Macroeconomic Updates

I just finished reading Paul Krugman’s 6800 word rant in the New York Times on the fields of finance and macroeconomics.  Thanks Tom, Prabhudev and the 40 or so other people who sent it to me!  (See “How Did Economists Get It So Wrong?” The New York Times, Sept. 6, 2009)

In usual Krugman form, he twists the history of economic thought to suit his politically motivated  arguments.  Before pointing out where he goes wrong, let me point out where I agree with Krugman.

First, I think Krugman is correct in lambasting modern day macroeconomists for their obsessive love affair with formal economic modeling.  So much intellectual capital has been wasted over the last 50 years in developing mathematically sophisticated economic models that have added absolutely nothing to our understanding of how the economy functions.  Economic departments, both freshwater and saltwater, are stuffed to the gills with mathematical geniuses claiming to be economists, who impress each other with things like their newest stochastic dynamic processes.

I cannot tell you the endless hours I have spent pouring over working papers and published academic articles, solving a multitude of equations only at the end to arrive having gained absolutely no insight into how and why economic outcomes are they way they are.

But such is the life of an academic economist these days:  you must learn to pray at the quantitative alter if you are to be “accepted” by the tenured high priests of our profession.  Never mind that these mathematically gifted soothsayers have no idea how to get us out of the current mess in which we find ourselves.

Second, I think Krugman is correct to point out the advancement made by behavioral economists.  The field of behavioral finance in particular has much to offer in giving us a better understanding of how markets actually function.  Behavioral economics, experimental economics, behavioral finance, etc. start with observations of what actually happens in markets and/or what people actually DO as opposed to how our elegant mathematical models suggest they should act.  More economists should be encouraged to observe how markets, societies and people actually do function and how they have functioned in the past.  Let us be more like the natural scientists that start with observations and then move to develop theory and models of behavior, not the other way around.

Next, Krugman is also correct in pointing out the disconnect between finance and macroeconomics.  I think The Economist did a much better job of describing this disconnect than does Krugman (I think that is where Krugman got the idea for his most recent op-ed, but that’s beside the point).  The Economist correctly described the “silos” macroeconomists and financial economists find themselves.  That is, the macroeconomists basically exclude financial interactions in their description of the overall economy, and financial economists basically ignore the total impact of financial market instability.

This siloization (if that is word) has come about because to uber-specialization of our fields.  Multi-disciplinary approaches to economic issues are shunned by both macro and financial economists.  In a recent meeting with colleagues when it was suggested that financial economists actually consider a multi-disciplinary approach to their subject, a leading “scholar” in the field snapped “none of the cross-discipline research that is being done is any good.”  What my esteemed colleague failed to recognize is that he and his ilk are the ones who decides what is “good” or not by determining what gets published in the leading academic journals.  Thus, since inter-disciplinary work is not “valued” by the quantitative high priests, very little of it actually gets done.

This leads to where I disagree with Krugman and/or where I find fault with his arguments.

First, Krugman misrepresents the Chicago School’s approach to business cycle fluctuations.   What he leaves out is that idea that government policies, while well intentioned, can actually prolong recessions by creating distortions in a variety of input markets.  Thus, it is not that markets work perfectly all of the time, as Krugman claims the Chicago models suggest, rather it is that excessive government rules and regulation keep markets from achieving equilibrium.

And so it is with the recent crisis.  Krugman completely leaves out how government policies were major contributors to this current economic crisis.  Nowhere does he mention how the defacto government guarantees of Fannie Mae and Freddie Mac lead to a misallocation of capital.  He also fails to mention how past government bailouts of our banking system created a massive moral hazard problem that contributed to this current crisis.  No, instead in Krugman’s view, government policies only seem to react perfectly in stimulating demand reversing the economy’s slide into recession that was brought about by “the casinos” that are financial markets.  And then he wonders why people snicker at the Keynesian simplistic explanations.

Next, Krugman’s argument of what went wrong in financial markets completely leaves out the role of incentives.  Because of past government bailouts, large financial institutions and the traders within them, realized that their institutions were “too big to fail.”  And yet, they also realized that if excessive risks they were taking paid off, they would be rewarded with huge financial bonuses.  Thus, the incentives within the financial markets were completely misaligned.  It was a replay of the savings & loan crisis of the 1980s:  heads I win, tails the government loses.

The massive Treasury/Fed bailout, supported by Larry Summers, Greg Mankiw and other leading Neo-Keynesians does little to address these misaligned incentives. At least the Europeans are looking at some type of restructuring of incentives within their financial markets to ensure a disaster like the current one does not occur again.  Where are the American Keynesians to suggest real world policies to correct the structural problems that exist?  Oh that’s right, they are too busy pointing the finger of blame at Chicago to be bothered with “reality.”

Which gets me to my final point:  yes, we need to rethink what economists do and how we do it.  Krugman is right that we need to learn from the past, but I think it is more John Hicks we should learn from as opposed to John Maynard Keynes.  About 20 years, Will Baumol wrote an excellent piece on Hicks entitled “Sir John Versus the Hicksians or Theorist Malgre Lui?” which appeared in the December 1990 issue of The Journal of Economic Literature.  In it Baumol described how Hicks, creator of the IS-LM model among other things, wanted to be known for his work on economic history.  In fact it was Hicks’ wish that he was awarded the Nobel Prize for that as opposed to his work on labor theory, money or value for which he is better know.  To quote Baumol:

“Hicks simply remained a product of the time of his training, when economic analysts were expected to derive understanding from explicit study of institutions and history, and when there was no doubt that real economic phenomena were the central preoccupation of economists.”

Let us return to that.

All the best,

MBrandl