There are tons of articles these days on the state of macro/eco. The fire has been ignited in particular by Krugman NYT article but before this also there were a few thoughtful pieces – (see this, this, this, this etc etc). Mark Thoma has a detailed list on the response of economists on the Krugman article. All this actually is very exciting but is fairly sad at the same time as there is just too much infighting. And with interent you can all see it happening. Some of the words being used are also not kind and is getting nastier by the day.
Now, a central banker chips in. José De Gregorio, Governor, Central Bank of Chile has given a much sober and useful speech on state of macro and finance. His main view is:
it is important to insist: models are only a part of the reality that allows us to organize our ideas before diagnosing and prescribing. The arguments’ logic and a good deal of judgment are also critical when it comes to making economic policy decisions.
He explains the tow types of models used by central banks- Real Business Cycle and New Keynesian Model (which is the basis for the much criticised DSGE models):
There are two categories of models that are commonly used in macroeconomics and that require some specific references, namely the Real Business Cycle model (RBC) and the New Keynesian model (NKM). Both share the characteristic of being general equilibrium intertemporal models with complete markets and rational expectations.3 Under the RBC model in its more traditional versions, the economy is fully flexible and there is no role for macroeconomic policies, whereas under the NKM there are sticky prices that result in money not being neutral, which assigns a role to monetary policy. These provide the conceptual basis for the formulation of inflation-target regimes.
It is important to place both types of models in their right dimension. The strategy of RBC models is to try to replicate economic fluctuations in the simplest, least distorted model possible. It originated in the attempt to use the neoclassical growth model to explain the business cycle as a result of productivity shocks, which is surely an interesting effort with theoretical consistency. These are very elegant models, but the difficulty of solving them analytically results in having to solve them using calibrations. As a result, there are often doubts regarding the values of the parameters, which in general are unobservable. To the extent that these models are free of distortions, there is no role for active monetary policies, since economic fluctuations are socially optimal. Certainly this is an attractive theoretical proposition, but it is absurd to think that this is how the world works. It will be difficult to explain the financial collapse with this type of model, because it has no frictions and provides very limited policy implications.
The New Keynesian model features no realistic frictions in financial markets either, at least to generate problems as severe as the current ones, so it has nothing to say about the origins of the crisis.4 These models are widely used in central banks to calibrate the monetary policy that is consistent with an inflation target.5 In that sense, they are a very useful tool for establishing well-specified, well-estimated transmission mechanisms, but they are certainly limited, and it is unrealistic to believe that they can provide a full description of the economy.
He says NKM models are still useful as they help central banks understand monetary transmission. What is instead needed is a seperate model to understand finance:
while a different type of model will have to be found to address the issue of financial stability, together with extensions that are yet to be formalized.
This brings me to the theory of finance. If there ever was one discipline that should have anticipated the vulnerabilities that were building up in financial markets, it was finance. Had the origin of the problem been inflationary, then the problem would have been macroeconomics, but the origin was financial. The origin of the crisis is closely related to financial innovation and the creation of instruments that should have diversified risks. Low interest rates, search for yields and a monetary policy that promised to rescue after severe falls in asset prices prompted the creation of a housing bubble.
Enormous efforts were made to price many extremely complex financial instruments, but even those academic efforts failed to build valuation models that realistically considered the instruments’ insolvency probabilities. No evidence is necessary to assert that these methods failed because of an extreme event that struck everything. These failures were exacerbated by severe liquidity shortages and widespread panic in the markets.
Broadly speaking, the theory of finance has two branches: asset price theory and corporate finance theory. It is paradoxical that while asset price theories, and their application to the real world, are based on the existence of complete markets and full arbitrage (consider, for example, CAPM), corporate finance theories that explain firms’ financial decisions are essentially dominated by information asymmetries and are plagued by frictions from principal (owner)-agent (executives) problems. This dichotomy will have to be corrected over time to ensure that more realistic models of how financial markets work become available, models which will shed more light on economic policy recommendations.
Excellent stuff. This is what is needed from economists now. There is an urgent need to learn from the mistakes and incorporate these in eco theories.
He then goes on to cover issues like crisis prevention and crisis management. In the end he says:
Nonetheless, that macroeconomic theory has failed is an overstatement. In particular, the comparatively better performance of emerging economies – with the exception of a few cases such as Eastern Europe that remind us of our mistakes of the past – demonstrate that economic research has taught us something. In particular, the majority of macroeconomic policies have sought not to replicate past mistakes. Now it is necessary to analyze more carefully the role of financial markets, their virtues and, of utmost importance, their vulnerabilities.
This crisis is an admonishment to professional arrogance. We must recognize that the real world is much more complex than what our models can explain. This is why so-called professional orthodoxy is discredited. However, we must also avoid the arrogance that comes from ignorance, which leads to abandoning all we have learned about the fundamentals of good macroeconomic policies.
Thank you Dr Gregorio…