In praise of macroeconomists (or at least one of them)

This is a title that is sure to spur some angry comments. Didn’t the financial crisis prove that mainstream macroeconomics was hopelessly flawed, that the ‘Great Moderation’ (fifteen or so years of relatively stable inflation and output) that preceded the crisis was a sham, or worse still a cause of the crisis, and basing policy on lots of maths and rational expectations has been totally discredited?

One of the architects of that macroeconomic mainstream is Lars Svensson. He wrote a number of key papers on inflation targeting using lots of maths and rational expectations. Probably for that reason, he was a member of Sweden’s equivalent of the Monetary Policy Committee from 2007 to 2013. By the middle of 2009 Swedish short term interest rates were, like most other places, close to their ‘zero lower bound’ - in this case 0.25%. But in mid 2010 they began to rise again, reaching 2% at the end of 2011. The primary motivation for this continuing rise in rates was a concern that Swedish consumers were taking on too much debt.

Svensson fiercely and publicly opposed these increases, and eventually left the central bank in frustration. He argued that there was still plenty of slack in the economy, and raising rates would be deflationary, so that inflation would fall well below the central bank’s target of 2%. By the end of 2012 inflation had indeed fallen to zero, and since then monthly inflation has more often been negative than positive. It was -0.4% in September. This week the Swedish central bank lowered their interest rate to zero.

OK, so one eminent macroeconomist got a forecast right. Plenty of others get their forecasts wrong. Why the big deal? Suppose you took the statement in my first paragraph seriously. The Great Moderation was about central banks having an explicit forward looking target for inflation, and varying interest rates with the aim of trying to achieve it. So if the success of that policy was a sham or worse, and had been exposed by the financial crisis, a central bank should not worry too much if they abandon it. They should certainly not worry if they deviate from it because of concerns about the financial health of the economy. Which is exactly what the Swedish central bank did.

Now Sweden has negative inflation, and interest rates have come right back to zero. Deviating from what mainstream macroeconomists in general advocate (and what one in particular recommended) has proved a costly mistake. (Svensson estimates it has cost 60,000 jobs.) So maybe the story with the financial crisis is a little more nuanced. Perhaps good monetary policy, aided by the analysis of mainstream New-Keynesian theory, did help bring about the pre-crisis moderation in inflation and output variability. The Achilles heel was that monetary policy lost traction when nominal rates hit zero, but a number of mainstream macroeconomists had discussed the implications of that possibility before it happened in 2009. In the UK at least (and also elsewhere), it was politicians and central bank governors that did not take the consequences of this possibility seriously enough. The financial crisis suggests that what was missing was better financial regulation (including macroprudential monetary policy tools), rather than a need to rewrite how we set interest rates.

I am certainly not claiming that mainstream macroeconomics is without fault, as regular readers will know (e.g.) However it is important to recognise the achievements of macroeconomics as well as its faults. If we fail to do that, then central banks can start doing foolish things, with large costs in terms of the welfare of its country’s citizens. And while it might appear unseemly to occasionally blow one’s own profession’s trumpet, I suspect no one else is going to. 

What have microfoundations ever done for us?

For those who do not know the reference, which I think is apposite, see here.

In my previous post on microfoundations I said I disagreed with Paul Krugman’s statement that “So as I see it, the whole microfoundations crusade is based on one predictive success some 35 years ago; there have been no significant payoffs since”. I should say why I disagree. Robert Waldmann has also challenged me along similar lines.

I think the two most important microfoundation led innovations in macro have been intertemporal consumption and rational expectations. I have already talked about the former in an earlier post, which focused on a UK specific puzzle in the late 1980s that I find difficult to address without an intertemporal consumption perspective. However I also think too strong an attachment to a very basic intertemporal view has blinded macro to some critical events in the last decade or so. (See John Muellbauer here, for example.) So let me focus on rational expectations. Again I could look at the UK in 1980/81 and talk about Dornbusch overshooting, but let me try and be less parochial.

Between the rapid inflation of the 1970s and the Great Recession, what events might we look to for rational expectations to help explain? It is not an easy question, because the adoption of rational expectations was not the result of some previous empirical failure. Instead it represented, as Lucas said, a consistency axiom. However between the 1970s and the Great Recession what needs explaining is why nothing very dramatic happened – the Great Moderation. In particular, why did the large rise in oil and other commodity prices around 2005 not lead to the kind of stagflation we saw in the mid-70s and early 80s?

I think an important part of the answer was implicit or explicit inflation targeting by independent central banks. That, in turn, reflected an understanding of the importance of rational expectations. If a central bank had a clear inflation objective, and established a reputation in achieving it, that would anchor expectations and reduce the impact of shocks on the macroeconomy. Just as the Friedman’s expectations augmented, accelerationist Phillips curve helped us understand what went wrong in the 1970s, so the New Keynesian Phillips curve led to better policy around the turn of the century.

Now virtually any empirical claim in macro is contestable. (Indeed, for some this is part of the attraction of the microfoundations approach!) There are other explanations of the weak response to oil price increases, although Blanchard and Gali (2007) do argue that the Great Moderation played an important role. Others might suggest that the Great Recession itself proved that the Great Moderation was an illusion. In a crude sense this does not follow. The Great Moderation was all about the stabilising role that monetary policy can play, and that should always (given Japan) have been conditional on not hitting the zero lower bound. A more challenging argument is that the Great Moderation prepared the ground for the financial crisis, but even if this is correct it does not follow that inflation targeting was not an improvement on what went before – we may just need to do better still. Indeed, if as a result of the Great Recession inflation targets are replaced by price level or nominal GDP targets, I believe rational expectations will be central in making that case.

I think macroeconomics today is much better than it was 40 years ago as a result of the microfoundations approach. I also argued in my previous post that a microfoundations purist position – that this is the only valid way to do macro – is a mistake. The interesting questions are in between. Can the microfoundations approach embrace all kinds of heterogeneity, or will such models lose their attractiveness in their complexity? Does sticking with simple, representative agent macro impart some kind of bias? Does a microfoundations approach discourage investigation of the more ‘difficult’ but more important issues? Might both these questions suggest a link between too simple a micro based view and a failure to understand what was going on before the financial crash? Are alternatives to microfoundations modelling methodologically coherent? Is empirical evidence ever going to be strong and clear enough to trump internal consistency? These are difficult and often quite subtle questions that any simplistic for and against microfoundations debate will just obscure.