Prior to the crisis, macroeconomists believed that large financial crashes – the type that could cause a Great Depression – were all but impossible in a modern economy guided by brilliant economists. Because of this, standard theoretical models focused on other questions.
I am not convinced that these “Dynamic Stochastic General Equilibrium” models will, in the end, be capable of being pushed as far as we need to go. But there is progress and we are finding that many of the results in the older models about liquidity traps, government spending multipliers, debt, inflation, and so on carry through to the modern models. Second, there are efforts to challenge the mainstream with competing models from groups such as the Institute for New Economic Thinking, and there is far more willingness than I expected among young researchers to look into alternatives such as network and agent-based theoretical models. This will help to push the research forward.
But when it comes to the empirical methods we use to sort between competing theoretical models, it’s hard to be as optimistic. Empirical research in macroeconomics is plagued by the uncertainty that comes with small data sets and the use of historical rather than experimental data. In addition, as the Reinhart-Rogoff episode makes clear, our devotion to the important tasks of validating and replicating empirical results leaves a lot to be desired. Even worse, too many minds in the profession cannot be changed even when the empirical evidence is relatively clear.
This last point fascinates me. There is no clear reason to undertake extreme austerity measures right now. Yes, government debt is too high but there is no theoretical reason to cut government spending right now. Yet, the politics say it is necessary. Why?
Why Politics and Economics Are a Toxic Cocktail
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