by Modern macroeconomics — totally messed up Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right. After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition. Economic advisers assured their bosses that recovery would be rapid. And there was some revival; but then it stalled in 2010. Meanwhile, governments were running large deficits – a legacy of the economic downturn – which renewed growth was
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Modern macroeconomics — totally messed up
Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right. After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition.
Economic advisers assured their bosses that recovery would be rapid. And there was some revival; but then it stalled in 2010. Meanwhile, governments were running large deficits – a legacy of the economic downturn – which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign-debt crises as bank bailouts turned private debt into public debt.
Attention switched to the problem of fiscal deficits and the relationship between deficits and economic growth. Should governments deliberately expand their deficits to offset the fall in household and investment demand? Or should they try to cut public spending in order to free up money for private spending?
Depending on which macroeconomic theory one held, both could be presented as pro-growth policies. The first might cause the economy to expand, because the government was increasing public spending; the second, because they were cutting it. Keynesian theory suggests the first; governments unanimously put their faith in the second.
The consequences of this choice are clear. It is now pretty much agreed that fiscal tightening has cost developed economies 5-10 percentage points of GDP growth since 2010. All of that output and income has been permanently lost. Moreover, because fiscal austerity stifled economic growth, it made the task of reducing budget deficits and national debt as a share of GDP much more difficult. Cutting public spending, it turned out, was not the same as cutting the deficit, because it cut the economy at the same time.
Indeed, there are many kinds of useless economics held in high regard within the mainstream economics establishment today. Few are less deserved than the post-real macroeconomic theory — mostly connected with Finn Kydland, Robert Lucas, Edward Prescott and Thomas Sargent — called Real Business Cycle theory (RBC).
In Chicago economics, one is cultivating the view that scientific theories have nothing to do with truth. Constructing theories and building models is not even considered an activity with the intent of approximating truth. For Chicago economists, it is only an endeavour to organize their thoughts in a ‘useful’ manner.
What a handy view of science!
What these defenders of scientific storytelling ‘forget’ is that potential explanatory power achieved in thought experimental models is not enough for attaining real explanations. Model explanations are at best conjectures, and whether they do or do not explain things in the real world is something we have to test. To just believe that you understand or explain things better with thought experiments is not enough.
Without a warranted export certificate to the real world, model explanations are pretty worthless. Proving things in models is not enough — not even after having put ‘New Keynesian’ sticky-price DSGE lipstick on the RBC pig.
Truth is an important concept in real science — and models based on meaningless calibrated ‘facts’ and ‘assumptions’ with unknown truth value are poor substitutes.