Progress in Macroeconomics: A Reply to Prof. Krugman

Paul Krugman has argued that macroeconomics is not making progress.   As a guy who entered the University of Chicago intending to become a “macro guy” and ended up switching plans, permit me to offer a quick defense of my “ex”.    The best thing going on in modern macro is the embrace of game theory and strategic thinking in modeling the interaction between “Big” players such as the Federal Reserve Board, regulators and Wall Street.    If government can commit (or can’t) to certain policies, then this has sharp impact on behavior and overall well being.  For technical details read this.   

Today’s Wall Street Journal offers a great example. 

“So there is still a too-big-to-fail club, but its membership may be a little more exclusive than Washington has previously suggested. Mr. Tarullo also said that the list of nonbanks initially deemed systemic “should not be a lengthy one.” This was treated as welcome news by hedge funds, mutual funds and private equity firms that have been lobbying to avoid joining the too-big-to-fail club—at least for now. They assume systemic firms will carry a heavier regulatory burden and thus higher costs, putting them at a competitive disadvantage. But it may also be the case that systemic firms will have a funding advantage, a la Fannie Mae, because they are assumed to be too big to fail. Either result would create market distortions.”

So, this is a discussion of what is the “optimal” set of firms who should face stringent regulation to protect the economy from the “domino effect” and what are the costs and benefits of making this list long vs. short.  Now, the hard macro question here concerns how the probability of deep recession hinges on how this set is selected. That is a hard question and this is why macro continues.

Author: Matthew E. Kahn

Professor of Economics at UCLA.

6 thoughts on “Progress in Macroeconomics: A Reply to Prof. Krugman”

  1. How does Macro and Game theory interact with trust-busting? It seems the old school approach of stopping ‘too big to fail’ by avoiding ‘too big’ was sensible.

  2. For some reason, I see no evidence of progress here. Progress would be a correct answer to this question, or least an approximately correct one.

  3. Money. Money makes the world go ’round. Money in its varied and extended forms gives rise to the phenomena of aggregate fluctuations in business activity, which macro is tasked to study. Money’s institutional regulation is what macro hopes to prescribe.

    And, in macro-economics, money was made to disappear. Viewed from Mars, it seems bizarre, but that is the case. The three main camps — RBC, New Classical, and New Keynesian — each in its own way, make money and finance disappear from their thinking. They blind their eyes to the main event, and wonder why they cannot see. RBC claims, against all evidence, that everything can be explain by the deus-ex-machina (technology); New Classical claims money is maya (illusion), and therefore cannot matter, as everyone will see through it (again, against the evidence); the New Keynesians claim the evidence as their ally, but admit only the mere shadows of money into their cave — ‘sticky’ prices and interest rates.

    The game theory is just one blindfold for these fools, the better to pompously pontificate, while ignoring the sources of risk, endogenous to finance — ignoring the ways financial practice creates risks out of nothing at all.

    Macroeconomics has been the most degenerate research programme in social science, for 30 years, maybe 50 years. Practioners and policy-makers — Larry Summers, himself, the Black Prince of the profession, nephew to both Samuelson and Arrow — report not using any idea with a vintage later than 1980.

    The cranks — the goldbugs and those railing against fractional-reserve banking — are better grounded than mainstream macro-economists.

  4. I’ve never liked Matthew’s posts, and now I know why: it takes a long time to recover from attending the Hellhole of the Midway.

  5. matt wilbert gets it right. The test of a functioning macro economics is its ability to come up with accurate answers. The piece linked by Kahn – exemplary of clear macro thinking, he tell us – doesn’t even describe the history accurately, much less the current regulatory dilemma. Most tellingly, the article that Kahn links explicitly endorses the futility of macroeconomics as a guide to policy:

    Regulators can’t possibly have the foresight to see over the horizon to the potential risks that will trigger the next crisis.

    We all knew that Fannie and Freddie would have to be bailed out if push came to shove. We didn’t know that AIG and many banks were in the same position. But the “science” of economics – per Kahn’s link – can’t even acknowledge this much:

    In the short term regulators should define systemic risk as narrowly as possible, but Congress would be wise to rewrite Dodd-Frank to end such public designations altogether. They merely offer the illusion of regulatory prescience with the guarantee of a taxpayer bailout.

    We must, the author tells us, ignore everything we know about systemic risk because we cannot really know anything about it. This is science? Hell, it’s not even history.

  6. To big to fail sounds like micro to me (I am currently employed as a macro-economist).

    The idea of applying game theory to macro was old when I took my second economics course in 1985. It dates back to Kydland and Prescott (the good paper) on subgame imperfect monetary policy. This was a good paper with the only defect that they called subgame imperfect “dyanically inconsistent” so now one has to call dynamically inconsistent “time inconsistent.”

    The idea that bailouts create moral hazard and so bailing out must be seen as a move in a repeated game is so old that I have no recollection of macro uninfluenced by that idea. I am 50 years old.

    To be fair, I too disagree with Krugman. I disagree with his two examples of progress in macro. I used to agree that the PIH was a great step forward. Then I understood that totally myopic thinking plus habit formation explains the same interesting facts. His other point was the end of the Phillips curve. Sad to say, Keynes very clearly warned not to trust the Phillips curve 23 years before Phillips published his key paper. He also very clearly presented the Lucas supply function.

    I will give page references if anyone is interested.

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