In this blog post, we walk through the evolution of the key ideas in historical order, and offer suggestions to interesting readings,
which will help you see the fuller picture. Many of them are on your reading list, but some are not.

The old paradigm

Nobody tells it better than The age of uncertainty by John Kenneth Galbraith.

The old paradigm is now in the dustbin of history. But in order to comprehend the revolution in macroeconomics, it is rather useful to start from there. One encounters these arguments from time to time, so it’s worth knowing about the furniture of that mind.

The revolution of modern macroeconomics

The starting point is a speech : The role of monetary policy by Milton Friedman, American Economic Review, 1968, which had enormous influence in arguing that the mainstream Keynesian paradigm was fatally flawed, and that it was not going to work as a guide to policy on a sustained basis. By the early 1970s, the empirical evidence was showing that Friedman was on the right track, which led to everything that followed. This speech is arguably the beginning of modern macroeconomics. At the same time, this was only an argument conducted in English, and not a model.

The next big milestone was the Lucas critique: Econometric policy evaluation: A critique by Robert Lucas, Carnegie-Rochester Conference Series on Public Policy, 1976. This devastated traditional macroeconomics. In addition, it’s a remarkably elegant idea.

Lucas, Sargent and others mapped out a work program in a series of non-technical pieces, which were enormously influential. They set a generation of economists going to build a class of models that were rooted in the intuition of Friedman, 1968, and were invulnerable to the Lucas critique. You should read: Understanding business cycles by Robert Lucas, Carnegie-Rochester
Conference Series on Public Policy, 1977; After Keynesian Macroeconomics by Lucas and Sargent, Federal Reserve Bank of Minneapolis Quarterly Review, 1978; Methods and problems in business cycle theory by Robert Lucas, Journal of Money, Credit and Banking, 1980.

As important as the Lucas Critique was Rules rather than discretion: The inconsistency of optimal plans by Kydland and
Prescott. An accessible set of materials on this work is found in their 2004 Nobel Prize page.

This work came to fruition in the early 1990s in the form of the NK-DSGE model with a policy rule. Important tools got developed in a
classical setting (the RBC model), and then Keynesian frictions were put in, to give the NK-DSGE model. It has many problems, but with this, the Lucas program did work out. Nice readings on the NK-DSGE model are The science of monetary policy: A new Keynesian perspective in the JEL by Clarida, Gali, Gertler (1999), and their Monetary policy rules and macroeconomic stability: Evidence and some theory in the QJE in 2000.

The new macroeconomics is nicely showcased in Technology, employment, and the business cycle: Do technology shocks explain aggregate fluctuations? by Jordi Gali in AER, 1999. This is a wonderful example of confronting empirics with theory, plus a fundamental (if highly controversial) contribution in the eternal quest for the sources of business fluctuations.

On the other side, there is a powerful critique of the micro-founded approach to macroeconomics: The scientific illusion of empirical macroeconomics by Larry Summers, Scandinavian Journal of Economics, 1992.

By the late 1990s, there was a lot of progress to report. There is a nice article: Thirty-Five Years of Model Building for Monetary Policy Evaluation: Breakthroughs, Dark Ages, and a Renaissance by John B. Taylor, Journal of Money, Credit and Banking, 2007. There is the best single book on monetary policy: Monetary Policy Strategy by Frederic S. Mishkin, 2007. And, there are two other nice articles: A stable international monetary system emerges: Inflation targeting is Bretton Woods, reversed by Andrew K. Rose, Journal of International Money and Finance, 2007, and How the World Achieved Consensus on Monetary Policy, by Marvin Goodfriend, Journal of Economic Perspectives, 2007.

The second stage

Once the basic plan was laid, important work emerged in connected fields. A critical issue that came to fore was the role of finance in macroeconomics. Agency costs, net worth, and business fluctuations by Bernanke and Gertler, AER 1989, is the most elegant illustration that financial structure matters for macroeconomics.

We close this off with a canonical reference about fiscal policy from a macro perspective. A good recent treatemnt is Activist fiscal policy to stabilise economic activity by Auerbach and Gale, from the 2009 Jackson Hole symposium.

Post-crisis revisionism?

On this, see Monetary policy and financial stability: Is inflation targeting passe? by Takatoshi Ito, July 2010.

So, in this one I would that I would look at an all together more practical topic in the form of asset demand and prices as a function of demographics. Again, this is a substantial area in the finance and macroeconomic literature and I will not give a detailed literary review here. Besides, if you want to move straight to investment and portfolio implications this piece by Alicia Damley and this piece by Ed Dolan are really spot on in terms of what you need to think about. Basically, you want to buy the young guns and sell the old farts and the key to obtaining this insight is to remove the focus from population size to population structure (age structure). I have been harping about this since this blog’s inception 5 years ago, I am doing a PhD about it, so it is with pleasure that I see the discourse hitting the tapes of Seeking Alpha which indicates that it is grabbing hold of other people than those stuck in the university ivory tower.

In this sense, this is hardly a new story . Emerging markets represent the main investment story in a post Lehman context. Everyone wants to buy India, China (although she is quite different), and Brazil and as a result of a myriad of ETFs and other types of market trackers, you don’t need to know your way around the streets of Bangalore to gain exposure to the Indian growth story.

This is a turkey shoot then. And I largely agree with the main thrust of the argument.

The real maturing of the emerging world which began some 10-12 years ago and which will continue for the next decades is undeniably a force of good for savers and investors and the real question is whether it is too good, and thus whether there will end up being too much capital chasing too little yield. In order to understand this link, you would need the second part of the equation (see part 1) and understand how demographics affect capital flows and the transfer of savings between economies as a function of demographics.

In this note I will talk about the idea of a life course but in the way that it is traditionally narrated. As such, the life course is a sociological theory which describes phases of life and in this sense it is more topical than the idea of a life cycle which only describes the flow of investment and savings. Indeed, in finance and economics you only hear about the life cycle even if scholars who investigate for example the dynamics of house prices as a function of demographics essentially are deploying a life course framework.

What is the Life Course then?

Well, Wikipedia does a good job of explaining it for the layman and this small snippet also captures the essence quite well especially

In particular, it [Life Course Theory] directs attention to the powerful connection between individual lives and the historical and socioeconomic context in which these lives unfold. As a concept, a life course is defined as “a sequence of socially defined events and roles that the individual enacts over time” (Giele and Elder 1998, p. 22). These events and roles do not necessarily proceed in a given sequence, but rather constitute the sum total of the person’s actual experience. Thus the concept of life course implies age-differentiated social phenomena distinct from uniform life-cycle stages and the life span.

The only mental leap you need to perform here is to replace socially defined events with economically defined events and you have yourself a working model. Now, if the finance geeks out there think that I am turning soft and if the sociologists believe that I am reducing their complicated theory of human lives into numbers and equations, both groups have my symaphaties.

I think the austerity debate is unhelpful. There are complicated trade-offs associated with government spending. If the question is framed as “more” or “less”, reasonable people will disagree about costs and benefits that can’t be measured. Even in a depression, cutting expenditures to entrenched interests that make poor use of real resources can be beneficial. Even in a boom, high value public goods can be worth their cost in whatever private activity is crowded out to purchase them. Rather than focusing on “how much to spend”, we should be thinking about “what to do”. My views skew activist. I think there are lots of things government can and should do that would be fantastic. A “jobs bill”, however, or “stimulus” in the abstract, are not among them. If we do smart things, we will do well. If we do stupid things, or if we hope for markets to figure things out while nothing much gets done, the world will unravel beneath us. We have intellectual work to do that goes beyond choosing a deficit level. The austerity/stimulus debate is make-work for the chattering classes. It’s conspicuous cogitation that avoids the hard, simple questions. What, precisely, should we do that we are not yet doing? What are the things we do now that we should stop doing? And how can we make those changes without undermining the deep social infrastructure of our society, resources like legitimacy, fairness, and trust?

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Elsewhere, in the world of academia, I also noted this piece by Mark Bauerlein, Mohamed Gad-el-Hak, Wayne Grody, Bill McKelvey, and Stanley W. Trimble in the Chronicle of Higher Education on the avalanche of poor research. The authors point towards a growing problem of sub-par research in general pointing to, as far as I can see, three things. First, that the growing amount of poor research is a strain on the system of peer-reviewed work (too many articles to review by too few able reviewers); secondly, that the pressure to produce in academic circles leads to quantity over quality and thirdly that the increasing tendency of money to flow to the amount of publications by default exacerbates the problem.

While brilliant and progressive research continues apace here and there, the amount of redundant, inconsequential, and outright poor research has swelled in recent decades, filling countless pages in journals and monographs. Consider this tally from Science two decades ago: Only 45 percent of the articles published in the 4,500 top scientific journals were cited within the first five years after publication. In recent years, the figure seems to have dropped further. In a 2009 article in Online Information Review, Péter Jacsó found that 40.6 percent of the articles published in the top science and social-science journals (the figures do not include the humanities) were cited in the period 2002 to 2006.

(…)

Our suggestions would change evaluation practices in committee rooms, editorial offices, and library purchasing meetings. Hiring committees would favor candidates with high citation scores, not bulky publications. Libraries would drop journals that don’t register impact. Journals would change practices so that the materials they publish would make meaningful contributions and have the needed, detailed backup available online. Finally, researchers themselves would devote more attention to fewer and better papers actually published, and more journals might be more discriminating.

In the context of the world of academic economics which I am accustomed to I can see most of the issues the authors point. Especially, I would point towards the pressure to produce which is extensive in the context of economics. However, I am not sure about the point that a large bulk of research is bad because it, in itself, takes a lot of time to digest. I like to think that a study which might not be deemed relevant today may find its day in the sun in the future if the consensus and discourse changes.

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Economist Kartik Athreya from the Richmond Fed (Virginia) is not too fond about econbloggers voicing their opinions on macroeconomic because, as he says, it is a topic much too complicated for econbloggers to understand (the original link to the essay is gone, but FT Alphaville and Scott Sumner provide good coverage and quotes). Now, I don’t even know where to begin here but as both an econblogger and a semi-academic economist I naturally ought to be able to muster some opinion. But really, where do you start here? Well, I especially noted this;

So far, I’ve claimed something a bit obnoxious-sounding: that writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy. Taken literally, I am almost certainly wrong. Some of them have great ideas, for sure. But this is irrelevant. The real issue is that there is extremely low likelihood that the speculations of the untrained, on a topic almost pathologically riddled by dynamic considerations and feedback effects, will offer anything new. Moreover, there is a substantial likelihood that it will instead offer something incoherent or misleading.

Let me be very, very clear here. The ability to solve dynamic optimization problems, to solve complex differential equations, to derive, on paper, various statistical estimators do not make a good economist. You do all this in order to become a part of the initiated crowd and in order to speak a language which dazzles colleagues and the greater public by its complexity and, crucially, is the main reason why economists today still form a gated community. This is natural since it takes half a mathematics degree to say anything which your fellow colleagues will accept as a real economic argument.

But I digress (and rant too). Math is not the problem as such but a symptom of some of the problems with modern economics. In general though, Math makes you smart and helps to build rigorous arguments which helps in any scientific context. As such, I will reciprocate Mr. Athreya’s point; just as the econbloggers are not stupid neither are academic economists (they are devilshy smart for the most part). Yet, the latter have remained stuck too long and too far up the ivory tower to see that the econbloggers are not leeches who prey on the public through simplification of a complex topic, but in fact helps to bring an otherwise unworldly macroeconomic discourse down to earth.

We as economists should encourage this, not move further up the ivory tower.

“Our research also shows that greater weakness in the economy raises the estimated multiplier: It increases by around 0.1 for each two percentage points by which the unemployment rate exceeds its long-run median of 5.6%. Thus the estimated multiplier reaches 1.0 when the unemployment rate gets to about 12% … For data that start in 1950, we estimate that a one-percentage-point cut in the average marginal tax rate raises the following year’s GDP growth rate by around 0.6% per year. However, this effect is harder to pin down over longer periods that include the world wars and the Great Depression.”

Rok Spruk is a supply-side economist and a libertarian.
He (currently) lives in Slovenia where he studies economics
and business. His fields of research are economic growth,
macroeconomics, international economy, global competitiveness,
and tax reforms. His views, observations and ideas are posted
on his blog.

Keynes is considered the father of macroeconomics, one of the two major divisions of modern mainstream economics. Microeconomics is the description of reality, the study of how people interact and how markets work. Macroeconomics, on the other hand, is the study of how government can efficiently manipulate markets and people.

In the present world, economic reality and truth is largely ignored. The vast body of brilliant intellectuals involved in economics occupy themselves with building and analyzing macro models for government to more easily control the economy. They use their massive mathematical and analytical brainpower to try to develop more clever and complex models to predict the future and show politicians which strings to pull.

It can be clearly seen that the macroeconomists have failed miserably with their interventions to achieve a stable economy and well being for the people. It was a vast experiment over many decades and is a profound and horrible tragedy. All macroeconomists who promoted the interventionist state should be ashamed that they brought this great country to its knees. They should be crawling under a rock in embarrassment. That is not the way of the intellectual, however. The problem, they say, is that they didn’t intervene enough.

All of the macro models and manipulation are built on false premises. The first one is that government intervention can be successful at bringing long term to people in an economy. The second one is that they should intervene, even if success was possible.

Keynes’s conceived that, by measuring and controlling aggregates, such as aggregate demand, total unemployment and gross domestic product, the central planning gurus pulling the strings could make everything coordinate, put everyone to work and advance toward a post scarcity utopia.

The coordination problem is one that central planners have always had to deal with, and the former Soviet Union was one of the clearest examples of the problem and its results. The abolition of voluntary markets and the institution of central planning after the Bolshevik Revolution resulted in mass starvation and deprivation for many millions of people. Lenin was forced by reality to enact the New Economic Program in 1922, the limited reinstitution of markets, to prevent further deaths and possible overthrow of the regime.

Macroeconomics is, in its very essence, the rationalization of central planning. The core fallacy with all of macroeconomics is that data aggregated over a large, diverse area can be used to coordinate the activities in each locality and each transaction between actors in the markets. Each locality in a vast economy has its own peculiarities of weather, geography, demographics, culture and a host of other characteristics. The people each have their own goals, hopes, dreams, advantages and limitations.

It is not possible to impose a uniform solution on 300 million different people over millions of square miles of coastline, mountains, deserts and tundra. The problems and opportunities for small desert communities is vastly different than those of northern metropolitan centers. Macroeconomic policy is necessarily a generic solution to particular problems. The inevitable result is discord, waste and conflict. Because macroeconomics is inherently political, the macro solutions pit one group against another for control of the strings.

This brings us to the second inherent weakness of macroeconomic policy. Even if it was possible to have efficient macro solutions, it is wrong to impose those solutions. A slave owner might become an expert at wringing the most productivity from slaves. That he is able to do so does not mean he should. He should, rather, not enslave them. He should respect their rights and only enter into voluntary trade.

The same applies to national governments. Many people assume that it is a proper role of government to use coercion and confiscation to make people do things that will increase employment, aggregate income, gross domestic product or any other artificial measure. People in a free country, however, are not slaves of the state. Whether a policy will increase GDP or not does not give a politician the right to interfere with the voluntary interaction of market participants.

J.M. Keynes was indeed a brilliant man. Like so many brilliant people today, he was profoundly wrong and arrogant in his wrongness.

However, these appointments are a key tell in what should be a key strategy for economic recovery- monetary expansion.  While the Federal Reserve has already implemented major rate cuts and recently undertaken quantitative easing, the effects of these policies will not be felt for 6-9 months, as is the general case with monetary stimulus.  The greater risk could be that, just as a brief monetary expansion was put on hold in 1932 (not a good decision, it turned out), renewed concerns about inflation could create pressure on the Fed to cut short an effective monetary response.   But these appointments indicate that will not be Obama-led pressure.

All three- Geithner, Summers, and Romer- have indicated an understanding of monetary stimulus to provide short term benefits for economic growth.  Geithner, for example, was one of the leading proponents of keeping rates lower back in 2006 and has historically been dovish on monetary expansion.  Summers, while touting the benefits of fiscal stimulus last year, has also supported monetary expansion.  The most interesting pick here could be Mrs. Romer, as she has has expressly written that nearly all the positive economic shifts during the Great Depression were attributable to monetary expansion rather than some Austrian school view of natural economic recovery.

While President Obama has indicated a desire for redistribution of wealth in the US economy, and based on the election results, will oversee it, there are different ways to effect this redistribution.  Taxation and welfare is one way, but monetary expansion is another, because it ultimately creates higher levels of inflation.  As long as capacity and technology can come to the rescue (and there is plent of both available) so that core inflation can be moderated, this monetary expansion can be expected to continue.

Just as money has time value, it should also have a half life.  Without inflation, the wealthy can all too easily hoard their capital.  With inflation, they must either spend, or invest- or their wealth is, in fact, redistributed.  And redistribution to money earners- those who labor and invest- is not a bad idea for growing an economy.  And make no mistake, Mr. Obama and his team are focused on growing this economy.