So where's the market failure (in macroeconomics)?

Mike Moffatt asks the right question; and it's the economist's question.

In economics, if we think the price of x is too high, we don't just say "we should lower the price of x". We look for the underlying causes of the price of x being too high. "Where's the market failure?"

There are two benefits to doing this. The first is that by forcing ourselves to think about what might cause the price of x to be too high, we are forced to re-examine our evidence for believing that it really is too high, all things considered. The second is that we might come to a better assessment of which cure, if any, would work best.

We economists should adopt the same approach if we think there is some problem in macroeconomics. Here's Mike:

"One thing in particular has been bothering me about this whole debate - nobody seems to be addressing why macroeconomics (or a subset of) went 'off the rails' (if you buy the hypothesis that it did) sometime in the late 1970s. If you agree that macro entered a 'dark age', then why did a group of researchers follow a research program that was so utterly useless? The Krugman explanation seems to be that all the freshwater guys were ignorant jerks; I do not find that particularly compelling. If we can understand the institutional factors that are at play, perhaps we can change our institutions to lead to better macroeconomic research. My own belief is macro went 'off the rails' much earlier than the mid 1970's, when academics went from largely publishing in books to publishing in peer-reviewed journal articles. We have a system that rewards complex, but irrelevant mathematical models over realistic assumptions and finding the truth. So why would we expect macroeconomic models to be useful in the real world?"

Discuss.

Comments

[Greg Ransom]

Here's a simpler way to ask the question:

What happened to macroeconomics which made it so that economists wouldn't listen to the macroeconomics of BIS chief economists William White -- the man who warned the central bankers of the coming economic bust:

http://www.spiegel.de/international/business/0,1518,635051,00.html

See more on White here:

http://hayekcenter.org/?p=444

and here:

http://hayekcenter.org/?p=931

You had excellent economists who understood what was happening and warned Greenspan and others at major central bank conferences.

And nobody would listen to them -- and the top 10 grad school macroeconomists head the list of those with hands over their ears.

[Greg Ransom]

Here's the simple answer.

Career & "he's smart" assessment was easiest if it involved mere math -- this came to dominate the profession at every level, from freshman in Econ 101 to the John Bates Clark prize.

And -- crucially -- the marginalist logic of heterogeneous production processes (i.e. a marginalist theory of capital and interest) turned out to be mathematically intractible.

So a marginalist take on production processes, monetary economics, and interest theory was eliminated for the mental world of the economist -- i.e. the very heart of the economy, and the very heart of the economics of the trade cycle & money found in Cantillon, Hume, Bohm-Bawerk, and Hayek.

With the heart of economics and marginalism removed, the patient lay dead on the table.

[Greg Ransom]

Note well that this is sort of like how physics & other natural sciences eliminated non-linear dynamic phenomena (e.g. the three body problem) from their mental world for 100 years, because this sort of phenomena was predictably intractable. They pretended this giant domain of phenomena simply didn't exit -- and it didn't in the textbooks.

In the mental world of model philosophers of science still wedded to the covering law / prediction-confirmation model of science (Mill, Hempel, Nagel) this sort of phenomena remains outside of their mental world -- one reason so many were incapable of including Darwinian biology within the republic of science.

I wrote:

"And -- crucially -- the marginalist logic of heterogeneous production processes (i.e. a marginalist theory of capital and interest) turned out to be mathematically intractable.

So a marginalist take on production processes, monetary economics, and interest theory was eliminated for the mental world of the economist -- i.e. the very heart of the economy, and the very heart of the economics of the trade cycle & money found in Cantillon, Hume, Bohm-Bawerk, and Hayek."

[Stephen Gordon]

I think that the problem is one of the depreciation of human capital: our understanding of problems diminishes as the problems become more distant.

If blogs had existed in the mid-1970's, there would be a sea of posts asking how could we be living in a world of stagflation - didn't our models all say that this was impossible? The Phillips curve said that we could have high unemployment or high inflation, but not both!

And it would be Milton Friedman who would be reminding everyone that there was a perfectly good theory for how inflation could co-exist with high unemployment, that the framework for these theories had been developed generations ago before being marginalised by Keynesians, and that macroeconomics was finally emerging from a Dark Age in which much useful knowledge had been forgotten.

[Matthew]

"We have a system that rewards complex, but irrelevant mathematical models over realistic assumptions and finding the truth."

I guess I should have read this post before commenting on the previous Dark Age post - where I said exactly the same thing, followed by a recounting of my own traumatic year at UWO.

[Mattyoung]

EMH can be said to still work, but it became inaccurate. An essential input became constrained relative to finished goods, hence the ability to build a production system that takes the essential input and produces finished output in accurate variations no longer works. The supply chain is too long to manage inventory volatility along the chain. We need application of technology or shorter distribution networks.

[Andrew F]

Supply Chain management has made huge improvements since the last big recession. I think we saw how effective supply chains have been at clearing the inventory backlog for most consumer goods. Restocking was already taking place in Q2 of this year.

[Too Much Fed]

"In economics, if we think the price of x is too high, we don't just say "we should lower the price of x"."

How about if the price of x is too low, will there be too much demand for it? Specifically, if the price (as in interest rates) of debt (loans denominated in currency) is too low, will there be too much of it?

"We look for the underlying causes of the price of x being too high. "Where's the market failure?""

How about the fed? Specifically and IMO, they think price deflation from cheap labor and positive productivity growth should be met with debt (loans denominated in currency) to keep the price deflation from occurring. If there is too much debt, asset prices are too high, and there is too much wealth/income inequality don't worry about that because we, the fed, know what we are talking about.

Plus, are there some markets that do not even exist?

[Patrick]

"Plus, are there some markets that do not even exist?"

If a market fails and no economist is listening, does it still create an inefficiency?

[Nick Rowe]

Answers received so far (please excuse the massive over-simplification):

Mike: we reward articles not books. And maths not truth.

Greg: we reward what we can easily measure, and maths is easier to measure.

Stephen: we are always in a Dark Age with respect to something, because we forget stuff. (Two variants here: it can be that we as individuals forget stuff, or that we collectively in a OLG model forget stuff because the people who remember die off).

Matthew: agrees with Mike.

And the rest of you get an 'F' for wandering off-topic! (Except Patrick who gets a C for a passable joke.)

I lean towards the OLG variant of Stephen's answer. Learning time is scarce, so we don't learn everything the old guys knew, because we have to leave room for some new stuff that seems relevant when we learn it. But this does not necessarily mean market failure.

[Andrew F]

Sorry Nick!

[Nick Rowe]

I'll let you off this time!

Thinking more, was Patrick's joke merely a joke? Do we have a tendency to miss market failure when there isn't a market?

[DW]

I'm with you on your conclusion, Nick, but, again, why?

It's like if every few decades a different physical force dominated (like, say, Gravity in the 80s, the Strong Nuclear force in the 50s, electromagnetism in the 20s), physicists would have these alternating theories for how the relationships between physical phenomena are governed.

After a few years, everyone figures the 'new' reality will persist and so discard the 'old' theory. Then, bam, it hits us again and we kick ourselves for "foregetting".

But isn't there a feedback loop in there somewhere? It's almost as if by focusing on the dominant force, we encourage the others to get out of control.

[www.facebook.com/profile.php?id=611985302]

You have to remember that Physics as a science only deals with relatively simple phenomena. They take all the hard stuff that needs to be dealt with and throw it over the wall into engineering. Economics could do with an engineering division.

The other problem is that, at least at the global level, economics only has one example. So when the economy changes state, you have to go back to when it was last in that state to see what to do about it.

[westslope]

Dark ages? Please.

You mean the Neo-Classical synthesis built around the Hicksian Cross-Keynsian model, and massive econometric models were somehow better?

Seems that the "Dark Ages" have permanently left their mark on the profession and I would argue for the better.

BTW, Nick, do you personally believe that economic agents can be permanently stupid (or irrational if you prefer)?

[westslope]

Jim Rootham,

Economics has had and continues to have all kinds of "engineering divisions".

[Matthew]

I think another problem is that economics has increasingly isolated itself from other social sciences - though certainly the other social sciecnes are almost as much to blame.

This wasn't always the case. Since this is a mostly Canadian economics blog, I will point out that up until the late 60s there was the Canadian Journal of Economics and Political Science. Now, of course, they are two separate journals. I'm not saying its appropriate to out them back together - just to illustrate the point above. also, Canada's most influential economists, like Harry Johnson, usually seemed to have had a good sense of the socio-political factors at play - something growing out of the U of T political economy tradition.

This whole psychology and economics movement seems to be gathering more steam in the US - may be promising.

[westslope]

Matthew, Economics continues to be most influential of the social sciences in terms of influencing research agendas (modeling and empirical innovations) of other social sciences.

Economics continues to draw heavily from psychology and evolutionary biology but to name two examples.

Political science fell from grace a while back when in many NA departments (not all thankfully), it started to minimize the quantitative analysis in order to shore up enrollment and departmental budgets.

[Matthew]

Westslope:

Agreed on the first point.

I'm not sure I agree with the last statement though. When would you say that political science began to minimize quantitative analysis? Canadian political science has always been qualitative, historical, institutional. I read the flagship journal - CDN Journal of Political Science fairly often and it seems to me that it has gotten more quantitative over the years, not less. Amercian political science has long been much more quantitative and at the influential departments there is lots of formal modelling, fairly sophisticated stats, etc. I'm not aware of an significant retrenchment here.

[Too Much Fed]

Why is my post off-topic?

[Nick Rowe]

westslope: "BTW, Nick, do you personally believe that economic agents can be permanently stupid (or irrational if you prefer)?"

Some people will be stupid/irrational all of the time, and all people will be stupid/irrational some of the time, but I don't believe that all people will be stupid/irrational all of the time, or at least not in the same way.

To put it another way, if you build a model which assumes people will make the same simple mistake in the same way year after year, despite evidence that they are making that mistake, I need some convincing. I suppose strong experimental evidence, or an evolutionary psych explanation, might convince me.

Model consistent expectations/REH is my benchmark hypothesis. But I interpret this in a weak form as the only stable long run equilibrium when patterns are repeated over time. I am wary of applying REH to new policy experiments, for example.

Too much Fed: because the topic is about whether or not macroeconomists, as producers of a good (macroeconomics) face incentives or constraints that might cause their personal interests to fail to align with what is socially optimal. The post is not about macroeconomics; it's about meta-macroeconomics.

[Min]

Nick Rowe: "To put it another way, if you build a model which assumes people will make the same simple mistake in the same way year after year, despite evidence that they are making that mistake, I need some convincing."

Visit your local casino or poker club. :)

[Greg Ransom]

Nick, I didn't mention measurement.

I'm talking strictly math equations and math models.

Marginalist valuation logic / math can't tractably be applied
to heterogeneous production processes across time -- pat of the lesson of the Cambridge capital controversies, among other things. You can't put this stuff into a math construct / model.

Measurement is a separate if related issue.

Economists don't try to measure his stuff because their math constructs tell them it doesn't exist.

In fact, some economists have measured it, to some limited extent.

[Nick Rowe]

Greg: sorry if I misunderstood you; but I think you might have misunderstood me!

This is the bit of what you said that really caught my eye: "Here's the simple answer. Career & "he's smart" assessment was easiest if it involved mere math -- this came to dominate the profession at every level, from freshman in Econ 101 to the John Bates Clark prize."

I was saying that you were saying that it's easier to measure (assess) economists if they use math.

[Greg Ransom]

I think I misunderstood you Nick.

Rather than say that math is easy to measure, what it does is I gives us a simple "objective"
metric for universal evaluation. Math is either valid or invalid, making it simple
minded to check, to grade, to publish or not publish.

Understand is HARD to evaluate, it's ime consuming and costly, and it doesn't give you a simple minded on-off "objective" metric for evaluation, grading, publishing.

E.g. how do you evaluated whether someone has understood Hayek's work
on the division of knowledge, local knowledge, entrepreneurial learning, socialist economics, and the Sinaloa
function of prices?

About 1/2 of the Nobel prize winner written about this work or have built math constructs inspired by literature
evolving out of his work. Do all of these people understand the same thing? Are these understandings compatible? re their constructs consistent?

We've entered a world here where there is no simple minded
objective metric, there are serious rival understandings, and the profession offers no
incentive to anyone to think hard about getting this stuff right.

[Greg Ransom]

Damn the iPhone. Let me correct that:

I think I misunderstood you Nick.

Rather than say that math is easy to measure, what it does is it gives us a simple / fast "objective" metric for universal evaluation. Math is either valid or invalid, making it simple minded to check, to grade, to publish or not publish.

Understand is HARD to evaluate, it's time consuming and costly, and it doesn't give you a simple minded on-off "objective" metric for evaluation, grading, publishing.

E.g. how do you evaluated whether someone has understood Hayek's work on the division of knowledge, local knowledge, entrepreneurial learning, socialist economics, and the communication function of relative prices?

About 1/2 of the Nobel prize winner written about this work or have built math constructs inspired by literature evolving out of his work. Do all of these people understand the same thing? Are these understandings compatible? Are their constructs even consistent?

We've entered a world here where there is no simple minded & fast "objective" metri -- instead there are serious rival understandings, and the economics profession offers no incentives to anyone who stops to think or work hard on getting this stuff right.

[Greg Ransom]

Nick -- Looks like you did understand me.

You wrote:

"Greg: sorry if I misunderstood you; but I think you might have misunderstood me!

This is the bit of what you said that really caught my eye: "Here's the simple answer. Career & "he's smart" assessment was easiest if it involved mere math -- this came to dominate the profession at every level, from freshman in Econ 101 to the John Bates Clark prize."

I was saying that you were saying that it's easier to measure (assess) economists if they use math."

[RebelEconomist]

I suspect that mathematics (by which I mean algebra, rather than econometrics) began to be used to model economic behaviour because it seems to add weight to what are often essentially common sense ideas - after all, most participants in the economy are not mathematicians. And, having been adopted, mathematics has a barb that made it increasingly deeply embedded - for most people mathematics is hard, so anyone avoiding mathematics is suspected of being dull or lazy and therefore gets less respect. Also, by limiting access to the academic discussion of economics, maths has raised the value of the insiders, so they have little incentive to minimise its use.

[Mandos]

It could *never* be the case that economics tells the people who matter what they want to hear at any given point in time, no, never...

[Mandos]

And there are people who live in this world who *don't* believe in actors that are permanently irrational?

[Stephen Gordon]

Present company excepted, presumably.