James Morley on the Failure of "Modern" Macroeconomics
Larry Meyer once claimed, I am told by perhaps-unreliable sources, that the slash-and-burn campaign conducted throughout macroeconomic theory by the Lucas-Prescott faction's main effect had been to ensure that he had next to no competitors in forecasting the current state and likely future direction of the economy--and that while this was profitable for him it was not terribly healthy for the profession.
James Morley of Macroeconomic Advisers, LLC: In a recent essay, Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, acknowledged that modern macroeconomics failed during the recent financial crisis.... Kocherlakota associates modern macroeconomics with a particular school of thought... that an economic model with “deep structural parameters” related to preferences and technology for households and firms should provide more reliable forecasts... the “microfoundations” approach to macroeconomics.... Kocherlakota explains the recent failure of modern macroeconomics as due to... [their] lack [of] sufficient complexity, especially in terms of their treatment of financial markets... [and] that the models are driven by “patently unrealistic shocks”.
However, the rehabilitation of modern macroeconomics requires a different tack than suggested by Kocherlakota....
[A] simple DSGE model [with deep structural parameters] is able to mimic the apparent AR(1) dynamics in real GDP growth... by assuming... exogenous technology shock... with an AR coefficient that happens to be the same... a rabbit was stuffed into the hat and then a rabbit jumped out of the hat.... After more than two decades of earnest promises to do better... models now “explain” variables like real GDP, inflation, and interest rates as the outcome of more than just serially-correlated technology shocks. They also consider serially-correlated preference shocks and serially-correlated policy shocks....
[I]t is perhaps useful to revisit Kocherlakota’s essay on modern macroeconomics. He writes:
In terms of fiscal policy (especially short-term fiscal policy), modern macro modeling seems to have had little impact. The discussion about the fiscal stimulus in January 2009 is highly revealing along these lines. An argument certainly could be made for the stimulus plan using the logic of New Keynesian or heterogeneous agent models. However, most, if not all, of the motivation for the fiscal stimulus was based largely on the long-discarded models of the 1960s and 1970s....
[T]he natural question that arises when reading his last sentence is “discarded by whom?” Certainly, it is not by policymakers trying to predict the quantitative effects of fiscal stimulus. The answer to “discarded by whom?” that Kocherlakota clearly has in mind is “modern” macroeconomists....
It is a safe bet that future versions of DSGE models will incorporate more complicated financial sectors and allow for different types of fiscal policies. And guess what? The new-and-improved DSGE models will turn out to imply (ex post) that the Great Recession was actually due to serially-correlated financial intermediation shocks and suboptimal fiscal policy. Alas, these conclusions will be driven much more by the DSGE framework than by the data....
[I]n terms of really predicting the crisis, the award obviously goes to theories of endogenous financial crises inspired by the ideas of Hyman Minsky. Formal evaluation of these more narrative approaches is hard and there may be an element of the “stopped-clock syndrome” at play. But it would be foolish to dismiss such theories out of hand. In particular, a ludicrous notion sometimes expressed in the ivory towers of academia is that, for Minsky to be taken seriously, his ideas need to be put into a DSGE model. Instead, the converse is true. For DSGE models to be taken more seriously outside of academia, they need to explain and predict as well as Minsky. And serially-correlated preference and technology shocks aren’t going to do it!...
