Wednesday, October 13, 2010

Of Streetlamps and Macroeconomics

Mark Thoma and Angus positively review Ricardo Caballero's new paper (previously covered by Peter Boettke) which argues that:

"the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected."

It's an intriguing and a cutting criticism, but I'm at something of a loss for how to react to it. Of course, a major part of why I'm at a loss is that I don't really have that much experience with DSGE models. I suppose some of what I did in my macro class for my master's degree could be considered DSGE - but even after that I didn't do anything with it. How familiar is Thoma, Angus, or Boettke with these models when they chime in? I don't know.

I would caution a few things. First, some people are going to be tempted to read this and take it and throw out all "mainstream" theory in favor of a heterodox approach that doesn't emphasize mathematics. The thing is, a lot of the Keynesian "mainstream" that has been expressed in this crisis isn't the kind of economics that Caballero is talking about. He's talking about the RBC and New Keynesian models of the 70s, 80s, and 90s - not the Old Keynesian stuff you see ressurected on the blogs. That doesn't mean the Old Keynesian stuff is up to the task, but it's not what Caballero is talking about here and it's important to realize that.

Second, a lot of what Cabellero describes as the "periphery" of macroeconomics is exactly what the loudest Keynesians now are saying is important and have been saying is important. Caballero writest his of the "periphery":

"To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fire sales, risk-shifting, contagion, and the like. However, much of this literature belongs to the periphery of macroeconomics rather than to its core. Is the solution then to replace the current core for the periphery? I am tempted—but I think this would address only some of our problems."

This has "Nick Rowe", "Paul Krugman", "Peter Diamond", etc. written all over it. A year ago, Krugman identified this same periphery and pointed out how many people were working on it, arguing that (1.) these are not trivial people, but (2.) they could still be more accepted by the core. None of this is to say that Caballero is wrong - it's only to say that you need to be careful who you try to bludgeon with this point. Some people (I'm not going to name names) have a tendency to lump the entire mainstream together, consider them all hopeless, and then embrace a heterodox position that really isn't up to the task of dealing adequately with any of this.

Third, I'm not sure Caballero is right at all that policymakers are neck-deep in this DSGE, street-lamp macro world. There was recently a flurry of controversy over some remarks made by former Fed governor Larry Meyer. That's discussed here, here, here and here. Essentially, Meyer argues (contra Caballero) that policy makers don't use the fancy new models and they are not "mesmerized with their internal logic". Meyer comes out against those models and asserts that the Fed doesn't usually play those games. I don't really know what goes on in the guts of the macroeconomic policy making apparatus, so I can't say. I do know the classic Fed models are old-school Keynesianism - Klein and Modigliani type stuff. I can't imagine there aren't guys running newer RBC and DSGE stuff there too, but I'll have to take Meyer's word on the general emphasis.

This whole discussion I think probably isn't that productive. A lot of the people weighing in and parroting the reactions probably know next to nothing about DSGE models. They probably also know very little about how government economists do their work. They're also probably not very familiar with the "periphery" literature, and so make the mistake of going for a heterodox economics that is a complete non-sequitor to Caballero's point.

Still, he does have a point and it's worth delving deeper. Just be careful.

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