The extent of our knowledge

One of the reasons I think modern macro is successful is that it cleanly separates what we know from what we don’t know. Making assumptions about how people make decisions and assumptions about how those decisions interact, modern macro models give expected behavior. In our models we capture all that we don’t know in what are called “exogenous shocks”. They’re “exogenous” because they’re outside the model and they’re “shocks” because they’re exact value is unpredictable even if the economic agents inhabiting the model’s world knows their distribution.

Given the behavior of exogenous shocks and the predicted behavior of the model’s agents to those shocks, we can take the output of the model and compare it to real data. If a model replicates real data then its assumed this is due to the assumptions about shocks and behavior. Because the shocks represent things we don’t know, we’d like to have the most simply shocks possible and therefore have the structure of the model explain as much of the data as possible.

Similarly, we can compare models by seeing which explains the most patterns in the data (or at least the patterns we care about) using the same exogenous shocks. If one model explains more data, we say that one tells us more about whatever is being studied. The shocks, however, continue to reflect our ignorance.

I like this paper by Eggertsson (h/t EotAW) because it shows how important the assumptions on exogenous shocks can be. Cole and Ohanian have several papers (findings summarized here) that show New Deal policies (by which they and Eggertsson mean industrial and union policies increasing monopoly power) were contractionary. This is actually the standard view that follows from microeconomic theory.

Eggertsson shows that after you include some standard modern macro model features (e.g. sticky prices, monopolistic competition) and you change the assumption on the exogenous shocks, these New Deal policies are, to my surprise, expansionary. The reason is at the zero lower bound for interest rates, without these policies, expectation for inflation doesn’t materialize and the economy falls into a deflationary spiral. When the government gives unions and big companies monopoly power, on the other hand, people expect those unions and big companies to use that power to raise prices. In this way, New Deal policies take over traditional monetary policies roles in setting inflation expectations.

But I really, really like the paper because it makes explicit that the reason its results are different from standard results from Cole and Ohanian is because of the assumptions about the shocks. In both sets of research, the shock is to preference for precautionary savings (“animal spirits”). Cole and Ohanian assume the 1929 crash and the bungles of Hoover were the exogenous shock and when Roosevelt took office that shock began to dissipate. Eggertsson, though, assumes the shock persisted through the great depression. Which is the right assumption, nobody knows.

The paper has very nicely separated what we know from what we don’t know. This makes task for future research very clear… what were the nature of those shocks to animal spirits?

To me, this strand of modern macro literature is encouraging. Everyone’s assumptions are laid out on the table, theories are making heavy contact with data and progress can easily be identified. Its almost like this is science.

6 thoughts on “The extent of our knowledge”

  1. I’ve really enjoyed reading your macro posts, so I’m going to ask you to go out on a limb. If President Obama called you up and said, “Will, what should I do?” what would you tell him?

    I’ve got my own answer to this question and want to check it against yours.

  2. I’d have him give speeches about positive prospects for growth (“your company will turn the corner! your wages will go up!”); I’d have him talk about how this recession is a short term bump in the road. No more talk about how shitty things are (without, of course, denying the statistics… I assume Obama’s a better rhetorician than I am). Pessimism feeds on itself so to the extent the president controls expectations, he should try to improve them. Even though I don’t think the President has that much control over expectations, I think Obama’s rhetoric of transformation is more useful than his rhetoric of crisis.

    I’d advise him that any actions he takes should reinforce his positive message. That this is the force of those actions. So if the stimulus has to happen for whatever political reasons, then it should be to improve long term prospects for growth. People have to feel like their wages will get higher.

    Secretly, I’d wish we didn’t live in a world that had political institutions that acted as if “something needs to be done; this is something” was good policy.

    That’s to address the crisis, which I assume is what you were talking about. As for “real” reform, I’m not an expert on regulation or finance. Clearly, though, something will need to be done there.

    Also, I’d want to think about ways to anticipate asset bubbles and to have institutions in place to deal with them before they become a problem. As we’ve seen, significantly sized bubbles can really distort allocations. Maybe this is a new role for the Fed because of its independence. No political institution would be able to stare down voters when it tried to deflate asset prices. “Sir, please vote for me. Yes, I reduced the price of your home, but it was for the greater good!” Maybe the Fed could get away with this though.

  3. Isn’t that exactly the tone he took with his inaugural speech? Something like “We’ve faced adversity before, we will defeat it again,” etc.

    I agree though – any government agency put in the path of an asset bubble will be fired from a cannon at the nearest bus the moment it looks like it’s impeding growth.

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