In his latest piece Paul Krugman defends the state of modern macro citing how much of the modern modelling was used quite effectively by certain economists (basically, himself and a few others). He says this was a big deal because it led to many accurate predictions. Which is fine except I made all the same predictions without using those models so that opens the door to the idea that these models are perhaps unnecessary and maybe even flawed (ie, right for the wrong reasons). More importantly, I think pretty differently about the state of modern macroeconomics – I think it’s terrible.
First, let’s look at some of the more prominent schools and how they’ve done in recent decades:
1) Monetarism – Monetarism’s heyday was in the 1970’s when the Keynesian models appeared to all fall apart under the stagflation of the decade. But the party didn’t last long. It soon became obvious that the focus on targeting “money”, rational expectations and laissez-faire policy was largely misleading. The Fed abandoned monetary targeting in the 80’s and Milton Friedman even admitted in 2003 that he didn’t believe in the idea as fervently as he once did.
In fact, the traditional Monetarist school has basically ceased to exist and was nearly erased from any credible record following the financial crisis when many of the ideas that form the foundation of Monetarism appeared to completely implode. The school has received a face lift in recent years under the guise of “Market Monetarism”, but this school looks like a one way bet on a different target – NGDP Targeting grounded in the same basic thinking that was the basis for traditional Monetarism.
2) New Classical Economics – This was another of the Chicago influenced schools that arose in the 1970’s when Keynesianism faltered. The school was also based on ideas like rational expectations, laissez-faire government approaches, continuous market clearing and the natural rate of interest. As Mark Thoma has explained, this view also faded over time as obvious flaws became apparent and the theory failed to accurately explain the business cycle.
3) Behavioral Economics – This school arose out of many of the failures of the aforementioned two schools of thought. These economists generally reject ideas like rational expectations and instead focus on understanding how economic participants are flawed and biased. Although the school has increased greatly in popularity in recent decades the lack of rigorous economic modeling has stalled its progress. While it’s useful in some aspects the school is better utilized as a complement to a more well-rounded approach to economics since it does not provide a comprehensive view of the macroeconomy. It likely will not and cannot become a dominate macro school because human behavior can only explain certain parts of the economy.
4) Post-Keynesian Economics – The PKE school claims to be the true descendants of Keynes and his work. Unfortunately, the school has become extremely polarized within itself and has become dominated by some extremist left-wing thinking. In fact, it’s become so polarized that most mainstream economists don’t even take it seriously and the persistent attacks by its adherents come off more as bitterness as opposed to anything useful.
Its focus on operational realities, institutions and accounting is, in my opinion, the most useful approach to economics that presently exists, but the extreme polarization within the school and with mainstream economics has rendered it void of impact.
5) Austrian Economics – Austrian economics is most popular with conservative Americans who reject just about anything the government does. They’ve been wrong about almost everything since the crisis occurred including the rate of inflation, direction of interest rates, the value of the USD, the stock market, the economy, the impact of stimulus, etc. The school has, in my opinion, been almost entirely debunked and rendered largely void of value yet it continues to dominate financial TV and garners huge amounts of attention for reasons that can only be attributed to the popularity of its political positions.
6) New Keynesian Economics – The New Keynesians are the modern adaptation of the Old Keynesians who rose up in response to the New Classicals. Although they are called “New Keynesians” they utilize many of the ideas that are essential to Monetarism such as rational expectations, the natural rate of interest, etc. Instead of viewing the money supply as the key variable in the economy they view the price of money as the key variable. This has led these economists to focus on the “zero lower bound” and interest rates in particular.
They’ve focused largely on the IS/LM model in recent years and have attributed it for their good predictions. I’ve been very critical of this school citing the flaws in the idea of a Wicksellian “natural rate of interest” adding that the focus on interest rates has distracted us from implementing more effective policy. In fact, this school has been one of the main reasons why there is so much faith in the Federal Reserve and QE since it claims that the Fed can still be highly stimulative with zero interest rates so long as it focuses on unconventional monetary policy by altering inflation expectations.
I would blame these ideas for the fact that there has been almost no other attempt at fiscal policy and tax cuts. It is, in my opinion, just an altered obsession with Central Banking – the same obsession with “money” and the “price of money” that ultimately proved Monetarism wrong. Except in the case of New Keynesian economics we’ve transitioned from obsessing over monetary targets to obsessing over inflation targets and interest rates. Same basic unrealistic model of the economy, different target.
So, those are the major schools. How are they doing? Well, if you ask me they’re all doing pretty pitifully. The state of macroeconomics is as messy as its ever been. If you can connect all the dots there we’ve basically been evolving from flawed theory to lesser flawed theory to flawed theory. Which I guess isn’t terribly shocking since it’s not a very old field of study when considered within the grand scheme of things. But we shouldn’t be fooled into thinking that everything is fine in the world of macroeconomics. It’s not. It’s a big heaping mess. And there’s a lot of work to be done in making progress here and people who imply that their unrealistic models have it all figured out, are probably among the most dangerous people out there as that’s really just an argument for the status quo – the same status quo that has left over 100 million people out of the workforce.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.