Reassessing Macroeconomics

William White, Chairman of the Economic and Development Review Committee of the Organization for Economic Cooperation and Development and ex-Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements from 1995 to 2008, writes on what’s wrong with Macro analysis today:

Modern Macroeconomics is on the Wrong Track

"What do the above considerations imply for the future of macroeconomics? The simplifying assumptions of the New Classical and New Keynesian models do not make them obvious candidates for near-term guidance on how best to conduct macroeconomic policies.

We are left then with the Keynesian framework, with all the likely fuzziness and uncertainties implicit in the principal functional forms being subject to “animal spirits.” At the least, this implies appropriate skepticism of the forecasts generated by the available empirical models. Recent experience of very large forecast errors—not least by the IMF, the Organization for Economic Cooperation and Development, and other official bodies—only accentuates a tendency under way in most forecasting shops for many years. Conscious of the potential shortcomings of individual models, many institutions have begun to maintain a variety of such models. Judgments about policy requirements are based on an overview of them all, plus whatever intuition experienced policymakers are prone to add. This blend of art and science may be the best we can ever hope for.

White nicely summarises the developments in empirical macro over the past fifty years (in layman’s terms!), and also covers the contributions that Austrian theory and Hyman Minsky's insights have toward explaining the events of the past two years. He should know - White was one of the very few to correctly predict both the crisis and its proximate causes. With very few exceptions, most academic economists and central bankers got only one or the other right.

He identifies a few areas for future research to get macro analysis back on track:

1. Blending Austrian theory into the structure of Keynesian models, by identifying factors contributing to macro-imbalances
2. Investigate firm and household propensity to consume and invest, independently from the financial system and the supply of credit
3. Who should have regulatory responsibility for monitoring financial imbalances and “pressures”?
4. Urgently conduct research into the micro-foundations of the financial system
5. Due emphasis on research into non-efficient market/non-rational expectations hypotheses as the driver for agent behaviour
6. The impact of government intervention and safety nets needs to be investigated more thoroughly.

This research agenda is being echoed by many prominent economists (Krugman for one), and many central banks and multilateral institutions are scrambling to add financial accelerators and/or positive feedback loops into existing models (essentially putting old wine into new bottles).

The idea of adding Austrian insights into the existing macro-framework is a good one, a long as its not taken too far. The problem I have with Austrian economics is less about their analysis of the business cycle, which I think has validity – booms and busts driven by excessive credit creation – but because they have almost nothing to say about how to manage a bust beyond prescribing an economic system (money independent from discretionary authority e.g. the gold standard) that is many times worse than the present one. It’s like someone yelling fire, then trying to help put it out by telling everyone they shouldn’t be playing with the stuff. Absolutely correct – and absolutely useless.

H/T David Beckworth