Tag Archive for 'Krugman'

On interest rates

Published on 23 November 2009 in Economics, Finance and USA. Tags: , , , , , . 0 Comments

In what Tyler Cowen calls “Critically important stuff and two of the best recent economics blog posts, in some time,” Paul Krugman and Brad DeLong have got some interesting thoughts on US interest rates.  First Krugman:

On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period … but well below the pre-crisis levels:

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Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem?

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.

Bear in mind that the whole problem right now is that the private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt. (Treasury bill rates briefly went negative yesterday). Meanwhile, the public sector is sustaining demand with deficit spending, financed by long-term debt. So someone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing.

Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates — I don’t see any reason for the Fed funds rate to rise for at least a year, and probably two — which should mean substantially lower long rates even if you expect yields eventually to rise back to 2005 levels. And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized.

And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue. What the worriers seem to regard as a danger sign — that supposedly awful carry trade — is exactly what you would expect to see even if fiscal policy were on a perfectly sustainable trajectory.

Then DeLong:

I am not sure Paul is correct when he says that the possible underlying problem is merely “a technical matter of maturity mismatch.” The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this “carry trade”–if it really exists–could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while–that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock…

For reference, here are the time paths of interest rates for a variety of term lengths and risk profiles (all taken from FRED):

interest_rates_1monthinterest_rates_3monthsinterest_rates_30years

To my own mind, I’m somewhat inclined to agree with Krugman.  While I do believe that the carry trade is occurring, I suspect that it’s effects are mostly elsewhere, or at least that the carry trade is not being played particularly heavily in long-dated US government debt relative to other asset markets.

Notice that the AAA and BAA 30-year corporate rates are basically back to pre-crisis levels and that the premium they pay over 30-year government debt is also back to typical levels.  If the long-dated rates are being pushed down to pre-crisis levels solely by increased supply thanks to the carry trade, then we would surely expect the quantity of credit to also be at pre-crisis levels.  But new credit issuance is down relative to the pre-crisis period.  Since the price is largely unchanged, that means that both demand and supply of credit have shrunk – the supply from fear in the financial market pushing money to the short end of the curve and the demand from the fact that there’s been a recession.

Just a smidgen more on US healthcare reform

Published on 13 October 2009 in Health Care, Politics and USA. Tags: , , , , , , . 0 Comments

My previous comment on US healthcare reform, which was actually a comment on the current Australian system, got quite a few eyeballs thanks to John Hempton’s shout-out.  Anyway, I thought I’d highlight a couple of new developments for my little audience.

First, Republican Senator Olympia Snowe (of Maine), who sits on the Senate Finance Committee, has said that she will vote in favour of the suggested bill being proposed by that committee’s chairman, Max Baucus.  That is good for the Democrats as it will provide valuable political cover.  It’s no guarantee that she will vote in favour of whatever the Senate as a whole end up producing, or for whatever the Senate and House then negotiate as the final bill, but it’s still a significant move and the probability of her voting for those later versions has just increased.

Second, we have the fact that the healthcare insurance industry has recently done an about-face, from actively promoting reform to actively fighting against it.  Nate Silver points out why:

Take a look at what’s happened to the share prices of the six largest publicly-traded health insurance companies since Labor Day, which was about the point at which the Democrats appeared to regain their footing — at least up to a point — on health care.

Weighted for market capitalization, these insurance stocks have lost 11 percent of their value since Labor Day, wiping out about $10 billion in value. And that’s understating the case since the major indices have gained 5-8 percent over the same period — the insurance industry stocks are underperforming the market by just shy of 20 percent.

So why have they tanked in the stock market?  Nate suggests two reasons:

Firstly, the individual mandate has been weakened to the point where it’s arguably a tokenish provision. There are good, policy reasons to be worried about this, although the insurance lobby’s reasons for being opposed — they’ll have less guarantee of an incoming phalanx of high-margin customers — are not necessarily the same as the public’s at large. The second factor is that the Baucus bill in certain ways treats the insurers fairly harshly, both taxing them directly as well as levying a surcharge on high-cost insurance plans.

I’d also suggest that the compromise version of the public option (that it be in the bill, but with states able to opt out if they wish [Paul Krugman, Talking Points Memo]) will have scared the insurance companies and investors as well.

In which I respectfully disagree with Paul Krugman

Published on 25 August 2009 in Academia, Economics, Labour and USA. Tags: , , , , , , , . 0 Comments

Paul Krugman [Ideas, Princeton, Unofficial archive] has recently started using the phrase “jobless recovery” to describe what appears to be the start of the economic recovery in the United States [10 Feb, 21 Aug, 22 Aug, 24 Aug].  The phrase is not new.  It was first used to describe the recovery following the 1990/1991 recession and then used extensively in describing the recovery from the 2001 recession.  In it’s simplest form, it is a description of an economic recovery that is not accompanied by strong jobs growth.  Following the 2001 recession, in particular, people kept losing jobs long after the economy as a whole had reached bottom and even when employment did bottom out, it was very slow to come back up again.  Professor Krugman (correctly) points out that this is a feature of both post-1990 recessions, while prior to that recessions and their subsequent recoveries were much more “V-shaped”.  He worries that it will also describe the recovery from the current recession.

While Professor Krugman’s characterisations of recent recessions are broadly correct, I am still inclined to disagree with him in predicting what will occur in the current recovery.  This is despite Brad DeLong’s excellent advice:

  1. Remember that Paul Krugman is right.
  2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

This will be quite a long post, so settle in.  It’s quite graph-heavy, though, so it shouldn’t be too hard to read. :-)

Professor Krugman used his 24 August post on his blog to illustrate his point.  I’m going to quote most of it in full, if for no other reason than because his diagrams are awesome:

First, here’s the standard business cycle picture:

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Real GDP wobbles up and down, but has an overall upward trend. “Potential output” is what the economy would produce at “full employment”, which is the maximum level consistent with stable inflation. Potential output trends steadily up. The “output gap” — the difference between actual GDP and potential — is what mainly determines the unemployment rate.

Basically, a recession is a period of falling GDP, an expansion a period of rising GDP (yes, there’s some flex in the rules, but that’s more or less what it amounts to.) But what does that say about jobs?

Traditionally, recessions were V-shaped, like this:

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So the end of the recession was also the point at which the output gap started falling rapidly, and therefore the point at which the unemployment rate began declining. Here’s the 1981-2 recession and aftermath:

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Since 1990, however, growth coming out of a slump has tended to be slow at first, insufficient to prevent a widening output gap and rising unemployment. Here’s a schematic picture:

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And here’s the aftermath of the 2001 recession:

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Notice that this is NOT just saying that unemployment is a lagging indicator. In 2001-2003 the job market continued to get worse for a year and a half after GDP turned up. The bad times could easily last longer this time.

Before I begin, I have a minor quibble about Prof. Krugman’s definition of “potential output.”  I think of potential output as what would occur with full employment and no structural frictions, while I would call full employment with structural frictions the “natural level of output.”  To me, potential output is a theoretical concept that will never be realised while natural output is the central bank’s target for actual GDP.  See this excellent post by Menzie Chinn.  This doesn’t really matter for my purposes, though.

In everything that follows, I use total hours worked per capita as my variable since that most closely represents the employment situation witnessed by the average household.  I only have data for the last seven US recessions (going back to 1964).  You can get the spreadsheet with all of my data here: US_Employment [Excel].  For all images below, you can click on them to get a bigger version.

The first real point I want to make is that it is entirely normal for employment to start falling before the official start and to continue falling after the official end of recessions.  Although Prof. Krugman is correct to point out that it continued for longer following the 1990/91 and 2001 recessions, in five of the last six recessions (not counting the current one) employment continued to fall after the NBER-determined trough.  As you can see in the following, it is also the case that six times out of seven, employment started falling before the NBER-determined peak, too.

Hours per capita fell before and after recessions

Prof. Krugman is also correct to point out that the recovery in employment following the 1990/91 and 2001 recessions was quite slow, but it is important to appreciate that this followed a remarkably slow decline during the downturn.  The following graph centres each recession around it’s actual trough in hours worked per capita and shows changes relative to those troughs:

Hours per capita relative to and centred around trough

The recoveries following the 1990/91 and 2001 recessions were indeed the slowest of the last six, but they were also the slowest coming down in the first place.  Notice that in comparison, the current downturn has been particularly rapid.

We can go further:  the speed with which hours per capita fell during the downturn is an excellent predictor of how rapidly they rise during the recovery.  Here is a scatter plot that takes points in time chosen symmetrically about each trough (e.g. 3 months before and 3 months after) to compare how far hours per capita fell over that time coming down and how far it had climbed on the way back up:

ComparingRecessions_20090605_Symmetry_Scatter_All

Notice that for five of the last six recoveries, there is quite a tight line describing the speed of recovery as a direct linear function of the speed of the initial decline.  The recovery following the 1981/82 recession was unusually rapid relative to the speed of it’s initial decline.  Remember (go back up and look) that Prof. Krugman used the 1981/82 recession and subsequent recovery to illustrate the classic “V-shaped” recession.  It turns out to have been an unfortunate choice since that recovery was abnormally rapid even for pre-1990 downturns.

Excluding the 1981/82 recession on the basis that it’s recovery seems to have been driven by a separate process, we get quite a good fit for a simple linear regression:

ComparingRecessions_20090605_Symmetry_Scatter_Excl_81-82

Now, I’m the first to admit that this is a very rough-and-ready analysis.  In particular, I’ve not allowed for any autoregressive component to employment growth during the recovery.  Nevertheless, it is quite strongly suggestive.

Given the speed of the decline that we have seen in the current recession, this points us towards quite a rapid recovery in hours worked per capita (although note that the above suggests that all recoveries are slower than the preceding declines – if they were equal, the fitted line would be at 45% (the coefficient would be one)).

How to value toxic assets (part 2)

Published on 20 January 2009 in Economics, Finance and USA. Tags: , , , , , . 0 Comments

Continuing on from my previous post on this topic, Paul Krugman has been voicing similar concerns (and far more eloquently).  Although his focus has been on the idea of a bad bank (to which all the regular banks would sell their CDOs and other now-questionable assets), the problems are the same.  On the 17th of January he wrote:

It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.

I suspect, though I’m not certain, that policymakers are once more coming around to the view that mortgage-backed securities are being systematically underpriced. But do we really know this? And how are we going to ensure that this doesn’t end up being a huge giveaway to financial firms?

On the 18th of January, he followed this up with:

What people are thinking about, it’s pretty clear, is the Resolution Trust Corporation, which cleaned up the savings and loan mess. That’s a good role model, as far as it goes. But the creation of the RTC did not rescue the S&Ls. The S&Ls were rescued by (1) having FSLIC seize them, cleaning out the stockholders (2) having FSLIC pay down enough debt to make them viable (3) reselling them to new investors. The RTC’s takeover of the bad assets was just a way for taxpayers to reclaim some of the cost of recapitalizing the banks.

What’s being contemplated now, if Sheila Bair’s interview is any indication, is the creation of an RTC-like entity without the rest of the process. The “bad bank” will pay “fair value”, whatever that is, for the assets. But how does that help the situation?

It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it — and that if only we get the price “right”, the banks will turn out to be solvent after all. In other words, we’re still in Super-SIV territory, the belief that fancy financial engineering can create value out of nothing.

Tyler Cowen points us to this article in the Washington Post that describes the issues pretty well.  Again, the crux of the matter is:

The difficulty is that banks think their assets are worth more than investors are willing to pay. If the government sides with investors, the banks will be forced to swallow the difference as a loss. If the government pays what the banks regard as a fair price, however, the markets may ignore the transactions as a bailout by another name.

Tyler Cowen’s own comment:

If the assets are undervalued by the market, buying them up is an OK deal. Presumably the price would be determined by a reverse auction, with hard-to-track asset heterogeneity introducing some arbitrariness into the resulting prices. If these assets are not undervalued by the market, and indeed they really are worth so little, our government wishes to find a not-fully-transparent way to give financial firms greater value, also known as “huge giveaway.”

Right now it seems to boil down to the original TARP idea or nationalization, take your pick. You are more likely to favor nationalization if you think that governments can run things well, if you feel there is justice in government having “upside” on the deal, and if you are keen to spend the TARP money on other programs instead.

Americans: Be afraid.

Published on 12 December 2008 in Economics and USA. Tags: , , . 0 Comments

With forecasts for annualised U.S. real GDP growth in 2008:Q4 as low as -6% (!) and seriously smart people worrying about next year, both from the left and the right, you really do have to wonder how ugly it’s going to get.  Looking at the world as a whole is a recipe for staying under the covers tomorrow morning, too.

Bush does the right thing

Published on 18 November 2008 in Economics, Finance and USA. Tags: , , , , , . 0 Comments

The US$700 billion Troubled Asset Relief Program, otherwise known as the mother of all pork, did have one redeeming feature:  It came in tranches.  The first US$350 billion were directly accessible (some of it needed a signature from the president), but the last US$350 billion needs congressional approval.  With just 10 weeks to go in his Presidency and every company big enough to hire a lobbiest bashing on the doors for a piece of the action, George W. Bush has done the right thing:  He’s deciced to not ask for the last 350.  If soon-to-be-President Obama wants to tap it, it’s up to him.

The Bush administration told congressional aides it won’t ask lawmakers to release $350 billion remaining as part of the $700 billion U.S. financial- rescue package, people familiar with the matter said.
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The Treasury Department has committed $290 billion, or about 83 percent of the total allocated so far in a program Congress enacted last month to inject capital into a wide spectrum of banks and American International Group Inc. The U.S. invested $125 billion in nine major banks, including Citigroup Inc. and Wells Fargo & Co. and plans to buy an additional $125 billion in preferred shares of smaller lenders.
…
Paulson told the Wall Street Journal today he is unlikely to use what remains of the package, estimated at $410 billion, unless a need arises.

“I’m not going to be looking to start up new things unless they’re necessary, unless they make great sense,” Paulson said. “I want to preserve the firepower, the flexibility we have now and those that come after us will have.”

Update: I don’t mean to suggest that the money shouldn’t be spent. Maybe it should. Professor Krugman, for one, might argue that it ought to be spent as part of a stimulus package. I just think that it’s correct for Bush to pass on deciding how to spend it. His moral authority as an economic leader was gone some time ago. Paulson’s flip-flopping, even if what he has moved to is the better plan, demonstrates the same for him. America will – I suspect – benefit from being forced to take a breather in their cries for help. Let the new team think about the whole mess carefully and then take up the responsibility handed to them.

Another update: The anonymous authors at Free Exchange aren’t so sure it’s a good idea:

It is, in effect, calling time-out on the rescue until Barack Obama is sworn in, and even then there will be a delay while funds are requested and authorised. Meanwhile, Congress has all but decided not to pursue a stimulus bill during the lame duck session. The legislature is taking up discussions on an automaker bail-out, but given resistance to a rescue among Republicans and conservative Democrats, it seems clear that any bill signed into law during the lame duck will be quite weak.

Now, Ben Bernanke will remain on duty right through the inauguration. There’s still an executive branch, and there are still plenty of international policy makers working to stabilise the global financial system. But in a very real sense, America is going to coast on its current economic policies for the next two (and in practice, three) months. I’m not sure this is a good idea, particularly given the critical nature of the holiday shopping season. By all accounts, consumers are locking up their piggy banks at the moment. A disastrous shopping season will probably mean a wave of post-holiday failures among retailers, which will, in turn, mean lay-offs (as well as pain for exporters to America).

Yes, it’s only three months, but three months is a long time for people and businesses struggling to pay bills. And if the economic situation deteriorates over that span, then the government may well feel pressured to pass a much larger and more expensive stimulus package in the spring.

I’m not convinced.  I do note that, as Paul Krugman points out, it’s difficult to have too large a fiscal stimulus in this environment.  I also think that we might benefit from backing off a little bit and abandoning the idea that America and the world at large can somehow escape the recession.  It needs to sink in.

More on the shift from Republican to Democrat

Published on 6 November 2008 in Politics and USA. Tags: , , , , , , . 3 Comments

Brad Delong observes that there is a clear regional exception to the idea of a broad shift in the vote from the Republicans to the Democrats (the original scatterplot comes from Andrew Gelman):

Paul Krugman takes it a bit further, emphasising this beauty of a map (I’m not sure of the source.  Probably the NY Times?):

The shifts to the Republicans in Arizona and Alaska and to the Democrats in Illinois and Delaware are clearly down to the candidates coming from those states.  I’m a little surprised at the strength of the Republican shift in southern Louisiana.  One might have thought that with the memory of Hurricane Katrina they would have moved blue.  Perhaps the administration’s management of Hurricane Gustav was seen as successful?  The Oklahoma-Arkansas-Tennessee shift is presumably McCain’s “real America.”  I’d love to see a demographic breakdown of the vote in those states.

Almost immediate update:

dbt on Brad Delong’s blog points out the obvious about Louisiana:

Don’t lump Louisiana into that. The changes there are demographic, not electoral.

Which of course must be the explanation. Southern Louisiana didn’t turn red because of the success of the handling of Gustav; it turned red because of the failure to handle Katrina – vast numbers of black Americans were forced out and haven’t come back.

Endogenous Growth Theory

Published on 22 October 2008 in Academia and Economics. Tags: , , , , , , , , , , . 0 Comments

Following on from yesterday, I thought I’d give a one-paragraph summary of how economics tends to think about long-term, or steady-state, growth.  I say long-term because the Solow growth model does a remarkable job of explaining medium-term growth through the accumulation of factor inputs like capital.  Just ask Alwyn Young.

In the long run, economic growth is about innovation.  Think of ideas as intermediate goods. All intermediate goods get combined to produce the final good. Innovation can be the invention of a new intermediate good or the improvement in the quality of an existing one. Profits to the innovator come from a monopoly in producing their intermediate good. The monopoly might be permanent, for a fixed and known period or for a stochastic period of time. Intellectual property laws are assumed to be costless and perfect in their enforcement. The cost of innovation is a function of the number of existing intermediate goods (i.e. the number of existing ideas). Dynamic equilibrium comes when the expected present discounted value of holding the monopoly equals the cost of innovation: if the E[PDV] is higher than the cost of innovation, money flows into innovation and visa versa. Continual steady-state growth ensues.

It’s by no means a perfect story.  Here are four of my currently favourite short-comings:

  • The models have no real clue on how to represent the cost of innovation. It’s commonly believed that the cost of innovation must increase, even in real terms, the more we innovate – a sort of “fishing out” effect – but we lack anything more finessed than that.
  • I’m not aware of anything that tries to model the emergence of ground-breaking discoveries that change the way that the economy works (flight, computers) rather than simply new types of product (iPhone) or improved versions of existing products (iPhone 3G).  In essence, it seems important to me that a model of growth include the concept of infrastructure.
  • I’m also not aware of anything that looks seriously at network effects in either the innovation process (Berkley + Stanford + Silicon Valley = innovation) or in the adoption of new stuff.   The idea of increasing returns to scale and economic geography has been explored extensively by the latest recipient of the Nobel prize for economics (the key paper is here), but I’m not sure that it has been incorporated into formal models of growth.
  • Finally, I again don’t know of anything that looks at how the institutional framework affects the innovation process itself (except by determining the length of the monopoly).  For example, I am unaware of any work emphasising the trade-off between promoting innovation through intellectual property rights and hampering innovation through the tragedy of the anticommons.

Paul Krugman wins the Nobel (updated)

Published on 13 October 2008 in Academia, Economics and Trade. Tags: , , , , , , . 0 Comments

There is no doubt in my mind that Professor Krugman deserves this, but who doesn’t think that this is just a little bit of an “I told you so” from Sweden to the USA?

Update: Alex Tabarrok gives a simple summary of New Trade Theory.  Do read Tyler Cowen for a summary of Paul Krugman’s work, his more esoteric writing and some analysis of the award itself.

I have to say I did not expect him to win until Bush left office, as I thought the Swedes wanted the resulting discussion to focus on Paul’s academic work rather than on issues of politics. So I am surprised by the timing but not by the choice.
…
This was definitely a “real world” pick and a nod in the direction of economists who are engaged in policy analysis and writing for the broader public. Krugman is a solo winner and solo winners are becoming increasingly rare. That is the real statement here, namely that Krugman deserves his own prize, all to himself. This could easily have been a joint prize, given to other trade figures as well, but in handing it out solo I believe the committee is a) stressing Krugman’s work in economic geography, and b) stressing the importance of relevance for economics

Formalism and synthesis of methodology

Published on 4 September 2008 in Academia and Economics. Tags: , , , , , , , , , . 0 Comments

Robert Gibbons [MIT] wrote, in a 2004 essay:

When I first read Coase’s (1984: 230) description of the collected works of the old-school institutionalists – as “a mass of descriptive material waiting for a theory, or a fire” – I thought it was (a) hysterically funny and (b) surely dead-on (even though I had not read this work). Sometime later, I encountered Krugman’s (1995: 27) assertion that “Like it or not, … the influence of ideas that have not been embalmed in models soon decays.” I think my reaction to Krugman was almost as enthusiastic as my reaction to Coase, although I hope the word “embalmed” gave me at least some pause. But then I made it to Krugman’s contention that a prominent model in economic geography “was the one piece of a heterodox framework that could easily be handled with orthodox methods, and so it attracted research out of all proportion to its considerable merits” (p. 54). At this point, I stopped reading and started trying to think.

This is really important, fundamental stuff.  I’ve been interested in it for a while (e.g. my previous thoughts on “mainstream” economics and the use of mathematics in economics).  Beyond the movement of economics as a discipline towards formal (i.e. mathematical) models as a methodology, there is even a movement to certain types or styles of model.  See, for example, the summary – and the warnings given – by Olivier Blanchard [MIT] regarding methodology in his recent paper “The State of Macro“:

That there has been convergence in vision may be controversial. That there has been convergence in methodology is not: Macroeconomic articles, whether they be about theory or facts, look very similar to each other in structure, and very different from the way they did thirty years ago.
…
[M]uch of the work in macro in the 1960s and 1970s consisted of ignoring uncertainty, reducing problems to 2×2 differential systems, and then drawing an elegant phase diagram. There was no appealing alternative – as anybody who has spent time using Cramer’s rule on 3×3 systems knows too well. Macro was largely an art, and only a few artists did it well. Today, that technological constraint is simply gone. With the development of stochastic dynamic programming methods, and the advent of software such as Dynare – a set of programs which allows one to solve and estimate non-linear models under rational expectations – one can specify large dynamic models and solve them nearly at the touch of a button.
…
Today, macro-econometrics is mainly concerned with system estimation … Systems, characterized by a set of structural parameters, are typically estimated as a whole … Because of the difficulty of finding good instruments when estimating macro relations, equation-by-equation estimation has taken a back seat – probably too much of a back seat
…
DSGE models have become ubiquitous. Dozens of teams of researchers are involved in their construction. Nearly every central bank has one, or wants to have one. They are used to evaluate policy rules, to do conditional forecasting, or even sometimes to do actual forecasting. There is little question that they represent an impressive achievement. But they also have obvious flaws. This may be a case in which technology has run ahead of our ability to use it, or at least to use it best:

  • The mapping of structural parameters to the coefficients of the reduced form of the model is highly non linear. Near non-identification is frequent, with different sets of parameters yielding nearly the same value for the likelihood function – which is why pure maximum likelihood is nearly never used … The use of additional information, as embodied in Bayesian priors, is clearly conceptually the right approach. But, in practice, the approach has become rather formulaic and hypocritical.
  • Current theory can only deliver so much. One of the principles underlying DSGEs is that, in contrast to the previous generation of models, all dynamics must be derived from first principles. The main motivation is that only under these conditions, can welfare analysis be performed. A general characteristic of the data, however, is that the adjustment of quantities to shocks appears slower than implied by our standard benchmark models. Reconciling the theory with the data has led to a lot of unconvincing reverse engineering
    …
    This way of proceeding is clearly wrong-headed: First, such additional assumptions should be introduced in a model only if they have independent empirical support … Second, it is clear that heterogeneity and aggregation can lead to aggregate dynamics which have little apparent relation to individual dynamics.

There are, of course and as always, more heterodox criticisms of the current synthesis of macroeconomic methodology. See, for example, the book “Post Walrasian Macroeconomics: Beyond the Dynamic Stochastic General Equilibrium Model” edited by David Colander.

I’m not sure where all of that leaves us, but it makes you think …

(Hat tip:  Tyler Cowen)