Sunday, December 04, 2016

My Advice to Macroeconomists

Take two aspirins and call me in the morning (or maybe in 100 years).

As usual, I want to talk about crude empiricism vs microfoundations. I will argue that we should look at what has been tried in the past and whether it seems to have worked. This means I think we should not just keep our heads to down and to the grind-stone working on microeconomics until we have done it right and only then dare to attempt to advise policy makers. I have nothing against empirical microeocomic research, but I think this question is whether there are macroeconomists who have something useful to say even before the empirical microeconomics research program is completed.

I want to consider an example from another field of research -- aspirin. For all of human history, it has been reported that the roots of willows contain an analgesic. I do mean this literally -- it was reported by Herodetus. The pain killer was purified and named salycilic acid. There were three problems -- its mechanism of action (microfoundation) was completely mysterious, it caused ulcers, and it tasted horrible. The third problem was crucial, but it was solved roughly a century ago by the same reaction which gave us heroin Acetylation. Now we have access to Aceto Salyclic Acid AKA aspirin. Decades later, the mechanism was understood. Aspirin blocks synthesis of a number of molecules collectively called prostaglandins.

Now the research which explained aspirin's effect was worthwhile (well worth the real Nobel prize that was awarded). But there was no reason to refuse to take aspirin and suffer when its side effects were known but its mechanism was mysterious.

The micro (in this case nano) reasearch was useful. It made it possible to develop other non steroid anti-inflamatories. Importantly, it was understood that there were two related moelecules one of which caused inflamation, feaver and tenderness and the other of which caused the stomach and small intestine to releqase mucouse to protect themselves. This scientific research, followed by a massive controlled trial, lead to the availability of Vioxx and over 50,000 deaths.

I think the example is relevant for those who wonder if macroeconomists should stick with tried and true models (not of couse the academic literature dominatinng tried and false models) for a good long while.

Of course the old Keynesian models have their empirical failures. Such as ... uhm well not the stagflation of the 70s which was consistent with the expectations augmented Phillips curve used by the old Keynesians throughout the 1960s (starting with Samuelson and Solow 1960) but, well there was the failure to consider the hypothesis that there is Ricardian equivalence which is implied by almost all mroe modern models and supported by no data of which I am aware at all.

Well I am sure that there must have been something badly wrong with those models which were abandoned before I took my first economics course.

But seriously, I know of no difference between using those models and using aspirin in the 1960s.

Buchanan Smith and Krugman

Mark Buchanan and Noah Smith discuss what is wrong with Macroeconomics.

I think it is best to just click and read, but I particularly like two points

Buchanan: ... In 20-plus years writing about science, I've studied research in physics, biology, chemistry, psychology, anthropology and always found, after looking closely enough, that the models people use in these fields are usually well-motivated, make basic logical sense and get rejected if they don't fit the facts very well. Macroeconomics has been the one exception.

and

Smith: ... I think the biggest problem with macro is that models never get thrown in the trash. Researchers pump out theory paper after theory paper, most of which contradict each other. Sometimes we see a big, spectacular event like the 2008 crisis, which just couldn't happen in any of the popular, dominant, or Nobel-winning models. But then macroeconomists just pull some obscure 20-year-old paper off the shelf and say "Of course macro can explain this." Macro theory is sort of like a big collective effort to cover all the bases, not to find which models really work and which don't.

So if people criticize macro by saying to add this or that feature, they’ll do what you ask. But the papers will just sit on the shelves, and when it comes time to make policy, people pick and choose the theories that suit their preconceptions.

I do think that Smith makes a very important point. It is what he discussed (brilliantly do click this link) here "We will continue using this falsified theory to 'organize our thoughts'" and what I had in mind when I typed "benchmarks" (twice).

As Noah notes, the problem is fundamental. Macroeconomists act like scientists -- we develop hypotheses, infer testable predictions, test them, reject them and then come up with new models which fit the data which rejected the old hypothesis. But the rejected hypothesis becomes a model and then a benchmark model and many macroeconomists

"keep treating it as if it were true. So ... will continue to make highly questionable policy recommendations. The fact that this theory is such a simple, clear, well-understood tool - so good for "organizing our thinking", even if it doesn't match reality - will keep it in use long after its sell-by date.

On the other hand, i don't think macroeconomists have attempted to cover all bases. Smith fears that any data which contradict the benchmark model used to "organize our thinking" and to make confident policy recommenations can be reconciles with some off the shelf macro model which is put right back on the shelf as soon as people stop pointing at those data. He is right that this is what macroeonomists do. However, we have not covered all bases. I think it is easy to find stylized facts which are not consistent with any macro model in the literature. I think it is important that Noah knows lots of troublesome facts are just ignored. He wrote "Sometimes we see a big, spectacular event like the 2008 crisis, which just couldn't happen in any of the popular, dominant, or Nobel-winning models." The point is that the dodge is only required when the failure of all the popular models is "spectacular".

I really want to focus on a hint of an interesting debate between Smith and Krugman here in

Recently, more top macroeconomists are taking a hard look at the data to figure out how consumers and companies really behave -- for example, how businesses make decisions about setting prices and hiring or firing workers.

[skip]

Note that this is the opposite of what a lot of macro critics are suggesting. Some, like Paul Krugman, advocate the use of very simple, old models, which are easy to use and interpret (especially in times of crisis). Others suggest tossing out the idea of individual decision-making as the foundation of macro models.

Noah concludes that Smith is right "The biggest challenge right now for macro is to move toward more realistic micro, using data as a guide. "

But there is a problem. Not all economists are macroeconomists. IO economists have tried to study how firms set prices and labor economists have tried to study labor demand. A practical form of Smith's proposal would be that macroeconomists should use the actual results of micro research and not microfound on decades old theories which have been rejected by the data. However, the actual proposal is that macroeconomists should first beat microeconomists in their own fields and then build macro models on the newly secured battlefield. Importantly Noah doesn't argue that there are perfectly good models of price setting in the empirical IO literature and macroeconomists just have to adopt them. Instead he proposes that we start to attempt to do empirical IO. But people have been working on that for decades. They aren't as numerous as macroeconomists, and they haven't made as little progress, but the history of that field doesn't suggest that the questions could be answered soon if they were just asked.

In constrast, Krugman's proposal is no good, because ... why ?

I wrote "an interesting debate," but not, I think, a fundamentally important debate. There is no reason why macroeconomists can't work on empirical microeconomics while also using old Keynesian models for forecasting and policy advice. Now one might argue that it would be better not to give advice until we have decent models based on empirical microeconomics. This would be true if macroeconomists forecasts were reliably worse than those of non-economists (indeed I am glad that Prescott who said that the then current problems were no big deal in early 2009 and Lucas who claimed to know that public investment couldn't cause increased nominal aggregate demand are not actively contributing to the policy debate).

It is not a sensible criticism of Krugman. I think it is clear that old Keynesian models are useful, beceause they give better forecasts and conditional forecasts than the judgment of non economists.

I have nothing against empirical micro research. Trying to understand price setting, hiring, firing and sayving decisions is worthwhile as pure social science in any case. But the idea that macroeconomists should be microeconomists for a while (how many decades ?) ignores that fact that policy makers are making horrible mistakes, and that (some) macroeconomists have reliably warned in advance that they are mistakes.