The Great Moderation In Macroeconomics

by Mario Rizzo  

I have now read both Paul Krugman’s New York Times essay on the state of macroeconomics and John Cochrane’s reply. They are each, in very different ways, quite disappointing. The level of argument is poor, the prejudices are simplistic, and the tones are annoying.  

Beginning with tones: Krugman is too dismissive of all macroeconomics since John Maynard Keynes. Cochrane responds by saying, in effect, that it is impossible that mainstream macro (read Chicago and probably “New Keynesians,” as well) could have been fundamentally mistaken over the past forty years or so. We don’t need to “rehabilitate an 80-years old book” (Keynes’s General Theory).  

The prejudices: Krugman thinks that if you lessen the reliance of macro on assumptions of rationality and efficient markets you find your way to Keynes. In a related fashion, he believes that formalism in macro theorizing is the root of the problem. Cochrane, on the other hand, thinks that traditional Keynesian approaches are too informal and that more, not less, mathematical formalism is needed. He believes that it is too easy to wave the banner of “irrationalities,” “animal spirits,” and so on.  

Isn’t there something else? I hope so.  

I am reminded of the economist Roger Garrison, quite a few years ago, characterizing Hayekian macroeconomics as the “middle ground.” At the time I pooh-poohed this. I argued that one could always situate something as a “middle” by suitably choosing the extremes. This is quite true. But what I missed was the argumentative context. In the context of today’s macroeconomics alternatives, the Austrian approach is very naturally the middle ground.   

The traditional Keynesian view is that if equilibrium obtains it will be a very bad one: depression. But ordinarily the uncertainty of the real world makes the economy prone to all sorts of bubbles, liquidity traps, aggregate demand failures. In other words, it is as if the economy is always on the precipice of some great disaster. Keynes advocated the permanent “socialization of investment” as insurance against this tendency toward disequilibrium leading to horrible equilibria.  

The Freshwater view, as I see it, is that we are (almost) always in a state of equilibrium. The only thing that can knock us out is inherently unpredictable shocks, usually of a supply or technological variety. Expectations are usually well-behaved and presumptively “rational” at least in the sense that we do not have to worry about big disturbances arising from this subjective (or “demand”) side of the picture.  

The Austrian perspective is more balanced. Austrians have been saying that the current recession was precipitated by excessively low interest rate policy followed by the Fed. They say that the structure of production was distorted in at least two ways. First, investment relatively far from the consumption stage was stimulated as was consumption spending – both at the expense of the middle (a different middle here) and of the replacement/maintenance of capital. (Traditional Austrian view.) Second, low interest rates stimulated greater risk-taking on the part of economic agents. (“New Austrian” view a la Tyler Cowen.) This was not an exogenous change in risk preferences but endogenous, that is, caused by low interest rates, not irrational spirits.  

So here you have a real, underlying distortion caused by poor monetary policy. We can call this a disequilibrium, if you like. The recession must involve a readjustment to the undistorted productive structure. This is not to say that the recession is simply resource re-allocation and therefore unambiguously “good.”  

It is not good because, after all, the original distortion was not good. But we can go even further.  

Once a recession starts certain secondary, but not necessarily unimportant, phenomena may be set in motion – chiefly the threat of cumulative price decline in almost all markets (aka “deflation”), systemic failures in the credit institutions caused by imperfect expectations of what is likely to happen, and general discoordination of plans. Keynes’s macroeconomics seems to be only about these secondary phenomena. Cochrane is right: Keynesians don’t know and don’t care what the fundamental causes of the recession are. 

The “bubble” – to the extent there was one – was strictly speaking a dependent phenomenon. It was dependent on the enabling policies of the Fed during the expansion. I do not believe it would have happened in a different interest-rate environment.  

Thus the Austrian view really is a middle ground. There are real underlying distortions – not simply animal spirits gone wild. They must be dealt with. But there are also secondary, subjective and expectational consequences induced by the original poor monetary policy. It is not so much that markets are inefficient and that actors can be irrational. Rather, in the process of market correction markets will seem inefficient but they are “trying” to correct errors. Actors may be prone to “irrational excesses” because the level of radical uncertainty has been increased, some of this induced by unpredictable government policies and some by the exigencies of readjustment. But the real misallocation problem underlies this.  

I hope this is not too balanced, too moderate, too middle-grounded. Generally, I dislike these things, but bad economics to one side and to the other makes a moderate of me. Woe is me.

25 thoughts on “The Great Moderation In Macroeconomics

  1. I have read the two op-ed pieces and I don’t think either one is very satisfying.

    On Krugman’s view, it is mystery as to why Canadian banks, with their American trained macro economists, did not fail. I doubt that the Canadian economists or financial wizards were using made in Canada models.

    On Cochrane’s view, we are to celebrate the fact that predictions of surprising events cannot be made. A surprise can be predicted, but it remains a surprise if we don’t know at the precise moment the surprise takes place.

  2. All the “Austrians” I’ve read say the size and scope of the bust was multiply and made much worse by various manipulations of the housing finance market and various regulatory pathologies on Wall Street — the Fed then turned on the firehose into this pathological environment.

    This causal story is rich and fits together coherently with the Hayekian production story and relative price story and credit price and supply story.

  3. The Austrian school of thought being the middle ground in economics is one of the biggest jokes i’ve heard all year. Just because the argument one person makes from a particular school of thought is unsatisfying doesn’t mean the concepts behind it are wrong. thats like saying 1+1=3 because the person arguing that 1+1=2 didnt argue his case very well.

  4. I see Saltwater and Freshwater economics as two sides of the same coin: markets are inherently unstable (even if in equilibrium) either due to nominal factors (salt) or real factors (fresh).

    Austrians are not in the middle but on their own coin as defenders of the inherent stability of markets in a world in which entrepreneurs face uncertainty – not the radical uncertainty of Keynes – but a contextual uncertainty in which they have some control over the course of future events.

  5. Wow, Nathan, that’s a great substantive critique of what Mario wrote! I love the way you carefully analyzed his ideas (I especially recall cringing at the passage where he claimed ‘1 + 1 = 3’) and offered a point-by-point rebuttal, sagely noting that, for instance, 1 + 1 does indeed equal 2. After reading the latter point, all Austrian economists will surely lay down their abacuses, tear up their PhD’s, and resume working as streetwalkers in Vienna.

  6. i would imagine the canadian banks are still standing because their regulators insisted on higher capital requirements and more review of whacky financial products. 100% financing wasn’t being pushed in canada. Plus canda having lacked 30 year fixed rate mortgages more canadians were aware of the risks of interest rate fluctuation.

  7. Mario,

    My main disagreement here is the ongoing claim that monetary policy looseness explains all bubbles. The housing bubble began in 1998, according to pretty solid evidence from Shiller. The super loose monetary policy was in 2003-04, which certainly goosed it up, but did not cause it, although obviously various folks can disagree.

    OTOH, it is not correct that the economy is always “on the precipice” due to the threat of bubbles (many are too micro to really impact the macroeconomy, including even sometimes some pretty big ones, such as the one preceding the stock market crash of 1987). But, endogenous bubbles do arise in our modern economies without necessarily being caused by monetary policy. Kindleberger argued (and Minsky agreed) that most really big bubbles do get stimulated further as “credit loosens” during their rise, but it is rarely loose credit that starts them.

    Regarding Cochrane, well, some of his complaints about overly personal attacks on so on are justified, but most of his substantive discussion is just deluded looney tunes.

  8. I dont see why Tyler cowen’s ‘endogenous’ agents can exist unless the low interest rate ‘exogenous’ activity happens first.It is tautological and disingenous to call them endogenous.

  9. The discrepancy between the start of the housing bubble and the super-loose monetary policy period can be explained with reference to the impact of longer-term saving rates.

    The Keynesian consumption function based theory of a steadily lowering APC has been steadily contradicted in the U.S. for a quarter century. The savings rate has fallen from 10-12% early eighties to 0% mid-two-thousands – exactly the opposite of the consumption function prediction. Yet in the entire period, the Fed’s growth, inflation and unemployment targets hardly budged. Something had to give…

    The issue is not that interest rates were too low for 20 months or so, or that this contradicts the thesis that loose monetary policy caused the housing bubble since the timing is wrong. The issue is that interest rates have been too low relative to the domestic savings rate for more than two decades. The 2003-04 period was just the worst excess of the entire period. Post the ’91 recession, it would have been appropriate for the Fed funds rate to have been hundreds of basis points higher than it was (and indeed this was more or less the case for Australia, who performed better over the same period with higher central bank rates – especially so in relation to that countries saving rate).

    The lesson is that whole notion of superior macroeconomic outcomes due to central banks manipulation of interest rates based on targeting is fallacious. The ‘correct’ interest rate at any time is the one determined by a free market.

    End the Fed.

  10. Yes, the correct interest rate is the market rate. But we don’t have a free market in credit (aka free banking). I do believe that some monetary policies (in the absence of free banking) are better than others. I do not believe that we must wait for the best in order to avoid problems such as those we have been experiencing.

  11. Mario, IMO PK tended to be correct in his assaults on New Classical (not neoclassical, as he termed it) maacro. I don’t know if you recall when Lucas came to NYU (about 1991); Nyarko and a few of the others kept after him about bayesian agents with subjective beliefs; Lucas was adamant that any reference to things subjective ends our ability to do systematic analysis; the NC “paradigm” buys this.

    It’s true that you can do many interesting things with a model with rational expectations and perfectly clearing markets, but explaining the real world isn’t one of them.

  12. And of course, you’re right that the Austrians are a useful middle ground between the NC (and the New Keynesians with their various ad hoc frictions) and the irrational agents approach PK advocates.

  13. I don’t know anyone who has claimed that monetary policy alone caused the housing bubble (much less all bubbles). Quite the contrary. And certainly not Mario, who spoke of the “enabling” effects of loose monetary policy. We have been on “stop-go” monetary policy for some time. After the 1987 stock market crash, Greenspan really loosened monetary policy and kept it loose for some time.

  14. I think a major problem in the debate is lack of agreement on common terminology. For example, when a Keynesian talks about saving, they mean demand for currency. When an RBC economist talks about saving, they mean investment. Both groups wind up shouting past one another and resorting to ad hominem and straw-man attacks.

    Much of the disagreement can be boiled down to whether or not Say’s law applies. Since Austrian macro recognizes that there are both real and nominal shocks to the economy, it could be thought of as a middle ground.

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