Paul Krugman Declares Victory

by
Robert Waldmann
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Paul Krugman put many of his thoughts together here “What Do We Actually Know About the Economy? (Wonkish)” Basically he concludes that some economists are confused but Paul Krugman knows a lot (no one has ever accused him of being diplomatic). Of course I agree with him.
However, I am very pleased to note that I finally find one or two points of disagreement.

I’d just click the link but to try to summarize

“Macroeconomics is better than you think, microeconomics worse, and data are limited”

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in an important sense the past decade has been a huge validation for textbook macroeconomics; meanwhile, the exaltation of micro as the only “real” economics both gives microeconomics too much credit and is largely responsible for the ways macroeconomic theory has gone wrong.

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Now, the thing about IS-LM-type analysis is that using it isn’t that big a deal in normal times, but it makes some very strong predictions – predictions very much at odds with many peoples’ priors — about abnormal times. Specifically, this kind of analysis says that when there is a really big adverse shock to demand – say, from the collapse of a major housing bubble – there’s a regime change, and neither monetary nor fiscal policy have the same effects they do in normal times.

On the monetary side, old-fashioned macro says that once interest rates have been driven down to the zero lower bound, monetary policy loses traction.

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What about fiscal policy? Traditional macro said that at the zero lower bound there would be no crowding out – that deficits wouldn’t drive up interest rates, and that fiscal multipliers would be larger than under normal conditions.

The overall story, then, is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn’t fail in the crisis – it worked extremely well. In fact, it’s hard to think of any other example of economic models working this well – making predictions that most non-economists (and some economists) refused to believe, indeed found implausible, but which came true. Where, for example, can you find any comparable successes in microeconomics?

Then by microeconomics he means mostly microeconomic theory (the micro on which the Chicago school decided Macro had to be founded) and by data without theory he means accidental theory — basically assuming any parameter you estimate is stabe so any estimate reveals the law of motion of the economy.

I have mild criticisms of each of the three parts of the essay.

First on macroeconmics we are short one equation. Krugman discusses IS-LM but 1960s macro was IS-LM-Phillips curve. In any case, to complete the model one needs a model of aggregate supply. Krugman doesn’t mention the death, rebirth and re-death of the Phillips curve. 1960s macro implies that wage inflation should be increasing. The change from 10 to 3.9% unemployment with a very modest change in the rate of nominal wage inflation is a mystery. The unreversed decline in the share of labor is a puzzle (not to mention a tough problem for workers). This is also a case in which Paul Krugman in particular made predictions which were contradicted by the data. He mocks those who forecast hyperinflation in 2010, but he forecast deflation. Instead wages and prices conditnued to increase albeit very slowly. Krugman recognizes that even he didn’t appreciate 1960s macroeconomists (for example James Tobin) who stressed downward nominal wage rigitidy. This shows that off the shelf 1960s macro wasn’t a total success (largely because some of it was left on the shelf).

The current puzzle is worse. It has lead some people to use the wages taboo site:angrybearblog.com . The failure is the exact opposite of that predicted by Friedman and Lucas who argued that the correctly understood Phillips curve (as a structural causal relationship) is not a downward sloping curve but a vertical line. The data seem to think it is pretty much a horizontal line. But changing parameters are a problem for macroeconomics no matter which direction they change.

On microeconomics, Krugman briefly praises empirical micro, but then goes on to criticize the theory.

I am contrarian enough to immediately try to think of a success of a surprising prediction based on micro theory which non-economists found implausible. The prediction was popularized by Krugman who argued that the California electricity crisis would be resolved if the Federal Government put a maximum price on electricity flowing across state lines. The argument was that the crisis was created by electicity companies (including Enron) and that, if they couldn’t charge huge prices to relieve shortages, they wouldn’t create shortages to relieve. The hypothesis was based on a close reading of California’s rules for electricity pricing and the guess that that really was time for some game theory. When they finally intervened, the shortages vanished. Then Enron went bankrupt and was investigated showing that the game theory was entirely exactly correct. I think this was good micro theory. They key point was that economics 101 (really 1st semester economics 101) was inadequate because one can’t assume the wholesale electricity market is perfectly competitive. It is dominated by a few firms hence the game theory. This shows how good micro is based on sweating the details. Someone not involved in the scam had to read the regulations to figure out how they were being manipulated.

But more generally Krugman’s review of micro does not correspond to the current balance of articles and citations, because most research is now empirical. Micro theory still exists, but it doesn’t interfere with empirical work in microeconmics.

This brings me to Krugman’s critique of the accidental theorist. He considers how one would go wrong assuming correlations are constant whether or not the economy is in a liquidity trap. This is, indeed, an example of how theory is useful. The theory is very very simple, the interest paid on cash is zero and can’t be negative (except for storage costs).

I really agree entirely with Krugman that one can’t analyse data without assumptions, without a specification or prior or something. But it is a bit odd to call all identifying assumptions “theory”. This is technically true but highly misleading. Non-economists don’t perceive arguments about keeping cash in a safe as theory (although they are theory in a way). Very generally, a lot of the new empirical economics consists of looking for natural experiments– often using the states which are the laboratories of democracy as uh laboratories.

The theory is also common sense. it is immediately comprehensible to ordinary people who also find it convincing. It is very very different from the sterile theory which lead macroeconomics astray. It is also very different from the industrial organization applied game theory which was useful when discussing elecriticy shortages in California, and, finally, not at all like the theoretical work for which Krugman was awarded a Nobel memorial prize.

Finally, new empirical micro is relevant to macroeconomics. The micro distribution of changes in wages with a huge spike at zero which appeared around 2009 is very strong evidence for downward nominal rigidity. Basing macro on the assumption that people’s behavior fits micro observations of peoples’ behavior is a way to micro found which is completely unlike the project started in the 70s. I don’t think it should be dismissed as un-necessary, like the failed effort or accidental theory.

I also don’t think Krugman dismisses it. But I do think his emphasis is other than ideal