Mark Thoma says economics is changing
But it's hard to deny that the questions [economists] are asking have gone through a considerable evolution since the onset of the recession, and when questions change, new models and new tools are developed to answer them.
I'm sure many people do not share this view -- they think change isn't coming fast enough or isn't radical enough. Me? I'm fine with this degree of change; I just worry about its direction. Thoma's post is all about adding complexity and relaxing assumptions of rationality. Is this a good thing?
Before I continue, let me define some terms I'll use.
- Zero-order theory: This kind of theory at best tells you orders of magnitude. Mostly it provide answers questions like: Does inflation exist?, Is growth positive or negative? or What is money? The quantity theory of money is a zero order theory. These orders of magnitude and answers aren't necessarily empirically correct. You can have an empirically correct (i.e. right) zero-order theory (within scope) or a wrong zero-order theory. You also can't tell the difference between measurement error and real fluctuations at this order.
- First order theory: This theory tells you orders of magnitude and directions of effects. Again, this can be right or wrong (within scope). The IS-LM and AD-AS models are (in some respects) first order theories. At this point you can usually tell the difference between what is a real fluctuation and what is a measurement error (at least given the first order theory).
- Higher order theory: This basically means you've gotten things right -- you have an empirically accurate first order theory -- and now you are trying to expand scope.
My mental picture is a "Taylor expansion" of a theory T with a scale x₀ (that sets scope) -- the scope of the zero order theory is e.g. δx << x₀ while the scope of the first order theory is e.g. δx² << x₀². A higher order theory can handle most values of δx. It looks something like this:
Each term added is a new effective theory with increased scope. Also note that a framework in a sense tells you how to go from zero order theory to first order to higher order (e.g. the scales and and how the theories relate to one another). It's not absolutely necessary, but is extremely useful because it organizes all of the empirical successes of zero order (and higher) theories.
And finally, a theory that gets better (by some metric) as you proceed from zero order to higher order is a progressive research program. One that doesn't get better (n.b. it doesn't actually have to get worse) is a degenerative research program.
There was a dominant macro paradigm that wasn't all that empirically accurate and seemed to predict that something like the global recession would not occur and that inequality was just about differences in effort. Economics as a profession seems to believe this paradigm was a first order theory. That is what I gather from Mark Thoma's post.
The financial crisis of 2008 was a striking failure of that paradigm. Note that we don't need to know if a financial crisis causes or is the effect of macro fluctuations to assert this. Thoma tells us what that pre-2008 paradigm said:
Our modern financial system couldn't crash like those antiquated systems that were around during and before the Great Depression. There was no need to include it in our macro models, at least not in any detail, or even ask questions about what might happen if there was a financial crisis. ... In the past, the Taylor rule was praised as responsible for the Great Moderation. We had discovered the key to a stable economy.
So 2008 was not the kind of event that happens in that paradigm and now monetary policy is under scrutiny. But, Thoma says, economics is changing -- by adding complexity: new monetary policy goals, adding financial sectors and asymmetric bargaining power.
But if you first order theory fails in its first order tasks (within scope), you don't go constructing a second order theory from it. You really only have three choices: 1) reduce the scope of the existing theory, 2) try other first order theories or 3) go back to zero order. We can consider the first two options represented by Dani Rodrik (using models only for their original purpose) and Paul Krugman (a "return to depression economics" like the ISLM model), respectively.
But the existing theory was never very empirically accurate so reducing its scope makes it all the more useless. And the general lack of scope conditions in economic models means we can't really choose which other first order theories apply ex ante, only ex post. Macroeconomists become "economic doctors" in Simon Wren-Lewis's vision.
That is the existential crisis macroeconomics is finding itself in. The only choice left is the one that is hardest for an established field to take: go back to the drawing board and come up with some new zero order theories .
 That's where the information equilibrium framework comes in. It represents a new framework for constructing zero order theories (and expanding them to first order).