Macroeconomics without the blinkers

Why was the 2008 Global Financial Crisis such a surprise to a surprising number of economists? A new book, Understanding Global Crises: An Emerging Paradigm 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.

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, Macroeconomics: Institutions, Instability and the Financial System. 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.

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……

Mastering ‘Metrics

I had thought Joshua Angrist and Jörn-Steffen Pischke had reached the pinnacle of accomplishment when it came to econometrics texts with their Mostly Harmless Econometrics. That’s a fabulous, clear, practical manual – it’s so good that my eldest son, a recently-minted economist, has perma-borrowed my copy. What was particularly good about that book is its clarity about the importance of thinking through your null and alternative hypotheses – it’s one of my bugbears in life that people so rarely are clear about their counterfactual.

Yesterday I read – devoured – almost all of Mastering ‘Metrics: The Path From Cause to Effect, their follow-up textbook, covering more basic material at a level suitable for students meeting it for the first time – but also for practising economists who learned their econometrics long ago. Econometrics is one of the unsung fields of economics where there has been a stupendous amount of progress during the past 20 years, due to a mixture of more data, faster computers, better software – and improved econometric methodology. A lot of this methodological advance happened after I did my PhD (macro – yes, really! – and econometrics), so although I’ve picked up a lot of the material this book covers, I found it an incredibly illuminating read.

The perspective the book takes is how to answer questions about causality, and it presents five approaches: randomised trials, regression, IV/2SLS, regression discontinuity design, and differences in differences. Each chapter sets out an empirical question which is used to take the reader step by step through the methodology. The chapters mainly use verbal explanation, with a minimum of equations, and each has a more technical but still extremely clear appendix for students or practitioners needing that material. There are plenty of practical tips, for example, on how to interpret the size of coefficients, how to sense check results, how to check whether there might be omitted variables bias and what sign/size it might be. I love it that they say, your software programme will calculate this complicated standard error for you, no need to memorize the extremely complicated formula (I speak bitterly as one who wrote Fortran programmes to calculate the damn things, 30 years ago). Each of the examples reveals why simple, compelling data correlations of the kind discussed constantly in the world of policy can be completely misleading – or not.

Another nice feature is that each chapter ends with a couple of pages on the pioneers of statistical methods, explaining their contribution and the kinds of empirical problem they were innovating to be able to address.

It isn’t a perfect book. There’s a Kung Fu theme which is meant to make it more approachable and fun, but grated with me a bit. Still, it may be as close to perfection as you can get in this world to an introductory econometrics text. Ideal for students, ideal for older economists who privately admit they could do with brushing up their econometric knowledge a bit, as they look at the figures generated by their software packages. I’ll find this a very useful book, not least when it comes to reading other economists’ papers. It explains how to set about delivering on the huge promise of economics as a careful, empirical science, although of course there is no substitute for thinking carefully about the context in which any given set of data has been generated, and what causal influences could have given rise to it.

Update: Dimitrios Diamantaras pointed me via Twitter to Francis Diebold’s dyspeptic review of Mostly Harmless Econometrics – I think the tone of this is harsh and seems to be mainly concerned with the title; but it is worth noting that the two Angrist and Pischke books indeed do not cover time series econometrics.

Oh so happy….

Maybe the universe is trying to send me a message. Last week I read a self-help book (about how to solve problems) that I’d been sent, It’s Not About the Shark by David Niven. This past couple of days I’ve read Paul Dolan’s Happiness by Design: Finding pleasure and purpose in everyday life. Although somewhat sceptical about happiness economics, I’d heard him talk about his work and thought it sounded interesting. Well, the first half of the book is indeed interesting – more below – but the second half is a self-help manual. Who knows what it says about me, but I’m just not interested. As far as I can tell, not having read many of them, it seems thoroughly sensible.

Back to the first half of the book. There are several things about Dolan’s approach that make it far more plausible than the conventional approach to happiness. One is that he defines ‘happiness’ as the combination of pleasure and a sense of purpose, and not just the first of these as is standard. This must surely be right; and he argues that the evidence indicates people need a mix of both. You then have to read the rest of the book remembering that ‘happiness’ is not just ‘pleasure’.

Another is that he distinguishes people’s retrospective evaluation of their ‘happiness’ from their experience through time, and argues – again, I think convincingly – that the latter is more reliable for empirical research. He therefore prefers the data collected from the day reconstruction method as coming closer to experienced ‘happiness’ rather than the surveys that ask people to evaluate their state: “overall, would you say on a scale of one to six that ….” The evidence suggests that: “The circumstances of your life (income, marital status, age etc) matter much more to your evaluating self, and what you do matters more to your experiencing self.” So for example, unemployment clearly leads to lower evaluations of happiness but makes little difference to people’s DRM responses because mostly being at work is not a pleasurable experience (although it does give people a sense of purpose).

The third point he makes is that: “Your happiness is determined by how you allocate your attention.” Attention is a scarce resource. In place of the conventional approach which seeks to relate inputs (income, health, sunshine, marriage) to the final output, happiness, Dolan sees these inputs as stimuli in competition for your attention, with attention determining how they affect your ‘happiness’. The same inputs (income, health, sunshine, marriage) can lead to a different output depending on your attentional ‘production function’. He suggests that you can change your production function by directing your attention differently (and in the second half offers advice about how to do it). As he notes: “There are surprisingly few researchers who think about happiness in terms of your time use.” But time is the ultimate scarce resource.

This seems plausible, although I don’t know enough of the psychology literature – dating back to William James – to really evaluate it. It strikes a chord with me though since attending a couple of years ago a fascinating workshop in Toulouse on the attention question, when it was clear from the way the cognitive scientists and psychologists talked that a standard economics model of competition subject to a budget constraint (brain energy) could offer real insight into thinking about attention.

Economics for the curious

Each August there’s a meeting in Lindau of economics (and other) Nobel laureates.* I’ve never attended but have just been looking at the book of essays for young economists written by the participants in the conference, Economics for the Curious edited by Robert Solow with Janice Murray. There’s an obviously impressive list of contributors, whose talks cover subjects ranging from natural resource sustainability (Robert Solow) to structural change in the global economy (Mike Spence, who taught me a graduate micro course once upon a time) to the role of transactions costs in the social sciences (Oliver Williamson) and the character of economics (Vernon Smith).

The essays (the ones I’ve read) are very accessible and non-technical. Solow’s essay on applying economic principles to renewable and non-renewable resources is a model of clarity that could be set for undergraduates. Williamson’s essay on transactions cost economics is fascinating. He insists on the importance of interdisciplinarity – I hadn’t known he started out an engineer and came to economics via business. He usefully describes Coase’s famous 1960 paper, The Problem of Social Cost (pdf), the origin of modern institutional economics, as an exercise in reductio ad absurdum – what happens when you push the logic of zero transactions costs to its conclusion? He usefully captures Coase’s stricture against ‘blackboard economics’ by explaining the need for comparing any activity being analysed, not to an abstract ideal of efficiency, but to a realistic alternative. He ends with advice to students to take elective courses in any filed that interests them. “Try it. You may like it.”

I’ll now finish reading the essays, but my impression is that it’s a little book which is perfectly pitched for undergraduates or sixth formers, and is currently only just over £10 on Amazon.




* I know it isn’t a ‘real’ Nobel, ok?