PROBLEMS OF MACROECONOMICS
Introduction
Surely, economic research can never reach its limit. When one thinks they’ve got all the knowledge they need, it’s just a matter of time when either an improvement or a different thing on the same comes up, making the previous a history. The Whig approach to the history of economic thought has it; that all economic thought is a progression of ideas toward the grand finale of present-day thought. Macroeconomics with its models have always seemed on track until the heterodox economist- Joseph Stiglitz and Paul Romer included- came out to challenge the conventional wisdom and knowledge in the subject of macroeconomics which had taken prevalence for the last 3 decades. Romer bases on the intellectual regress in macroeconomics while Joseph Stiglitz focuses on the failures of the DSGE models.
The problems of macroeconomics
To begin with, Joseph Stiglitz in his paper, “where macroeconomics went wrong”, criticizes the DSGE models that have come to dominate macroeconomics during the past quarter-century. He argues that the DSGE models provide a poor basis for policy and tweaks to it are unlikely to be helpful. The paper also argues that the heart of the failures was the wrong micro-foundations, which failed to incorporate key aspects of economic behaviour e.g. incorporating insights from information economics and behavioural economics. The models are not able to provide accurate predictions of changes in consumptions, saving rates and shifts in preferences or technology. The following gives a detailed summary of the failures associated with the DSGE models:
As the author points out, the failings of the DSGE models can be traced to the attempt, decades ago, to reconcile macroeconomics with microeconomics. He explains two approaches; the first strand being taken by the Real Business Cycle and the second stand entering into the mainstream aftermath of the great recession. It’s the second strand that gave rise to Irving Fisher (1933) who promulgated a quite different version of the Hicksian interpretation of Keynes based on wage and price rigidity. He indicates that his proposed model together with the DSGE begins with the same starting point; the comparative equilibrium of Arrow and Debreu but it’s clear that DSGE cannot explain many aspects of the economy and whenever it seemed that their proposal is failing to do an adequate job, they added more shocks and distortions in a fairly ad hoc way,
Joseph Stiglitz also critiques the DSGE models by explaining deep downturns on shocks, finance, amplification and persistence, adjustment and equilibrium and on financial frictions. He critiques the DSGE model claims that most downturns are caused by exogenous technology shock. By contrast, he observes that the shocks giving rise to economic fluctuations in many, if not most cases are endogenous e.g. the 2008 shock was endogenously caused by the breaking of the housing bubble; something that markets created, and to which misguided policies have contributed.
On finance, he points out that finance and the structure of the financial system matter for stability but DSGE models do not answer or even contain any structures that are most conducive to stability and the central tradeoffs ( e.g. between the ability to withstand small and large shocks). Also, to a very limited extend does DSGE models show macroeconomic externalities even though they are important in understanding why markets on their own may be excessively exposed to risks .the issue of systematic to do not rise in the DSGE models.
Amplification and persistence: one source of amplification is ‘balance sheet effects’; the contraction in production investment that arises when firms suffer a shock to their balances. The effects are amplified still further if there is credit rationing whose at its centre, as observed at the macro level, are banks, a critical institution which is missing in the DSGE models. Given how long it takes for balance sheets to be restored when confronted with a shock of the size of that of 2008, it’s not surprising that the effects persisted. DSGE models are particularly unsuited to address their implications due to several reasons given by the author.
On the adjustment and equilibrium, one of the reasons that downturns with high levels of unemployment persists relates to the process of adjustment of which DSGE models don’t address. They simply assume that the economy jumps to the new equilibrium path.
On financial frictions, the writer observes that in the aftermath of 2008 crisis, there was a growing consensus that at least one critical failing of the DSGE model was its (non-) treatment of the financial sector. He goes ahead to propose a simple benchmark model that incorporates financial frictions than to ignore them altogether.
He further critiques the DSGE model by showing the importance of differences in beliefs in macroeconomic fluctuations, something that the DSGE model couldn’t just observe. He also elaborates the critical assumption of aggregation in which too little attention is given in macroeconomic analyses.
The article of ‘The Trouble with Macroeconomics’ by Paul Romer has pointed out how supremely unhappy are some physicists because of falling of their career into 25 years without any change in their core beliefs. The article has gone further and explained that the core problems of macroeconomics have continued for the past 30 years and that no advancement has been made and that the discipline may have regressed. According to Paul Romer, macroeconomists have not been able to solve the identification problem since the 1960s and 1970s. We, therefore, have the trouble for causality determination as the variables and observations exist within a simultaneous system.
Furthermore, Paul Romer has called into question a presumption under which majority of the economist’s labour; that monetary policy cannot have any real impact and it is not important either. The major question of Paul Romer is on how monetary policy can be effective because the data shows that the Fed under Volcker was able to make the inflation rate rise by 500 basis points. There is a theory which has been outlined by Romer that imaginary shocks are what make the inflation rate seem less likely when it is scrutinized closely; despite it is held as some universal truth. The problem with unrealistic assumptions is that they are used by economists to make models flexible and force favourable outcomes. The facts are seen irrelevant and nothing changes as they point the theory to be wrong. Macroeconomic work is judged to be based on mathematical theory today and not real progress.
Another problem of macroeconomics which has been stated by Paul Romer is that macroeconomics is substantially broken. The reason behind this is the Keynesians, where the building of macro models has been done on incredible assumptions. Another problem is concerning the sense of loyalty that is existing on macroeconomists currently. Romer has explained that the resulting unwillingness to question the “authority figures” is the one which is perpetuating the problem. For instance, Paul Romer has pointed out a critical article which he wrote on Bob Lucas, whereby, he received disapproval for some personal attack, not for critique. Some economists claim post-real macro can be ignored safely. The statement is because no one believes that there is no real impact on the output which will be caused by a tight monetary policy. It is the fact that the problem these obvious errors are not taken issue on by anyone.
Solutions
Firstly, as presented by Joseph Stiglitz, the complexities of the DSGE model require drastic simplifications; to analyze the model, strong parameterization are required because the parameterization used in the DSGE models yield predictions that can be easily rejected. He has tried to explain some of the core elements that need to be incorporated into the benchmark models with which macroeconomics are taught to students. He goes ahead to propose a simple benchmark model called the barebones model, a three-period model; the centre of attention being in today (period 1) but this linked to the past (decision and shocks in the past affecting current state variables) and the future. We don’t say that it’s absolute but it can make a good solution to the problems of macroeconomics when it considering the deficiencies in the DSGE model because:
- The model is a general equilibrium model but with a far richer set of interrelationships than characterizes the standard DSGE model.
- It incorporates three effects missing from the standard DSGE i.e. Distribution, banks and credit constraints.
- The point of the barebones model is to help us understand better how changes in the environment (in the agricultural economy, say, bad weather yesterday or today) or policy affect outcomes and the channels through which the effects are felt.
- The model can provide insights into the cyclical fluctuations which would occur even in the absence of nominal wage and price rigidities.
- It attempts to incorporate the insights of modern microeconomics into the basic aggregate equations which are meant not to represent the behaviour of a representative individual, but the aggregation of many individuals.
On the challenges presented by Paul Romer, we can see that the authenticity of a discipline of economics will continue to be lost until the economist are more concerned more with the truth than a distressing workmate
References
1.Romer, P. (2016). The trouble with macroeconomics. The American Economist, 20, 1-20.
- Joseph. E. Stiglitz (2018). Where Modern Economics Went Wrong, Oxford Review of Economic Policy, 34(1-2) – New York University.