Tuesday, August 30, 2016

Not My Usual Comment on Simon Wren-Lewis

I think Simon Wren-Lewis's post "Heterodox economics, mainstream macro and the financial crisis" is excellent even by his high standards. I advise you to just read it, but if you insist on staying here I attempt a brief summary and some comments.

1) Heterodox economists make two valid points about what the financial crisis showed us about inadequacies of 2008 vintage mainstream macro models.

2) The models did not include a financial sector. Banking and bank regulation was considered a sub field separate from macroeconomics. Thus macroeconomists such as Wren-Lewis (and I) didn't even know about the alarming increase in bank leverage. Since 2008 " there has been an explosion of DSGE and other microfounded analysis putting a financial sector into macromodels."

3) Heterodox economists also note that mainstream macro models failed to consider household finance and household balance sheets. Unfortunately while "heterodox economists also have a point, ... they tend not to put it very well and, perhaps as a result, it has not yet impacted on the mainstream " (here I have to note he means on mainstream theory as there is a very active largely empirical research program)

4) I think this [] was/is ignored because incorporating this analysis into microfounded models raises serious problems associated with heterogeneity across age and income. ... Playing around with habits or some ‘rule of thumb consumers’ is much easier. Blanchard has recently made a similar point in his critique of DSGE models.

5) This reveals a key problem with mainstream macro methodology which "allows you to be very selective about what empirical features you do or do not explain.

6) "As Jo Michell writes “The problem with heterdox economics is that it is self-definition in terms of the other”."

7) Macroeconomists might not have ignored bank and household balance sheets if they hadn't insisted on micro founding everything.

My effort to summarize shows why it is better to just click the link. The summary is almost as long as the post and consists mainly of quotes.

I do have some thoughts.

I think that point 5) is fundamental. Macroeconmists have a problem that there are few aggregate data points and no experimental data at all, but the standard approach makes this problem much worse by ignoring most of the available data. In particular, I think this applies to banking, prudential regulation and financial crises too. The 2008 financial crisis wasn't the first in human history, but it had been decided for some reason that macroeconomists could and should ignore data from long ago (the 30s) and far away (East Asia, Russia, Brazil and Argentina). One of Krugman's favorite boasts is that international macroeconomists weren't as blind as other macroeconomists, because they couldn't ignore those crises. Most macroeconomics was cut off not only from banking and finance but also from international -- that is from data from countries (including Korea and Japan) outside of Western Europe and North America. I have to add that, even aside from financial crises, data on unemployment rates collected east of the English Channel were neglected.

Personally, I think it is better to banish intertemporal optimization from models of aggregate consumption. Incorporation of realistic consideration of liquidity constraints and precautionary savings is, as Wren-Lewis notes, very difficult. I agree it is very costly to avoid such difficulties by assuming a representative consumer. but I think that there is no evidence that consideration of optimal intertemporal consumption choices adds anything useful to macroeconomic models. That is a very strong statement and I mean it literally. I fear that assuming consumers solve some sort of highly constrained optimization problem might be required to get papers published. That is I agree with Wren-Lewis that macro should cease to "shun what it calls policy models (models that use aggregate relationships justified by an eclectic mix of theory and data)", and, in particular, I think such models should include a simple empirical reduced form consumption equation. I am quite sure that, even if macroeconomists cease to shun policy models, it will shun the models I have in mind. Consumers' intertemporal optimization is the main dynamic aspect of DSGE. It won't be abandoned just because it leads to one false prediction after another. I am sure that aggregate relationships justified by data will be accepted, if at all, only in less central equations in the model, and probably only in equations including a variable which was totally ignored in 2008. I agree that, for the forseable future, the best we can hope is that macroeconomists will accept mixed models which consider things totally excluded from existing models but do not micro found that consideration.

4 comments:

Blissex said...

«Simon Wren-Lewis's post "Heterodox economics, mainstream macro and the financial crisis" is excellent»

I liked that article too, but it did not go far enough, it seemed fairly banal to me; but after all every "New Keynesian" or "RBC" macroeconomist has a few skeletons in a closet and needs to move carefully, and some change in outlook is better than no change.

«macroeconomists could and should ignore data from long ago (the 30s) and far away (East Asia, Russia, Brazil and Argentina)»

But there have been financial crises in place like the UK in the 1970s and 1990s, including massive house price crashes and sudden bank failures, and the USA S&L horror was a pretty large financial crisis too.

Perhaps the least bad thing that can be said is that "macroeconomists" realized that finance screws up Arrow-Debreu-Lucas style microfoundations so they decided that finance must be ignored in its entirety, and when H Minsky speaks they should just put fingers in ears and sing "lalalalalala I don't hear you".

«Thus macroeconomists such as Wren-Lewis (and I) didn't even know about the alarming increase in bank leverage.»

I dearly hope that this statement is wholly inaccurate.
That there was a giant leverage and credit boom was widely known, and indeed *praised* by the usual suspects, like central bankers.

Robert said...

You can be amazed by my ignorance. I mean I knew about mortgage standards and the housing bubble and stuff. But I knew basically nothing about banks' balance sheets.

Blissex said...

«didn't even know about the alarming increase in bank leverage.»
«knew about mortgage standards and the housing bubble and stuff»

Not connecting the two seems an excellent qualification for being a central bank governor and financial system regulator, if Greenspan (and many others) is a model :-).

More seriously I can imagine that bank balance sheets are not usually a concern of macroeconomists, with the curiously popular illusion that debts and credits must cancel each other out, so don't matter in the aggregate, despite what GK Galbraith wrote many years ago about "psychic wealth". Then we can hope with you:

«the best we can hope is that macroeconomists will accept mixed models which consider things totally excluded from existing models but do not micro found that consideration»

But it may still be somewhat optimistic.

Robert said...

Let me try to explain further. Some people consider me a macroeconomist (and I present myself as one from time to time). But I have trouble focusing. So I dabble in this and that including almost all of economics (and various other fields).

In 2007, if asked to define my field, I would have said "I don't do money and banking" -- that is suggest I do everything else.

After 2008 it was no longer possible to be an economist who had some interest in macroeconomics but didn't do banking. Also I have gotten a bit involved in some monetary theory.

Also I don't do agricultural economics, urban economics, uh I didn't do housing economics.

But really my effort to avoid money and banking was my last chance to deny the fact that I am a dissipated diletante (who can't spelll).