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September 2, 2010

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A Dream House After All

Posted: 02 Sep 2010 12:42 AM PDT

Karl Case says the American dream is still alive:

A Dream House After All, by Karl Case, Commentary, NY Times: If you read the coverage of the latest figures on the sales of existing homes..., you may well have come to the conclusion that the American dream is dead. It is indeed worrisome that sales in July were down 25 percent from a year ago. But a little perspective is in order.
First, the bad news. What has happened in the housing markets since 2005 is a catastrophe that may take years for our economy to recover from. ...
Depressing, yes — but the end of a dream? Not exactly. I have never quite understood what the American dream really means when it comes to housing. For some people, it means having a solid and fairly safe long-term investment that is coupled with the satisfaction of owning the house they live in. That dream is still alive.
Others, however, think the American dream is owning property that appreciates by 30 percent a year, making a house into a vehicle for paying bills. But those kinds of dreams have become nightmares for the millions of foreclosed property owners who have found themselves sliding toward bankruptcy.
But for people with a more realistic version of the American dream, buying a house now can make a lot of sense. Think of it as an investment. The return or yield on that investment comes in two forms. First, it provides what is called "net imputed rent from owner-occupied housing." You live in the house and so it provides you with a real flow of valuable services. ... Consider it this way: when Enron went belly up, shareholders ended up with nothing, but when the housing market drops, homeowners still have a house. And this benefit is tax-free.
The second part of the yield on investment in a house is the capital gain you receive if it appreciates and you sell the house. Gains are excluded from taxation if the property is a primary residence...
Consider a few other bonuses of buying a home today. You can deduct the interest you pay on the mortgage. Interest rates are about as low as they can get. And, don't forget, home prices are down by 30 percent on average from the peak. ...
Do the math. Four years ago, the monthly payment on a $300,000 house with 20 percent down and a mortgage rate of about 6.6 percent was $1,533. Today that $300,000 house would sell for $213,000 and a 30-year fixed-rate mortgage with 20 percent down would carry a rate of about 4.2 percent and a monthly payment of $833. In addition, the down payment would be $42,600 instead of $60,000. ...
[H]ousing has perhaps never been a better bargain, and sooner or later buyers will regain faith, inventories will shrink to reasonable levels, prices will rise and we'll even start building again. The American dream is not dead — it's just taking a well-deserved rest.

There's been a lot of talk about the virtues of renting lately, but for me -- and from the sounds of it perhaps I'm one of the few -- renting and owning are nowhere near perfect substitutes. Not even close.

links for 2010-09-01

Posted: 01 Sep 2010 11:04 PM PDT

Christina Romer’s Farewell Address

Posted: 01 Sep 2010 04:50 PM PDT

Here's a summary of:

Christina Romer's Farewell Address

I also explain one reason I'm so furstrated with fiscal policymakers.

Thomas Sargent on Modern Macroeconomic Models

Posted: 01 Sep 2010 12:33 PM PDT

As a follow-up to the post below this one on the usefulness of modern macroeconomic modes, here's Tom Sargent. Given my remarks below, I was pleased to read this:

The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised.6 These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.

Here's more (and there's even more in the original interview, I left out the interesting discussion on Europe). While I don't agree with everything, I am simply going to give Sargent the floor. He's earned the right to have his say:

Interview with Thomas Sargent, by Art Rolnick, Minneapolis Fed, June 15, 2010: ...MODERN MACROECONOMICS UNDER ATTACK
Rolnick: You have devoted your professional life to helping construct and teach modern macroeconomics. After the financial crisis that started in 2007, modern macro has been widely attacked as deficient and wrongheaded.
Sargent: Oh. By whom?
Rolnick: For example, by Paul Krugman in the New York Times and Lord Robert Skidelsky in the Economist and elsewhere. You were a visiting professor at Princeton in the spring of 2009. Along with Alan Blinder, Nobuhiro Kiyotaki and Chris Sims, you must have discussed these criticisms with Krugman at the Princeton macro seminar.
Sargent: Yes, I was at Princeton then and attended the macro seminar every week. Nobu, Chris, Alan and others also attended. There were interesting discussions of many aspects of the financial crisis. But the sense was surely not that modern macro needed to be reconstructed. On the contrary, seminar participants were in the business of using the tools of modern macro, especially rational expectations theorizing, to shed light on the financial crisis.
Rolnick: What was Paul Krugman's opinion about those Princeton macro seminar presentations that advocated modern macro?
Sargent: He did not attend the macro seminar at Princeton when I was there.
Rolnick: Oh.
Sargent: I know that I'm the one who is supposed to be answering questions, but perhaps you can tell me what popular criticisms of modern macro you have in mind.
Rolnick: OK, here goes. Examples of such criticisms are that modern macroeconomics makes too much use of sophisticated mathematics to model people and markets; that it incorrectly relies on the assumption that asset markets are efficient in the sense that asset prices aggregate information of all individuals; that the faith in good outcomes always emerging from competitive markets is misplaced; that the assumption of "rational expectations" is wrongheaded because it attributes too much knowledge and forecasting ability to people; that the modern macro mainstay "real business cycle model" is deficient because it ignores so many frictions and imperfections and is useless as a guide to policy for dealing with financial crises; that modern macroeconomics has either assumed away or shortchanged the analysis of unemployment; that the recent financial crisis took modern macro by surprise; and that macroeconomics should be based less on formal decision theory and more on the findings of "behavioral economics." Shouldn't these be taken seriously?
Sargent: Sorry, Art, but aside from the foolish and intellectually lazy remark about mathematics, all of the criticisms that you have listed reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished. That said, it is true that modern macroeconomics uses mathematics and statistics to understand behavior in situations where there is uncertainty about how the future will unfold from the past. But a rule of thumb is that the more dynamic, uncertain and ambiguous is the economic environment that you seek to model, the more you are going to have to roll up your sleeves, and learn and use some math. That's life.
Rolnick: Putting aside fear and ignorance of math, please say more about the other criticisms.
Sargent: Sure. As for the efficient markets hypothesis of the 1960s, please remember the enormous amount of good work that responded to Hansen and Singleton's ruinous 1983 JPE [Journal of Political Economy] finding that standard rational expectations asset pricing theories fail to fit key features of the U.S. data.1 Far from taking the "efficient markets" outcomes for granted, important parts of modern macro are about understanding a large and interesting suite of asset pricing puzzles, brought to us by Hansen and Singleton and their followers—puzzles about empirical failures of simple versions of efficient markets theories. Here I have in mind papers on the "equity premium puzzle," the "risk-free rate puzzle," the "Backus-Smith" puzzle, and on and on.2
These papers have put interesting new forces on the table that can help explain these puzzles, including missing markets, enforcement and information problems that impede trades, difficult estimation and inference problems confronting agents, preference specifications with novel attitudes toward the timing and persistence of risk, and pessimism created by ambiguity and fears of model misspecification.
Rolnick: Tom, let me interrupt. Why should we at central banks care about whether and how those rational expectations asset pricing theories can be repaired to fit the data?
Sargent: Well, there are several important reasons. One is that these theories provide the foundation of our ways of modeling the main channels through which monetary policy's interest rate decisions affect asset prices and the real economy. To put it technically, the "new Keynesian IS [investment-savings] curve" is an asset pricing equation, one of a form very close to those exposed as empirically deficient by Hansen and Singleton. Efforts to repair the asset pricing theory are part and parcel of the important project of building an econometric model suitable for providing quantitative guidance to monetary and fiscal policymakers.
Another important reason for caring is that monetary policymakers have often been urged to arrest bubbles in asset markets. Easier said than done. Before you can do that, you need a quantitatively reliable theory of asset prices that you can use to identify and measure bubbles.
Rolnick: Before I interrupted, you had begun responding to those criticisms of modern macro. Please continue.

Sargent: I have two responses to your citation of criticisms of "rational expectations." First, note that rational expectations continues to be a workhorse assumption for policy analysis by macroeconomists of all political persuasions. To take one good example, in the Spring of 2009, Joseph Stiglitz and Jeffrey Sachs independently wrote op-ed pieces incisively criticizing the Obama administration's proposed PPIP (Public-Private Investment Program) for jump-starting private sector purchases of toxic assets.3 Both Stiglitz and Sachs executed a rational expectations calculation to compute the rewards to prospective buyers. Those calculations vividly showed that the administration's proposal represented a large transfer of taxpayer funds to owners of toxic assets. That analysis threw a floodlight onto the PPIP that some of its authors did not welcome.

And second, economists have been working hard to refine rational expectations theory. For instance, macroeconomists have done creative work that modifies and extends rational expectations in ways that allow us to understand bubbles and crashes in terms of optimism and pessimism that emerges from small deviations from rational expectations. An influential example of such work is the 1978 QJE [Quarterly Journal of Economics] paper by Harrison and Kreps.4 You should also look at a fascinating paper that builds on Harrison and Kreps, written by José Scheinkman and Wei Xiong in the 2003 JPE.5 As I mentioned earlier, for policymakers to know whether and how they can moderate bubbles, we need to have well-confirmed quantitative versions of such models up and running. We don't yet, but we are working on it.

Rolnick: And the other criticisms?
Sargent: OK. The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised.6 These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.
By the way, participants within both the real business cycle and new Keynesian traditions have been stern and constructive critics of their own works and have done valuable creative work pushing forward the ability of these models to match important properties of aggregate fluctuations. The authors of papers in this literature usually have made it clear what the models are designed to do and what they are not. Again, they are not designed to be theories of financial crises.
Rolnick: What about the most serious criticism—that the recent financial crisis caught modern macroeconomics by surprise?
Sargent: Art, it is just wrong to say that this financial crisis caught modern macroeconomists by surprise. That statement does a disservice to an important body of research to which responsible economists ought to be directing public attention. Researchers have systematically organized empirical evidence about past financial and exchange crises in the United States and abroad. Enlightened by those data, researchers have constructed first-rate dynamic models of the causes of financial crises and government policies that can arrest them or ignite them. The evidence and some of the models are well summarized and extended, for example, in Franklin Allen and Douglas Gale's 2007 book Understanding Financial Crises.7 Please note that this work was available well before the U.S. financial crisis that began in 2007.
Rolnick: I'll come back to that in a second, but you haven't said anything yet about what is to be gained in terms of understanding financial crises from importing insights of behavioral economics into macroeconomics.
Sargent: No, I haven't.
Financial crises

Rolnick: OK then. Well, what useful things does macroeconomics have to say about financial crises, what causes them, how to manage them after they start and what can be done to prevent them?

Sargent: A lot. In addition to the formal literature summarized in the Allen and Gale book, I want to mention the example of the 2004 book by Gary Stern and Ron Feldman, Too Big to Fail.8 That book doesn't have an equation in it, but it wisely uses insights gleaned from the formal literature to frame warnings about the time bomb for a financial crisis set by government regulations and promises. Indeed, one of the focuses of Gary Stern's long tenure as president of the Minneapolis Fed was steadily to draw attention to financial fragility issues and what the government does either to arrest crises or, unfortunately as an unintended consequence, to incubate them.

Rolnick: Thanks for the nice words about Gary, but please elaborate further on macro scholarship and financial crises.
Sargent: I like to think about two polar models of bank crises and what government lender-of-last-resort and deposit insurance do to arrest them or promote them. Both models had origins in papers written at the Federal Reserve Bank of Minneapolis, one authored by John Kareken and Neil Wallace in 1978 and the other by John Bryant in 1980, then extended by Diamond and Dybvig in 1983.9 I call them polar models because in the Diamond-Dybvig and Bryant model, deposit insurance is purely a good thing, while in the Kareken and Wallace model, it is purely bad. These differences occur because of what the two models include and what they omit.
The Bryant and Diamond-Dybvig model starts with an environment in which banks can do things that are very worthwhile socially; namely, they provide maturity transformation and liquidity transformation activities that improve the efficiency of the economy. They enable coalitions of people, namely, the banks' depositors, to make long-term investments—loans, mortgages and the like—while at the same time the bank's depositors hold demand deposits, bank liabilities that are short term in duration, because they can withdraw them at any time. Banks thereby facilitate risk-sharing among people with uncertain future liquidity needs. These are all good things.
But there is a potential problem here because for the long-term investments to come to fruition, enough patient depositors must leave their funds in the bank to avoid premature liquidation of a bank's long-term investments. Without deposit insurance, situations can arise that induce even patient depositors to want to withdraw their funds early, causing the banks prematurely to liquidate the long-term investments, with adverse affects on the realized returns.
What triggers a bank run is patient depositors' private incentive to withdraw early when they think that other patient investors are also choosing to withdraw early. Technically speaking, that amounts to multiple Nash equilibria. There are situations in which I run (i.e., withdraw from the bank early) because I expect you to run, and when you also run because you expect me to run. But there are other situations in which we both trust that the other person isn't going to run and we don't run. Which equilibrium prevails is anyone's guess, or something resolved only by an extraneous random device for correlating behavior, a device that economists sometimes call a "sunspot."
So without deposit insurance, the economy is vulnerable to bank runs. The situations where depositors don't run lead to good outcomes, but when there are bank runs, outcomes are bad. The good news in the Diamond-Dybvig and Bryant model, however, is that if you put in government-supplied deposit insurance, that knocks out the bad equilibrium. People don't initiate bank runs because they trust that their deposits are safely insured. And a great thing is that it ends up not costing the government anything to offer the deposit insurance! It's just good all the way around.
Rolnick: Do you think that an abstract model like this ever influences policymakers?

Sargent: I believe that the Bryant-Diamond-Dybvig model has been very influential generally, and in particular that it was very influential in 2008 among policymakers. A perhaps oversimplified but I think largely accurate way of characterizing the vision of many policy authorities in 2008 was that they correctly noticed that a Bryant-Diamond-Dybvig bank is not just something that has "B A N K" written on its stationary and front door. It's any institution that executes liquidity transformation and maturity transformation, thereby offering a kind of intertemporal risk-sharing.

So in 2008, there were all sorts of institutions that were really banks in the economic sense of the Bryant-Diamond-Dybvig model but that did not have access to explicit deposit insurance, institutions like money market mutual funds, shadow banks, even hedge funds that were doing exactly those maturity-transforming and risk-transforming activities.

When monetary policy authorities, deposit insurance authorities and others looked out their windows in the fall of 2008, they saw Bryant-Diamond-Dybvig bank runs all over the place. And the logic of the Bryant-Diamond-Dybvig model persuaded them that if they could arrest the runs by effectively convincing creditors that their loans—that is, their short-term deposits—to these "banks" were insured, that could be done at little or no eventual cost to the taxpayers. You could nip the run in the bud and really prevent the next Great Depression. This is a very optimistic view of those 2008 interventions enlightened by the Bryant and Diamond-Dybvig model.
But Diamond and Dybvig themselves were cautious about promoting such optimism. In the last part of their 1983 JPE paper, Diamond and Dybvig recommend that their readers take seriously the message of a 1978 paper (written at the Minneapolis Fed, as I mentioned earlier) by Kareken and Wallace. That paper includes something important that Diamond and Dybvig recognize that they left out: moral hazard.
Rolnick: And the Kareken-Wallace story?
Sargent: The main idea is that when a government is in the business of being a lender of last resort or a deposit insurer, depending on how it regulates banks, it affects the risk that banks take and the probability that the government is actually going to be required to exercise lender-of-last-resort and bail out facilities. Neil and Jack call it the "moral hazard" problem, which is the idea that when you insure a bank, you alter its incentives to undertake risks.
In the Kareken-Wallace model, deposit insurance is purely a bad thing. Kareken-Wallace envisions a different economic setting than Bryant and Diamond-Dybvig. Of course, like all models, it's an abstraction; it simplifies things in order to isolate key forces. The Kareken-Wallace setting has complete markets. There are markets in all possible risky claims. There are also some people who wanted to hold risk-free deposits.
Kareken and Wallace compare two different situations. In one, there is no deposit insurance; depositors are on their own and know that their deposits are uninsured. If they want to hold risk-free deposits, they'd better hold them in banks that are holding risk-free portfolios. Some very conservative banks emerge that can issue safe deposits because the bank portfolio managers themselves hold assets that allow these banks to pay depositors in all possible states of the world.

Kareken and Wallace compare that no-deposit-insurance situation to another situation in which a government agency provides deposit insurance that is either free or is priced too cheaply, meaning that it's not priced with a proper risk-loading. Kareken and Wallace show that in that situation, banks have an incentive to become as risky as possible, and as large as possible. Therefore, with a positive probability, banks will fail and taxpayers will have to compensate banks' depositors. It is in banks' shareholders' interest that he banks organize themselves this way. This lets them gamble with the insurers' and depositors' money.

The Kareken and Wallace model's prediction is that if a government sets up deposit insurance and doesn't regulate bank portfolios to prevent them from taking too much risk, the government is setting the stage for a financial crisis. On the basis of the Kareken-Wallace model, Jack Kareken wrote a paper in the Federal Reserve Bank of Minneapolis Quarterly Review referring to the "cart before the horse."10 He pointed out that if you're going to deregulate financial institutions, which we in the United States did in the late '70s and early '80s (deregulation is the cart), you'd better reform deposit insurance first (that's the horse). You'd better make it clear that financial institutions that take these risks are not allowed to have access to lender-of-last-resort facilities. But the U.S. government didn't do that.

So, of those two models, the Kareken-Wallace model makes you very cautious about lender-of-last-resort facilities and very sensitive to the risk-taking activities of banks. The Diamond-Dybvig and Bryant model makes you very sensitive to runs and very optimistic about the ability of insurance to cure them. Both models leave something out, and I think in the real world we're in a situation where we have to worry about runs and we also have to worry about moral hazard. As you know, an important theme of research for macroeconomics in general and at the Minneapolis Fed in particular has been about how to strike a good balance.
Rolnick: Jack and Neil concluded their 1978 paper with a proposal for dealing with this tension, and that was to require much more capital than was required at the time. Now the government actually requires even less capital than it did when Jack and Neil wrote. If you go back prior to FDIC insurance, turn-of-the-century banks were holding, by some estimates, 20 percent, maybe 30 percent, capital. Capital-equity ratios were that high.
What would you recommend? You just observed that if deposit insurance isn't priced properly, that leads you in one direction. And Jack and Neil had this idea of making sure there's a lot more skin in the game, meaning much closer to what banks used to hold when there was no deposit insurance, no too-big-to-fail.
Sargent: The function of capital is exactly to protect against making risky loans. Another proposal is the narrow banking proposal of Milton Friedman and [other economists at the University of] Chicago, which is a proposal to force deposit banks to hold safe portfolios.
Rolnick: Well, with large banks, too-big-to-fail concerns and deposit insurance, I would make the case to tier it based on size. Jack and Neil made the point, I believe, that shareholders of large banks can diversify, but shareholders of smaller banks find it harder to diversify, so they tend to be more risk-averse. Their prediction would therefore have been, I think, that moral hazard is more likely to manifest itself in larger banks—and I think that's what we saw in the 2007-09 financial crisis. How seriously would you take the relevance of the historical evidence that I cited?
Sargent: I would take it very seriously. I recommend a very interesting paper by Warren Weber presented at the Minneapolis Fed conference in honor of Gary Stern this past April in which Warren compared different private insurance arrangements for managing banks' risk-taking before the U.S. Civil War.11
The 2009 fiscal stimulus
Rolnick: A January 2009 article quotes you as saying, "The calculations that I have seen supporting the stimulus package are back-of-the-envelope ones that ignore what we have learned in the last 60 years of macroeconomic research."12 What calculations had you seen?
Sargent: I said something like that to a reporter. I had just read an Obama administration's Council of Economic Advisers document e-mailed to me by my friend [Stanford University economist] John Taylor.13 I agreed with John that the CEA calculations were surprisingly naive for 2009. They were not informed by what we learned after 1945.

But I suspect that the council was asked to do something quickly, and they did what they thought was "good enough for government work," as some of us said during my days at the Pentagon in 1968 and 1969. Back-of-envelope work can be a useful starting point or benchmark. But it does mischief when it is oversold.

In early 2009, President Obama's economic advisers seem to have understated the substantial professional uncertainty and disagreement about the wisdom of implementing a large fiscal stimulus. In early 2009, I recall President Obama as having said that while there was ample disagreement among economists about the appropriate monetary policy and regulatory responses to the financial crisis, there was widespread agreement in favor of a big fiscal stimulus among the vast majority of informed economists. His advisers surely knew that was not an accurate description of the full range of professional opinion. President Obama should have been told that there are respectable reasons for doubting that fiscal stimulus packages promote prosperity, and that there are serious economic researchers who remain unconvinced.

Rolnick: Do any New Keynesian models provide any support for the CEA numbers?
Sargent: Some do; some don't. I recommend looking at calculations by John Taylor and his pals.14 Based on that work, John remains very skeptical of the 2009 CEA calculations. But Christiano, Eichenbaum and Rebelo have used variants of a New Keynesian model together with particular assumptions about paths of shocks to create quantitative examples of situations in which fiscal multipliers can be as big as those assumed by the CEA.15
Persistent unemployment in Europe (and now the United States?)  ...
Europe and "unpleasant arithmetic"  ...

The Great Depression in Economic Memory

Posted: 01 Sep 2010 09:53 AM PDT

Jean Pisani-Ferry argues that "In extraordinary times, history is, in fact, a better guide than models estimated with data from ordinary times":

The Great Depression in Economic Memory, by Jean Pisani-Ferry, Commentary, Project Syndicate: The dispute that has emerged in the United States and Europe between proponents of further government stimulus and advocates of fiscal retrenchment feels very much like a debate about economic history. Both sides have revisited the Great Depression of the 1930's – as well as the centuries-long history of sovereign-debt crises – in a controversy that bears little resemblance to conventional economic-policy controversies.
The pro-stimulus camp often refers to the damage wrought by fiscal retrenchment in the US in 1937... So, are we in 1936, and does the budgetary tightening contemplated in many countries risk provoking a similar double-dip recession?
Clearly there are limits to the comparison. ... Nevertheless, the 1937 episode does seem to illustrate the dangers of attempting to consolidate public finances at a time when the private sector is still too weak for economic recovery to be self-sustaining. (Another case with similar consequences was Japan's value-added tax increase in 1997, which precipitated a collapse of consumption).
Fiscal hawks also rely on history-based arguments. The economists Carmen Reinhart and Kenneth Rogoff have studied centuries of sovereign-debt crises, and remind us that today's developed world has a forgotten history of sovereign default. A particularly telling example is the aftermath of the Napoleonic wars of the early nineteenth century, when a string of exhausted states defaulted on their obligations. The 1930's are relevant here as well, given another series of defaults among European states, not least Germany.
What history tells us here is that defaults are not the privilege of poor, under-governed countries. They are a threat to all... Again, there are limits to comparisons...
In normal times, history is left to historians and economic-policy debate relies on models and econometric estimates. But attitudes changed as soon as the crisis erupted in 2007-2008. Indeed, central bankers and ministers were obsessed at the time by the memory of the 1930's, and they consciously did the opposite of what their predecessors did 80 years ago.
They were right to do so. In extraordinary times, history is, in fact, a better guide than models estimated with data from ordinary times, because it captures variance that standard time-series techniques ignore. If one wants to know how to deal with a banking crisis, the risk of a depression, or the threat of a default, it is natural to examine times when those dangers were around, rather than to rely on models that ignore such dangers or treat them as distant clouds. In times of crisis, the best guides are theory, which captures the essence of a problem, and the lessons of past experience. Everything in between is virtually useless.
The danger with relying on history, however, is that we have no methodology to decide which comparisons are relevant. Loose analogies can easily be regarded at proofs, and a vast array of experiences can be enrolled to support a particular view. Policymakers (whose knowledge of economic history is generally limited) are therefore at risk of being drowned in contradictory historical references.
History can be an essential compass when past experience provides unambiguous headings. But an undisciplined appeal to history risks becoming a confusing way to express opinions. Governance by analogy can easily lead to muddled governance.

My argument is a bit different. In "extraordianry times," the questions that are important change, and economists build models to answer those questions. When those same questions are asked again, it's natural to look to the models built to answer them:

Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.
The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice? Hopefully, it is the ability to answer questions that are the least important, so the modeling choices that are made reveal what the modelers though was most and least important.
The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment, or when we found ourselves in mild, "normal" recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, or when prices depart from fundamentals. When this crisis hit, I looked into our tool bag of models and policy recommendations and came up empty (for the most part). It was disappointing. There was really no choice but to go back to older Keynesian style models for insight.
The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades,; did not even envision that this could happen, let alone build it into their models. Markets work, they don't break down, so why waste time thinking about those possibilities.
So it's not the math, the modeling choices that were made and the inevitable sacrifices to reality those choices entail reflected the importance the people making the choices gave to various questions. We weren't forced to this end by the mathematics, we asked the wrong questions and built the wrong models. ...
The fight - and main question in academics - has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it's been a fairly brutal fight at times - you've seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.
What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important (some don't even believe that policy can help the economy, so why put effort into studying it?).
I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.

Paul Krugman:

Brother, Can You Paradigm?: A few months back one of my original mentors in economics — someone who got his graduate training in the pre-fresh-water era — asked me whether there was anything about the current crisis that required fundamentally new analysis. We agreed that there wasn't.
This is one of the untold tales of the mess we're in. Contrary to what you may have heard, there's very little that's baffling about our problems — at least not if you knew basic, old-fashioned macroeconomics. In fact, someone who learned economics from the original 1948 edition of Samuelson's textbook would feel pretty much at home in today's world. If economists seem totally at sea, it's because they have carefully unlearned the old wisdom. If policy has failed, it's because policy makers chose not to believe their own models.
On the analytical front: many economists these days reject out of hand the Keynesian model, preferring to believe that a fall in supply rather than a fall in demand is what causes recessions. But there are clear implications of these rival approaches. If the slump reflects some kind of supply shock, the monetary and fiscal policies followed since the beginning of 2008 would have the effects predicted in a supply-constrained world: large expansion of the monetary base should have led to high inflation, large budget deficits should have driven interest rates way up. And as you may recall, a lot of people did make exactly that prediction. A Keynesian approach, on the other hand, said that inflation would fall and interest rates stay low as long as the economy remained depressed. Guess what happened?
On the policy front: there's certainly a real debate over whether Obama could have gotten a bigger stimulus. What we do know, however, is that his top advisers did not frame the argument for a small stimulus compared with the projected slump purely in political terms. Instead, they argued that too big a plan would alarm the bond markets, and that anyway fiscal stimulus was only needed as an insurance policy. Neither of these arguments came from macroeconomic theory; they were doctrines invented on the fly. Samuelson 1948 would have said to provide a stimulus big enough to restore full employment — full stop.

So what we have here isn't really a lack of a workable analytical framework. The disaster we're facing is the result of the refusal of economists, both in and out of the corridors of power, to go with the perfectly good framework we already had.

As the video from George Evans hopefully makes clear, we are starting to ask the right questions and building the models we need to answer them. Hopefully, decades from now when economists have moved on to other questions and another crisis hits, the theorists who are so defensive of the models being built today won't mind if economists of the future try to learn something from their work.

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