Romer’s Trouble With Macro

Let us start with Five Fundamental propositions, which would be startling to the general public, but familiar to my current audience of heterodox economists.

  1. Mainstream modern economic theory is complete garbage. This is true of Micro, Macro, Econometrics, Trade, Monetary, Industrial Organization — EVERYTHING.
  2. It is very EASY to prove this assertion. Fundamental principles on which the entire discipline is built are easily proven to be wrong. The axiomatic theory of human behavior encapsulated in homo economicus has no match to real human behavior. The theory of perfect competition devised to explain prices and markets has no relation to the realities of oligopolies, multinationals, excess production, and shaping of demand by advertisements and culture. The welfare theory implicit in maximization of lifetime utility is exceedingly harmful to our human welfare, which comes from social associations and character traits, rather than excess consumption. The optimization/equilibrium methodology is a complete failure. Humans do not and cannot optimize; they lack the information required to do so. Dynamic systems cannot be understood by looking at their equilibria. Standard econometrics techniques can be used to prove anything at all, given any data. In any place you look, the theory is flawed beyond belief. The young earth theory, as well as the flat earth theory are more defensible, in comparison.
  3. Many leading economists are aware of the astonishing conflicts between economics and simple facts of observation. See Quotes Critical of Economics for a choice collection of quotes to prove this assertion.
  4. The Global Financial Crisis of 2007 created widespread public awareness of this catastrophic failure of Economics. The Queen of England went to London School of Economics to ask why no one saw this coming. The US Congress appointed a commission to study why economists not only did not foresee the crisis, they confidently predicted that such an event could not happen.
  5. What is most amazing is the (lack of) response of the Economics Profession to the Crisis. As documented by many, there has been NO response. The same old theories which failed miserably continue to be taught the world over. Teachers continue to believe in, and preach, the same sermons which led to global disaster. Students continue to be indoctrinated into the same poisonous doctrines which ruin our own personal happiness, and destroy possibilities of building a good society. The same ARCH/GARCH models which failed to predict the volatility of stocks in the GFC continue to be used. The same monetary policies which led to the crisis and could not prevent the Great Recession which followed are lauded and praised, and continue to be practiced. There seems to be increasing general awareness of this failure of the profession as a whole; see, for example,  “Economics: The Profession that Refuses to Change”.

In light of the five propositions listed above, there are two major tasks that emerge as important for the heterodoxy. One of the tasks is to prove the truth of the five propositions. This is generally where most of the effort is being made. The present post also deals with this same issue — how to prove the five propositions listed above. One way to do so is to read the article on “Trouble with Macroeconomics” by Paul Romer, which is summarized below.

However, I believe that the SECOND task, not undertaken here, is much more important, as well as greatly neglected, and not well understood. We must reflect on the nature of a world where lunatic asylum class theories are propounded at leading universities throughout the world, and taught to the brightest (but innocent) students who come to believe them.  What is the nature of knowledge? How do we come to believe in ridiculous theories? How is knowledge transmitted from generation to generation? Very serious meta-questions about all of these issues arise, which must be studied seriously and deeply in order to be able to craft a coherent response to the state of affairs summarized in the five points above. When talking among ourselves, as in this blog and the RWER blog, it is not worth repeatedly re-establishing the five propositions. Rather, we should take these five as axiomatically agreed upon, and proceed to the more difficult tasks that emerge in terms of understanding a world where bright people can be convinced of absurdities, and how we can undo this damage. I will defer this task to a later date (although many of my earlier posts do deal with many different aspects of this issue which require study), and study the article of Paul Romer below.

Paul Romer, recent Nobel Prize winner in economics, wrote “The Trouble with Macroeconomics” which contains a devastating critique of modern macroeconomics.  In particular, Romer writes that modern macro got started when Lucas and Sargent wrote that predictions based on Keynesian economics “were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed”. But after three decades of research, during which the profession has gone backwards, losing hard-won insights into the nature of the economy, exactly the same criticism can be leveled at modern macro theories — they give wildly incorrect predictions and are based on fundamentally flawed doctrines, beyond the possibility of repair. The LAST section of the paper is the most interesting — Romer asks why he is unique in making such a strong critique, basically saying all of modern macro is complete nonsense; others have voiced sharp critiques but stopped short of saying what Romer has said. He says that this is due to the extreme pressure in the profession to conform, and to kow-tow to the mainstream. While others major economists privately agree to his views, they cannot afford to say so in public, because of the serious damage it would do to their careers.  A Video lecture which provides a coherent summary is linked here

Below I pick out some choice quotes from the paper which also provide an outline of the contents of the paper, for those with insufficient time to watch the video-lecture. My own interpolations and explanations are italicised and enclosed in double square brackets [[ ]] below — Other material is direct quotes from the paper itself.

Paul Romer: The Trouble With MacroEconomics

For more than three decades, macroeconomics has gone backwards

Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes

[[Modern macro started with the Lucas critique of incredible identifying assumptions used in econometric models, but, after thirty years of work instead of progress, there has been regress]] Canova and Sala (2009) signal with the title of a recent paper, we are now “Back to Square One.” Macro models now use incredible identifying assumptions to reach bewildering conclusions.

[[Romer finds it incredible that a leading macroeconomist would feign ignorance about effects of monetary policy]] To appreciate how strange these conclusions can be, consider this observation, from a paper published in 2010, by a leading macroeconomist:
… although in the interest of disclosure, I must admit that I am myself less than totally convinced of the importance of money outside the case of large inflations.

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model.

In this [RBC] model, the effects of monetary policy are so insignificant that, as Prescott taught graduate students at the University of Minnesota “postal economics is more central to understanding the economy than monetary economics” (Chong, La Porta, Lopez-de-Silanes, Shliefer, 2014).

[[After discussing an episode of tightening of monetary policy by the FED]] If the Fed can cause a 500 basis point change in interest rates, it is absurd to wonder if monetary policy is important. Faced with the data in Figure 2, the only way to remain faithful to dogma that monetary policy is not important is to argue that despite what people at the Fed thought, they did not change the Fed funds rate; it was an imaginary shock that increased it at just the right time and by just the right amount to fool people at the Fed into thinking they were the ones who were the ones moving it around.
To my knowledge, no economist will state as fact that it was an imaginary shock
that raised real rates during Volcker’s term, but many endorse models that will say
this for them

Macroeconomists got comfortable with the idea that fluctuations in macroeconomic
aggregates are caused by imaginary shocks, instead of actions that people take, after
Kydland and Prescott (1982) launched the real business cycle (RBC) model. The real business cycle model explains recessions as exogenous decreases in phlogiston (an unexplained residual).

The noncommittal relationship with the truth revealed by these methodological
evasions and the “less than totally convinced …” dismissal of fact goes so far beyond
post-modern irony that it deserves its own label. I suggest “post-real.”

Once macroeconomists concluded that it was reasonable to invoke an imaginary
forcing variables, they added more. The resulting menagerie, together with mysuggested names now includes:
• A general type of phlogiston that increases the quantity of consumption goods
produced by given inputs
• An “investment-specific” type of phlogiston that increases the quantity of
capital goods produced by given inputs
• A troll who makes random changes to the wages paid to all workers
• A gremlin who makes random changes to the price of output
• Aether, which increases the risk preference of investors
• Caloric, which makes people want less leisure
With the possible exception of phlogiston, the modelers assumed that there is
no way to directly measure these forces. Phlogiston can in measured by growth
accounting, at least in principle. In practice, the calculated residual is very sensitive
to mismeasurement of the utilization rate of inputs, so even in this case, direct
measurements are frequently ignored.

To allow for the possibility that monetary policy could matter, empirical DSGE
models put sticky-price lipstick on this RBC pig. The sticky-price extensions allow
for the possibility that monetary policy can affect output, but the reported results
from fitted or calibrated models never stray far from RBC dogma. If monetary policy
matters at all, it matters very little

FWUTV: Facts with unknown truth value [[Romer shows that in order to identify parameters, we feed in lots of arbitrary assumptions — which he calls FWUTVs — into the model. Shows several specific examples of this in action. Lucas critique said that use of arbitrary assumption to identify econometric models made estimates unreliable. However, their techniques introduce even more arbitrary assumptions to identify their models.]] “Post-real macroeconomists have not delivered the careful attention to the identification problem that Lucas and Sargent (1979) promised. They still rely on FWUTV’s. All they seem to have done is find new ways to fed in FWUTV’s ”

[[Romer explains how identification is achieved by hiding the assumption within a maze of mathematics almost impossible to track down, and never made explicit. He provides a specific example where an assumption the E log u = 0, about an unobservable error creates identification. Assumptions on unobservables are hard to spot, and harder to challenge, since they are, after all, unobservable — hence the term FWUTV. Another way to achieve identification is via Bayesian priors. You can put anything you like into the priors, which are arbitrarily chosen, and achieve identification. This section reminds us of the following Keynes quote: Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. GT Book 5, Chapter 21,Section 3, p. 298  

Romer shows how members of the Chicago school support each other, even in face of conflicting evidence known to them. He explains the sociology of knowledge, how the publications process ensures loyalty. He explains that he is free of the constraints, and therefore free to express his deep dissent, because he is no longer operating within an Academic environment: “Parenthetically, it is similarly true, that I can make very bold attacks on economics and economists ONLY because my pay, promotions, publications are no longer dependent on how professional economists in the USA evaluate me.” Those operating within the Western academia find that severe penalties are imposed upon them if they dare to step outside the boundaries of permissible dissent. ]]

Back to Square One: I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day relied on identifying assumptions that were not credible. The situation now is worse. Macro models make assumptions that are no more credible and far more opaque.

[[Romer argues that the Chicago School criticized Keynesian harshly for failing to predict stagflation. However, the Lucas prophecy that there would be no more recessions is an even more dramatic prediction failure.]] ” what Lucas and Sargent wrote of Keynesian macro models applies with full force 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 …(Lucas and Sargent, 1979, p. 49)”

Some economists counter my concerns by saying that post-real macroeconomics is a
backwater that can safely be ignored; after all, “how many economists really believe
that extremely tight monetary policy will have zero effect on real output?”
To me, this reveals a disturbing blind spot. The trouble is not so much that
macroeconomists say things that are inconsistent with the facts. The real trouble is
that other economists do not care that the macroeconomists do not care about the
facts. An indifferent tolerance of obvious error is even more corrosive to science
than committed advocacy of error.
It is sad to recognize that economists who made such important scientific
contributions in the early stages of their careers followed a trajectory that took them
away from science. It is painful to say this so when they are people I know and like
and when so many other people that I know and like idolize these leaders.

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