Where macroeconomics went wrong

In my view, the answer is in the 1970/80s with the New Classical revolution (NCR). However I also think the new ideas that came with that revolution were progressive. I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy.

That is why discussion about these issues can become so confused. New Classical economics made academic macroeconomics take a number of big steps forward, but a couple of big steps backward at the same time. The clue to the backward steps comes from the name NCR. The research programme was anti-Keynesian (hence New Classical), and it did not want microfounded macro to be an alternative to the then dominant existing methodology, it wanted to replace it (hence revolution). Because the revolution succeeded (although the victory over Keynesian ideas was temporary), generations of students were taught that Keynesian economics was out of date. They were not taught about the pros and cons of the old and new methodologies, but were taught that the old methodology was simply wrong. And that teaching was/is a problem because it itself is wrong.

There had always been opposition to Keynesian ideas, and much (though not all) was ideological, such as attempts to remove Keynesian textbooks from US universities. However the NCR gave what should more precisely be called ‘aggregate demand denial’ an intellectual respectability that it never deserved. The reasons for believing that shifts in demand move output and employment in the short run and prices are sticky are overwhelming, so to deny both was a seemingly impossible task. It was achieved by adopting a methodological position which could ignore inconvenient evidence.

I do not think it had to be like this. Mainstream macroeconomics did not need a revolution in the 1970s and 1980s. Ideas like rational expectations could have been assimilated into the mainstream methodology, and microfounded models could have been developed alongside more eclectic econometric models (SEMs, not VARs), or aggregate theoretical models that Blanchard and Fischer rightly called ‘useful models’. Microfounded models could have shown the kind of errors that can arise in more empirically based models when theory is ignored or only applied piecemeal, and these empirical models could have highlighted the key areas where additional microfoundations were needed.

I think if this had happened, macroeconomics would have been better prepared when the financial crisis hit. Take just one issue: the role of credit conditions in influencing consumption. This is clearly crucial in understanding how consumption might respond to a credit crunch, yet any mechanism of this kind was absent from most DSGE models in 2008. However a more empirically based model of consumption would have had to address this issue well before 2008, as I argue here. If these types of models had continued to be developed within academia, rather than confined to the dustbin by the microfoundations revolution, then at least policymakers would have had something to work with. If there had been interaction between empirical and microfounded models some of the financial frictions literature that has flourished since 2008 might have appeared earlier.

So why didn’t this happen? Why did we have a revolution which overturned an existing methodology and temporarily banished Keynesian theory, rather than an adaptation and augmentation of what was then mainstream? Was the attraction of overturning orthodoxy too strong, as it is for a minority of heterodox economists today? Did an ideological imperative of dismissing Keynesian ideas play a role? To what extent was the hostile reaction of many in the macroeconomic establishment to eminently sensible ideas like rational expectations responsible? Was the attraction of a methodology where at least you could be sure you were consistent too enticing, perhaps encouraged by increasing segmentation between theoretical and empirical macro? I would love to know the answer to these questions. 

  

US savings behaviour, and empirical research strategies

In this post I want to look at a paper by Chris Carroll, Jiri Slacalek and Martin Sommer for two reasons. The first is for what the paper tells us about US consumption behaviour, and potentially consumption behaviour in any advanced economy. The second thing I want to use it for is as an example of different ways of doing empirical research in a microfoundations world.

The mainstay of modern macroeconomics is the consumption Euler equation, where consumption is proportional to the sum of financial wealth and human wealth, where human wealth is the discounted present value of future labour income. This model implies consumption aims to smooth out erratic movements in income through borrowing and saving. In this model periods of high saving can reflect periods of temporarily higher income, or temporarily high real interest rates. Adaptations of this model that are commonplace are to assume that some proportion of consumers are liquidity constrained, and therefore consume all their income, or that consumption is subject to ‘habits’, which generates additional inertia. This model with or without these adaptations is not very helpful in explaining why savings rose sharply in the Great Recession.

Rather more worrying is that this model is not very good at explaining US savings behaviour before the Great Recession either. As I noted here, US savings rates fell steadily for about twenty years from the early 1980. You might think that explaining such a large and important trend would be a sine qua non of any consumption function routinely used in macromodels, but you would be wrong. Consistency with the data is not the admissibility criteria for a microfounded macromodel.

The Carroll et al paper finds two explanations for the pre-recession trend and the increase in savings during the recession. The first is easier credit conditions, and the second is employment uncertainty. The mechanism through which both work is precautionary savings. If the risk increases that your income will fall sharply because you will lose your job, you need to build up some capital to act as a buffer. The easier credit is to obtain, the less precautionary savings you need.

The reason why precautionary savings represents a significant departure from the basic Euler equation model is intuitive. If you want to hold a certain amount of precautionary savings, you have a target for wealth. A wealth target pulls in the opposite direction to consumption smoothing. If you have a one-off increase in income, consumption smoothing says you should consume it very gradually, perhaps only consuming the interest. The marginal propensity to consume that extra income is tiny. But this leaves wealth higher for a very long time. If you have a wealth target, your marginal propensity to consume that additional income will be larger, perhaps a lot larger.

Now for the methodology part. These empirical results are in sections 3 and 4 of their paper. They call their empirical results in section 4  ‘reduced form’, because they come from a regression relating saving to wealth, credit constraints and expected unemployment. However the authors feel that this is not enough. In section 2 they discuss a structural theoretical model. Because modelling labour income uncertainty is very difficult, their microfounded model assumes that once someone becomes unemployed, they become unemployed forever. Section 5 then estimates this structural model.

The authors describe a number of reasons why directly estimating the structural model may be better than estimating the reduced form. But in order to get their structural model they have to make the highly unrealistic assumption noted above. The reduced form, on the other hand, does not have this assumption imposed on it. So I do not think we can say that the results in Section 5 are more or less interesting than those in Section 4, which is why both are interesting, and why both are included in the paper. There does not seem to be any compelling reason to elevate one above the other.

OK, a last  - perhaps wild - pair of questions. Is it the case that, compared to a few decades ago, there are far fewer papers in the top journals that simply try and explain historical time series for a single key macro aggregate (like consumption or saving)? If that is the case, is this due to the difficulties in getting microfounded models to fit, or something else?  

House prices, consumption and aggregation

A simplistic view of the link between house prices and consumption is that lower house prices reduce consumers’ wealth, and wealth determines consumption, so consumption falls. But think about a closed economy, where the physical housing stock is fixed. Housing does not provide a financial return. So if house prices fall, but aggregate labour income is unchanged, then if aggregate consumption falls permanently the personal sector will start running a perpetual surplus. This does not make sense.

The mistake is that although an individual can ‘cash in’ the benefits of higher house prices by downgrading their house, if the housing stock is fixed that individual’s gain is a loss for the person buying their house. Higher house prices are great for the old, and bad for the young, but there is no aggregate wealth effect.

As a result, a good deal of current analysis looks at the impact house prices may have on collateral, and therefore on house owners ability to borrow. Higher house prices in effect reduce a liquidity or credit constraint. Agents who are credit constrained borrow and spend more when they become less constrained. There is no matching reduction in consumption elsewhere, so aggregate consumption rises. If it turns out that this was a house price bubble, the process goes into reverse, and we have a balance sheet recession[1]. In this story, it is variations in the supply of credit caused by house prices that are the driving force behind consumption changes. Let’s call this a credit effect.

There is clear US evidence that house price movements were related to changes in borrowing and consumption. That would also be consistent with a wealth effect as well as a credit constraint story, but as we have noted, in aggregate the wealth effect should wash out.

Or should it? Let’s go back to thinking about winners and losers. Suppose you are an elderly individual, who is about to go into some form of residential home. You have no interest in the financial position of your children, and the feeling is mutual. You intend to finance the residential home fees and additional consumption in your final years from the proceeds of selling your house. If house prices unexpectedly fall, you have less to consume, so the impact of lower house prices on your consumption will be both large and fairly immediate. Now think about the person the house is going to be sold to. They will be younger, and clearly better off as a result of having to fork out much less for the house. If they are the archetypal (albeit non-altruistic) intertemporal consumer, they will smooth their additional wealth over the rest of their life, which is longer than the house seller. So their consumption rises by less than the house seller’s consumption falls, which means aggregate consumption declines for some time. This is a pure distributional effect, generated by life-cycle differences in consumption.

In aggregate, following a fall in house prices, the personal sector initially moves into surplus (as the elderly consume less), and then it moves into deficit (as the elderly disappear and the young continue to spend their capital gains). In the very long run we go back to balance. This reasoning assumes that the house buyer is able to adjust to any capital gains/losses over their entire life. But house buyers tend to be borrowers, and are therefore more likely to be credit constrained. So credit effects could reverse the sign of distributional effects.

This is a clear case where micro to macro modelling, of the kind surveyed in the paper by Heathcote, Storesletten and Violante, is useful in understanding what might happen. An example related to UK experience is a paper by Attanasio, Leicester and Wakefield (earlier pdf here). This tries to capture a great deal of disaggregation, and allows for credit constraints, limited (compared to the Barro ideal) bequests and much more, in a partial equilibrium setting where house price and income processes are exogenous. The analysis is only as good as its parts, of course, and I do not think it allows for the kind of irrationality discussed here. In addition, as housing markets differ significantly between countries, some of their findings could be country specific.

Perhaps the most important result of their analysis is that house prices are potentially very important in determining aggregate consumption. According to the model, most movements in UK consumption since the mid-1980s are caused by house price shocks rather than income shocks. In terms of the particular mechanism outlined above, their model suggests that the impact of house prices on the old dominate those on the young, despite credit constraints influencing the latter more. In other words the distributional effect of lower house prices on consumption is negative. Add in a collateral credit effect, and the model predicts lower house prices will significantly reduce aggregate consumption, which is the aggregate correlation we tend to observe.

But there remains an important puzzle which the paper discusses but does not resolve. In the data, in contrast to the model, consumption of the young is more responsive to house price changes than consumption of the old. The old appear not to adjust their consumption following house price changes as much as theory suggests they should, even when theory allows a partial bequest motive. So there remain important unresolved issues about how house prices influence consumption in the real world.

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[1] This is like the mechanism in the Eggertsson and Krugman paper, although that paper is agnostic about why borrowing limits fall. They could fall as a result of greater risk aversion by banks, for example.

Microfoundations and Evidence (1): the street light problem

                One way or reading the microfoundations debate is as a clash between ‘high theory’ and ‘practical policy’. Greg Mankiw in a well known paper talks about scientists and engineers. Thomas Mayer in his book Truth versus Precision in Economics (1993) distinguishes between ‘formalist’ and ‘empirical science’. Similar ideas are perhaps behind my discussion of microfoundations and central bank models, and Mark Thoma’s discussion here.

                In these accounts, ‘high theory’ is potentially autonomous. The problem focused on is that this theory has not yet produced the goods as far as policy is concerned, and asks what economists who advise policy makers should do in the meantime. But the presumption is generally that theory will get there as soon as it can. But will it do so of its own accord? Is it the case that academics are quite good at selecting what the important puzzles are, or do they need others more connected to the data to help them?

                There is a longstanding worry that some puzzles are selected because they are relatively easy to solve, and not because they are important. Like the proverbial person looking under the street light for their keys that they lost somewhere less well lit. This is the subject of this post. A later post will look at another concern, which is that there may be an ideological element in puzzle selection. In both cases these biases in puzzle selection can persist because the discipline exerted by external consistency is weak.

The example that reminded me about this came from this graph.

US Savings Rate

The role of the savings rate in contributing to the Great Recession in the US and elsewhere has been widely discussed. Some authors have speculated on the role that credit conditions might have played in this e.g. Eggertsson and Krugman here, or Hall here. But what about the steady fall in savings from the early 1980s until the recession?

                Given the importance of consumption in macroeconomics, you would imagine there would be a huge literature, both empirical and theoretical, on this. Whatever this literature concluded, you would also imagine that the key policy making institutions would incorporate the results of this research in their models. Finally you might expect any academic papers that used a consumption model which completely failed to address this trend might be treated with some scepticism. OK, maybe I’m overdoing it a bit, but you get the idea. (There has of course been academic work on trying to explain the chart above: a nice summary by Guidolin and Jeunesse is here. My claim that this literature is not as large as it should be is of course difficult to judge, let alone verify, but I’ll make it nonetheless.)

                It would be particularly ironic if it turned out that credit conditions were responsible for both the downward trend and its reversal in the Great Recession. However that is exactly the claim made in two recent papers, by Carroll et al here and Aron et al (published in Review of Income and Wealth (2011), earlier version here), with the later looking at the UK and Japan as well as the US. Now if you think this is obvious nonsense, and there is an alternative and well understood explanation for these trends, then you can stop reading now. But otherwise, suppose these authors are right, why has it taken so long for this to be discovered, let alone be incorporated into mainstream macromodels?

                Well in the discovery sense it has not. John Muellbauer and Anthony Murphy have been exploring these ideas ever since the UK consumption boom of the late 1980s. As I explained in an earlier post, there was another explanation for this boom besides credit conditions that was more consistent with the standard intertemporal model, but the evidence for this was hardly compelling. The problem might be not so much evidence, as the difficulty in incorporating credit effects of this kind into standard DSGE models. Even writing down a tractable microfounded consumption function that incorporates these effects is difficult, although Carroll et al do present one. Incorporating it into a DSGE model would require endogenising credit conditions by modelling the banking sector, leverage etc . This is something that is now beginning to happen largely as a result of the Great Recession, but before that it was hardly a major area of research.

                So here is my concern. The behaviour of savings in the US, UK and elsewhere has represented a major ‘puzzle’ for at least two decades, but it has not been a major focus of academic research. The key reason for that has been the difficulty of modelling an obvious answer to the puzzle in terms of the microfoundations approach. John Muellbauer makes a similar claim in this paper. To quote: “While DSGE models are useful research tools for developing analytical insights, the highly simplified assumptions needed to obtain tractable general equilibrium solutions often undermine their usefulness. As we have seen, the data violate key assumptions made in these models, and the match to institutional realities, at both micro and macro levels, is often very poor.”

                I do think microfoundations methodology is progressive. The concern is that, as a project, it may tend to progress in directions of least resistance rather than in the areas that really matter – until perhaps a crisis occurs. This is not really mistaking beauty for truth: there are plenty of rather ugly DSGE macro papers out there, one or two of which I have helped write. It is about how puzzles are chosen. When a new PhD student comes to me with an idea, I will of course ask myself is this interesting and important, but my concern will also be whether the student is taking on something where they can get a clear and publishable result in the time available.

When I described the Bank of England’s macromodel BEQM, I talked about the microfounded core, and the periphery equations that helped fit the data better. If all macroeconomists worked for the Bank of England, then that construct contains a mechanism that could overcome this problem. The forecasters and policy analysts would know from their periphery equations where the priority work needed to be done, and this would set the agenda for those working on microfounded theory.

                In the real world the incentive for most academics is to get publications, often within a limited time frame. When the focus of macroeconomic analysis is on internal consistency rather than external consistency, then it is unclear whether this incentive mechanism is socially optimal. If it is not, then one solution is for all macroeconomists to work for central banks! A more realistic alternative might be to reprise within academic macroeconomics a modelling tradition which placed more emphasis on external consistency and less on internal consistency, to work alongside the microfoundations approach. (Justin Fox makes a similar point in relation to financial modelling.)     

What have Keynesians learnt since Keynes?

                That is the question asked by RobertWaldman (9th Feb) in a comment on my post, and also in a dialog with Mark Thoma. I’ll not attempt a full answer – that would be much too long – and Mark makes a number of the important points. Instead let me just talk about one episode that convinced me that one part of New Keynesian analysis, the intertemporal consumer with rational expectations, was much more useful than the ‘Old Keynesian’ counterpart that I learnt as an undergraduate.

                In the mid 1980s I was working at NIESR (National Institute for Economic and Social Research) in London, doing research and forecasting. UK forecasting models at the time had consumption equations which included current and lagged income, wealth and interest rates on the right hand side, using the theoretical ideas of Friedman mediated through the econometrics of DHSY (Davidson, J.E.H., D.F. Hendry, F. Srba, and J.S. Yeo (1978). Econometric modelling of the aggregate time-series relationship between consumers' expenditure and income in the United Kingdom.Economic Journal, 88, 661-692.) While the permanent income hypothesis appealed to intertemporal ideas, as implemented by DHSY and others using lags on income to proxy permanent income I think it can be described as ‘Old Keynesian’.

As the decade progressed, UK consumers started borrowing and spending much more than any of these equations suggested. Model based forecasts repeatedly underestimated consumption over this period. Three main explanations emerged of what might be going wrong. In my view, to think about any of them properly requires an intertemporal model of consumption.

1) House prices. The consumption boom coincided with a housing boom. Were consumers spending more because they felt wealthier, or was some third factor causing both booms? There was much macro econometric work at the time trying to sort this out, but with little success. Yet thinking about an intertemporal consumer leads one to question why consumers in aggregate would spend more when house prices rise. (I don’t recall anyone suggesting it changed output supply, but then the UK is not St. Louis.) Subsequent work (Attanasio, O and Weber, G (1994) “The UK Consumption Boom of the Late 1980s” Economic Journal Vol. 104, pp. 1269-1302) suggested that increased borrowing was not concentrated among home owners, casting doubt on this explanation.

2) Credit constraints. In the 1980s the degree of competition among banks and mortgage providers in the UK increased substantially, as building societies became banks and banks starting providing mortgages. This led to a large relaxation of credit constraints. While such constraints represent a departure from the simple intertemporal model, I find it hard to think about how shifts in credit conditions like this would influence consumption without having the unconstrained case in mind.

3) There was also much talk at the time of the ‘Thatcher miracle’, whereby supply side changes (like reducing union power) had led to a permanent increase in the UK’s growth rate. If that perception had been common among consumers, an increase in borrowing today to enjoy these future gains would have been the natural response given an intertemporal perspective. Furthermore, as long as the perception of higher growth continued, increased consumption would be quite persistent.

Which of the second two explanations is more applicable in this case remains controversial -see ‘Is the UK Balance of Payments Sustainable?’ John Muellbauer and Anthony Murphy (with discussion by Mervyn King and Marco Pagano) Economic Policy Vol. 5, No. 11 (Oct., 1990), pp. 347-395 for example. However, I would suggest that neither can be analysed properly without the intertemporal consumer. Why is this a lesson for Keynesian analysis? Well in the late 1980s the boom led to rising UK inflation, and a subsequent crash.  Underestimating consumption was not the only reason for this increase in inflation – Nigel Lawson wanted to cut taxes and peg to the DM – but it probably helped.

So this episode convinced me that it was vital to model consumption along intertemporal lines. This was a central part of the UK econometric model COMPACT that I built with Julia Darby and Jon Ireland after leaving NIESR in 1990. (The model allowed for variable credit constraint effects on consumption.) The model was New Keynesian in other respects: it was solved assuming rational expectations, and it incorporated nominal price and wage rigidities.

As I hope this discussion shows, I do not believe the standard intertemporal consumption model on its own is adequate for many issues. Besides credit constraints, I think the absence of precautionary savings is a big omission. However I do think it is the right starting point for thinking about more complex situations, and a better starting point than more traditional approaches.

One fascinating fact is that Keynes himself was instrumental in encouraging Frank Ramsey to write "A Mathematical Theory of Saving" in 1928, which is often considered as the first outline of the intertemporal model. Keynes described the article as "one of the most remarkable contributions to mathematical economics ever made, both in respect of the intrinsic importance and difficulty of its subject, the power and elegance of the technical methods employed, and the clear purity of illumination with which the writer's mind is felt by the reader to play about its subject. " (Keynes, 1933, "Frank Plumpton Ramsey" in Essays in Biography, New York, NY.)  I would love to know whether Keynes ever considered this as an alternative to his more basic consumption model of the General Theory, and if he did, on what grounds he rejected it.