Lucas on the Shortcomings of Modern Macro

And so the debate about the state of modern macroeconomics continues. As the rhetoric escalates, perhaps it’s worth digging through the archives for real insight, instead. Here’s Robert Lucas in his 2003 keynote address to the History of Political Economy conference:

The problem that the new theories, the theories embedded in general equilibrium dynamics of the sort that we know how to use pretty well now — there’s a residue of things they don’t let us think about. They don’t let us think about the U.S. experience in the 1930’s or about financial crises and their real consequences in Asian and Latin America; they don’t let us think very well about Japan in the 1990’s.

Honestly, it sounds like Lucas agrees with Krugman. Enough said.

(Hat tip: This quote is highlighted in David Laidler‘s recent paper, “Lucas, Keynes, and the Crisis.”)


qingl

so are you saying that krugman doesn't offer real insight?

PJ

Bottom line, guys- if it's not predictive; it is NOT a science. Economics has MUCH more in common with Science Fiction than Science. Both fields make stuff up and try to make it as believable as possible. The recent staggeringly short sighted application of various equations and models to a very poorly understood system (verifiable data? since when?) is pretty indicative of how little Economists actually know about what they do every single day. Nice losing MY job over YOUR hubris.

Sean

It is predictive. Economics is the conceptual framework. The financial crisis happened mainly b/c of the lack of financial governance in the US Financial Markets.

Joe Smith

Start with the facts beyond dispute: (1) there was a bubble (2) the bubble popped (3) banks took on unreasonable levels of risk (4) the financial system and the world economy stared into the abyss last year (5) the US government had to save the financial system (and the economy) by injecting enormous amounts of money and assuming large risks that the private sector was no longer willing to carry.

Any economic theory that says there could not be a systemic breakdown of the banking system is wrong. Any economic theory that says that the banking system could self regulate or self correct is wrong. We have run the "experiment" and some theories need to be discarded.

Chris

#5 is not a fact beyond dispute. That the government attempted to save the financial system by injecting money into the economy is true. That they "had to" do it, or that it was successful in its goals, is your opinion.

I don't agree with the second paragraph, either: an ECONOMIC theory can say the banking system could not break down this way, because as an economic theory it should not necessarily be expected to account for political interference, which as you may have noticed, many believe to be the primary culprit here.

Bruce

PJ: There are lots of non-predictive sciences. Evolutionary biology, for one: we know a lot, if not everything, about how organisms evolve and how the underlying genetics works. But we can't predict what organisms will evolve, and certainly not what genes will arise from random mutation. Similarly for cosmology.

Brett

I'm an economist.

I predicted the recession and financial collapse (circa 2006). My best guess at the time was early 2008 so NEBR says I was late by a few months.

I used classical economics and out of favor European liberal economic analysis to do so.

After talking to a PhD economist in 2006 who was working in the mortgage industry, I discovered the disconnect between the players and the ultimate external costs of what they were doing. The epiphany came when the PhD didn't understand my question about how mortgages are bundled into MBS's and then insured with CDS's. He was writing a book on the mortgage industry and somehow I seemed to know more than him about what took place outside the office.

That's the myopia that most people suffer in their everyday lives. They never get the big picture and never think more than a couple steps ahead. Some economists are not much better.

The common sense that one must apply from knowing human nature is that if the actors don't have to take on the risk they will become wreckless. Everyone in real estate and finance became risk takers as long as the risk was short and easily offloaded.

So there you go. Not alot of math or equations, but application of "human behavior" theory which correctly predicted the fall of real estate and the subsequent collapse of the financial industry relying on its derivatives.

I lost no money in 2008 thanks to following basic economic theory and seeing the inverted yield curve more than a year before. Yes, very predictive, but not 100%. However, good enough theory not to be shelving 300 years of economic thought as useless.

PJ lost all his money apparently because he didn't understand any of the previous problems nor the importance of an oil shock. When that came on top of all that was already happening, any half witted economist new that we were going over the cliff in a Hummvi. He's right that it's not rocket science, but then he can't really explain why he was unable even to implement the basics of economic theory to protect himself.

Enough said on using what you know to predict the future. There is a problem with modern neoclassical economics; it ignored the common sense sophisms of its predecessors. It became so wrapped up in mathematics, that it forgot human nature wasn't that easily predictable.

Black Swans are real. Some of us had always known that and plan for it. It's intellectualized paranoia, but it can sometimes have its benefits. It can also make you paranoid.

What this thread should concentrate on is Behavioural Economics and what it has to offer to the quants. They need to get heir deltas right and stop using unknown constants as if they were known. Their adjust R squares are played with until the data fits the equation, but the fundamental drivers of the variables are not well understood. However, they sleep well at night thinking that their curves fit the data just write, because they wrote the equation to do just that.

It's like observing the periodicity of a watch, but knowing nothing about when it needs to be wound or how the inner workings may break.

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Seiji Fetter

Chris,

Economic theory is supposed to take political interference into account. Unless I misunderstood you, the entire Political Economics, Public Choice and New Institutional Economics research fields seems to have been left out in your second paragraph. As economists, we are actually ought to take into account (and try to explain) several factors which aren't purely economic, but significantly affect the economy, such as the regulatory enviroment, the incentives which define and sustain that enviroment, the behaviour of a political leader that reacts to prestige and monetary incentives, and so on.

But you are partially right, because CURRENT (mainstream) economic theory is too naïve, by not including many relevant factors (yet), one of which political interference is definately is a very important one.

David

Bruce: Evolutionary biology can make predictions—if you ask it the right questions. In this way, it is much like economics. So, for example, given a certain environment and lifeforms within it, Natural Selection will predict certain population changes. It will also predict certain general human behaviours based on our understanding of human evolution. These predictions can be tested by anthropological studies and statistics. Another example (which appeared on NOVA): humans have one fewer pair of chromosomes than chimpanzees. Why? Evolutionary biologists theorized that two pairs fused into one. This theory produced a testable hypothesis: that one pair of chromosomes would contain an extra set of end-of-chromosome markers within the chromosome. This prediction turned out to be true. And I'm sure any cosmologist will tell you the same:predictions are made and tested all the time, which is how better telescopes keep allowing us to refine our understanding of the universe.

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Jim

Economics doesn't make scientific predictions. It makes, so the lingo goes, "forecasts."

So it's a predictive science like meteorology is one--except that meteorology seems to improve as its computer models get more complex, while in economics, this increasing complexity seems to produce more bewilderment.

It's not that economists disagree in their predictions. But pay attention. Practically every major piece of economic news reported is accompanied by a version of the phrase "a number that is [higher/lower] than most economists were expecting."

So economists seem to agree enough to be, as a group, consistently wrong.

Jon

what if a dominant sect of physicists insisted that non-equilibrium phenomena were not only difficult to compute but also irrelevant? And what if these physicists then designed, say, water pipes through the chilly north, never really acknowledging that water could ever turn into ice.

One would hop they'd be some unemployed physicists.

perhaps

Meteorology is a useful analogue. The weather system is extraordinarily complex, as is the (inter)national economy. This makes outcomes difficult to predict with precision.

The difference is that gaining more measures of wind speed, moisture levels etc. globally enables better prediction about outcomes. Wind in SE Asia blows in the same way as wind in Texas. There is no significant measurement problem; just a very complex system with a huge number of variables driving outcomes.

Humans are different. We all know that the strong assumption of rationality (wealth maximization) is empirically false. Nevertheless it remains the assumption that is at the basis of economic analysis. So long as this is the case, economists will continue to predict, but predict wrongly.

Solution? less Hubris. (Do you understand this Greg Mankiw?)

JKD

It isn't predictive because the lack of governance was part of the model. Businessmen were supposed to be rational enough not to leverage (over 30-1) the fate of the world on the premise that real estate doesn't decline in value.

Brian Czech

After his presidential address at the American Economic Association meeting approximately 7 years ago, I asked Lucas if he thought there was a limit to economic growth. His knee-jerk reaction was, “No, that's what technological progress is for,” demonstrating the shallowness of conventional macroeconomic thinking vis-à-vis the environment. Meanwhile, Romer helped to “endogenize” technological progress into conventional economic growth theory, smartly so yet not with a rigorous application of natural sciences, thereby leaving the door open for the win-win political rhetoric of perpetual economic growth. In contrast, here's what we have to offer in ecological economics:

http://steadystate.org/Files/Czech_Technological_Progress.pdf

Join the likes of E.O. Wilson, Gus Speth, Peter Victor, and Herman Daly in setting the record straight via the CASSE position on economic growth:

http://www.steadystate.org/CASSEPositionOnEG.html

Brian Czech, Ph.D., President
Center for the Advancement of the Steady State Economy

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wjd123

I have a formula. There are as many types of human nature as there are societies. The more capitalistic the society the less social is economic man. Therefore in order to protect what is social from economic man in a capitalistic society rules and regulations need to be inversely proportional to the type human nature capitalism creates.

science minded

I guess one could argue that keynes already was discovered. And Bruce, all sciences are capable of making predictions--even evolutionary Biology. My suggestion--reread Darwin---I did for the first time a while ago-- and found that it is possible to make a certain prediction that has already been verified.

As for "human nature"- I am having difficulty with the notion of many types. IF you are referring to cultural differences or the difference between the West and East-- even that difference(already identified) calls attention to what we as humans share in common.

wjd123

sceince minded,

I'm referring to Durkheim's idea that the catagories of the human mind are social constructs and arbitrary ones at that.

My problem with classical economists is that they posit human nature as a given and proceed from there. Anthropology would indicate that such assumptions are arbitrary.

Where is this given from which economists assume how economic man will act?

Think of organic man as the id and society as the superego. From where comes the ego? Without the id and the superego it doesn't develope. Does our self awareness naturally grow into maturity from some human nature seed. No, it's a process dependent on the id and the superego.

And feral child deprived of the stimilus of language for a number of years is incapable of learning any language. The language learning part of the brain shuts down.

The economic man of Adam Smith was local and temperal. He couldn't have functioned in the Roman Empire. He would have had to many scruples. His sociology of morals even his sociology of knowledge would have been different.

Today one could argue that both these sociologies are becoming more and more universal. That's an empirical statement about social constructs and not a metaphysical statement about the nature of man.

Macroeconomists are free to model the most efficient way for an economy to return to equalibrium. They are not free to assume the same economic man for every model.

It's not enough to say that we are more alike than different when it comes to human nature without showing why.

Personally every time I'm exposed to the editorial board of the Wall Street Journal I'm left wondering from what planet these people came. And we know that instinctally dogs won't soil the areas around where they eat. Greenspan assumed the same about economic man and was badly mistaken.

There is no thread in a capitalistic society that ensures that social interests will be served by individual interests. Nor is there one in a communistic or socialistic society. The best we can do to ensure a "just right moment" is to get the incentives--which includes sanctions--right for the human nature here and now that does exist so social interests won't go begging.

It's my contention that in dealing with the problem of "Who is economic man?" there is no one ideal or empirical "human nature" that can be fitted for all people at all times.

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science minded

Dear wjd123

First off, you claim that according to Durkheim, the categories of the mind are "social constructs." Durkheim never used such a term. At least in English and I have no reason to doubt the translation at this time, Durkheim claimed that from the action and reaction of people they develops thoughts, feelings beliefs in common--hence Durkheim's idea of a "conscience collective" or collective consciousness and conscience. Durkheim uses the analogy of adding hydrogen and oxygen and getting water (with properties of its own). So as far as human nature was a concern to Durkheim, he did compare humans and other animals and by means of such comparisons developed his' general understanding of a society's relationships to its members with implications as to what humans would be like in a state of nature. But Then you skip to classical economics (with its emphasis on economic man) and hence upon the self interested, historical individual. My point, you need to decide how you wish to define and delimit the scope of reality and remain consistent. Otherwise, there is no science in the sense that anything goes and that is not science. (Goldstein, copyright 2003)-

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