The State of Macroeconomics Post author By Philip Lane Post date August 26, 2011 John Kay joins the debate on the state of macroeconomics in this FT Analysis article. Categories In Uncategorized 22 Comments on The State of Macroeconomics ← Economists and the Media → Are Windfalls a Curse? 22 replies on “The State of Macroeconomics” I was about to suggest that someone open a link to this article as the recurrent bouts of psychoanalysis of the economics profession in Ireland on this blog are beginning to go beyond even the description of tedious. Krugman’s column in yesterday’s NYT can help get the ball rolling. http://krugman.blogs.nytimes.com/2011/08/25/fiscalization-watch/ I know that New Keynesian economic models incorporate rational expectations. Does this mean that by logical extension they allow for ricardian equivalence? Or is that just new classical DSGE models? Soooooooooo…….. Sounds good, DSGE, Ricardian equivalence….just as long as we ignore the cost of debt and the drag that this debt creates for the present…. Never to be mentioned, never to appear…. So if household A borrows 10x their household income at an interest cost of 7% on average, how much of their household income do they need to service the interest cost, and how much to repay the debt over 15 years? And if enough potential consumers have lots of debt, how does that affect their decision making for the future? Bernanke says this doesn’t matter because the interest paid remain within the system. Banks, apparently, are ordinary people just like you or me! Krugman and the Keynsians say if the government spends more, then eventually, by some magic, animal spirits will revive and off we go again! And the monetarists say, market forces do everything and government shouldn’t interfere….BUT, depressions are exceptions….in depressions, nothing must be allowed to damage banks….government money must be used, in unlimited supply if necessary, to prevent bank collapses… So Ricardian equivalence…hmmm….reduce fiscal deficits and regulation in good times by privatizing, using PPI projects and lowering reserve/supervisory requirements (so banks are richer in the present)….and in bad times, increase monetary stimulus by pushing free reserves into the banks and fiscal stimulus to prevent collapse, (again banks get rusher in the present)…..I think that’s what Ricardian equivalence means…..Ricky’s a banker! From the article: “These systems are also reflexive, in the sense that beliefs about what will happen influence what does happen.” I think it’s also one step more recursive than that. Because some actors know about – or rather believe in – this reflexivity, they try and manipulate it now by making decisions that are based upon it – not what the current situation seems to demand, and other actors then react to those decisions factoring in the belief that they are being manipulated. @humble student Seems to me – but I won’t be marking the exam 😉 that ricardian equivalence is very rational and really happens. The question is how much of it – is it so small as to be trivial and if so under what circumstances would more or less players act in that way? If a model ignores it, it shouldn’tdn’t leave you wondering, it should say why. It also seems to me that ricardian equivalence has recently been wheeled out as an intellectual device to oppose “government” in the US political economy scene and imho is rather flimsy given the way it is being used. Quite possibly though, it doesn’t matter what I believe if you really are a student. Find out what the lecturers think, then believe whatever you want after the course 🙂 @grumpy Thanks for the reply. I don’t like the idea of ricardian equivalence being anything other than negligible and was wondering if models unavoidably considered it and therefore underestimated the effects of fiscal policy. If anyone is interested I found this paragraph in a paper. ‘Since the agents in basic middle-size New Keynesian models optimize their life time utility, these models implicitly assume the Ricardian equivalence. Therefore, these basic models insufficiently treat the effect of fiscal policy. To analyze fiscal policy, many previous studies, e.g., Gali et al. (2004), assume the existence of liquidity-constraint households (also known as “non-Ricardian” households.) Nowadays, many policy-making institutions built their models with such households, which do not optimize their lifetime utility, e.g., SIGMA built by the Federal Reserve board, QUEST III by the European Commission, GIMF by IMF.’ http://www.webmeets.com/files/papers/ESWC/2010/2576/jpYanoIidaWago002.pdf Ps I am most definitely a student if not quite a humble one 🙂 @Humble Student: I know that New Keynesian economic models incorporate rational expectations. Does this mean that by logical extension they allow for ricardian equivalence? Or is that just new classical DSGE models? Rational expectations aren’t enough to give you Ricardian equivalence. For example, in an overlapping-generations model, future generations will bear some of the debt burden. I’m no expert, but from what I’ve read I gather that we really do need to assume immortal agents (and no births) in order for Ricardian equivalence to hold. @Kevin Donoghue Thanks. ‘I’m no expert, but’ You better watch out or Professor Tol will be after you 😉 It says a lot when a leading economics professor says economics has either failed or, at best, made no progress since the 1930s. It also says a lot when I observe only 8 comments on this thread.Kay’s imagery is compelling. Academic economists are essentially playing a version of Grand Theft Auto when they play with their DSGE models. Kay engages in too much effort over complexifying the problem – indeed economies are very complex dynamic things but the basic info of breakdown was in your face like. The growth of credit over and above GDP for decades that accelerated into the stratosphere post 1980. What else could happen unless we discovered free energy or something ? @ Dork John Kay’s article reminds me of the writings from the 18 th c. Enlightenment. The endless struggle to come to terms with the evidence that there is no God. Isn’t it interesting that the resurgence of US Creationism and (its mirror image) Muslim fundamentalism should have coincided with the era of global financial looting ? …one of those cosmic jokes I suppose…:) @Paul I guess he needs to earn a living also ., if he was a Dork and kept repeating the same obvious thing over & over he would be working for the Evening Echo I guess. He knows damn well where the problem resides – but perhaps the scale of the monster surprises him , these people have been divorced from the breakdown crisis for so long now it must be hard to comprehend the mischievous malice of the credit markets. Dork You got it there…they all know where the problem resides, and they (economists) drop the odd hostage to fortune that suggests they fully understand the problem. silences on the issue of paper money, the BS about “confidence”, the propaganda against gold as the ONLY asset vulnerable to sharp declines. Every dip in equities is a buying opportunity, bond prices are ALWAYS “right” and credit is ALWAYS available. This can’t be accidental, somebody out there understands. try and engage them, though and you become a broken record… @Dork “Over-complexifying”!?! Reaally??? Is that not just something people say when they come up against an article that is just a little too taxing and the thought a little too psychologically perturbing? Sure Ciaran – I am a simple soul. But the above vista is a very Anglican view of the world encompassed in a modern ecumenical framework. I am instinctively uncomfortable with fitting square pegs into round holes. This verbal embroidery can be quite satisfying to some but I am a fan of the engineering maxim “keep it simple stupid” Indeed I believe it is no accident that enginners interested in economics since the beginning of this phase in the crisis starting in 2006 / 7 have consistently got it right for the most part. But I agree you can’t teach a simple creature such multi-dimensional spiritual meanderings – its a impossibility. http://www.youtube.com/watch?v=IvvwNR3vF44 Hayek entitled his Nobel speech ‘Pretence to Knowledge’. Apparently it’s not just economics that is in a spot of bother: “Dr Joseph Lykken of Fermilab, who is among the conference organisers, says he and others working in the field are “disappointed” by the results – or rather, the lack of them. “There’s a certain amount of worry that’s creeping into our discussions,” he told BBC News. The worry is that the basic idea of supersymmetry might be wrong. “It’s a beautiful idea. It explains dark matter, it explains the Higgs boson, it explains some aspects of cosmology; but that doesn’t mean it’s right. “It could be that this whole framework has some fundamental flaws and we have to start over again and figure out a new direction,” he said. Down the drain Experimental physicists working at the LHC, such as Professor Nash, say the results are forcing their theoretical colleagues to think again. “For the last 20 years or so, theorists have been a step ahead in that they’ve had ideas and said ‘now you need to go and look for it’. “Now we’ve done that, and they need to go scratch their heads,” he said” The Higgs Bosun, yes, is proving elusive; possibly/probably it does not exist. The Efficient Markets Hypothesis is proving elusive; possibly/probably it does not exist. Rational Man is proving elusive; possibly/probably such man does not exist. Ignorance is bliss 😆 @all John Kay has given up the Soma; but looks like a lot of soma still around in economics – wonder who the dealer is? Found this one useful some time back. L Randall Wray …. The Dismal State of Macroeconomics and the Opportunity for a New Beginning The Queen of England famously asked her economic advisers why none of them had seen “it” (the global financial crisis) coming. Obviously, the answer is complex, but it must include reference to the evolution of macroeconomic theory over the postwar period—from the “Age of Keynes,” through the Friedmanian era and the return of Neoclassical economics in a particularly extreme form, and, finally, on to the New Monetary Consensus, with a new version of fine-tuning. The story cannot leave out the parallel developments in finance theory-with its efficient markets hypothesis-and in approaches to regulation and supervision of financial institutions. This paper critically examines these developments and returns to the earlier Keynesian tradition to see what was left out of postwar macro. For example, the synthesis version of Keynes never incorporated true uncertainty or “unknowledge,” and thus deviated substantially from Keynes’s treatment of expectations in chapters 12 and 17 of the General Theory. It essentially reduced Keynes to sticky wages and prices, with nonneutral money only in the case of fooling. The stagflation of the 1970s ended the great debate between “Keynesians” and “Monetarists” in favor of Milton Friedman’s rules, and set the stage for the rise of a succession of increasingly silly theories rooted in pre-Keynesian thought. As Lord Robert Skidelsky (Keynes’s biographer) argues, “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” By returning to Keynes, this paper attempts to provide a new direction forward. http://www.levyinstitute.org/pubs/wp_652.pdf Ignorance appears to be more interesting than ‘knowledge’ at the mo … @David Both the Keynesian framework and its modern equivalent MMT practise accept the principle of private credit creation – is it time to call last drinks at the bar ? There is simply not enough good Keynesian priests or maybe Trappist monks if they are selling beer. This ability to extract wealth from the future via credit & consume now is obsolete in a confined limited world. Excellent Newsnight on Friday, should be available on the website form Monday. Really resonated. Essentially we have the beginnings of possibly going mainstream on the idea that both left and right dislike banker-style capitalism. The premise is that the right has lost track of why it believed in promoting capitalism, and that the left never really did – but joined with the agenda of globalisation and global financial capitalism because it though that was what it had to do. Take a look on Monday. @Grumpy There was I thinking the left was always all about globalism… workers of the world unite and all that. This is a battle between idle speculators and the remaining bits of capital & labour I guess , but the 20th century left was very different from the easier money silver crowd of the 19th century as the single gold standard created a massive depression in the 1870s and beyond. http://www.youtube.com/watch?v=HeTkT5-w5RA. As long a the modern day synthetic slave market otherwise known as oil has the upper hand the speculators will win – if production drops further relative to population all bets are off as wealth will need to be created internally again. Notice Bryans view that the hinterland kept the cities going – back then yes but the cities have bypassed their surroundings and tapped directly into a very powerful liquid opiate. Interesting times. Grumpy, No they only dislike the inevitable crashes that banker style capitalism creates, they LOOOOOOOOVVVVEE the bankers when credit is growing and they can hide all their pet projects in off balance sheet debt……they are debt-aholics, they hate the hangover. I suppose the system is inevitable and it does create massive benefits to society over time. I don’t object to that part of it, but an extractive sector like banking and all intermediation fee businesses, need to be regulated ferociously. Our economists refuse to accept this, indeed, their overly convoluted papers etc are always framed to avoid the core issue…..that private credit creation is private debt creation and private debt creation is private moneyncreation….sup too freely at that well and the hangover is nasty…. Governments need to be tough on credit, tough on the causes of credit….ALWAYS Comments are closed.