Count to 10
The paper by Paul Romer, The Trouble with Macroeconomics, has been in the news, and many bloggers have posted about it (Lars Syll here, to name one) and some of the major newspapers (for example, here and here). This follows his previous critiques on what he referred to as mathiness. It's also important since now Romer is the World Bank's chief economist. In all fairness, the only refreshing thing in the paper is the sarcasm, and the internal sociological critique of the profession that "places an authority above criticism."
This paper is better than the previous one on mathiness. He clearly notes that Real Business Cycle (RBC) models including in the synthesis version with New Keynesian models, the Dynamic Stochastic General Equilibrium (DSGE) models he discusses, use productivity shocks as something akin to phlogiston. He's not wrong. My favorite quote is this one also by Ed Prescott, Romer's bête noir, who argues that:
"In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment."So you ask: what was the negative shock that caused the Great Depression? Lucas, a mentor and friend of Prescott that shares his views, said (cited here) about this: "Where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn't we be able to see it in the data?" [For more on the problems with the interpretation of the Depression go here]. And Romer is right also that Friedman's instrumentalism, the idea that it is "as if" there is a negative productivity shock, is not serious.
In his paper, Romer takes issue with Prescott's explanation of productivity shocks as being like "that traffic out there." Here is his explanation of why this is problematic:
"What is particularly revealing about this quote is that it shows that if anyone had taken a micro foundation seriously it would have put a halt to all this lazy theorizing [about imaginary shocks]. Suppose an economist thought that traffic congestion is a metaphor for macro fluctuations or a literal cause of such fluctuations. The obvious way to proceed would be to recognize that drivers make decisions about when to drive and how to drive. From the interaction of these decisions, seemingly random aggregate fluctuations in traffic throughput will emerge. This is a sensible way to think about a fluctuation. It is totally antithetical to an approach that assumes the existence of imaginary traffic shocks that no person does anything to cause."This is very close to getting lost in the analogy, but at any rate, for what is worth, Romer is essentially fine with the methodological individualism of marginalism, and he implies that if you look hard enough you can find in the behavior of economic agents the reasons for why productivity fell and caused a Depression. There is no discussion of causality issues, which are central in the understanding of scientific differences, and why productivity might be endogenous. Romer perhaps thinks, not differently from Lucas or Friedman, that the Fed caused the Depression.
While the tone of the paper is that "Keynesian" ideas that money matters are relevant, and that RBC and DSGE models (or some of them) can't even get the effects of the Volcker stabilization right, it is probably true that Romer doesn't get it either. Anybody that worked with Phillips curves knows that the output gap is relatively weak, and that in order to get reasonable results supply side factors must be included (often the price of oil and other commodities). So the fall in commodity prices, and the indirect effects of the recessions on the bargaining power of the labor force (besides other things like Reagan's anti-union policies) played a role in the stabilization.
And should I mention that Romer writes a whole paper on the troubles with macroeconomics without one single note on the limitations of the idea of a natural rate of unemployment (or interest) and the inability of economists, which use it all the time for policy purposes, to even measure it? Oh well. Now the World Bank, with him as chief economist, will emphasize even more the need to spend on "human capital," because knowledge unleashes increasing returns and development. Yeah nobody though that education was central for development [and he doesn't even think of reverse causality]! Don't get me wrong, macroeconomics has been in trouble since the 1930s, when it developed as a field, but Romer's ideas are not particularly helpful. Being angry at RBC and New Classicals (angriness?) does not provide a clear path for macroeconomics.
PS1: I won't even go on the fact that he thinks that the Cowles Commission methodology is flawed, a position he shares with Lucas and Sargent. On that Ray Fair has said:"If the macro 2 [the RBC/DSGE models Romer criticizes] message is not sensible or its methodology is not feasible for estimating realistic models, it is perhaps time to move back to macro 1 [the Cowles Commission models that Romer also thinks are problematic]. This requires dropping the assumption of rational expectations and trusting the theory to impose exclusion restrictions." I may not agree with Fair, and other Old Keynesians (not sure he would like that label), on the restrictions that need to be applied, but at least methodologically we're on the same page. Not sure what Romer wants.
PS2: Romer doesn't even know of the problems with the growth accounting methodology and Solow's residual. On that see this paper by Jesus Felipe and Franklin Fisher.