Monday, July 23, 2012

Did the financial crisis and recession discredit macroeconomists?

This post is a short essay I wrote for another purpose reviewing Ricardo Caballero's paper, "Macroeconomics after the crisis: Time to deal with the pretense-of-knowledge syndrome." It's not necessary that you read Caballero's paper to understand this post--but if this topic interests you, his essay is a nice starting point. 

Caballero joins others in taking stock of the field of macroeconomics. The paper is motivated by the crisis, but he rightly excuses the profession for failing to predict it. “Knowing [crisis-relevant] mechanisms is quite different from arguing that a severe crisis can be predicted.” He focuses more on understanding economic phenomena. His specific complaints are about overemphasis on the “core” of macroeconomics instead of the “periphery.”

For Caballero, the “core” of macroeconomics consists of researchers employing DSGE models. While noting that general equilibrium is important, he takes issue with these models and what he suggests is economists' excessive reliance on them. In contrast, researchers on the “periphery” focus on specific economic problems without attempting to fit their models into large general equilibrium structures. These simpler models can isolate specific mechanisms and are good sources of intuition, but Caballero notes that their resistance to broader application limits their usefulness.

Caballero avoids making specific suggestions about methodological changes or new approaches. He does advise that economists gain a greater appreciation for complexity, but he does not reject the DSGE framework or its use in policy analysis. His points are well taken. Hayek's admonitions about the pretense of knowledge are just as relevant and necessary today as they were when he made them. That said, however, it is not clear what Caballero is trying to achieve with his essay. Far from taking issue with his central argument, I believe that he has no central argument.

It is true that few macroeconomists provided useful, specific predictions of what would unfold starting in 2005 and continuing to the present day; but, as Caballero notes, prediction is not a reasonable goal of economic science. Understanding economic phenomena, including business cycles and financial crises, is the goal. Caballero provides no evidence that the discipline is lacking in tools for understanding what happened in recent years.

Complaints about DSGE models and rational expectations are widespread. While it is easy to see shortcomings in these approaches, it is not clear that their use rendered economists unable to understand crises. The amplification of financial shocks is easily understood with models suggested by Bernanke and Gertler (1996) or others. The persistence of sluggish output following a crisis is well documented by Reinhart and Rogoff (2009) and others, and the reasons for such sluggishness are not impossible to ascertain using existing models. The discipline's focus on DSGE modeling has not rendered us unable to think about how counterparty risk and uncertainty created demand for bailouts. The portrayal of economists drawing blanks on how to explain the crisis is inaccurate.

Caballero raises interesting questions but fails to demonstrate that we lack the tools to understand the recent crisis. Criticism of the field is most useful if it (a) reveals flaws in our ability to understand economics, or (b) provides new approaches which allow us to dispose of conventions which are unrealistic. Caballero does neither. If the goal is understanding rather than prediction, our commentary is better applied to convincing people outside the discipline to temper their expectations. In the meantime, sufficient incentives exist for individual researchers to improve the science at the margins, as they have been doing and will continue to do.

References

Bernanke, Ben and Mark Gertler. 1996. The financial accelerator and flight to quality. Review of Economics and Statistics 78 no. 1:1-15.

Reinhart, Carmen and Kenneth Rogoff. 2009. This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press.

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