Posted by: Dirk | October 10, 2008

Rethinking progress in macroeconomics

I can’t help but think that somethink went wrong in macroeconomics. It’s not the time to discuss it, but after the financial crisis is over, this should be addressed. Time Blog reminds us of Robert Lucas’ s 2003 presidential address to the American Economics Association:

Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

Hm. Perhaps that’s why economist’s use phrases like “ceteris paribus” or “on the one hand, …, but on the other hand.” Well, that was then, but this morning I received an e-mail containg a link to a new paper entitled DSGE Models and Central Banks. Here’s the abstract, with some highlighting by me:

Over the past 15 years there has been remarkable progress in the specification and estimation of dynamic stochastic general equilibrium (DSGE) models. Central banks in developed and emerging market economies have become increasingly interested in their usefulness for policy analysis and forecasting. This paper reviews some issues and challenges surrounding the use of these models at central banks. It recognises that they offer coherent frameworks for structuring policy discussions. Nonetheless, they are not ready to accomplish all that is being asked of them. First, they still need to incorporate relevant transmission mechanisms or sectors of the economy; Second, issues remain on how to empirically validate them; and finally, challenges remain on how to effectively communicate their features and implications to policy makers and to the public. Overall, at their current stage DSGE models have important limitations. How much of a problem this is will depend on their specific use at central banks.

The DSGE models are a disaster when it comes to explaining financial crises. And those are creating recessions of the 21st century, it seems. The dot-com bust in 2000/2001, the sub-prime crisis of 2007-? – these were not caused by technological shocks or a change in preferences. The causes were expansion of credit and international capital flows interacting (the latter caused the former, but maybe it worked the other way around as well?). But in these models investment is equal to saving and there are no bubbles, so it is not even possible to talk about what happened.

However, the knowledge is not lost. Here’s the abstract of a Bank for International Settlements paper from 2005, Debt-deflation: concepts and a stylised model by Goetz von Peter (again, I highlighted some sentences), which looks pretty good by now:

This paper proposes a model of how agents adjust their asset holdings in response to losses in general equilibrium. By emphasising the relation between deflation and financial distress, we capture some original features of the early debt-deflation literature, such as distress selling, instability, and endogenous monetary contraction.

The agents affected by a shock sell off assets to prevent their debt from crowding out consumption. But their distress-selling causes a decline in equilibrium prices, and the resulting losses elicit reactions by all agents. This activates several channels of debt-deflation. Yet we show that this process remains stable, even in the presence of large shocks, high indebtedness, and wide-spread default. What keeps the asset market stable is the presence of agents without prior debt or losses, who borrow to exploit the expected asset price recovery. By contrast, debt-deflation becomes unstable when agents try to contain their indebtedness, or when a credit crunch interferes with the accommodation necessary for stability.



  1. […] Lucas, who in 2003 thought depressions to be impossible now and in the near furture, is also on record: Robert E. Lucas, the undisputed dean of the […]

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