Destructive Creativity
Still thinking my way through the Reinhart-Rogoff debacle and related issues, and I think there’s an important point to be made here about the state of macroeconomics.
You can already see quite a few people reacting to this affair by declaring that macro is humbug, we don’t know anything, and we should just ignore economists’ pronouncements. Some of the people saying this are economists themselves!
But the truth is that basic macroeconomics — IS-LM type macro, the stuff that’s in Econ 101 textbooks — has performed spectacularly well in the crisis.
The true test of an analytical framework is how it performs in unusual or extreme circumstances, how well it predicts “out of sample”. What we have experienced since 2007 is a series of huge policy shocks — and basic macroeconomics made some very counterintuitive predictions about the effects of those shocks. Unprecedented budget deficits, the model said, would not drive up interest rates. A tripling of the monetary base would not cause runaway inflation. Sharp government spending cuts wouldn’t free up resources for the private sector, they would depress the economy more than one-for-one, so that private spending as well as public would fall.
Quite a few people considered these predictions not just wrong but absurd; they braced for soaring rates and inflation, they waited for the good news from austerity. But the model passed the test with flying colors. Remember how Romer and Bernstein were savaged for assuming a multiplier of around 1.5? Four years later, after much soul-searching from the IMF about why it underestimated the costs of austerity, estimates seem to be converging on a multiplier of … about 1.5.
So how is it that economists look so bad? The answer is that too many prominent economists chose, for one reason or another, to reject the existing model. Maybe they were just trying to score points by being different; maybe they were sucked in by the approbation of the VSPs, the rewards that came from telling important people what they wanted to hear. In any case, we had Alesina/Ardagna saying that austerity is actually expansionary thanks to confidence effects; Reinhart/Rogoff saying that debt has terrible effects on growth via unexplained channels. This stuff was creative, different, deeply appealing to powerful people — and dead wrong. If you stayed with Econ 101, you got it right, if you went with the trendy stuff you made a fool of yourself.
The lesson we should have taken from this crisis was that plain ordinary macro is actually a very powerful, very useful tool, one that you ignore at your peril.
