Monday, May 17, 2010

The State of Macro

Greg Mankiw points out a nice essay on modern macro by Minneapolis Fed President Narayana Kocherlakota. A week too late for this semester, but definitely on the reading list for the next equilibrium macroeconomics course.

Kocherlakota argues that macro has largely gotten beyond the "saltwater" - "freshwater" schism that has, I think, been overplayed in much of the conversation about macroeconomics and the recession (including Krugman's widely noted NYT magazine article, that I responded to in this post). His picture is of a field that is more pragmatic than ideological. For example, he suggests the use of "social planner" solutions in dynamic stochastic general equilibrium models has been more a matter of convenience than of a rigid belief that perfectly competitive market conditions hold at all times. He writes:
My own idiosyncratic view is that the division was a consequence of the limited computing technologies and techniques that were available in the 1980s. To solve a generic macro model, a vast array of time- and state-dependent quantities and prices must be computed. These quantities and prices interact in potentially complex ways, and so the problem can be quite daunting.

However, this complicated interaction simplifies greatly if the model is such that its implied quantities maximize a measure of social welfare. Given the primitive state of computational tools, most researchers could only solve models of this kind. But—almost coincidentally—in these models, all government interventions (including all forms of stabilization policy) are undesirable.

With the advent of better computers, better theory, and better programming, it is possible to solve a much wider class of modern macro models. As a result, the freshwater-saltwater divide has disappeared. Both camps have won (and I guess lost). On the one hand, the freshwater camp won in terms of its modeling methodology. Substantively, too, there is a general recognition that some nontrivial fraction of aggregate fluctuations is actually efficient in nature.

On the other hand, the saltwater camp has also won, because it is generally agreed that some forms of stabilization policy are useful. As I will show, though, these stabilization policies take a different form from that implied by the older models (from the 1960s and 1970s).


pclemb said...

Only within the smugly cloistered confines of self-referential dsge modlers could anyone talk about "victory". The global financial crisis has sunk these models spectacularly, not least because of their absurd equilibrium underpinnings. The models were totally incapable of providing a language to even think about the crisis since there was no financial sector. They failed in modeling economies as self-equilibrating: The only reason we have an economy left at all now is thanks to quite extraordinary, extra-model policy interventions. The models do not provide any language for understanding capitalism as a process that inherently generates instability that can only be righted by government interventions that in themselves may provide the seeds for further inefficiencies and instabilities. If salt or freshwater represents the state of macro, that state is terminally ill. We're going to have to look elsewhere for understanding.

Bill C said...

Thanks for the comment. In some ways it is telling how much we're still leaning implicitly on old-fashioned Keynesian thinking to interpret the crisis and recession.

I'm more willing to forgive the absence of finance from standard DSGE models - I don't think every econ model should include everything, though its important to bear in mind their limits (which are too often forgotten).

It will be interesting to see if economics is able to incorporate some of the issues you mention into existing frameworks or whether more fundamental change occurs.