By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
We are in the midst of severe economic and financial crises. These crises have led to reappraisals of received economic and financial doctrines. The Institute for New Economic Thinking was established to challenge recent conventional (economic and financial) wisdom. Lord Turner did just that in a speech to the Institute’s inaugural conference. Even as I find myself in general agreement with Turner, I think that there are two areas in this speech where Lord Turner’s criticism is either too narrow in scope or overemphasizes one factor at the expense of others.
Perhaps it reflects Turner’s current position as a regulator, but in his speech he focused almost exclusively on the (micro) economics of markets and by implication suggests that the conventional macro wisdom is not in need of as rigorous a re-think.
Turner also describes a process by which economic and financial policymakers became prisoners of an ideology. I do not doubt that ideology has affected the evolution of economics and policy. However, I believe that Mr. Turner has underestimated the importance that macro economists attached to the elegance of their models and their failure to continuously verify the models’ accuracy and usefulness.
Turner On Economics
Turner attributes the crises to “..bad economics – or rather over-simplistic and overconfident economics–” I would have preferred he reversed the order, i.e., overconfident before over-simplistic. Simplicity is required in economic model building. Economic models, like maps, are useful because they are simpler than the reality that they represent. (Have you ever seen a map with a scale of “1 mile=1 mile”?) However, it is impossible to ex ante know with certainty if a model remains useful despite abstractions or is overly simplistic.
Given the dynamic and stochastic world in which we live, policymakers, traders and investors and other users of models face a sad truth: their models will not always be appropriate. The resulting forecasts, decisions and policies will produce results that would have best been avoided.
While macro-policy decision makers must be confident enough to make a decision, they must also be open minded enough to admit a mistake and correct it. They must trust their models, but they must also continuously verify their accuracy and usefulness. Much as the safety and effectiveness of drugs and medical devices are monitored even after they pass tests and are approved, macroeconomic policy makers should have actively explored the possibility that policies were producing unexpected and unintended consequences.
Unfortunately, while US macro-economists and policymakers were quick to take credit for the efficacy of policy in moderating swings in output and inflation, they dismissed the signs of unsustainabilities in asset prices, balance sheets and external imbalances. The unwillingness of policy makers to explore the possibility that they have made an error poses a great risk.
In the speech, Lord Turner’s relative emphasis suggests that he limits “bad economics” to microeconomics: “There was a dominant conventional wisdom that markets were always rational and self equilibrating, that market completion by itself could ensure economic efficiency and stability, and that financial innovation and increased trading activity were therefore axiomatically beneficial.”
However, to support the view that the dominant conventional wisdom was used to dismiss warnings, he cites the dismissal of warnings that were aimed at least as much at macroeconomic policy as they were at microeconomic-based regulatory policies: “..that dominant conventional wisdom was used to dismiss the concerns expressed by several commentators – by, for instance, Bill White in his BIS Reviews, or by Raghuram Rajan in his paper at Jackson Hole in 2005.”
As part of his “caricature” of the dominant conventional wisdom: Turner presents a set of four policy prescriptions, only one of which relates to macroeconomics: “Macroeconomic policy – fiscal and monetary – was best left to simple, constant and clearly communicated rules, with no role for discretionary stabilisation.”
This prescription appears on page two and is the last sentence in the fourteen-page speech which links to macroeconomics or monetary policy, although argues for enhanced regulatory regimes. However, Lord Tuner had previously linked the current crisis to macroeconomic variables:
“At the core of the crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10-15 years, and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances.”
Given that monetary policy and regulatory policy are intertwined (monetary policy is in part transmitted the expansion and contraction of financial institutions balance sheets) and that macro-economic imbalances were at the core of the crisis, should not a new macro-economic thinking be as central to any new economic thinking as micro- or regulatory economics?
Turner is correct. There are decided shortcomings in conventional economic wisdom, but there are shortcomings are in macroeconomics as well as in microeconomics.
The Role of Ideology in Macroeconomic and Financial Models
Some economists are ideologues. I have no doubt that economists drawn to politics and policy areas are even more likely to carry ideological baggage than other economists, but it is a leap to assume that a “free market ideology” embedded in macro and regulatory economics was the driving force behind the crises. However, Turner’s speech suggest just that: “For it is striking in the pre-crisis years how dominant and how overconfident, at least in the arena of financial economics, was a simplified version of equilibrium theory which saw market completion as the cure to all problems…”
However, a desire for elegance and tractability on the part of macro-and financial model builders is a better explanation for the crises than is adherence to a free market ideology. Turner points out that economic equilibrium theory has not been monolithic. He notes that economists working in the area of microeconomics and general equilibrium theory (the presumed home of the ideology) and who questioned the conventional wisdom are viewed as stars by the profession (and hold Nobel prizes). On the other hand, he notes that economists (including Schiller, Rajan and White), who prior to the crisis questioned the conventional macroeconomic wisdom, were dismissed or marginalized by officialdom and the economics profession. The macroeconomic orthodoxy closed ranks, while equilibrium theorists have not.
While micro-based economists first assumed perfect knowledge and then explored the implications of relaxing the assumption, macro and financial economists assumed perfect knowledge and then added “rational expectations” which might more accurately be called perfect foresight. They have never looked back. Attributing clairvoyance to economic agents was not part of any received microeconomic canon or ideology.
Other sub-disciplines of economics are built on “market failures” and their implications, e.g., environmental economics is largely driven by market incompleteness. Hence if one is to ascribe failures of macro and financial economics to an overarching microeconomic-based ideology, one must explain why that ideology is reflected in those two sub-disciplines of economics but not in others.
Furthermore, there is a problem, even if one assumes that a free market ideology explains why the Fed and monetary economists did not feel a need to adjust the Taylor Rule in light of asset market behavior. Given that the exchange value of the Dollar was not determined in anything like a free market, adherence to a free market-based ideology cannot explain why monetary policy was not adjusted to reflect the unsustainable external imbalances and the impact of imported deflation on inflation.
Occam’s Razor suggests a simpler explanation is better than a compound explanation. There is a simple single explanation for failures of macroeconomics, regulation, and financial models: the model builders prized elegance and simplicity above all else.
Turner made note of Lancaster and Lipsey’s theory of the second best during his discussion of the fact that economists had recognized violations of the assumptions underlying the argument that markets promote optimal allocations of resources. Second best considerations support the thesis that simplicity and elegance were the principle drivers of choices made by the macroeconomic model builders.
Turner summarized Lancaster and Lipsey’s findings as: “Lancaster and Lipsey illustrated that if some markets were imperfect, then making other markets closer to perfect might not be welfare optimal.” Transporting Lancaster and Lipsey’s finding from the realm of general equilibrium to that of macro policy suggests the following: if some macro policies were sub-optimal, then making other policies closer to perfect might not maximize sustainable growth. In the current case, given the absence of any market or policy promoting external balance as well as a regulatory structure incapable of maintaining financial stability, a move to an otherwise more optimal monetary policy regime might very well be detrimental to sustaining trend growth.
Second best considerations inherently introduce a bewildering amount of complexity. Second best considerations preclude theory-based a priori judgments on the welfare and efficiency effects of policy regimes or change in policy. For the sake of elegance and to retain their influence over policy, macroeconomists of many persuasions went along with the herd and happily turned a blind eye to a series of market imperfections, second best considerations and disturbing unsustainable financial and macro-imbalances.
Many economists have promoted economics as a hard-mathematical-non-laboratory science such as astronomy and certain branches of physics. Unfortunately and for many reasons, economics will never have the predictive or explanatory power of astronomy or physics.
Astronomy and physics are simply bad role models for economics. (Medicine or public health might be better fits). Recognizing the short comings of the astronomy/physics paradigm, some economists are now focused on finding and using “natural” experiments, but it will be difficult, if not impossible, to find a body of “natural” macroeconomic experiments. This does not imply that macroeconomics is without value and good macroeconomic policy an oxymoron. It does imply that macroeconomics has been oversold and that macroeconomic models will never be in the set-it-and-forget-it camp.
Complacency and overconfidence are risks to good macroeconomic policy. Economists and policymakers must be open to any evidence that the economy or markets are adapting in an unforeseen and counterproductive manner.
Turner is correct in saying we need new economic thinking, but macroeconomics is as much in a need of a rethink as microeconomics and overconfidence in models is more of a risk than any ideology.