You’ve heard before that Christie “I heart fiscal policy” Romer wrote a paper claiming monetary policy ended the Great Depression and that it ends recessions in general. I thought this criticism of the latter paper was interesting:
Romer and Romer completely ignore all of this literature. There is not a mumble of an apology in the direction of Tobin and Solow’s methodological concerns, much less their formal statements by Sims and others. Despite its fundamental importance for identification, there is not a hint of a reference to monetary theory, even David Romer’s thesis or the collection of papers in his book with Greg Mankiw (1991). The empirical findings of the huge VAR literature go unmentioned (with one lonely exception). The paper reads as if Romer and Romer are the first to ever examine recognition, decision, and action lags at the Federal Reserve.
The underlying economics, like the empirical methods, is straight from the 1960s: The paper does not ask whether the economy returns to a natural rate without policy intervention; the 1970s challenge that systematic policy might have no real effects is not even dismissed, to say nothing of the 1980s challenge from stochastic growth models that not even the beginnings of recessions need policy shocks.
The omission is so glaring it must be intentional. Here is my — quite sympathetic — interpretation. The last 30 years of macroeconomics are difficult, and the period hasn’t provided firm answers to the earlier questions. VARs address Tobin and Solow’s criticisms, but lots of problems remain. One has to identify shocks from the residuals, consider the potential effects of omitted variables, and worry about whether the AR representation, MA representation, or some combination is policy invariant. Identification isn’t easy. The empirical results are sensitive to specification; the standard errors are big, and one ends up with the impression that the data really don’t say much about the effects of monetary policy-which may in fact be true. Theoretical models seem equally sensitive to assumptions and do not connect easily with empirical work.
We’ve been at this over 30 years, and look how little progress we have made toward answering such simple questions! Can understanding monetary policy really be so difficult? Why don’t we just throw all the formal methodology overboard and go read the history of obvious episodes and see what happened? If, like me, you have struggled with even the smallest VAR, this approach is enormously attractive.
Perhaps this is Romer and Romer’s motivation. But if so, I think that Romer and Romer are falling into the same trap that ensnared the rest of us. Perhaps they started with a desire to just look at the facts. But then they wanted to make quantitative statements. How much would output have changed if the Fed followed a different policy? To do so, they reinvented the St. Louis Fed approach-an econometric technique. Despite the desire to “do something simple” (David Romer, during the discussion), they in fact evaluated policy from the autoregressive representation of an output-fed funds VAR. Now they face Tobin and Solow’s classic causal and identification problems, which cannot be addressed by quotes from FOMC meetings.
Adam and Eve in the garden of Friedman, they have taken one bite of the forbidden econometric fruit. But the serpent (me) is still there, whispering “go ahead, just add a few more variables;” “you can fix that, just put in a Fed reaction function;” “Why don’t you write down a few structural models and verify what your regressions are picking up?” I don’t see how they can resist taking bite after bite, until they are cast out of the garden, explicitly running VARs, and working hard for identification with the rest of us.
This sounds like the dialog in my head when I’m reading Prof. Kling. Then there’s this line: “VAR methods did not evolve as recreational mathematics. They evolved as the best response a generation of talented economists could come up with to genuine and serious concerns.” The same goes for DSGE models and modern theory. Macroeconomics is difficult and its frustrating that we don’t know more.