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Economics Gets Real

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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"It works in practice, but does it work in theory?" This joke is so commonly applied to economists that no one even knows who said it originally. The idea fits with the stereotype of economists as out-of-touch theory-obsessed philosophers, wasting time arguing about what would happen in a made-up world of their own devising, while all around them the real world unfolds in ways that are totally different. 

Whether this stereotype was ever true, it certainly isn't true today. Empirical papers are taking over from theoretical papers in the economic literature, and the methods used for untangling cause and effect are getting more and more scientific. The big driver is information technology, which has made the entire world into economists' laboratory. So econ, in general, is becoming more like a science and less like philosophy. 

Now, in macroeconomics -- the study of business cycles and long-term growth -- this shift has been a lot harder and slower. The reason is that in macro, there's just much less data. History only happens once, and it's hard to know to what degree the future will be like the past. To make matters worse, there's just not that much data out there -- we've been keeping good records for less than a century. 

So where there's less data, we would expect theory to expand to fill the gap. And in fact, macro is the main battleground for a perpetual argument about whether theory or evidence should be in the driver's seat. Ed Prescott, a Nobel-winning economist, famously declared in 1986 that theory was "ahead" of measurement in business cycle theory. But since the financial crisis, there has been a clamor to elevate data to its rightful place. University of California-Berkeley economist Barry Eichengreen writes:

While older members of the economics establishment continue to debate the merits of competing analytical frameworks, younger economists are bringing to bear important new evidence about how the economy operates...These developments amount to a sea change in [macro] economics. As recently as a couple of decades ago, empirical analysis was informed by relatively small and limited data sets. To be sure, [theories] are still needed to help make sense of the data. But now there is reason to hope that, in the future, economists' conclusions and policy advice will be shaped not by those frameworks' elegance, but by their ability to fit the facts.

As examples of the new approach, he cites a number of efforts to use the Internet to get more comprehensive data, such as Massachusetts Institute of Technology's Billion Prices Project, which collects a more accurate measurement of inflation than the consumer price index. He also mentions researchers who are digging deeper into historical data and examining political institutions more closely. 

I think Eichengreen is right that macro is due for its own empirical revolution. But I think the flood of data is much wider than just the sources he identifies. The list of heroic macroeconomists working to turn the unknowable grows longer every day. 

For example, consider the work of rising stars Emi Nakamura and Jon Steinsson of Columbia University. The dynamic duo of Nakamura and Steinsson set out to investigate the idea that price "stickiness" -- the inability of prices to adjust to changing economic conditions -- is a big factor in causing recessions. The stickier prices are, the more a fall in aggregate demand will damage the economy. Nakamura and Steinsson found that a lot of the non-sticky prices in the economy are concentrated in a few items, such as gasoline, or the result of temporary sales and discounts. 

When you account for these price patterns, overall prices in the economy look a lot stickier than economists previously thought. That means that aggregate demand -- the same force that Paul Krugman constantly talks about in his blog -- is a more important factor than economists had previously thought. It also implies that policies such as monetary easing and fiscal stimulus will be effective in counteracting the effect of the sticky prices and bringing the economy back from recession. Other teams of economists, using different methodologies, have recently found very similar patterns. Opponents of monetary easing and fiscal stimulus are going to have to confront these facts. 

Another example is the work of John Haltiwanger of the University of Maryland. Haltiwanger is a pioneer of the use of microeconomic data to yield macroeconomic insights. Haltiwanger is incredibly prolific. In just the past few years, he and a small army of co-authors have been digging through the data to find out which kinds of companies hire workers, why the U.S. business sector is less dynamic than in the past, whether private equity improves productivity and a number of other questions that tell us a huge amount about what is actually happening to our economy. Haltiwanger's work blurs the traditional lines between "macroeconomics" and "microeconomics," and thus brings data to bear that would have been ignored by traditional macroeconomic theorists focused on broad aggregates such as gross domestic product and unemployment. 

When you compare the data work of economists like these to the broad brushstrokes of macroeconomic theorists, it isn't hard to tell where the real progress is being made. Like the rest of economics, macroeconomics is transitioning from a philosophical, theory-first discipline to a hard-nosed, practical data-first profession. This is a good thing.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net