Misunderstanding macroeconomic models

The first half of this post is meant for non-economists, but it ends with a couple of points on OLG modelling

I recently wrote a post on the Eggertsson and Mehrotra paper on secular stagnation, because I thought the paper was interesting. A much more critical post from Unlearning Economics (UE) has just appeared in Pieria. UE says it “helps to illustrate the troubles faced by contemporary macroeconomics”. One of UE’s complaints seems to reflect a misunderstanding, often shared by non-economists, about what much academic macromodelling is designed to do.

UE objects to the fact that the model assumes that the amount the young can borrow (the degree of leverage) is exogenous, which means that there is no attempt to explain where this constraint on the borrowing of the young comes from. UE also complains that the model contains no banks, and no investment in physical capital. In other words, the model is much too simple. It is a natural enough idea: to explain what might be currently going on, you need a more complex model that includes everything that could be important.

There is certainly a place for this kind of more elaborate model. Christiano, Eichenbaum and Trabandt in this paper want to argue that a model based on New Keynesian theory can track what has happened over the last ten years. Their model has 40 equations. If I was trying to do a similar exercise, I would want to augment the standard New Keynesian framework with at least the following: nominal wage stickiness as well as price stickiness, a financial sector that endogenised both the cost and rationing of credit, a model of consumption which allowed for credit constraints and precautionary saving, a housing market, a model of the labour market that combined matching with rationing (as here), and something that allowed recessions to have long lasting (hysteretic) impacts on labour supply and technical progress. However large models like this will involve many macroeconomic ‘mechanisms’, and it will generally be unclear which mechanisms are important at driving particular results or explaining particular facts. We do not want to treat the elaborate model as a black box, but instead we want to understand its properties.

To understand complex models, we need much simpler models. (I once - in this paper - called the process of relating complex models to simpler models ‘theoretical deconstruction’.) In fact it is often sensible to start with the simpler model. For example, a particular issue with secular stagnation is to show how the natural real interest rate can be negative for decades rather than years (i.e. beyond the Keynesian short term)? What mechanism can do this? As I explained in my post, neither a standard representative agent model nor a standard two period overlapping generations model (OLG model, where the two generations are those earning and those retired) will give you that result. What Eggertsson and Mehrotra show is that a very simple three period OLG model (which adds a young generation that borrows) where borrowing by the young is constrained (they would like to borrow more but cannot) can provide just that mechanism.

That is a key point of the paper. The paper is not designed to explain where borrowing constraints come from: there is now a big literature on that. Thankfully the authors do not feel compelled to microfound these constraints. Instead the paper simply offers and explores a mechanism whereby an increase in these borrowing constraints could move the natural interest rate into negative territory, and for it to stay there. Having established that result, it is for subsequent work (which the authors intend to do) to see if that mechanism survives complicating the model, by for example adding investment.

Suppose the endeavour is successful, and a more complex but realistic model is able to provide an account of secular stagnation that includes other important mechanisms and which is based on a realistic set of parameter values. That would be a success, but those not familiar with all the work would ask: why does this model allow real interest rates to be negative when the standard models we know do not. The reply would be that the three period OLG structure was critical, and to see why have a look at the original, simple model.

Now you might say the authors should wait until they have built the more realistic model before creating what could turn out to be a research path that might fail to achieve its goal. That would be quite wrong, because the more debate there is within the academic community when ideas are at their early stages the better. I want to give an example of this, but here I will go into territory that will probably only interest macroeconomists.

It might be the case, for example, that the authors intuition that their results will survive introducing other assets like physical capital can be shown to be wrong very quickly. Indeed, Nick Rowe has already made such a claim, arguing that the presence of land as an asset ensures a positive real interest rate. If Nick was right this could be enough to kill the research programme, without any more time being wasted. Whether he is right is another matter: this paper by Rhee may be relevant in that respect.

Here I just want to add a final thought. Within an OLG framework, it may not be necessary to establish the existence of a steady state with negative real interest rates. The typical period in an OLG model lasts two or more decades. So if the dynamics of such a model involved some overshooting, it might be possible to generate prolonged periods (in years) of negative interest rates even if the steady state real interest rate was positive. To be honest I’m not sure what might give rise to overshooting of this kind, but that may just reflect my inadequate imagination.