Macroeconomics: Some Defects
Some of the reasons I do not like the way the economics profession approaches macro
Macroeconomics is the branch of economics that deals with overall economic activity. It includes concepts like GDP, inflation, and unemployment. I have many concerns about the way that economists approach this topic. Here are a few of them.
PSST and the GDP Factory
I think of the economy as a complex emergent process for producing hundreds of thousands of goods and services. I call this Patterns of Sustainable Specialization and Trade.
Macroeconomics treats the economy as if it were a simple process that can be centrally managed. I call this the GDP Factory.
If the economy produced only one type of output, and it were clearly measurable, then GDP would be well defined. Suppose that the one output is bricks of a standard size, shape, and composition. Then annual GDP is the number of bricks. Annual inflation is that rate of increase in the price of bricks. Labor productivity is the number of bricks produced divided by the hours of work.
In the real world, government statisticians have to deal with the full array of different goods and services that people work to produce. The statisticians have to compute a weighted average of apples, oranges, knee surgeries, business presentations, substack posts, and everything else to arrive at a single number for GDP. They have to treat as “labor input” the sum of hours worked by farmers, firefighters, janitors, investment bankers, brain surgeons, government bureaucrats, and everyone else with a paying job.
The conceit of macroeconomics is that the mix of goods and services does not matter. The government can use its overall level of spending and taxes, along with monetary policy, to manage GDP. And whatever statisticians decide is real GDP and labor input gives such a precise measure of labor productivity that one may attach significance to the second differential of this number.1
What do Banks do?
An economics student can go through freshman economics, intermediate undergraduate macroeconomics, and the required courses to earn a Ph.D without ever having to answer a single exam question about the role in the economy of banks or the financial sector. Banking crises and credit crunches have played a role in every major downturn in U.S. history, but the mechanism that drives this is little studied, much less understood.
I take the view that as consumers and businesses we wish to issue risky, long-term liabilities while holding riskless, short-term assets. Banks allow us to do this by taking the reverse position, holding long-term loans as assets and issuing liquid deposits as liabilities. When bank intermediation expands, the economy is able to grow. A bank crisis or credit crunch messes up patterns of specialization and trade, leading to a recession.
Ahistorical
Macroeconomic theory is presented as a set of equations that exist outside of time. In physics, forces like gravity and friction always work the same way. Macroeconomists teach their subject as if it were like physics.
In the real world, the structure of the economy constantly changes. There is creative destruction in the markets for goods and services. Over time we have seen dramatic reductions in the percentage of workers in agriculture and manufacturing. Employment has shifted to education and health care.
Demographic factors can alter the composition of the population. Culture evolves. The financial sector innovates. Regulations change.
In the 1950s and 1960s in the United States, home mortgages were financed by consumer deposits at banks and savings and loan associations. It was illegal for banks to pay interest on checking accounts, and the maximum interest rate on saving deposits was fixed by regulation. As a result, whenever the Fed raised interest rates, consumers were disincentivized to keep deposits, the housing market would experience a credit crunch, and a construction downturn would generate a recession.
Late in the 20th century, new institutions and regulatory changes served to insulate housing from small increases in interest rates. For a long period of time, there were no housing recessions. Until in 2006-2008 the new methods of housing finance blew up, followed by the worst downturn since the 1930s.2
I look at macroeconomics as a historical discipline. There are periods of steady economic growth that are interrupted up by specific events and crises that reflect the environment at the time they occur. Like unhappy families, each unhappy macroeconomic experience is unhappy in its own way.
That is, if productivity is measured as having risen 3 percent one year and 2 percent next year, we can assert that there has been a “productivity slowdown” and pontificate about the supposed causes.
I am aware of the view of Scott Sumner and others that the 2008 downturn was a monetary policy error. I think that view is of no use, because it has no empirical statement. For Sumner, “economic downturn” and “monetary policy error” are two ways of saying the same thing. To make the issue empirical in principle (although not in practice), I would assert the following: If we could re-run history with the Fed making more open-market purchases of Treasury bills in 2006-2008, we would find that the economic results would not be much different.
I was drawn to economics as a young man by the promise of doing good through macro economic policy implemented by government agents following prescriptions of Keynesian macro economic theory. I was lied to by my professors who assured me that the Fed used and expansive mathematical models that accurately predicted macro economic outcomes that result from flicking a switch here, pulling lever there.
Today, I am an old economist who long ago became enamored with Austrian economic thinking and public choice theory, after spending 10 years consulting and conducting contract research for federal agencies in DC. My personal belief, based on 45 years of experience paying attention to the political economy is that macro economic modeling is delusional, mystical, and postulated on nonexistent epiphenomenon.
Econometric modeling has proved to be useless for what I take to be obvious reasons that are roundly ignored by macro economists. The fundamental issue is that there are no economic constants to be estimated using advanced statistical methods. That fact does not deter macro economists, surprisingly enough.
In other words, Arnold, bravo and a HT to you for writing this thoughtful essay.
Your footnote 2 critique of Sumner's view is spot on.
I've tried to reconcile this with the argument that under Scott's ideas the central bank can control expectations of NGDP, which enables it to control trend growth of realized NGDP but it doesn't control actual, realized NGDP.
So basically the Fed got surprised by weak NGDP in H2 2008, but then allowed NGDP to recover at a slower trend.
That results in the question: if the Fed really control expectations of NGDP and trend growth of it, then why did they allow the slower trend growth in the 2010s? One potential answer is that in the aftermath of a financial crisis, the usual channels of monetary policy were disrupted such that this was not possible. Another is that the Fed simply preferred a slower pace of trend NGDP growth. I don't know if we can know which of these is right.