Sunday, May 22, 2011

It's the model stupid!

Brad DeLong, that together with Krugman has been a force for sanity within the mainstream, arguing for more fiscal expansion, shows why we need heterodox economists.  He says in a recent post:

This is a bad time to be an economist. If you were fresh from the womb and had no past opinions to defend, if you had never said anything notable before, it might be a fine time to be an economist. If you are one of those soap-opera characters who has complete amnesia and no memory of anything that they ever said or did or any intellectual position they took before January 1, 2010, it might be a fine time to be an economist. But for the rest of us--we who are now looking back at our opinions and analytic judgments and statements and pronouncements of the past 15 years and thinking: "how could I ever have been so stupid; how could I have missed so much?"--it is a bad time to be economist?
Four years ago we economists were writing learned papers about the "Great Moderation": about how it looked as though the governing institutions of the world economy had finally learned how to control and moderate if not completely eliminate the business cycle--the epileptic seizures of the economy that leave us with pointlessly high unemployment, pointlessly idle capacity, and pointlessly rusting away machines in spite of there being no fundamental cause for machines to be idle, factories closed, and workers unemployed.
Funny, I know of several economists that suggested that an economy based on debt-led consumption, on the basis of asset bubbles, was not sustainable and that a crisis was coming.  It would be tedious to cite all, and I'm lazy and don't want to find links to their papers, but a limited list of names (do a google search) would include Dean Baker, Jane D'Arista, Jerry Epstein, Jamie Galbraith, Wynne Godley, Thomas Palley, Bob Pollin and Lance Taylor (before hand I'm sorry for any significant omissions).  I knew enough to be sure that it was not sustainable.

But I'm glad that the best in the mainstream admit that it was stupid not to see it coming. I would suggest to him that part of the problem of the inability of the mainstream to see it coming is their theoretical framework.  The consensus macroeconomic model, based on an IS curve, a monetary policy rule, and a Phillips Curve with a natural rate of unemployment, in particular because it assumes that the economy automatically returns to the natural rate, is a flawed basis for understanding the real world.

4 comments:

  1. Indeed. As I say further down from the passage you quote:

    >Back when I started in this business, back in the Spring of 1980, I had as teachers two of the smartest men I have ever known: Marty Feldstein and Olivier Blanchard. They taught that John Maynard Keynes had feared that if the economy got itself wedged into a situation of high unemployment that it would never recover by itself--that it would settle into an "underemployment equilibrium." It would need some large positive shock--either a wave of business exuberance, either rational or irrational, or activist stimulative monetary, banking, and/or fiscal policy on the part of government in order to knock unemployment down and employment back up to where it ought to be. Back in 1980 they said that we economists had learned that the market system worked better than that, and that there were substantial equilibrium-restoring forces in the world economy.

    >But look at the U.S. labor market over the past two years. Those forces are not there. There are no signs that the share of American adults with jobs has been growing, or is about to start growing. Ben Bernanke and Barack Obama both like to talk about how the unemployment rate is falling. But all of the decline in the unemployment rate has come from the fact that people have been dropping out of the labor force. None of it has come from any increase in the share of the adult population with jobs.

    >That suggests, to me, that we fact a very long slog. The economy will grow, but we won’t close the gap between actual and potential output. We will not for a long time to come get back to the 62 to 64% of the adult population having jobs that we thought was normal back in the decades of the 2000.

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  2. And that is the problem that models assumed "there were substantial equilibrium-restoring forces in the world economy." Part of Friedman's legacy. There is almost no recognition that demand forces influence the capacity limit of the economy, and it has led to very timid fiscal measures, insufficient for a more robust recovery. Thanks for the additional citation.

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  3. Thanks for recognizing that we are in a Keynesian underemployment equilibrium; I was about to say "classic," but since they are not all that common, I should say "clear."

    The solution, as all here understand, is both classic and clear: Fiscal stimulus until employment is at reasonable levels.

    The last major time it took a world cataclysm to finally fix things. Have we learned?

    Is it time to (mostly) free fiscal policy from politics as we did (partly) with monetary policy? An independent Treasury? Of course we get to pick the staff.

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  4. I kind of prefer not to have an independent Treasury (or Fed for that matter). Mind you most people would be for increasing taxes on the wealthy to deal with fiscal sustainability issues, and are in favor of social spending (Medicare and Social Security). So politics is not necessarly that bad.

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