The main thing you have to understand about macroeconomic theory — both of the type used by academics and the type employed by private-sector forecasters — is that it doesn’t really work. Events are constantly taking macro people by surprise, counterexamples to pet theories are a dime a dozen, and the rare theory that can be tested against available data is usually rejected outright. In macroeconomics, your choice of model is usually between “awful” and “very slightly less awful.”
Most macroeconomic theories can be easily tested: all we have to do is take a look at Japan. Japan has a number of unusual traits that make it a very good proving ground for macro models, including a shrinking population, inefficient labor markets, an economy out of sync with the rest of the world and a government willing to engage in dramatic economic experiments. Once we start examining theories used to explain the U.S. economy, and apply them to Japan, we find that these theories usually fail.
He points to 4 econ ideas which have failed:
- Loanable funds theory which says as govt borrows more, rates go up. In Japan borrowing has zoomed but rates have only crashed
- Quantity theory of money which says higher Money supply leads to higher inflation. In Japan MS has increased manifold but inflation remains in negative
- New Keynesian Phillips Curve which says when everyone has a job, competition for workers is supposed to push up wages and prices, thus increasing inflation. Jobs have increased since Abe came but no inflation
- Employment should boost productivity. But this too has not happened.
One theory which has worked is Neo Fisherism which says if rates remain low, inflation will only fall. Though this has been rejected by most econs.
Best lines are reserved for the end:
In any case, Japan offers a clear object lesson that macroeconomic theory is very, very hard to get right. If macroeconomists are always having to explain away Japan as a special case, it should make us that much less confident that they can predict the future of Western economies.
But we continue to believe them..