Paul Krugman gives us a fabulous review of macroeconomics and current ideological debate within the field.
He also nails the cruxes of where current macroeconomics, of both Keynesian and neoclassical stripes, falls short. One problem is that current theories lack a fundamental cause for crises and ensuing recessions. Another is that current theories ignore the central role of financial market failures. The answer, he suggests, is fundamentally psychological or behavioral. To get our models right we'll need to make them less elegant. He presents a clear and compelling case.
My main criticism with Krugman's review, and more generally with his writings on business cycles, is that he doesn't acknowledge or emphasize that asset prices (stocks, houses, etc) appear most rational--in the textbook economic sense--just before the "bubble" is about to pop. During normal or more depressed times, asset prices appear too low as compared to textbook theory.
Too many overlook this essential puzzle. It seems irrational pessimism rather than irrational exuberance is the greater psychological challenge. Irrational pessimism also seems better suited the baby-sitting-coop story and Keynesian models in general.
Update: John Cochrane responds to Paul Krugman. I think maybe he should have sat on it a few days before posting.
Also, as I state in the comments, I understand that within the Keynesian (and Friedman) models recessions are caused by liquidity preference--an unexplained shift in the demand for money. But what causes liquidity preference? In a word, fear. And given history and the generally limited duration of recessions, seemingly irrational pessimism about the long-run return of less liquid assets. The asset pricing literature calls it the equity premium puzzle (i.e., too much risk aversion).
Why not call it irrational pessimism? Anyway, since the equity premium is generally too high rather than too low it seems to me that irrational pessimism as opposed to irrational exuberance is the more pervasive behavioral problem. No?
Another Update: Nick Rowe and Brad Delong explain why Cochrane probably should have sat and thought about his response to Krugman for a few days before posting.
Yet Another Update: Paul Krugman gets a little pithy (he's probably right, but this probably doesn't help freshwater folks to become less insulated) and Brad Delong further disembowels Cochrane's specific arguments.
Yet Another: Mark Thoma provides a whole list...
Would you believe Cochrane got his PhD at Berkeley and (I think) took his first graduate macro course from George Akerlof? I can attest that at Berkeley graduate students get healthy exposure to both freshwater and saltwater macro. Is that so in Chicago and Minnesota? I don't know.
Both sides are a little heavy on snark. But the facts do sit much more heavily on the saltwater side of things. Cochrane's refusal to acknowledge and wrestle honestly with these facts hurts his position badly (i.m.h.o. as a non-macro guy). At least Nick Rowe is aiming at a more scholarly debate.
Maybe in the long run the snark will help attract more attention and thought to an important debate. As Krugman spells out in his article, even the Keynesian (saltwater) side of things has a lot holes that need filling. And it's clear there needs to be more integration of finance and macro.
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Liquidity preference, as opposed to irrational pessimism, is a Keynesian tenet.
ReplyDeleteAnonymous: I understand liquidity preference--an outward shift in the demand for money--is the "cause" of recessions in the Keynesian model. But what causes that shift? It would seem incipient fear is the fundamental cause. Where does that come from?
ReplyDeleteThe link to asset pricing is the equity premium puzzle. Prices only look about right--with an appropriately sized premium--near the height of a bubble. Then "liquidity preference" drives asset prices back down to seemingly irrational valuations, and we have a recession.
"My main criticism with Krugman's review, and more generally with his writings on business cycles, is that he doesn't acknowledge or emphasize that asset prices (stocks, houses, etc) appear most rational--in the textbook economic sense--just before the "bubble" is about to pop. During normal or more depressed times, asset prices appear too low as compared to textbook theory."
ReplyDeleteI'm not an economist but it seems that bubbles are pretty easy to identify as they build, although it is admittedly difficult to call the top "because the market can stay irrational longer than you can stay solvent." But the irrational exuberance is no mystery to traders. Unsustainable equity premium always involves extreme departure from historical standards, excessive use of leverage, and wide disparity between market price and fundamental value. The icing on the cake is regulatory laxity and loose or non-existent oversight. Of course, moral hazard now plays a big role, too, since the "boyz" know that the government will back them up if they implode.
All of this was building in 2005-2006 in the RE market, for example, and the coming financial meltdown was clear by the spring of 2007.
The proof that this is simple to identify is in the sudden reversion in the direction of the mean on reversal. Virtually everyone in the market has already realized that this is a game of musical chairs (Prince's words, not mine), and when the cresting of the wave comes, everyone bolts for the door, resulting in overshoot at the bottom. Then there is a dead cat bounce, which can be quite extreme also, especially when there is strong government intervention on the monetary side.
What's so hard to understand about this? Surely melding macro, finance, and behavioral could model it, no? I'm not saying predict the top here but be strong enough for regulators like the Fed to take away the punchbowl before it is too late. Oh, and where were the Feds and local authorities when things like predatory practices and risk misrepresentation were multiplying toward the top? For that matter, where is the accountability now. This is forensic as well as financial and economic.
YOu can't just look at models without looking at the real world.