Wednesday, January 12, 2011

The Empire strikes back.... Of course it does.

I'm working my way (backwards) through a pile of blogpostings that I wanted to read. Here's a couple of quotes from a longer interview where new classical Thomas Sargent brushes off that silly criticism that has been directed towards modern macro. It is foolish, intellectually lazy, and misinformed. Basically - they were doing very well and were not at all surprised by the financial crisis, and there's already interesting work available on how to generate this stuff within their models.

Sargent: I know that I’m the one who is supposed to be answering questions, but perhaps you can tell me what popular criticisms of modern macro you have in mind.
Rolnick: OK, here goes. Examples of such criticisms are that modern macroeconomics makes too much use of sophisticated mathematics to model people and markets; that it incorrectly relies on the assumption that asset markets are efficient in the sense that asset prices aggregate information of all individuals; that the faith in good outcomes always emerging from competitive markets is misplaced; that the assumption of “rational expectations” is wrongheaded because it attributes too much knowledge and forecasting ability to people; that the modern macro mainstay “real business cycle model” is deficient because it ignores so many frictions and imperfections and is useless as a guide to policy for dealing with financial crises; that modern macroeconomics has either assumed away or shortchanged the analysis of unemployment; that the recent financial crisis took modern macro by surprise; and that macroeconomics should be based less on formal decision theory and more on the findings of “behavioral economics.” Shouldn’t these be taken seriously?
Sargent: Sorry, Art, but aside from the foolish and intellectually lazy remark about mathematics, all of the criticisms that you have listed reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished. That said, it is true that modern macroeconomics uses mathematics and statistics to understand behavior in situations where there is uncertainty about how the future will unfold from the past. But a rule of thumb is that the more dynamic, uncertain and ambiguous is the economic environment that you seek to model, the more you are going to have to roll up your sleeves, and learn and use some math. That’s life.
Rolnick: Putting aside fear and ignorance of math, please say more about the other criticisms.
Sargent: Sure. As for the efficient markets hypothesis of the 1960s, please remember the enormous amount of good work that responded to Hansen and Singleton’s ruinous 1983 JPE [Journal of Political Economy] finding that standard rational expectations asset pricing theories fail to fit key features of the U.S. data.1 Far from taking the “efficient markets” outcomes for granted, important parts of modern macro are about understanding a large and interesting suite of asset pricing puzzles, brought to us by Hansen and Singleton and their followers—puzzles about empirical failures of simple versions of efficient markets theories. Here I have in mind papers on the “equity premium puzzle,” the “risk-free rate puzzle,” the “Backus-Smith” puzzle, and on and on.2
Rolnick: What about the most serious criticism—that the recent financial crisis caught modern macroeconomics by surprise?
Sargent: Art, it is just wrong to say that this financial crisis caught modern macroeconomists by surprise. That statement does a disservice to an important body of research to which responsible economists ought to be directing public attention. Researchers have systematically organized empirical evidence about past financial and exchange crises in the United States and abroad. Enlightened by those data, researchers have constructed first-rate dynamic models of the causes of financial crises and government policies that can arrest them or ignite them. The evidence and some of the models are well summarized and extended, for example, in Franklin Allen and Douglas Gale’s 2007 book Understanding Financial Crises.7 Please note that this work was available well before the U.S. financial crisis that began in 2007.

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