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In defense of modern macro theory

Author(s): David Andolfatto

The dynamic general equilibrium (DGE) approach is the dominant methodology in macro today. I think this is so because of its power to organize thinking in a logically consistent manner, its ability to generate reasonable conditional forecasts, as well as its great flexibility--a property that permits economists of all political persuasions to make use of the apparatus.

From Macromania:

The 2008 financial crisis was a traumatic event. Like all social trauma, it invoked a variety of emotional responses, including the natural (if unbecoming) human desire to find someone or something to blame. Some of the blame has been directed at segments of the economic profession. It is the nature of some of these criticisms that I'd like to talk about today.

One of the first questions macroeconomists get asked is: How could you possibly not have predicted the crisis? We all remember when the Queen of England asked this (supposedly embarrassing) question. Put on the spot, I might have replied that the same question could have been asked of her ancestor, King Charles I, whose death in 1649 also came about under rather unexpected circumstances. Or, I might have replied that many economists did in fact predict this crisis...along with the many other crises that failed to materialize (recall the old joke about the economist who successfully predicted 10 out of the past 2 recessions).

But seriously, the delivery of precise time-dated forecasts of events is a mug's game. If this is your goal, then you probably can't beat theory-free statistical forecasting techniques. But this is not what economics is about. The goal, instead, is to develop theories that can be used to organize our thinking about various aspects of the way an economy functions. Most of these theories are "partial" in nature, designed to address a specific set of phenomena (there is no "grand unifying theory" so many theories coexist). These theories can also be used to make conditional forecasts: IF a set of circumstances hold, THEN a number of events are likely to follow. The models based on these theories can be used as laboratories to test and measure the effect, and desirability, of alternative hypothetical policy interventions (something not possible with purely statistical forecasting models).

There is a sense in which making predictions is very easy. Here's one for you: Mt. Vesuvius will experience another major eruption on the scale of AD 79, when it buried the city of Pompeii, tragically killing thousands of people (among them, the famous naturalist Pliny the Elder). While volcanologists are getting progressively better at predicting eruptions, it remains very difficult to forecast their size. So when an event like this arrives, it always comes as a bit of a shock. In any case, like I said, making predictions (unconditional forecasts) that will eventually come true is easy. There are thousands of people predicting that the world will end in 2015, 2016, 2016, etc. Some of these prognosticators will one day be proven correct. Those making predictions that fail to come true hide in the shadows for a while, but then re-emerge bolder than ever. I don't blame these soothsayers: there seems to be an insatiable demand for the likes of Nostradamus, and this is clearly a case of demand creating its own supply. In this spirit then, permit me to deliver my own forecast (remember, you heard it here first): there will be another major financial crisis on the scale experienced in 2008.

While we can't predict when the next major crisis will occur (I hope the Queen can forgive us), it is reasonable to expect experts to make good conditional forecasts. IF Vesuvius blows, THEN a lot of people are going to die. This type of conditional forecast should lead policymakers to think of ways in which the potential death toll can be avoided or reduced. Perhaps citizens should be prohibited from inhabiting dangerous areas. At the very least, an emergency evacuation procedure should be put in place. The same is true for financial crises. Perhaps restrictions should be placed on the exchange of some types of financial products. At the very least, an emergency response strategy should be put in place. Actually, there is an emergency response strategy--the Fed's emergency lending facility--which essentially worked according to plan in 2008-09. Now, maybe you don't like various aspects of the Fed's liquidity facility and that's fine (even if it did make a healthy profit for the U.S. taxpayer). But you can't say that economists hadn't predicted the possible need for such a facility. Indeed, the Fed was set up on the premise that financial crises would continue to afflict modern economies (by the way, financial crises were a common part of the economic landscape well before the founding of the Fed in 1913, so think carefully before you accuse the Fed as the source of market instability).

Alright, so much for blaming economists and their less-than-crystal balls (hmm, a part of me says I should have edited that last sentence.) What else? Well, I notice a lot of blame also being heaped on modern macroeconomic theory and the professors of such theory. "What's Wrong With Macro?" the headlines wail (roll eyes here). Things have become so bad that we now see students telling professors how macro should be taught. Next we'll have teenagers telling their parents how to raise children. Well, we already have that of course. But the point is that while parents patiently hear out these protestations (having been young for much longer than the youth in question), they do not generally capitulate to them. I'm sorry, but you're only 16, I love you, and no, you can't have the keys to the car!


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