The bathwater

Because I stopped reading it at about the third paragraph where he starts listing all the things that macroeconomists do but claims they don’t do (e.g. financial channels, model robustness, unemployment), can someone explain to me the argument Krugman makes?

From Sumner’s critique it sounds like Krugman wants to go back to old school Keynesian modeling. Cool. If we can test those models and they have more to say than our current models, I’m down. Anyway, I gather from Sumner’s post that Krugman says we should make this move because modern macroeconomics has nothing to say about about depressions and deflations and the zero lower bound.

How does he get from the failure of models to understand once in three generation events to the failure of models in between those events? I mean couldn’t we have two theories? One for the 95% of the time where the lower bound doesn’t hold and another for when it does?

I’m probably wrong because I can’t make heads or tails out of the General Theory, but confusing this point — thinking Keynes’ policy prescriptions for getting out of the Depression applied outside moments of depression — led to the failure of post-war macroeconomics. It lead to terrible monetary policy and the mistaken idea that Feds could fine-tune the economy.

8 thoughts on “The bathwater”

  1. Even in the most favorable interpretation, his comments make little sense.

    A failure of a particular model or class of models does not imply:

    a) that the method used to develop those models is wrong;
    b) that a particular assumption is wrong (e.g. rationality);
    c) that the profession did anything other than its best, all things considered.

    Also, I’m eagerly looking forward to Krugman’s papers on behavioral finance’s consequences for macro modeling.

    Practically, I’m sure we’re going to see a bunch of new DSGE models with a) different market structures; b) more treatment of information; c) finance stuff. That is, people will still build on Lucas, Prescott and co.

    Was Keynes right, whatever that means? Yes, no, maybe, who cares?! It doesn’t matter anymore, it has no consequences.

  2. Krugman isn’t talking about credit channels as financial channels, he is talking about bubbles and other violations of the EMH. Violation of EMH weren’t included in major DSGE models (at least as far as I know, please correct me if I’m wrong).

    Regarding unemployment, it is true that the original RBC models had no unemployment- supply of labor met demand at a given wage. To have unemployment, you need some mechanism where workers willing to work at prevailing wages cannot work immediately. But many models still don’t include sticky prices/wages or search models or any other mechanism to look at unemployment.

    Here I’ll do your blogging work for you:

    “So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.”

    IMHO, Krugman is right about incorporating behavioral finance and that Keynesian economics should be given more credence, but he is too creitical of DSGE models. They are quite flexible and can probably incorporate many if not all of his suggestions given enough time. Also, I don’t know that I’ve seen a convincing explanation for the fundamental causes of the onset of the Great Depression, even from Keynes. I see the General Theory as more of an explanation for the lack of recovery from the GD and potential escapes.

    “thinking Keynes’ policy prescriptions for getting out of the Depression applied outside moments of depression — led to the failure of post-war macroeconomics.” The 50s and 60s were decades of high growth and low inflation, fardly a failure. If Martin had stayed instead of Burns, I don’t think keynesianism would be viewed in the same light. Why can’t one have Keynesianism without an exploitable Philipps curve? This hardly discredits the General Theory or any other core Keynesian views. Keynes of the General Theory thought monetary policy was ineffective generally. To blame expansive monetary policy on Keynes is somewhat problematic.

    Other schools of thought have had flaws too (Friedman’s “always and everywhere” or “long and variable lags”, RBC’s exogeneous productivity shocks, etc.) I wouldn’t say these have been “failures” because of one flaw. Why should Keynesianism be different? (We can trash the consumption multipliers too, but already Modgliani did that, as a Keynesian).

  3. Sorry it took me so long to respond…

    Krugman should have typed “dsge asset bubbles” into google scholar. Many models don’t include bubbles or unemployment because those aren’t the variables of interest in those models. If you’re interest is bubbles or unemployment then, by all means, put those in your model.

    Keynes may… MAY… be the best we have for understanding depressions, but not for recessions in general. When Keynesian mechanisms are modeled in the modern framework, we see his policy prescriptions do nothing (because agents are, at least partially, forward looking), i.e. fiscal multipliers are less than 1. You only get action from Keynesian stuff when monetary policy is ineffective (as in, assumed to be ineffective).

    (And would Krugman be satisfied with incorporating Keynesian elements into DSGEs? What does he mean we he says we should go back to Keynesian other than what New Keynesians have already done?)

    We can debate whether or not monetary is ineffective at the zero lower bound, but that situation comes up very rarely. Why throw out everything we’ve learned about the economy because twice a century it may… MAY… not apply?

    My post-War/ pre-1970s monetary policy history is a little shaky, but I do know we were in a fixed exchange regime so monetary policy wasn’t as important. That said, Bretton Woods was a Keynes love child and, while those institutions reflected his technocratic fine-tune-ism, the setup was doomed to failure from the start. Keynes planned for BW to be a compromise that allowed smart bureaucrats to work around the trilemma, e.g. “flexible pegs”. It didn’t work out.

    Also, can you point out where Keynes says monetary policy is ineffective generally? My third or fourth hand understanding is that money policy is rarely mentioned in the General Theory.

    You need a blog so you can explain your last parenthetical…

  4. He means the Ando-Modigliani’s Lifecycle Model which, in the aggregate, looks a lot like Friedman’s PIH in the short-run and which, at the micro level, might be a bit better, w/ more free parameters, of course.

    And yes, more people who are into Economics and who don’t talk out of their assess need blogs! Dammit!

  5. “(And would Krugman be satisfied with incorporating Keynesian elements into DSGEs? What does he mean we he says we should go back to Keynesian other than what New Keynesians have already done?)”

    Probably not, and I don’t really know. Could you really incorporate old Keynesian models into DSGE? The general theory doesn’t have a mechanism that bring the economy back into equilibrium, but DSGE’s have a hard time creating large deviations from equilbrium (but they can).

    “We can debate whether or not monetary is ineffective at the zero lower bound, but that situation comes up very rarely. Why throw out everything we’ve learned about the economy because twice a century it may… MAY… not apply?”

    I tend to agree that the current criticisms of macro are fairly hysterical. Inability to deal with events that happen twice a year is a flaw, but its not fatal. And definitely no reason to throw out the baby, well you know the rest.

    Bw saw capital controls, so monetary policy could have been effective. But it is true that the world didn’t see as large of shocks. Still, Martin was a fairly good Fed chair.

    Re: Bretton Woods, it was doomed for failure. But if you believe Triffin, then the problem was using a national currency, so maybe Keynes’ bancor’s would have been better. Regarding fixed vs. float vs. something in between, I think its hard to pin down politically/ideologically. Friedman argued for the float, but Barro and other orthodox economists argued for the Argentine currency board (for example).

    In the General Theory, monetary policy isn’t mentioned much. Look in chapter 21. It meanders a lot, but this quote is telling: “If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.”

    Gabriel is right about the parenthetical. Nice name, btw 😀

  6. My big problem with the Krugman piece is that … he didn’t go far enough in elucidating just how psuedo-scientific modern macro, and, indeed, most of economics, has become. He seems almost oblivious to how poor and one-dimensional the training is in all econ-phd programs (for there is little difference in first year curricula at different schools)…

  7. The diversity of the curriculum for graduate physics would be proof of physics’ status as a science?

    You’re going to have to unpack that a little Thorstein for there is an obvious, and more simple, theory to explain these data.

Comments are closed.