Paul Krugman has a well-written piece on the current state of macroeconomics, "How did Economics Get it so Wrong?" in the NY Times Magazine. It does a good job of presenting the current state of macroeconomics. There has been a failure in macroeconomics. It was not able to correctly forecast the current downturn. Of course, macroeconomics has never been good at forecasting any downturn but that may be another issue. There also has been a failure in the policies that can be used to solve the problem. Macroeconomics does not seem to have easy solutions for current crisis, but then we have not seem many crises like this one.
Nevertheless, the current state of economics may not be as bad as Krugman suggests. We have been aware of the problems with macroeconomics and there has been significant work in trying to solve the limitations within the field. The problems are fundamental to all of economics. The study of market behavior is a social science that is affected by the actions of market participants. The aggregation of behavior is not well understood in any field especially when faced with high uncertainty. We like to believe that everyone is rational but that may not be the case. Market may be rational in the long-run and on average but not at all times. What it means to be rational also differs across individuals. If by rational we mean that behavior is consistent, then we may see that behavior with most investors. If by rational you mean that investors are able to effectively use all information to properly assess the value of all assets, then there may be problems.
There is no ready solution. Krugman dos not have the answers even though he may be able to present a spirited critique of the current state of the field. If we do not understand macro behavior, why would we think that a Keynesian approach is the solution. Keynesian economics is not going to solve the basic problems of determining investor and consumer behavior. This is one of the reasons why Keynes discusses "animal spirits" to describe the behavior of market participants who make investment decisions. The animal spirits represents an unknown that has to be jump-started by fiscal policy. It is difficult to determine what drives investments decisions is more important that then often quoted view of the stock market as a beauty pageant.
Nevertheless, the current state of economics may not be as bad as Krugman suggests. We have been aware of the problems with macroeconomics and there has been significant work in trying to solve the limitations within the field. The problems are fundamental to all of economics. The study of market behavior is a social science that is affected by the actions of market participants. The aggregation of behavior is not well understood in any field especially when faced with high uncertainty. We like to believe that everyone is rational but that may not be the case. Market may be rational in the long-run and on average but not at all times. What it means to be rational also differs across individuals. If by rational we mean that behavior is consistent, then we may see that behavior with most investors. If by rational you mean that investors are able to effectively use all information to properly assess the value of all assets, then there may be problems.
There is no ready solution. Krugman dos not have the answers even though he may be able to present a spirited critique of the current state of the field. If we do not understand macro behavior, why would we think that a Keynesian approach is the solution. Keynesian economics is not going to solve the basic problems of determining investor and consumer behavior. This is one of the reasons why Keynes discusses "animal spirits" to describe the behavior of market participants who make investment decisions. The animal spirits represents an unknown that has to be jump-started by fiscal policy. It is difficult to determine what drives investments decisions is more important that then often quoted view of the stock market as a beauty pageant.
We do not have a grip on why investors make investments and take risks that are hard to handicap. We also do not understand how consumers will react to uncertainty and to changes in policies like tax changes. Changes in taxes cause changes in behavior. The markets are rational about the impact of taxes and that they will have to be paid in the future. If we cut taxes, will this money be spent? What will it take to get people to change their savings behavior? We already know that there are behavior biases and this effects investment decisions. We just do not know the extent of behavior biases across the entire economy.
Some of the failures of the distinctions across macroeconomics are not for real. There is little disagreement that regulation is needed in any economy. The issue is what is the level that is necessary to get the job done. Will regulation increase the proper functioning of markets. We do not know. Regulation has a cost and a benefit.
There is little disagreement that taxes have to fund the government, but what is the level that is appropriate. Is a 50% marginal tax rate too high or too low? Will taxing small business to fund government programs create more long-term jobs? Do deficits matter? These are all questions for which we do not have the answers. This is not a failure concerning the crisis but a failure for economists to understand their field.
We already know that there will be bubbles in markets both on the upside and the downside. When did the tech boom become a bubble? When did housing become a bubble? The issue whether we can identify these events before they burst and do something about them. After the fact, it is easy to see we should not have gone down this path. There will always be someone who warned us about these dangers. Does that mean there was a collective failure?
Krugman is correct in noting that macroeconomics stagnated between 1985 and 2007 because we were in the period of great moderation. Since there were limited shocks to the global economy there was little interest in answering and developing the vexing questions of macroeconomics. Why work on issues which may be of limited value given they have a low probability of occurring?
The unsatisfying theories of unemployment have been issues for macroeconomist for decades. Krugman notes the problem with current theory, but they are well known by most economists. These are the same issues that I was exposed to as a grad student in the early 1980's. This was one of the reasons for the ongoing pursuit of micro foundations for macroeconomics.
The problem of efficient markets have been well-know and the idea that behavior financial is useful is not surprising. So where is the failure? Yes, a neat answer has not been found to explain macroeconomics but that is not failure but the pursuit of science.
What is so surprising about this current crisis? It is a banking crisis and they are hard to manage from just adding liquidity. Banking crises take longer than normal recessions. The fact that financial firm balance sheets are in disarray means that normal monetary policy of just lowering rates will not work is not surprising. The fact that financial firms are not lending when there balance sheet are in disarray is not surprising. The fact that financial firms and consumer believed there was a Greenspan put and acted rationally is not surprising. The excessive speculative behavior is a reaction to low interest rates and excessive liquidity from the early 2000 Greenspan era. The failure of certain financial institutions which have lead the investors into a environment that is truly uncertainty has caused a flight top quality. This is not surprising. The fact that savings was too low during the great moderation and now consumers are saving more and not spending tax cuts is not surprising. So where is the failure? Why would we expect that excessive behavior for the last few years will now be reversed in a matter of months?
The failure of current macroeconomics is with patience. After setting behavior for a period of years, it will take some time for investor and consumer behavior to change once again. The failure of policy markets is that they want the same level of immediacy that consumers wanted from their earlier spending binge. It cannot happen and we already know that.
Some of the failures of the distinctions across macroeconomics are not for real. There is little disagreement that regulation is needed in any economy. The issue is what is the level that is necessary to get the job done. Will regulation increase the proper functioning of markets. We do not know. Regulation has a cost and a benefit.
There is little disagreement that taxes have to fund the government, but what is the level that is appropriate. Is a 50% marginal tax rate too high or too low? Will taxing small business to fund government programs create more long-term jobs? Do deficits matter? These are all questions for which we do not have the answers. This is not a failure concerning the crisis but a failure for economists to understand their field.
We already know that there will be bubbles in markets both on the upside and the downside. When did the tech boom become a bubble? When did housing become a bubble? The issue whether we can identify these events before they burst and do something about them. After the fact, it is easy to see we should not have gone down this path. There will always be someone who warned us about these dangers. Does that mean there was a collective failure?
Krugman is correct in noting that macroeconomics stagnated between 1985 and 2007 because we were in the period of great moderation. Since there were limited shocks to the global economy there was little interest in answering and developing the vexing questions of macroeconomics. Why work on issues which may be of limited value given they have a low probability of occurring?
The unsatisfying theories of unemployment have been issues for macroeconomist for decades. Krugman notes the problem with current theory, but they are well known by most economists. These are the same issues that I was exposed to as a grad student in the early 1980's. This was one of the reasons for the ongoing pursuit of micro foundations for macroeconomics.
The problem of efficient markets have been well-know and the idea that behavior financial is useful is not surprising. So where is the failure? Yes, a neat answer has not been found to explain macroeconomics but that is not failure but the pursuit of science.
What is so surprising about this current crisis? It is a banking crisis and they are hard to manage from just adding liquidity. Banking crises take longer than normal recessions. The fact that financial firm balance sheets are in disarray means that normal monetary policy of just lowering rates will not work is not surprising. The fact that financial firms are not lending when there balance sheet are in disarray is not surprising. The fact that financial firms and consumer believed there was a Greenspan put and acted rationally is not surprising. The excessive speculative behavior is a reaction to low interest rates and excessive liquidity from the early 2000 Greenspan era. The failure of certain financial institutions which have lead the investors into a environment that is truly uncertainty has caused a flight top quality. This is not surprising. The fact that savings was too low during the great moderation and now consumers are saving more and not spending tax cuts is not surprising. So where is the failure? Why would we expect that excessive behavior for the last few years will now be reversed in a matter of months?
The failure of current macroeconomics is with patience. After setting behavior for a period of years, it will take some time for investor and consumer behavior to change once again. The failure of policy markets is that they want the same level of immediacy that consumers wanted from their earlier spending binge. It cannot happen and we already know that.
