Saturday, November 5, 2016

A list of unsupported narratives in macroeconomics

I was watching Money for Nothing last night (exciting Friday night, I know) and since I had just compiled a list of valid and not so valid arguments against economics I thought of adding a valid one about creating false narratives that will link to this post. Humans love to create narratives; it's one of our skills. Macroeconomics loves a good story, and Money for Nothing is a good example (most of the narratives below appear in it). 

The (potentially growing) list below will consist of a set of narratives that are not conclusively supported by data. The general takeaway is that macroeconomic theory is not yet good enough empirically to support any particular story.

"Stagflation proved Keynesian economics was wrong"
The story goes that inflation and high unemployment (H/T John) in the 1970s was not supposed to happen in Keynesian economics, and therefore it was abandoned for some other theory (monetarist, natural rate, microfounded) that gets it right.

This is one of those cases where the victors seemed to re-write the history. There was apparently no reason "stagflation" couldn't happen -- in technical terms  that the Phillips curve was structural in Keynesian economics -- as discussed here and here (and scholarship by James Forder at the links).

"The Great Inflation and the Volcker Disinflation"
The stagflation story is part of this story. Basically, Lyndon Johnson's Great Society and the Vietnam War lead to too much government spending/aggregate demand. Coupled with Johnson bullying of Fed chair Martin to keep interest rates low, the country ended up with inflation. Carter's nomination of Volcker to the Fed, and the subsequent rise in interest rates put an end to high inflation.

However, the Martin story doesn't really make sense given the data. There were two major real shocks that plausibly contributed to inflation (the oil crises of 1973 and 1979). And we can't rule out that the inflation of the 60s and 70s wasn't actually demographic (see Steve Randy Waldman).

I've written more about this here (contra Paul Romer) and here (contra Matthew Yglesias).

"The Fed caused the Great Depression/Great Recession with monetary policy"
It's not so much of saying this story is wrong as saying it's not clear how the Fed did this. There are many stories involving monetary policy in different ways. Rising interest rates do appear to precede recessions, but generally the stories behind monetary policy involve you to believe in the detailed operation of theories where there isn't much evidence of them working for normal forecasting (because not much does) or on other data besides the Great Depression/Recession.  Another way to put this is that these theories tend to be "just so" stories.

"The Fed saved us from recessions with monetary policy"
This is usually in reference to the market crashes of 1987 (which resulted in no recession) and the early 2000s (which resulted in a mild one). Again, like the causes of Great Depression, these stories require you to believe the detailed operation of theories that don't match empirical data well (because few macro theories do).


9 comments:

  1. "Coupled with Johnson bullying of Fed chair Martin to keep interest rates low, the country ended up with inflation."

    Not to forget to mention the Nixon/Burns contribution in the late 60s and early 70s - the neoliberals tend to neglect that one all too easily.

    Johnson put the car in gear and Nixon/Burns flattened the accelerator (except that Burns tried to put the hand brake on with a prices and incomes policy).

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    1. I was only specifically calling out the Johnson/Martin story because it's one of those parables people like to tell where dudes physically shoving each other around somehow have an impact on the world ...

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  2. "The story goes that inflation and high employment in the 1970s..."

    I think you're missing an "un" before employment...

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    1. Ha!

      The scourge of high employment will not hurt us anymore!

      I'll fix it :)

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  3. "There were two major real shocks that plausibly contributed to inflation (the oil crises of 1973 and 1979)."

    "As already mentioned, the most important inflationary episode in post-WWII history was that during the 1970s and early 1980s. From 1968 through 1972, consumer price inflation averaged 4.6%. Over the next ten years it was 7.5%. What happened? What caused this sudden and dramatic acceleration in prices? Did the Fed accidentally print too much money? As already explained, that can’t happen–you simply can’t raise the money supply above the demand. M did rise, however, and largely proportionally to the increase in P. This is a much more realistic story of those events.

    As the price of oil skyrocketed, so costs of production rose for many, many US businesses. Because there is a lag between purchasing inputs and selling output, most firms have to borrow money (working capital) to bridge the gap. As the ripple effect of the OPEC price increases moved throughout the economy, the demand for cash by these businesses rose. Quite reasonably, private banks and the Fed did what they could to accommodate. These were fair requests on the part of US entrepreneurs. Loans were extended and government debt sold by the private sector to the central bank. This raised the supply of money. Therefore, the rising prices led to an increase in the supply of money and not the other way around."

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    1. http://www.forbes.com/sites/johntharvey/2011/05/14/money-growth-does-not-cause-inflation/4/#6e38191ef9f8

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  4. Regarding cause and effect, I just saw this short video (~3.5 min) from Sean Carroll last night:
    https://www.youtube.com/watch?v=3AMCcYnAsdQ
    Enjoy!

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  5. "The general takeaway is that macroeconomic theory is not yet good enough empirically to support any particular story."

    Well worth repeating. :)

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    1. "The general takeaway is that macroeconomic theory is not yet good enough empirically to support any particular story."

      This economist thinks his evidence supports a particular 'story'?

      Inductive methodology {as 'used' by the natural sciences and most scientific disciplines} is the basis of this economist's approach.

      "The critics of neoclassical economics agree that economics should be about economic reality and should be demonstrably relevant to it. This will strike the non-economist as obvious. However, it is not obvious in mainstream economic thinking: the neoclassical school of thought is based on the deductive approach. This methodology argues that knowledge is brought about by starting with axioms that are not derived from empirical evidence, to which theoretical assumptions are added (again not empirically backed), and on the basis of which tools of logic (mathematics) are utilized to prove theoretical results. There is an alternative approach. This approach examines reality, identifies important facts and patterns, and then attempts to explain them, using logic, in the form of theories. These theories are then tested and modified as needed, in order to be most consistent with the facts of reality. This methodology is called inductivism."

      http://www.palgraveconnect.com/pc/doifinder/view/10.1057/9780230506077

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