Paul Krugman has arguedÂ that macroeconomicsÂ is not making progress.Â Â 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”.Â Â Â 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.Â Â Â If government can commit (or can’t) to certain policies, then this has sharp impact on behavior and overall well being.Â For technical details read this.Â Â Â
Today’s Wall Street Journal offers a great example.Â
“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 clubâ€”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.Â 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.