otherwise should be required to wear a scarlet-letter O around their necks, for “overconfidence.””

The point is that the available economic data will always support a range of different theories, and Leamer advocates sensitivity analyses that illustrate the spectrum of parameter values and theories consistent with observed data. Economists need to go back to 1921, he argues, and read Keynes’s [amazon_link id=”B0080K73L6″ target=”_blank” ]Treatise on Probability[/amazon_link] and Frank Knight’s [amazon_link id=”0486447758″ target=”_blank” ]Risk, Uncertainty and Profit[/amazon_link]. Both books point out that decisions are subject to three-valued logic (yes, no, don’t know) whereas economic theory assumes away the large territory of don’t know.

I strongly agree with Leamer’s conclusions:

“Ignorance is a formidable foe, and to have hope of even modest victories, we economists need to use every resource and every weapon we can muster, including thought experiments (theory), and the analysis of data from nonexperiments, accidental experiments, and designed experiments. We should be celebrating the small genuine victories of the economists who use their tools most effectively, and we should dial back our adoration of those who can carry the biggest and brightest and least-understood weapons. We would benefit from some serious humility, and from burning our “Mission Accomplished” banners. It’s never gonna happen.”

He, like me, is profoundly sceptical about macroeconomics: “Our understanding of causal effects in macroeconomics is virtually nil, and will remain so.”

I must go away and read Leamer’s 2009 book, [amazon_link id=”364207975X” target=”_blank” ]Macroeconomic Patterns and Stories[/amazon_link].

[amazon_image id=”364207975X” link=”true” target=”_blank” size=”medium” ]Macroeconomic Patterns and Stories[/amazon_image]