Source of the breakdown.

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Economics Struggles to Cope With Reality

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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There are basically four different activities that all go by the name of macroeconomics. But they actually have relatively little to do with each other. Understanding the differences between them is helpful for understanding why debates about the business cycle tend to be so confused.

The first is what I call “coffee-house macro,” and it’s what you hear in a lot of casual discussions. It often revolves around the ideas of dead sages -- Friedrich Hayek, Hyman Minsky and John Maynard Keynes. It doesn’t involve formal models, but it does usually contain a hefty dose of political ideology.

The second is finance macro. This consists of private-sector economists and consultants who try to read the tea leaves on interest rates, unemployment, inflation and other indicators in order to predict the future of asset prices (usually bond prices). It mostly uses simple math, though advanced forecasting models are sometimes employed. It always includes a hefty dose of personal guesswork.

The third is academic macro. This traditionally involves professors making toy models of the economy -- since the early ’80s, these have almost exclusively been DSGE models (if you must ask, DSGE stands for dynamic stochastic general equilibrium). Though academics soberly insist that the models describe the deep structure of the economy, based on the behavior of individual consumers and businesses, most people outside the discipline who take one look at these models immediately think they’re kind of a joke. They contain so many unrealistic assumptions that they probably have little chance of capturing reality. Their forecasting performance is abysmal. Some of their core elements are clearly broken. Any rigorous statistical tests tend to reject these models instantly, because they always include a hefty dose of fantasy.

The fourth type I call Fed macro. The Federal Reserve uses an eclectic approach, involving both data and models. Sometimes the models are of the DSGE type, sometimes not. Fed macro involves taking data from many different sources, instead of the few familiar numbers like unemployment and inflation, and analyzing the information in a bunch of different ways. And it inevitably contains a hefty dose of judgment, because the Fed is responsible for making policy.

How can there be four very different activities that all go by the same name, and all claim to study and understand the same phenomena? My view is that academic macro has basically failed the other three.

Because academic macro models are so out of touch with reality, people in causal coffee-house discussions can’t refer to academic research to help make their points. Instead, they have to turn back to the old masters, who if vague and wordy were at least describing a world that had some passing resemblance to the economy we observe in our daily lives.

And because academic macro is so useless for forecasting -- including predicting the results of policy changes -- the financial industry can’t use it for practical purposes. I’ve talked to dozens of people in finance about why they don’t use DSGE models, and some have indeed tried to use them -- but they always dropped the models after poor performance.

Most unfortunately, the Fed has had to go it alone when studying how the macroeconomy really works. Regional Fed banks and the Federal Reserve Board function as macroeconomic think tanks, hiring top-level researchers to do the grubby data work and broad thinking that academia has decided is beneath it. But that leaves many of the field’s brightest minds locked in the ivory tower, playing with their toys.

Fortunately, this may be changing. Justin Wolfers, a University of Michigan professor and well-known economics commentator, recently presented a set of slides at a conference celebrating the career of Massachusetts Institute of Technology economist Olivier Blanchard. The slides, although short, are indicative of the sea change underway in the macro field.

Wolfers discusses how some of the main pillars of modern academic macro theory are now being challenged. The idea of “rational expectations,” which says that people on average use the correct mental model of the economy when they make their decisions, is being challenged by top professors, and many are looking at alternatives.

But that’s just the beginning -- far deeper changes may be in the offing. Wolfers suggested abandoning DSGE models, saying that they “haven’t worked.” That he said this at a conference honoring Blanchard, who was an important DSGE modeling pioneer, is a sign that the winds have shifted.

In place of the typical DSGE fare, Wolfers suggests that the new macroeconomics will focus on empirics and falsification -- in other words, looking at reality instead of making highly imaginative assumptions about it. He also says that macro will be fertilized by other disciplines, such as psychology and sociology, and will incorporate elements of behavioral economics.

I’d go even farther. I think the new macroeconomics won’t just be new kinds of models and a more empirical focus; it will redefine what “macroeconomics” even means.

As originally conceived, macro is about explaining national-level data series like employment, output and prices. Eventually, economists realized that to explain those things, they would need to understand the smaller pieces of the economy, such as consumer behavior or competition between companies. At first, they just imagined or postulated how these elements worked -- that’s the core of DSGE.

Economists now realize that consumers and businesses behave in ways that are much more complicated and difficult to understand. So there has been increased interest in what’s called “macro-focused micro” -- studies of businesses, competition, markets and individual behavior that have relevance for macro even though they weren’t traditionally included in the field. Examples of this would include studies of business dynamism, price adjustment, financial bubbles and differences between workers.

Let’s hope more and more macroeconomists focus on these things, instead of trying to make big, grandiose, but ultimately vacuous models of booms and recessions. When we understand the pieces of the economy better, we’ll have a much better chance of grasping the whole. If this continues, maybe the ivory tower will have more relevance for the Fed, the financial industry and maybe even for our coffee-house discussions.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

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James Greiff at jgreiff@bloomberg.net