Tuesday, March 3, 2009

The irrelevance of modern macroeconomic theory

Warning: This entry is of interest to economists only.

The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member of during the years 1997-2000 contained... quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity. ...

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible...

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked. ...

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave. So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved. This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances. ...

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc. will appreciate what is lost by this castration of the macroeconomic models. ...

Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right.
--Willem Buiter, Financial Times, on why most macroeconomic research has proven useless in the face of the current crisis

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