Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 27 April 2015

Received wisdom in macroeconomics

For both non-economists and economists

There has been some talk recently about what is wrong with macroeconomics. (Jérémie Cohen-Setton has a good summary, although non-economists are allowed to do a bit of skipping. And yes, I am a little late on this - cannot think why.) Of course there is always talk of this kind - it just ebbs and flows. But I think this recent upsurge has missed an important point (which, as is often the case, is an elaboration of a point already made by Paul Krugman). .

Many of the complaints about macro are along the lines that it needs more models involving X. Now X can be many things: a financial sector, nonlinearities, multiple equilibria etc. Yet as anyone who is involved in modern macro knows, pretty well whatever X is, there are models that have those things. If you want chapter and verse on this, see Tony Yates (as in here). Indeed, one of the characteristics of modern macro, as opposed to the stuff I dimly remember from my youth, is the huge variety of approaches on offer. In that sense, academic macro is flourishing.

Does that mean the critics are wrong? Not necessarily. I think what is missing in this discussion is the concept of a received wisdom which non-academics (including politicians and civil servants) can readily access. There may be plenty of models which allow for recessions to persist indefinitely, for example, but the received wisdom might still be that recessions are temporary affairs caused by price stickiness and therefore the economy always ‘self-corrects’. So the criticism should not be that there is no analysis of X, but that X is not part of the received wisdom.

A related point can be made about the financial crisis. It is not the case that we need a whole new set of economic tools to understand financial crises: it turns out we had most of the tools already. (Most, not all - see for example the reference here to the Bank of England’s work on networks). The problem was more the received wisdom, which was that the problems that the financial system had shown in the past had been solved, and so we could just ignore them. Once that received wisdom was shattered, there were plenty of tools in the toolbox to analyse what had gone wrong.

So where exactly is this received wisdom of which I speak? An obvious place to look is the textbooks we use. However the pace at which the subject moves (often propelled by events) means they are far from a perfect source, and they are not that accessible for non-economists. In the sciences the received wisdom is normally common knowledge among academics; in macroeconomics less so. One place you will clearly find it is in institutions that have to use that knowledge to do their job. So there is clearly a received wisdom about monetary policy, and you will find it among the economists in central banks.

That is why I’m happy to talk about the New Keynesian model being the consensus model as far as business cycles are concerned, because that is the case in central banks. Others have disagreed with this consensus label, but often because they are thinking about the lack of consensus among the wider academic community. Sometimes you can go further still, and argue that the received wisdom in an institution can be found quite precisely in the model that they use to forecast and do policy analysis.

I think this way of thinking can help us understand one reason why governments across the globe have so easily failed by implementing premature austerity. In the past, and perhaps if they did not have an independent central bank, they would probably have had in house capacity (and perhaps a model) to know what damage austerity would cause. But with the widespread adoption of independent central banks, that capacity has faded. Finance ministries have lost that expertise, and become much more about expenditure control. Independent central banks had the knowledge to know that fiscal austerity would be damaging, but for a variety of reasons typically chose not to express it.

Without a clear sense of received wisdom, policymakers are at the mercy of policy entrepreneurs or ideology-based think tanks, and may be unaware that the line they are being sold might be viewed as rubbish by many academics. That of course is putting it very charitably: the problem may be that the policymaker is fully aware of what they are doing, but know they can get away with it because the media is unaware of any received wisdom, or may find it difficult to express. Whichever it is, it suggests one particular route by which independent central banks are part of the reason for the persistence of the Great Recession. By locating the received wisdom about fiscal policy in an institution that was unwilling to express this wisdom, that wisdom was effectively lost.     


  1. Maybe Osbourne's agenda is to comply with the Maasticht treaty on deficit spending levels.

    1. Yes, I would like to know Simons view on that

      Deficit Policy was handed to Brussels in the Maastricht Treaty, Nice Treaty and Lisbon Treaty? That’s why all across Europe they are defict hawks. Macroeconomic and Deficit Policy was handed to Brussels when we joined European Monetary Union. Deficit Limits were first set in the Maastricht Treaty in 1992, expanded in the Nice Treaty, and joined by Macroeconomic Policy in the Lisbon Treaty, Articles 121 and 126 respectively. It was Gordon Brown who put Britain in the Excessive Deficit Procedure administered by Brussels in 2008, and Gordon Brown who locked us into Austerity when he signed the Lisbon Treaty in 2009.

      We are signed up to what is called The stability and growth pact. It states.

      The Stability and Growth Pact (SGP) is an agreement, among the 28 Member states of the European Union, to facilitate and maintain the stability of the Economic and Monetary Union (EMU). Based primarily on Articles 121 and 126 of the Treaty on the Functioning of the European Union, it consists of fiscal monitoring of members by the European Commission and the Council of Ministers, and the issuing of a yearly recommendation for policy actions to ensure a full compliance with the SGP also in the medium-term. If a Member State breaches the SGP’s outlined maximum limit for government deficit and debt, the surveillance and request for corrective action will intensify through the declaration of an Excessive Deficit Procedure (EDP).

      Which is – 3% for budget deficit and 60% debt to GDP ratio.

      Now Considering Our debt to GDP ratio in 2010 was 78.4% of GDP and 5 years later It’s now 90.6% of GDP and increased way above the 60% debt to GDP target outlined by the EU. Our defict % to GDP in 2015 is 4.1%. Which is also 1.1% over the 3% limit set by the EU – We are in pretty bad shape and in breach of the pact.

      If we don’t show we are making serious attempts to meet this target then we are awarded with the Excessive deficit procedure from the EU. These are never made public by the corrective arm of the EU.

      Only a few weeks ago HM Treasury and the OBR produced a report for the EU. It details fully what the UK government is going to do in the next 5 years to meet it’s targets of the stability and growth act.

      It can be found in google called 2014-15 Convergence Programme for the United Kingdom: All 263 pages of it and reads like the Labour and Tory manifesto’s.

      It’s all well and good saying we are going to do things differently. Not if the EU has a say we are not.

      Which explains the HM Treasury and OBR – 2014-15 Convergence Programme for the United Kingdom: growth and stabulity pact.

      Have the EU put us in straight jacket ?

    2. My instinct is to say that it does not matter at all - it had no influence on the Labour government when it enacted fiscal stimulus in 2009.

    3. Thats because it allows for extraordinary emergency situations. Extending deficit spending out over a whole parliament as an economic policy does not come under that.

    4. Yes, the fiscal stimulus was an emergency.

      If you read HM Treasury report all 263 pages of it - 2014-15 Convergence Programme for the United Kingdom: Growth and stability pact.

      They are taking it very seriously. Dozens of items in the report have been announced by the establishment parties during the campaign.

      Page 63 of the report

      It states clearly the next government is…………….

      Going to spend £742 billion this year 39.6% of GDP.

      £740 billion 16-17 38.1% of GDP.
      £743 billion 17-18 36.8% of GDP.
      £759 billion 18-19 36% of GDP.
      £797 billion 19-20 36% of GDP.

      That’s a huge amount of money over a 5 year period.

      Page 29 of the report

      The government’s financing plans for 2015-16 are set out in full in the ‘Debt and reserves management report 2015-16’, published alongside the Budget. It is anticipated that the netfinancing requirement of £140.4 billion will be met through gilt issuance of £133.4 billion and an increase of £7.0 billion in the stock of Treasury bills.

      They are going to borrow £140 billion this year alone.

      Yet, if the SNP or any other party say they are going to borrow £140 billion they are attacked from all sides because of it.

      Their plan as they've told the EU is to reduce

      Defict % of GDP

      2015/16 4.3%

      2016/17 2.2%

      2017/18 0.8%

      2018/19 0.0%

      2019/20 -0.1% Surplus.

      Debt % of GDP

      2015/16 88.8%

      2016/17 88.7%

      2017/18 87.1%

      2018/19 84.4%

      2019/20 81.4%

      It was also the corrective arm via the Excessive Deficit Procedure that told the UK Treasury to raise VAT the last time around.

    5. But you could have argued that the emergency persisted in 2010 and 2011. After all, at the time the EZ countries had other things to worry about than UK fiscal policy. I've never heard anyone in the UK mention the SGP as an important influence on UK policy, even in private.

    6. Eurozone countries are subject to economic sanctions if they do not stay within the Stability and Growth Pact limits. The UK is exempt. The UK is not bound by the fiscal provisions of the Fiscal Compact either.

  2. Simon, I have always thought it was likely that the Coalition's policy of austerity must have found favour at the Treasury in 2010, if it had not then Chancellor would have been presented with forecasts of the economy going into recession, deficit increasing not falling, unemployment soaring and so forth. "A very brave policy indeed Chancellor" said Sir Humphrey.

    Which gives two interesting outcomes - he was presented with the doomsday scenario but decided to do it anyway which requires a politician of unusual political bravery, or he wasn't because Treasury economists thought the policy was the right one.

    I suspect the latter rather than the former and it would be consistent with your idea of missing wisdom at the Treasury (and elswhere)

  3. If you want this 'received wisdom' to carry any weight, it needs to be tested.
    You know what to do.
    Does it pass the David Blanchflower test?

  4. Well Economics has become so popular now that its almost impossible not to find a model for everything. Its all well and good to say "if you were an academic you would understand too!" but that is not the point. The point is that you need to be able to say a priori which model you should be looking at.

    It is completely unfeasible for the economy/politicians to look at every possible economic model and prepare for all of them at once. If you want to make these models useful you must be able to pinpoint which model is most appropriate in what circumstances a priori.

    These models that encompass multiple equilibria and non-linearities have the hope of being able fuse numerous concepts(not in the DSGE sense) so that model selection becomes less important.

  5. Make no mistake: there can be only one true theory
    Comment on ‘Received wisdom in macroeconomics’

    Once upon a time in Vienna, what set Popper's young brain in motion was that he stumbled upon the curious fact that psychoanalysis could explain everything including its own failure. From this he famously derived the basic rule of science that a theory must be refutable in principle. Or, to put it the other way round, a theory that explains everything explains nothing.

    We know that economists never understood this methodologically crucial point because they were and still are very proud that they can explain everything -- if only with some tweaking after the fact. One of the great methodologists told economists in no uncertain terms that this is always a red hot indicator of scientific dilettantism.

    “Everything can be ‘explained’ if we place no restrictions on what we mean by ‘explanation’.” (Blaug, 1994, p. 123)

    Wren-Lewis, for one, is entirely unaware of his methodological self-debunking.

    “Yet as anyone who is involved in modern macro knows, pretty well whatever X is, there are models that have those things. If you want chapter and verse on this, see Tony Yates. Indeed, one of the characteristics of modern macro, as opposed to the stuff I dimly remember from my youth, is the huge variety of approaches on offer. In that sense, academic macro is flourishing.” (See thread intro)

    Yes, but only in that senseless sense. Just imagine you ask a physicist about how the lever works and he answers “Oh, physics is flourishing, there is a huge variety of approaches on offer.”

    From the fact that you can construct a model about everything follows only one thing for sure: that you know nothing.

    Let us become concrete. Here is the scientific self-test. You apply one of these items
    • supply-demand-equilibrium,
    • general equilibrium,
    • marginal utility,
    • well-behaved production functions,
    • total income = value of output,
    • total income = wages + profits,
    • I=S,
    • behavioral axioms?

    Then your received wisdom is for the birds* and you have nothing of scientific value to offer.

    “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)

    Egmont Kakarot-Handtke

    Blaug, M. (1994). Why I am Not a Constructivist. Confessions of an Unrepetant
    Popperian. In R. E. Backhouse (Ed.), New Directions in Economic Methodology,
    pages 109–136. London, New York, NY: Routledge.
    Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic
    Method in Economics and Econometrics. Cambridge, MA: MIT Press.

    *For the correct approach see cross-references

    1. If you read the link under 'flourishing', you will see that I'm not equating 'a theory' with 'a useful theory'. That, in a sense, is the point of the post. Received wisdom is about theories that work. But more generally, do not presume that I know less about Popper and Blaug than you do, and certainly do not presume that your comment says anything serious about the methodology of economics. Read some of the posts that I have written on the methodology of macro, and come back when you have something interesting to say.

    2. “Just imagine you ask a physicist about how the lever works”

      Just imagine you ask a physicist what they think of incoherent rants about economics and science.

    3. I don't know much about methodology, but I do know that economists do not have a "true theory" but rather different models which might provide some guidance in the right circumstances, so it's a matter of knowing which models to use when. And this isn't because economists are idiots who don't understand science, it's because economists deal in a subject matter which is too complex to submit to a small set of true models.

      this is worth reading on methodology: economic models as analogies

  6. "Many of the complaints about macro are along the lines that it needs more models involving X. Now X can be many things: a financial sector, nonlinearities, multiple equilibria etc. Yet as anyone who is involved in modern macro knows, pretty well whatever X is, there are models that have those things."

    Given that economics is a social science, I think it makes sense for macro to model people's expectations and preferences as being socially influenced. Are there models that do this yet? I know it's been shown that herding is compatible with rational behavior, but I'm not aware of macro models that reflect this behavior.

  7. Show me some mainstream economists whose models show that the global economy is predominantly wage-led , and has been for some time but it was not as evident because of debt-led consumption. This explains the current "secular stagnation" ( aka savings glut , commodity glut , oversupply , etc ), and since global debt/gdp ( or debt/income) levels are above even the crisis levels , a return to debt-led growth is not a sustainable proposition , absent interest rates plunging into a bottomless , negative pit.

    This is not mainstream thought , and won't be anytime soon , because mainstream economics was designed so that it can't be thought about. Events in coming years will show that economics once again "missed it" , but economists like yourself will have used the time until then wisely , formulating your excuses. This is one prediction that can be made with confidence , no models needed.


  8. "... [government policy modelling] capacity has faded. Finance ministries have lost that expertise, and become much more about expenditure control."

    As an Australian that rings true. The way you can see that is that Oz had a big stimulus package in 20008-9, on the advice of the Treasury.

    Now in Australia the finance ministry has long been split in two - a Treasury, which is mainly about economic policy (both micro and macro) & hence is full of economists, and a Department of Finance which is explicitly the guardian of the public purse and is hence full of accountants and financiers.

    Now the instincts of the Department of Finance are always and everywhere for austerity; in fact faced with the slowdown they kept muttering things like "when people are tightening their belts governments should too". Not so with Treasury, which is often enough wrong but has much more economically sophisticated views in these things.

    Maybe over in the UK you should split your Treasury up a bit.

  9. Hi Simon,

    I am in complete agreement with you about the modelling of different aspects of the economy with different models.

    But I would be really interested, and extremely grateful to you if you could show me, which macroeconomic models deal with the cost to the economy of high private sector debt.

    I have done some empirical work showing it the cost to be very high:

    And have even written a very simple model to show the mechanism:

    But I can't see the issue being discussed by the macroeconomic mainstream and it appears to me to be a clear and important issue.

    I do appreciate that, to a distinguished and knowledgeable economist such as yourself, my modelling will appear amateurish. But I would really like to know what the professional approach is, and how it explains the clear, empirically demonstrable, impact of private sector debt on economic growth.

    Many thanks,


    1. I will just say one more thing. I have a huge amount of respect for your ideas, and because of this I am very interested in your opinion. But I am getting nowhere so will stop trying to ask you anything after making this one last point.

      It feels like there are these hugely intelligent people who are at the frontline of macroeconomics who are completely resistant to changing their ideas, especially if forced to agree with people whom they don't like. If I were to make up a fictional one of these macroeconomists, whom I will call PK, I will have an imaginary conversation with him….

      Me: What do you think about the effect of private sector debt on the economy?

      PK: Hardly anything. One person's debt is another's credit. There's nothing to see here, please move along.

      Me: But what about the crash in 2008 caused by too much debt?

      PK: That's just one of those freak events. Couldn't be predicted. No-one did. My models work in the short term. No-one could have predicted the crash so I'll just go back to what I was doing before, safe in the knowledge that it's correct.

      Me: But what about evidence that the debt/savings glut is hurting the economy.

      PK: Bad economy? Then we need to keep interest rates low and increase government spending.

      Me: Won't low interest rates increase the private sector debt?

      PK: There's no problem with debt.

      Me: But look at the evidence

      PK: There can’t be any – your evidence must be incorrect. There is no reason for it. It’s only those fruit-loop post-Keynesians who think that. Not proper economists who trained at MIT in the 1970s.

      Anyway, I have tried a lot because I enjoy your posts so much and would love to know your thoughts on how to incorporate this into the Hicksian/Keynesian framework. I don’t see why two schools of thought can’t be combined – in fact I feel that it is really individual stubbornness.

    2. Ari - I was not trying to ignore you. You actually ask an important question, and whenever I have to think a bit before replying, other things can get in the way.

      First, why this is a difficult issue for macro. If you had to say what the key equation of modern macro was, you would probably say the consumption Euler equation, which is based on intertemporal optimisation by the consumer. Macro is used to modelling departures from this, but they do not usually involve consumers taking on more debt than they should. To do this you would seem to need some kind of irrationality on the part of consumers: over optimism for example.

      Second, this is not something I have ever looked into, so I may be unaware of some literature out there which does try to do this. What I do know about is work by Michael Kumhof and others at the IMF looking at inequality and the crisis - here for example

      This deals with some of the issues you raise. Among heterodox economists, Steve Keen has always emphasised the role of private sector debt.

      Sorry not to be of more help.

    3. Thank you Simon, that paper is extremely interesting.

      And I apologise for the frustrated tone before. It is just that I present empirical evidence that the increase in private sector debt overhang (and thus inequality) is responsible for a 1.5% per year reduction in GDP growth but no-one (apart, actually, from Steve Keen) seems to think that this is significant. That is 1.5% per year, every year.

      And maybe they assume that my research is flawed, but I can see other research showing a similar effect:

      Anyway, I appreciate you responding and I do know that you are busy enough as it is.

      Another interesting point, for me, is that, with all the talk of reducing inequality, everyone suggests raising taxes for the rich - something that is very difficult in practice. My conclusion is that all you have to do is reduce the share of debt in the economy by printing more central bank money. No-one else seems to suggest this, although it seems to me to be a straightforward conclusion from my simple model.

      Anyway, thanks again. Appreciate you taking the time. Ari

    4. Hi Simon, I have written a post partly in response to this. I speak about you nicely as always.

  10. When the 'received wisdom' is itself nothing but self-serving guess-work, what difference does it make how widely it is understood?

    The record of failure compiled by macro-interventionistas since 1921 isn't guess-work or 'received wisdom - it's demonstrated fact, and should earn the entire discipline a permanent exile from policy-making influence.

  11. Ari

    perhaps not exactly what you are looking for, but work like "Credit Cycles" by Kiyotaki and Moore, and Leverage Cycles by John Geanakoplos might be relevant.

    here is a paper written in 2006, so prior to crisis, that has over borrowing as an equilibrium.

    its conclusion starts with the sentences:

    "The policy debate on financial supervision and regulation has been recently shifting towards a “macroprudential” approach (Borio, 2003). According to this approach, the regulator should be concerned most of all about the aggregate consequences of financial instability, and the main source of instability is identified in the common exposure to macroeconomic risks across financial institutions"

    shame these idea hadn't made it into the "received wisdom" of economics rather sooner

    1. Thanks Luis, I am looking at these now.

      I am actually concerned less with the financial stability aspect (which is important but well known) and more with the impact on growth.

      Borrowers tend to be poorer than lenders and spend more of thier income. Savers tend to be richer and spend less. A transfer of interest and dividends from borrower to saver increases the savings rate in the economy. As this gets higher demand, and therefore GDP, gets lower. At the moment we have a shortage of demand precisely from this debt overhang.

      I am sort of aiming for more realisation of this as, at the moment, we are destined, in my opinion, for slow growth for a very long time.

  12. 1) "In the past, and perhaps if they did not have an independent central bank, they would probably have had in house capacity (and perhaps a model) to know what damage austerity would cause. But with the widespread adoption of independent central banks, that capacity has faded. Finance ministries have lost that expertise, and become much more about expenditure control" I can only agree but I must say that in EU member countries net receivers of EU Support Funds the SGP has been a very serious straitjacket: The SGP has led to an influx of accountants into Finance ministries to devise how to circumvent the rules of the "Manual on Government Deficit and Debt" (sometimes advised by the big international financial firms) and not so uncommon have taken steps to fulfill the limits of SGP, immediately, undermining the medium-long term sustainability of Government accounts (mainly the public pensions systems).
    2) Concerning the present accuracy of macro-modeling I agree but I add that calibration will remain for a long time an art that enable the customization of the results of simulations


  13. As I commented at Paul Krugman's:

    Would we ever in a million years be able to really get a message like this out, at least in less than decades, without the internet?

    Where would it go? Fit into the 7x4 inch column space twice a week in the back of a newspaper?

    Something's happening here, what it is ain't exactly clear,...

  14. As I commented at Paul Krugman's:

    Would we ever in a million years be able to really get a message like this out, at least in less than decades, without the internet?

    Where would it go? Fit into the 7x4 inch column space twice a week in the back of a newspaper?

    Something's happening here, what it is ain't exactly clear,...

  15. My usual unconstructive irrelevant comment.

    I absolutely agree that the increased variety of macro models being explored is an improvement. I absolutely agree that people who were unsatisfied with the new Keynesian model which was dominant in 2007 (Eichenbaum et al and Smets-Wouters) should have argued for an eclectic approach (as you did and do) and not attempted to convince people that their entire working lives had been wasted (as I did and do).

    But a field with variety of theoretical efforts is not necessarily "flourishing". It may be thrashing about desperately. A field with a variety of promising theoretical efforts is flourishing, but even to be promising, theory has to have surprising success. The pattern of an anomaly which is reconciled with core assumptions by adding a new complexity to models and new free parameters might be success of a sort, but it is not surprising success. It is a pattern caracteristic of extremely non-flourishing research programs such as classical physics in the early 20th century.

    Also I am not convinced that "the *New* Keynesian model ...[is] the consensus model as far as business cycles are concerned, because that is the case in central banks. "

    My understanding is that the Federal Reserve Board only recently made the model they use public and it is a spreadsheet. This shows that *New* Keynesian macro was the orthodoxy such that the heterodox who used an ad hoc and old Keynesian model hid their heterodoxy as carefully as medievel Albigensians. But it doesn't show that people who care about the accuracy of their forecasts are sincerely convinced by the New Keynesian approach.

    To be even ruder, I read that the Bank of England uses a model with a New Keynesian "core" which yields bad forecasts but then tacks on ad hoc corrections to give a non micro founded model which yields good forecasts.

    I read those things at this blog. I think the consensus among non-fresh water macroeconomists is that one must write down micro-founded New Keynesian models to get published in good journals, but should covertly use old Keynesian models to predict what will happen.


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