“The State of Macro Is Good”

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The quote is from Olivier Blanchard in August 2008, at the beginning of the extreme instability that nearly tipped global economies into depression. His full statement is: “After the explosion (in both the positive and negative meaning of the word) of the field in the 1970s, there has been enormous progress and substantial convergence. For a while—too long a while—the field looked like a battlefield. Researchers split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies. Over time however, largely because facts have a way of not going away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good.”

Chronic Delusion

Blanchard goes on to admit that others believe his optimism is “delusional”, citing in particular his MIT mentor Robert Solow. Within a couple of years, the delusional interpretation gathered a lot of steam. Most damning, stabilization policymakers were trashing the state of macro as useless, which is a far cry from good. Jean-Claude Trichet was Governor of the European Central Bank when he complained that mainstream macro models failed to provide stabilization authorities useful guidance on how to understand and deal with the Great Recession. From Trichet (November 2010): “When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policymaker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.” The other crucial policymaker felt the same way. I experienced Ben Bernanke, during the design and execution of the Fed’s successful strategy to prevent the crisis from morphing into a 21st-century depression, disdainfully dismissing the relevance of mainstream macro theory.

Blanchard’s delusion is at least partly rooted in his habit of glossing over debilitating flaws in NK macro theory that existed in 2008 and continue unchanged today. A particularly fatal mainstream error is combining the admonition to microfound (rational behavior being a good thing) with the disastrous restriction that all rational exchange must occur in the marketplace. Blanchard seems unable to grasp that core problem. In modern economies, where a significant share of economic activity rationally occurs in highly specialized, bureaucratic firms, arbitrary market-centricity prevents microfounding meaningful wage rigidity (MWR), prevents the rational suppression of wage recontracting, prevents the rational existence of involuntary job loss, prevents evidence-sized same-direction causality from nominal-demand disturbances to employment and output, prevents chronic wage rents, and prevents the proper organization of stabilization policy-making around the management of total spending.

All of that prevention is bad, not good. And none of that prevention will be prevented by adding more financial-market detail to mainstream market-centric general-equilibrium modeling. To believe that greater regulation can prevent future financial crises and attendant dangerous instability goes well beyond academic naivety and does qualify as delusional. In contrast to Blanchard’s Panglossian dreams, the flaws of the NK model remain deadly.

The NK Argument

Blanchard’s what-me-worry story centers on the famous NK 3-equation model. “The model starts from the RBC model without capital, and, in its basic incarnation, adds only two imperfections. It introduces monopolistic competition in the goods market. The reason is clear: If the economy is going to have price setters, they better have some monopoly power. It then introduces discrete nominal price setting, using a formulation introduced by Calvo, and which turns out to be the most analytically convenient. Within this frame, the three equations take a specific form.

“First, the aggregate demand equation is derived from the first-order conditions of consumers, which give consumption as a function of the real interest rate and future expected consumption. As there is no other source of demand in the basic model, consumption demand is the same as aggregate demand. And given the assumption that, so long as the marginal cost is less than the price, price setters satisfy demand at existing prices, aggregate demand is equal to output. Putting these three assumptions together, the first relation gives us output as a function of the real interest rate and future expected output.

“Second, under the Calvo specification, the Phillips curve-like equation gives inflation as a function of expected future inflation, and of the ‘output gap’, defined as actual output minus what output would be absent nominal rigidities.

”Third, the monetary policy rule is formalized as a ‘Taylor rule’, a reaction function giving the real interest rate chosen by the central bank as a function of inflation and the output gap….

“The model is simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses (although not yet in undergraduate textbooks). Like the IS-LM model, it reduces a complex reality to a few simple equations. Unlike the IS-LM model, it is formally rather than informally derived from optimization by firms and consumers.”

Blanchard admits that “while tractable, the first two equations of the model are patently false (more obviously so than those in the more loosely specified IS-LM model). The aggregate demand equation ignores the existence of investment, and relies on an intertemporal substitution effect in response to the interest rate, which is hard to detect in the data on consumers. The inflation equation implies a purely forward looking behavior of inflation, which again appears strongly at odds with the data.” To those ills, as anticipated above, the GEM Project adds the nonexistence of involuntary job loss, the nonexistence of MWR and its capacity to suppress wage recontracting, the nonexistence of chronic wage rent, the nonexistence of pure profit, the hugely exaggerated role of interest rates in investment and consumption, the deemphasis on the centrality of nominal demand in the effective management of instability, and much more. But, thinking about it, aren’t Blanchard’s abbreviated toned-down criticisms by themselves enough to ratify that the state of macro is bad.

Final Word

The message should be hammered home. The state of macro theory, in 2008 and today, was and remains bad. Really bad. Despite the urge of mainstream theorists to be oblivious, “facts have a way of not going away”. The NK market-centric, general-equilibrium model, unchanged in any meaningful way since Blanchard praised it more than a decade ago, is badly out of line with crucial instability evidence and badly misleads its entire range of clients, from policymakers to students. Mainstream macroeconomists recognize the damage they continue to inflict.

But they probably won’t. Blanchard is the poster boy of mainstream oblivion. His insistence on having it both ways drives me nuts. He wants to appear sympathetic with the obvious criticisms of NK analysis while refusing to countenance doing anything effective about them. He wants to continue to use the failed model in classrooms, in gatekeeping duties, in advising policymakers. In particular, why is it so difficult to consider that the stabilization-relevance of NK macro theory may be harmed by its market-centricity? If that is indeed a core problem, searching for more robust market frictions in the hope that they will  enable model alignment with the crucial evidence is delusional. If market centricity is worthy of being considered in the identification of NK problems – surely a low bar – then  research on the rigorous modeling on rational exchange not restricted to the marketplace should be encouraged, not obstructed. There will be more n this next week.

Blog Type: New Keynesians San Miguel de Allende, Mexico


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