Ramblings on 21st century macroeconomics

Guillermo Calvo wrote a post on what he thinks is the new macroeconomics. Minsky gets cited, but that's pretty much the only concession to heterodox macroeconomics. The interpretation of what the "new" macro for the 21st century should be is basically New Keynesian price/wage rigidities models cum debt-deflation (the finance and Minsky part). But even the understanding of debt-deflation is limited to the notion of sudden stops (slowdown or reversal of capital inflows).

According to him:

"many of us have been involved in developing and testing theories in which imperfections in financial markets play a central role – and coining new terms like Sudden Stop and Phoenix Miracles. The dominant view, however, was that financial crises in EMs reflected weak institutions in that part of the world, and could not possibly take place in advanced economies. Unfortunately, the subprime crisis revealed, to the dismay of many in advanced economies, especially in Europe, that the world is more uniform than we thought!"

In other words, he seems to think that market imperfections are pervasive and that developed countries are vulnerable to sudden stops, like emerging markets (a terrible name popularized in the 1990s for developing countries, as if the only thing were the 'markets'). Note that while developing countries have not experienced sudden stops with the financial crash of 2008, and have used international reserves to insure against the volatility of financial markets (and often introduced capital controls too, when those were not already in place), no significant sudden stop affected the US, the epicenter of the crisis.

As noted by several heterodox economists the crisis in the US the deep causes of the crisis were associated to wage stagnation (worsening income distribution) and the associated increase in private debt, which led to a collapse of spending in the aftermath of the Lehman crisis. Mind you, at that point capital flows went into Treasury bonds, and no sudden stop affected the American economy (in contrast to say Argentina in 2002). So no, the world is not flat or "more uniform" that Calvo thought.

Just for those that might not remember, on dollarization this is what Calvo (paper with Carmen Reinhart) used to say back in 2000 (a few years before the Argentinean crisis; he was rumored as a possible finance minister at the time in Argentina, and the notion was that he was for dollarization):

"Exchange rate movements are costly in this environment. If policymakers take a hard look at the options for exchange rate regimes in emerging economies, they may find that floating regimes may be more of an illusion and that fixed rates--particularly, full dollarization--might emerge as a sensible choice for some countries, especially in Latin America or in the transition economies in the periphery of Euroland."

The sensible choice was dollarization (sic)! Note that his point was that with sufficient fiscal austerity, credibility would be restored, and capital would flow in the right direction (if you are from Greece, you should be afraid if this is the 'new' macro).

But back to sudden stops, which is the basis of his claim to have introduced financial markets into modern macro, here is what he had to say in his post, about the puzzles ahead:

"As recent empirical research has amply demonstrated, financial crisis follows credit boom; this is somewhat of a puzzle, but the most challenging puzzle in my opinion is that credit flows (both gross and net) increase in the run up of crisis, only to crash precipitously after the crisis' onset. ... In other words, if herding is the key word, forget about microfoundations of macroeconomics. I must confess that I am not ready to take such a radical stance. My view is that perhaps this very puzzling phenomenon is linked to liquidity and, more to the point, endogenous liquidity, a phenomenon that has been largely ignored in 20th century macroeconomics."

In other words, sudden stops are associated with collapse of liquidity, and those might be associated to herding behavior, which is irrational and is not amenable to formalizing microfoundations along conventional lines. There are so many misconceptions in this quote that one wonders when is he going to get the Sveriges Riksbank Prize (the often referred to as Nobel).

Endogenous liquidity, or endogenous money is no puzzle, and in fact, mainstream models that accept a Taylor rule have basically incorporated it, like Wicksell. Herding is not that complicated to understand, and is NOT the main problem with microfoundations. The problem with microfoundations is not lack of rationality of economic agents, but the fact that even with very rational (even by the limited mainstream standards) you cannot prove that markets lead to full utilization of resources, with flexible prices and full information (yes please go read on the capital debates).

Note that the effects of debt-deflation on demand are not discussed by Calvo. Or income distribution for that matter. Let alone the recognition that the idea of a natural rate is very difficult to defend, and I don't even mean logically, just empirically after this crisis. The essential information out of this piece is about the degree of confusion of the mainstream. It is increasingly clear that that we are living in a period of decadence of economics as a science, in which the profession is dominated by Vulgar economics.