Thanks! This response makes a lot more sense to me than many of the other materials I’ve been able to find online (including the various Krugman pieces I’d found, and the debate between Summers and Kelton on Bloomberg). Appreciate the time you’ve taken to write it.
It’s still astonishing to me that we seem to have such an imperfect understanding of how monetary systems, which humans created, work. I guess it’s just a product of these being very complex systems, somewhat akin to a weather system. I’d be interested to see though how well the mainstream macroeconomic theories fare in terms of predictive power? That is, not with the benefit of hindsight, but whether from the outset the impact of different macroeconomic interventions can be reliably predicted by leading economists.
It’s also kind of interesting that so much rests on markets’ subjective expectations rather than the objective intervention undertaken. Seems like, if the government can satisfy markets that the present time is extraordinary, then they might get a free kick at printing extra money without paying the price in terms of inflation.
Thanks again. I’m going to try to keep learning more about all of this, as it’s pretty fascinating.
I actually don’t think it’s that surprising that we have so much difficulty modeling the macroeconomy with high fidelity. In part, this is because of large degrees of endogeneity and general equilibrium effects (the shocks you are trying to model may alter key parameters of the models themselves), and in part, it is because contemporary macroeconomic models (i.e. DSGE/New Keynesian models) must necessarily make assumptions about human psychology in establishing their “microfoundations.” For a long time, for the sake of simplicity, there was little focus among macroeconomists on ensuring that those assumptions about human psychology were accurate. More recently, significant focus has been dedicated to that question, and more sophisticated, hopefullymoreaccurate New Keynesian models have emerged. That said, even if these models better reflect the expert consensus in psychology and behavioral economics, they are still reliant on empirical findings in those fields for their accuracy, and given the replication crisis in psychology, that reliance may be compromising. It seems that there is no easy way around the difficulty of modeling human behavior.
Regarding the reliability of macroeconomic predictions, I think it’s safe to say that macroeconomists have developed a poor reputation as predictors. Particularly, in the aftermath of the 2008 financial crisis, there was a lot of highly critical discussion about why “no one saw it coming,” where “no one,” more often than not, referred to macroeconomists. While this is not completely accurate (some macroeconomists, like Robert Shiller, did see it coming), macroeconomists, by and large, failed rather grandly to understand what was going on in markets. There are many reasons for this, but a large one, arguably, especially among experts at the U.S. Federal Reserve, was that they were looking at DSGE models based on implausible and largely discredited assumptions both about people (e.g. rational expectations, the permanent income hypothesis, etc.) and about markets (e.g. perfect competition, no asymmetric information, no price stickiness, no financial or labor market frictions, etc.). This inspired a substantial backlash against DSGE models in general (typified in work like chapter three of John Quiggin’s book Zombie Economics).
This criticism, I think, has proven misguided (and not only because the critics never seemed to be equipped with a superior alternative to DSGE). In the years since the crisis, as I mentioned earlier, DSGE models have been updated and improved, and many authoritative New Keynesian approaches today are (to the best of our knowledge) realistic in precisely the same areas in which their predecessors were unrealistic. The Federal Reserve Bank of New York actually now publishes its standard DSGE model on GitHub. If you’re curious about it, you can take a look here. Only time will tell whether the best models of today materially outperform the models of the early 2000s, but I will say that thus far, it looks like the Federal Reserve has done a vastly better job of responding to the COVID-19 economic crisis than it did in responding to the 2008 housing crisis, so I am optimistic about the progress the field has made in the last ten years.
Finally a minor clarification based on your comment: While the impact of monetary policy is mediated just about exclusively through the expectations channel when an economy is at the zero lower boundand nonetheless lacks full employment (like now, in most advanced economies), this is generally not the case when interest rates are well above zero, and monetary policy is reliant upon traditional rather than extraordinary tools (e.g. open market operations rather than quantitative easing).
I found your discussion very interesting. Curious to know if you have any updated thoughts on this two years on. For me, I tend to agree with Wei Dai’s comment below, that the federal reserve and government working closely together is a synthetic form of MMT. Would you say that Japan’s “yield curve control” (pegging interest rates with unlimited money printing) is demonstrating that they are going down the MMT route? And what about Europe’s transmission protection instrument to peg Italian bonds?
Curious to know if the massive inflation numbers have changed your mind about whether the central banks have handled covid better than 2008.
Thanks! This response makes a lot more sense to me than many of the other materials I’ve been able to find online (including the various Krugman pieces I’d found, and the debate between Summers and Kelton on Bloomberg). Appreciate the time you’ve taken to write it.
It’s still astonishing to me that we seem to have such an imperfect understanding of how monetary systems, which humans created, work. I guess it’s just a product of these being very complex systems, somewhat akin to a weather system. I’d be interested to see though how well the mainstream macroeconomic theories fare in terms of predictive power? That is, not with the benefit of hindsight, but whether from the outset the impact of different macroeconomic interventions can be reliably predicted by leading economists.
It’s also kind of interesting that so much rests on markets’ subjective expectations rather than the objective intervention undertaken. Seems like, if the government can satisfy markets that the present time is extraordinary, then they might get a free kick at printing extra money without paying the price in terms of inflation.
Thanks again. I’m going to try to keep learning more about all of this, as it’s pretty fascinating.
I’m happy to hear that what I wrote was helpful!
I actually don’t think it’s that surprising that we have so much difficulty modeling the macroeconomy with high fidelity. In part, this is because of large degrees of endogeneity and general equilibrium effects (the shocks you are trying to model may alter key parameters of the models themselves), and in part, it is because contemporary macroeconomic models (i.e. DSGE/New Keynesian models) must necessarily make assumptions about human psychology in establishing their “microfoundations.” For a long time, for the sake of simplicity, there was little focus among macroeconomists on ensuring that those assumptions about human psychology were accurate. More recently, significant focus has been dedicated to that question, and more sophisticated, hopefully more accurate New Keynesian models have emerged. That said, even if these models better reflect the expert consensus in psychology and behavioral economics, they are still reliant on empirical findings in those fields for their accuracy, and given the replication crisis in psychology, that reliance may be compromising. It seems that there is no easy way around the difficulty of modeling human behavior.
Regarding the reliability of macroeconomic predictions, I think it’s safe to say that macroeconomists have developed a poor reputation as predictors. Particularly, in the aftermath of the 2008 financial crisis, there was a lot of highly critical discussion about why “no one saw it coming,” where “no one,” more often than not, referred to macroeconomists. While this is not completely accurate (some macroeconomists, like Robert Shiller, did see it coming), macroeconomists, by and large, failed rather grandly to understand what was going on in markets. There are many reasons for this, but a large one, arguably, especially among experts at the U.S. Federal Reserve, was that they were looking at DSGE models based on implausible and largely discredited assumptions both about people (e.g. rational expectations, the permanent income hypothesis, etc.) and about markets (e.g. perfect competition, no asymmetric information, no price stickiness, no financial or labor market frictions, etc.). This inspired a substantial backlash against DSGE models in general (typified in work like chapter three of John Quiggin’s book Zombie Economics).
This criticism, I think, has proven misguided (and not only because the critics never seemed to be equipped with a superior alternative to DSGE). In the years since the crisis, as I mentioned earlier, DSGE models have been updated and improved, and many authoritative New Keynesian approaches today are (to the best of our knowledge) realistic in precisely the same areas in which their predecessors were unrealistic. The Federal Reserve Bank of New York actually now publishes its standard DSGE model on GitHub. If you’re curious about it, you can take a look here. Only time will tell whether the best models of today materially outperform the models of the early 2000s, but I will say that thus far, it looks like the Federal Reserve has done a vastly better job of responding to the COVID-19 economic crisis than it did in responding to the 2008 housing crisis, so I am optimistic about the progress the field has made in the last ten years.
Finally a minor clarification based on your comment: While the impact of monetary policy is mediated just about exclusively through the expectations channel when an economy is at the zero lower bound and nonetheless lacks full employment (like now, in most advanced economies), this is generally not the case when interest rates are well above zero, and monetary policy is reliant upon traditional rather than extraordinary tools (e.g. open market operations rather than quantitative easing).
I found your discussion very interesting. Curious to know if you have any updated thoughts on this two years on. For me, I tend to agree with Wei Dai’s comment below, that the federal reserve and government working closely together is a synthetic form of MMT. Would you say that Japan’s “yield curve control” (pegging interest rates with unlimited money printing) is demonstrating that they are going down the MMT route? And what about Europe’s transmission protection instrument to peg Italian bonds?
Curious to know if the massive inflation numbers have changed your mind about whether the central banks have handled covid better than 2008.