State of modern macro

State of modern macro

1. 1. Wickens: nothing wrong with modern macro

   • not the theory, but the way the theory was applied that caused the crisis
     • poor policy & incorrect assessment of risk by hh's and banks to blame
   • macro criticised for not capturing complexity of human decisions
     • but that's not what macro is there for in the first place
       • it's a series of simplifications which we should use to gain insight about what would otherwise be intractable problems
   • macro has weaknesses, but these are way fewer than its strenghts
   • current system has incentives for individuals to deviate from what macro theory suggests
     • should align private interests in banking with public welfare

2. 2. Caballero: pretense-of-knowledge-syndrome

3. 3. Blanchard et al: rethinking macro policy

   • Tension between
     • theory
       • successful macro policy = low, stable inflation rate
         • if met = no output gap, natural unemployment
         • no need to intervene in financial markets
       • one instrument = repo rate
     • practice
       • flexible inflation targeting
         • only long-run inflation needs to be low and stable
       • more than one instrument
         • require banks to hold reserve quantities
         • CB's as lenders of last resort
       • increased popularity of monetary policy (Friedman) over fiscal (Keynes)
         • fiscal disproved by Ricardian equivalence
         • fin market developments improved effectiveness of monetary policy
         • lags in design & implementation of fiscal plus short length of recessions = fiscal measures take effect too late to be useful
         • fiscal more likely than monetary to be distorted by political constraints
       • financial deregulation
         • regulation = improper mingling with functioning of credit markets
         • soundness of individual institutions all that mattered - no thought of their impact on macro economy
   • "Great Moderation"
     • decline in variability of output & inflation
     • looked like it was the result of better monetary policy
       • e.g. advanced economies responded well to oil price increases in 1970's & 2000's
     • Thus crisis unforeseen
   • Lessons from crisis
     • 1. Stable inflation necessary, not sufficient
       • Can't use a single index
       • No simple relationship between output and inflation
       • need to include other indeces, e.g. housing prices
     • 2. Low inflation limits scope of monetary policy in deflationary recessions
       • Need higher inflation & low nominal interest rates to be able to cut interest rates in times of crisis
     • 3. Financial intermediation NB
       • Repo rate sufficient instrument for policy only as long as demand for liquidity is limited to banks
         • not always the case
       • prevent asset bubbles - bad because they form around speculation, not demand for liquidity
       • Not the same as financial regulation!
     • 4. Countercyclical fiscal policy NB tool
       • monetary policy not sufficient (shown by limits of zero lower bound interest rates, etc.)
       • esp when effects of crisis are expected to be long-lasting
       • but only to be used in times of real crisis, not during normal business cycle fluctuations
     • 5. Regulation not macroeconomically neutral
       • regulation contributed to amplifying effects of decrease in US house prices to whole world
         • e.g. allowing different financial intermediaries to play by different rules
         • rules aimed at saving individual institutions during the crisis threatened the stability of the system as a whole
     • 6. Need reinterpretation of Great Moderation
       • result of better dealing with SOME shocks, not all
         • specifically demand and supply shocks
         • but bad at responding to financial shocks
   • Implications for design of policy

4. 4. Kirman: crisis for econ theory

   • Can't blame any specific part of fin system for the crisis; rather, evolution of system as a whole led to its downfall
   • response to argument that crisis merely part of system
     • then DGSE models should incorporate possibility of crises
   • explains crisis in terms of contagion, interdependence, interaction, networks, and trust
     • none of these feature in modern macro theory
       • building blocks of macro
         • individuals act in isolation; only interact through the price mechanism
         • aggregate = sum of parts who neither observe nor come into contact with those around them
         • relations between variables fixed; system functions at equilibrium in mechanical way
           • logically, any movement away from equilibrium can only be the result of an external shock
     • local interaction NB in the real economy
       • transmission of info, views, expectations
   • econ system should be studied like physical system
     • e.g. heating up a specific volume of water
     • NB of norms that develop over time
     • aggregate behaviour doesn't correspond to that of a 'rational indivdual'
       • rather, it's a complex adaptive system
         • no simple relationship between individual and aggregate behaviour
       • yet all macro models assume this
       • behavioural econ has shown that individuals aren't rational
         • why would you assume a whole made of irrational parts is rational?