Macroeconomics: Back to Square One

I agree with the harsh judgment that Lucas and Sargent (1979) made about the macromodels of their day– that they relied on identifying assumptions that were not credible. The situation now is worse. Models make assumptions that are no more credible and far more opaque.

I also agree with the harsh judgment that Lucas and Sargent made about the predictions of those Keynesian models, the prediction that an increase in the inflation rate would cause a reduction in the unemployment rate.

Lucas (2003) introduces his Presidential lecture to the American Economics Association by saying:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save,not from better fine-tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management.

Using the worldwide loss of output as a metric, for Lucas, the financial crisis of 2008-9 is a failed prediction that is much more serious than the failure of the Keynesian models. So what Lucas and Sargent wrote of Keynesian macro models applies with full force today to post-real macro models and the program that generated them:

That these predictions were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed, are now simple matters of fact … … the task that faces contemporary students of the business cycle is that of sorting through the wreckage …

Someday, medicine might reach a point where any of us would be willing to let a dynamic stochastic simultaneous equations equilibrium model of the human body determine which course of treatment we follow for a family member faced with a life-threatening disease.

It is not at this point now. As far as I can tell, no one in medicine sees work on such a model as a practical path toward better treatment of disease. Perhaps this time, macroeconomists should admit that the wreckage runs so deep that they should abandon the quest for the sacred simultaneous equation model. It might be wiser to adopt the messy methods that medical researchers have used to make discoveries that were implemented and actually improved health.

This is the conclusion of a brave paper (then “corrected”) written by recently announced Nobel Prize Paul Romer. The original version of the document can be found here 

Macroeconomics: Back to Square One by Manuel Fraga is licensed under a Creative Commons Attribution 4.0 International License.

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