State of modern macro

1. Wickens: nothing wrong with modern macro
1. not the theory, but the way the theory was applied that caused the crisis
  1. poor policy & incorrect assessment of risk by hh's and banks to blame
2. macro criticised for not capturing complexity of human decisions
  1. but that's not what macro is there for in the first place
    1. it's a series of simplifications which we should use to gain insight about what would otherwise be intractable problems
3. macro has weaknesses, but these are way fewer than its strenghts
4. current system has incentives for individuals to deviate from what macro theory suggests
  1. should align private interests in banking with public welfare
2. Caballero: pretense-of-knowledge-syndrome
3. Blanchard et al: rethinking macro policy
1. Tension between
  1. theory
    1. successful macro policy = low, stable inflation rate
      1. if met = no output gap, natural unemployment
      2. no need to intervene in financial markets
    2. one instrument = repo rate
  2. practice
    1. flexible inflation targeting
      1. only long-run inflation needs to be low and stable
    2. more than one instrument
      1. require banks to hold reserve quantities
      2. CB's as lenders of last resort
    3. increased popularity of monetary policy (Friedman) over fiscal (Keynes)
      1. fiscal disproved by Ricardian equivalence
      2. fin market developments improved effectiveness of monetary policy
      3. lags in design & implementation of fiscal plus short length of recessions = fiscal measures take effect too late to be useful
      4. fiscal more likely than monetary to be distorted by political constraints
    4. financial deregulation
      1. regulation = improper mingling with functioning of credit markets
      2. soundness of individual institutions all that mattered - no thought of their impact on macro economy
2. "Great Moderation"
  1. decline in variability of output & inflation
  2. looked like it was the result of better monetary policy
    1. e.g. advanced economies responded well to oil price increases in 1970's & 2000's
  3. Thus crisis unforeseen
3. Lessons from crisis
  1. 1. Stable inflation necessary, not sufficient
    1. Can't use a single index
    2. No simple relationship between output and inflation
    3. need to include other indeces, e.g. housing prices
  2. 2. Low inflation limits scope of monetary policy in deflationary recessions
    1. Need higher inflation & low nominal interest rates to be able to cut interest rates in times of crisis
  3. 3. Financial intermediation NB
    1. Repo rate sufficient instrument for policy only as long as demand for liquidity is limited to banks
      1. not always the case
    2. prevent asset bubbles - bad because they form around speculation, not demand for liquidity
    3. Not the same as financial regulation!
  4. 4. Countercyclical fiscal policy NB tool
    1. monetary policy not sufficient (shown by limits of zero lower bound interest rates, etc.)
    2. esp when effects of crisis are expected to be long-lasting
    3. but only to be used in times of real crisis, not during normal business cycle fluctuations
  5. 5. Regulation not macroeconomically neutral
    1. regulation contributed to amplifying effects of decrease in US house prices to whole world
      1. e.g. allowing different financial intermediaries to play by different rules
      2. rules aimed at saving individual institutions during the crisis threatened the stability of the system as a whole
  6. 6. Need reinterpretation of Great Moderation
    1. result of better dealing with SOME shocks, not all
      1. specifically demand and supply shocks
      2. but bad at responding to financial shocks
4. Implications for design of policy
4. Kirman: crisis for econ theory
1. Can't blame any specific part of fin system for the crisis; rather, evolution of system as a whole led to its downfall
2. response to argument that crisis merely part of system
  1. then DGSE models should incorporate possibility of crises
3. explains crisis in terms of contagion, interdependence, interaction, networks, and trust
  1. none of these feature in modern macro theory
    1. building blocks of macro
      1. individuals act in isolation; only interact through the price mechanism
      2. aggregate = sum of parts who neither observe nor come into contact with those around them
      3. relations between variables fixed; system functions at equilibrium in mechanical way
        logically, any movement away from equilibrium can only be the result of an external shock
  2. local interaction NB in the real economy
    1. transmission of info, views, expectations
4. econ system should be studied like physical system
  1. e.g. heating up a specific volume of water
  2. NB of norms that develop over time
  3. aggregate behaviour doesn't correspond to that of a 'rational indivdual'
    1. rather, it's a complex adaptive system
      1. no simple relationship between individual and aggregate behaviour
    2. yet all macro models assume this
    3. behavioural econ has shown that individuals aren't rational
      1. why would you assume a whole made of irrational parts is rational?

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State of modern macro

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