Wednesday, January 24, 2018

What's Wrong with Macro? A Symposium from the Oxford Review of Economic Policy

Macroconomists were notorious for their disagreements before 2007. Such wrangling only increased with the carnage of the Great Financial Crisis and its aftermath. The Oxford Review of Economic Policy  has now devoted a special double issue (Spring-Summer 2018) to a symposium on the topic of "Rebuilding macroeconomic theory." Lots of big names (to economists!) are featured, and at least for now, all the papers are freely available and ungated.  

In an introductory essay, David Vines and Samuel Wills isolate some of the common theme in their introductory essay: "Four main changes to the core model are recommended: to emphasize financial frictions, to place a limit on the operation of rational expectations, to include heterogeneous agents, and to devise more appropriate microfoundations." However, I found myself most struck by an essay by Ricardo Reis which dares to pose the question "Is something really wrong with macroeconomics?"
Here are a couple of the points that stuck with me from that essay.

One common complaint about macroeconomics is that most models did not forecast the Great Recession, and indeed, that macroeconomic forecasts in general are often incorrect. Reis points out that most macroeconomic research is not about forecasting, which he illustrates by referring to recent issues of a leading research journals in macroeconomics and to the PhD topics of young researchers in macroeconomics. With regard to the specific sub-topic of forecasting, Reis offers a provocative analogy to the state of medical knowledge:
"Imagine going to your doctor and asking her to forecast whether you will be alive 2 years from now. That would sound like a preposterous request to the physician, but perhaps having some actuarial mortality tables in her head, she would tell you the probability of death for someone of your age. For all but the older readers of this article, this will be well below 50 per cent. Yet, 1 year later, you have a heart attack and die. Should there be outrage at the state of medicine for missing the forecast, with such deadly consequences?
"One defence by the medical profession would be to say that their job is not to predict time of death. They are driven to understand what causes diseases, how to prevent them, how to treat them, and altogether how to lower the chances of mortality while trading this off against life quality and satisfaction. Shocks are by definition unexpected, they cannot be predicted. In fact, in practice, most doctors would refuse to answer the question in the first place, or they would shield any forecast with a blank statement that anything can happen. This argument applies, word for word, to economics
once the word ‘disease’ is replaced by the words ‘financial crisis’. ...
"Too many people all over the world are today being unexpectedly diagnosed with cancer, undergo enormously painful treatment, and recover to live for many more years. This is rightly hailed as a triumph of modern oncology, even if so much more remains to be done. After suffering the worst shock in many decades, the global economy’s problems were diagnosed by economists, who designed policies to respond to them, and in the end we had a painful recession but no melt-down. Some, somehow, conclude that economics is at fault. ...
"Currently, the major and almost single public funder for economic research in the United States is the National Science Foundation. Its 2015 budget for the whole of social, behavioural, and economic sciences was $276m. The part attributed to its social  and economic sciences group was $98m. The main public funder of health studies in the United States is the National Institute of Health (NIH), but there are many more, including several substantial private funders. The NIH’s budget for 2015 was $29 billion. Its National Institute of Allergy and Infectious Diseases alone received $4.2 billion in funding. A very conservative estimate is that society invests at least 40 times more trying to study infectious diseases, including forecasting the next flu season or the next viral outbreak, than it does in economics. More likely, the ratio of public investment to science devoted to predicting and preventing the next disease is two or even three orders of magnitude larger than the budget of science dedicated to predicting and preventing economics crises. There is no simple way to compare the output per unit of funding across different fields, but relative to its meagre funding, the performance of economics forecasting is perhaps not so bad."

Another complaint about modern macroeconomics is that doesn't seem to offer clear guidance for policy. Reis points out that macroeocnomics is not the only area of economics with this issue: for example, there is considerable dispute among economists about topics like minimum wages or what tax rates to levy on those with high incomes, too. But perhaps even more to the point, economists often have little control over economic policy--except, in recent years, for central banks. Reis observes:
"In deciding the size of the budget deficit, or whether a fiscal stimulus or austerity package is adopted, macroeconomists will often be heard by the press or policy-makers, but almost never play a decisive role in any of the decisions that are made. Most macroeconomists support countercyclical fiscal policy, where public deficits rise in recessions, both in order to smooth tax rates over time a nd to provide some stimulus to aggregate demand. Looking at fiscal policy across the OECD countries over the last 30 years, it is hard to see too much of this advice being taken. Rather, policy is best described as deficits almost all the time, which does not match normative macroeconomics. Moreover, in popular decisions, like the vote in the United Kingdom to leave the European Union, macroeconomic considerations seemed  to play a very small role in the choices of voters. Critics that blame the underperformance of the economy on economists vastly overstate the influence that economists actually have on economic policy.
"One area where macroeconomists have perhaps more of an influence is in monetary policy. Central banks hire more PhD economists than any other policy institution, and in the United States, the current and past chair of the Federal Reserve are distinguished academic macroeconomists, as have been several members of the Federal Open Market Committee (FOMC) over the years. ... Looking at the major changes in the monetary policy landscape of the last few decades—central bank independence, inflation targeting, financial stability—they all followed long academic literatures. Even individual policies, like increasing transparency,the saturation of the market for reserves, forward guidance, and balance-sheet policy, were adopted following academic arguments and debates." 

Reis points out that central banks around the world were tasked with the job of keeping inflation low, and they have largely done so. Moreover, the response of central banks to the Great Financial Crisis was heavily shaped by macroeconomic research: 

"Macroeconomists did not prevent the crises, but following the collapse of Lehman or the Greek default, news reports were dominated by non-economists claiming that capitalism was about to end and all that we knew was no longer valid, while economists used their analytical tools to make sense of events and suggest policies. In the United States in 2007–8, the Federal Reserve, led by the certified academic macroeconomist Ben Bernanke, acted swiftly and decisively. In terms of its conventional instruments, the Federal Reserve cut interest rates as far as it could and announced it would keep them low for a very long time. Moreover, it saturated the market for reserves by paying interest on reserves, and it expanded its balance sheet in order to affect interest rates at many horizons. Finally, it adopted a series of unconventional policies, intervening in financial markets to prevent shortages of liquidity. Some of these decisions are more controversial than others, and some were more grounded in macroeconomic research than others. But overall, facing an adverse shock that seems to have been as serious as the one behind the Great Depression, monetary policy responded, and the economy recovered. While the recession was deep, it was nowhere as devastating as a depression. The economic profession had spent decades studying the Great Depression, and documenting the policy mistakes that contributed to its severity; these mistakes were all avoided in 2008–10."
Macroeconomics is a juicy target for controversy, and many of the essays in this volume hit their mark. But it's also true that, shocking though this may sound, macroeconomics isn't magic, either. Economics is a developed analytical structure for thinking about issues and potential tradeoffs, not a cookbook full of easy answers. Reis makes a strong case that macroeconomics has its fair share of success stories, and also its fair share of open questions--just like a lot of other policy-relevant academic research.

Here's a listing of the articles in the special issue of the Oxford Review of Economic Policy, with links to the individual articles.  Again, all of the articles appear to be ungated and freely available, at least for now.