The failings of Macro

Anonymous1987

Economics may be dismal, but it is not a science

A remarkably distinguished group of economists gathered last weekend for the inaugural conference of the Institute for New Economic Thinking, an initiative of George Soros. They were soul searching over the failures of economics in the recent crisis. Such failures are most evident in two areas: the inadequacies of the efficient market hypothesis, the bedrock of modern financial economics, and the irrelevance of recent macroeconomic theory.
The central idea of the efficient market hypothesis is that prices represent the best estimate of the underlying value of assets. This thesis has recently taken a battering. The boom and bust in the money markets was precipitated by a US housing bubble. That bubble followed the New Economy fiasco and was preceded by the near-failure of Long Term Capital Management, a hedge fund designed to showcase sophisticated financial economics.
The macroeconomics taught in advanced economics today is largely based on analysis labelled dynamic stochastic general equilibrium. The unappealing title gives the game away: the theorists are mostly talking to themselves. Their theories proved virtually useless in anticipating the crisis, analysing its development and recommending measures to deal with it.
Recent economic policy debates have not only largely ignored DSGE, but have also been remarkably similar to the economic policy debates of the 1930s, although they have been resolved differently. The economists quoted most often are John Maynard Keynes and Hyman Minsky, both of whom are dead.
Both the efficient market hypothesis and DSGE are associated with the idea of rational expectations – which might be described as the idea that households and companies make economic decisions as if they had available to them all the information about the world that might be available. If you wonder why such an implausible notion has won wide acceptance, part of the explanation lies in its conservative implications. Under rational expectations, not only do firms and households know already as much as policymakers, but they also anticipate what the government itself will do, so the best thing government can do is to remain predictable. Most economic policy is futile.
So is most interference in free markets. There is no room for the notion that people bought subprime mortgages or securitised products based on them because they knew less than the people who sold them. When the men and women of Goldman Sachs perform “God’s work”, the profits they make come not from information advantages, but from the value of their services. The economic role of government is to keep markets working.
These theories have appeal beyond the ranks of the rich and conservative for a deeper reason. If there were a simple, single, universal theory of economic behaviour, then the suite of arguments comprising rational expectations, efficient markets and DSEG would be that theory. Any other way of describing the world would have to recognise that what people do depends on their fallible beliefs and perceptions, would have to acknowledge uncertainty, and would accommodate the dependence of actions on changing social and cultural norms. Models could not then be universal: they would have to be specific to contexts.
The standard approach has the appearance of science in its ability to generate clear predictions from a small number of axioms. But only the appearance, since these predictions are mostly false. The environment actually faced by investors and economic policymakers is one in which actions do depend on beliefs and perceptions, must deal with uncertainty and are the product of a social context. There is no universal economic theory, and new economic thinking must necessarily be eclectic. That insight is Keynes’s greatest legacy.
John Kay is a member of the advisory board of the Institute for New Economic Thinking

In light of the above is it time for greater recognition of a field such as behavioural economics to understand the economy? What kind of developments would people like to see in macroeconomics? How can it be improved?

Flamed Diving

Well the notion that rational expectations in DSGEs is patently absurd is hardly ignored by macroeconomists. I myself don't think that the 'Law of Iterative Expectations' is realistic either. So I guess these two assumptions need to be relaxed somewhat. I would imagine this would make the models extremely complex and difficult to estimate, but I don't see why that should hold the field back. Many areas of physics require complex models, so why not economics?

Anonymous1987

I should point out I know very little about DSGEs so sorry if what I say sounds naive but I'd like to incorporate something like the herd effect and heuristics into macro modelling or something that better reflects real human decision making. This is a big ask to micro modelling not to mention macro but its just somewhere I'd like to see macroeconomics attempt to development although the complexity of the model might be so great as to undermine its usefulness.

BESman

That is the single most comprehensive article I've yet encountered on the current state of macroeconomics. Very simple, doesn't attack but lets the reader understand the limitations that exist in the models. Thanks for posting that.

SkepticOne

From the article:

The standard approach has the appearance of science in its ability to generate clear predictions from a small number of axioms. But only the appearance, since these predictions are mostly false.

There was another thread here about the validity of economics as a science and I think zaraba made a good point:

Economics suffers from an expectations gap (def. here), where people expect them to be effectively able to predict the future.

However whilst the expectations gap may have been a problem in the past, recent events have done a lot to close it.

Flamed Diving

Yeah, expectations is really the biggest challenge of all for Macro. It may not even be possible to model it, without nonsensical assumptions.

Anonymous1987

SkepticOne wrote: »

From the article:
There was another thread here about the validity of economics as a science and I think zaraba made a good point:
However whilst the expectations gap may have been a problem in the past, recent events have done a lot to close it.

The best way to think of Economists is as informed policy experts who formulate optimal policies based on the information (pretty much always incomplete) available to them, they can't tell the future but they can weigh the costs and benefits and come to a reasonable decision on the best course of action with what is known to them.

silverharp

their videos are up, some interesting ones

http://ineteconomics.org/

Tricity Bendix

Flamed Diving wrote: »

Yeah, expectations is really the biggest challenge of all for Macro. It may not even be possible to model it, without nonsensical assumptions.

The latest issue of the Economist has an article on this conference and the state of macro. I can't remember the exact wording, but they put forward the idea that maybe macro shouldn't be about forecasting, but about explaining why things happened the way they did.

BESman

Tricity Bendix wrote: »

The latest issue of the Economist has an article on this conference and the state of macro. I can't remember the exact wording, but they put forward the idea that maybe macro shouldn't be about forecasting, but about explaining why things happened the way they did.

Thats called history isn't it?

Flamed Diving

Tricity Bendix wrote: »

The latest issue of the Economist has an article on this conference and the state of macro. I can't remember the exact wording, but they put forward the idea that maybe macro shouldn't be about forecasting, but about explaining why things happened the way they did.

Yup, and there is a lot to be said for backward-looking thinking like that. If we can correctly identify what/how/why caused the issues which affect the present, perhaps this knowledge could be used to set new policy/regulation/etc. Of course, this already occurs, but I'm not so sure if anyone outside of the field is actually paying attention. When the majority think of Macro, they immediately think of forecasting.

Tricity Bendix

BESman wrote: »

Thats called history isn't it?

Pffffft. I'd like to see a historian disentangle oil price shocks like Lutz Killian did. Fact is, economists are just people with a certain set of tools and a certain training. They're not mystics that can see in to the future.