Hamilton on oil prices and the recession

Michael Giberson

James Hamilton, “Will rising oil prices derail the recovery?“:

I have no doubt that the problems with financial markets were a bigger factor than oil prices in the striking collapse in output in 2008:Q4 and 2009:Q1. The other approaches to measuring the contribution of oil to the downturn surveyed in my Brookings paper would estimate a smaller contribution of oil to the downturn than suggested by the figure above. On the other hand, all of the approaches surveyed in that paper suggest that oil made a material contribution to the initial downturn, and it seems hard to deny that that the severity of the financial crisis was exacerbated by the fact that the U.S. had spent three quarters in recession prior to the failure of Lehman in September 2008.

Hamilton then considers the concern that rising oil prices will dampen or destroy prospects for economic recovery.

Some complexity-based thoughts on macro

Lynne Kiesling

I am doing a lot of reading and thinking, trying to make some headway on a way-overdue paper, and have been reading a striking working paper from David Colander, Richard Holt, and Barkley Rosser, “The Complexity Era in Economics” (August 2009). Their insights are directed toward the evolution of economics methodology and the absorption of complexity-related concepts and techniques. In addition to being relevant to my own work on regulatory institutions and technological change, I found the paper insightful in the context of the discussion a couple of weeks ago about this year’s new institutional economics Nobel prize and the dominant methodological hegemony in economics.

One of their interesting observations is also pertinent to the reexamination of macroeconomic theory in light of the financial market context of the past year and a half. This quote, in particular, illustrates what I find especially striking in macroeconomics:

However, while the new theoretical models have done a good job in eliminating the old theory, it is less clear as to what the new theoretical work has added to our understanding of the macro economy. At best, the results of the new macro models can be roughly calibrated with the empirical evidence, but often the calibration of these new models is no better than any other model, and the only claim they have to being preferred is aesthetic—they have micro foundations. However, it is a strange micro foundation—a micro foundation based on assumptions of no heterogeneous agent interaction, when, for many people intuitively, it is precisely the heterogeneous agent interaction that leads to central characteristics of the macro economy.

It’s also interesting that in that section they footnote Leijonhufvud, who wrote the only macroeconomic theory that I ever felt like I had any kind of grasp on, On Keynesian Economics and the Economics of Keynes:A Study in Monetary Theory.

If you haven’t had you fill of current critiques of macro theory, and you are interested in reading their thoughts on the evolution of economics to incorporate the analysis of economic systems as complex adaptive systems, I recommend this short working paper.

Reactions to Krugman on the state of macroeconomics

Michael Giberson

Krugman’s long essay in the New York Times Magazine last week continues to stir responses. (All of which are much more substantive and engaging than my supercilious remarks on Jane Smiley’s goofy Marxism in the Huffington Post. ADDED: For a more measured response to Smiley, see Steve Horwitz and Art Carden’s short explanation at Forbes.)

David Colander, writing in the Causes of the Crisis blog newly established by the Critical Review Foundation, reports having been frequently asked his opinion of Krugman’s piece over the last week:

It’s difficult to respond; he’s a wonderful writer, and there’s some parts of the story he tells that are nicely expressed. But there are other parts that, from my viewpoint as an historian of economic thought and an economist watcher, he got quite wrong—sufficiently wrong to warrant a response.

The biggest general problem with the story Krugman tells is that it’s so black and white. There’s the good guys—the Keynesian gang, and bad guys—the Classical/Chicago gang. That, in my view, is seriously wrong. The real story is one of shades of grey, and full of nuances; it is a story in which it is hard to tell who are the good guys and who are the bad guys.

Colander asserts Krugman also misstates the position of the Classical economists, fails to clarify just which kind of Keynesian economics he prefers, and mistakenly claims math in economics is to blame for the crisis rather than the misuse of math in economics.  Colander recently testified to a House committee on the role of economics and financial modeling in the crisis.

Vernon Smith, also posting at Causes of the Crisis, sees a surprising similarity in some of Krugman’s point and F.A. Hayek’s Nobel Lecture in 1974.  Both Krugman and Hayek observe that economists’ views and policy recommendations may have contributed to the arrival of economic problems they did not foresee.  Smith notes that Hayek’s response was one of fundamental intellectual modesty driven by his views of the nature of society.  Smith quotes Hayek:

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Smith observes that, “Economic scientists have precious little understanding of this rule governed complex order, and how to keep it on its demonstrated long term path of growth and human betterment… Less pretence and a commitment to learn from the new data being generated… will be both humbling and informative, after the inevitable human political impulse to blame one’s long standing political adversaries has run its course.”

Jeffrey Friedman, in a post announcing the Causes of the Crisis blog, calls it “an experiment in scholarly discourse using what is usually the worst venue for careful discussion–the blog.”  The contributors to the blog are authors of articles in a recent special issue of the journal Critical Review.  According to the announcement, the blog is aimed at “the past – what caused the crisis? – not on the future – what should be done about it?”  Friedman said, “We will leave the policy recommendations to the pundits.”

Elsewhere (and in a somewhat different editorial mood), University of Chicago economist John Cochrane offers his view of the Krugman essay:

It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this schlock instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

And that’s the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and “spend like a drunken sailor” are pretty superficial compared to all the fascinating things economists are writing about it these days.

Okay, so “personal attacks and innuendo mean the author has run out of ideas,” but what do personal attacks without innuendo mean?  There is no innuendo in Cochrane’s reply; Cochrane is nothing if not direct in his personal attacks.

Cochrane goes on to conclude, “the problem [with macroeconomics] is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the ‘then’ really does follow the ‘if,’ which it so frequently does not if you just write prose.”

At ThinkMarkets, Mario Rizzo reacts to Krugman and the reply by Cochrane and finds himself in an uncomfortable middle ground – neither traditional Keynesian nor Freshwater rationalist. Rizzo finds the Austrian macro perspective more balanced.

Thus the Austrian view really is a middle ground. There are real underlying distortions – not simply animal spirits gone wild. They must be dealt with. But there are also secondary, subjective and expectational consequences induced by the original poor monetary policy. It is not so much that markets are inefficient and that actors can be irrational. Rather, in the process of market correction markets will seem inefficient but they are “trying” to correct errors.

(RELATED: Last week I posted on Barry Eichengreen’s essay of a few months back on the topic of “what went wrong with economics.”

ALSO: Alex Tarborrak on Krugman’s essay at Marginal Revolution: “It’s a good story–not the least because there is some truth to it–but there are also many omissions which cast doubt on the thesis.”)

Eichengreen on how economists went astray

Michael Giberson

When Paul Krugman wrote about “how economists got it wrong” in the New York Times Magazine, after a few preliminary remarks the story became all about Keynes, Keynesians, and New Keynesians.  By my count the name “Keynes” or some variant of it shows up over 50 times in the essay. He talks a lot about “saltwater” economists and “freshwater” economists as well, with “saltwater” in essence another name for Keynesian-style economics.  His concluding section is titled “Re-embracing Keynes,” and he said, “Keynesian economics remains the best framework we have for making sense of recessions and depressions.”  Keynes is the foundation in Krugman’s view.

Greg Mankiw points out on his blog an essay by Barry Eichengreen that addresses the same question – how did economists get it so wrong. I couldn’t help but notice as I read that essay, Eichengreen manages to mention “Keynes” or some variant name exactly zero times.  Lest you think Eichengreen is some anti-Keynesian “freshwater” economist that Krugman warns about, note that Eichengreen is firmly planted at the “saltwater” bastion of the University of California-Berkeley.

Part of the difference is explained by Krugman’s focus on macroeconomic theorizing and Eichengreen’s stronger attention to financial economics and its applications.  Krugman attends more to the academic theorist to public policy maker connection, while Eichengreen looks more at links between academia and business.  To some degree they are telling different parts of the story, so different characters feature in the narrative.

But the Eichengreen story provides richer institutional details, discussing frankly the role that financial incentives and a kind of peer pressure within economics played in diverting attention away from the growing financial problems. All in all, I felt better informed about what went wrong, and maybe what should be done, after reading it.

And in a way, Eichengreen’s essay reminded me of Jane Smiley’s execrable scribblings in the Huffington Post. Discussed here. Smiley, too, believes corporate money biases economists. But now that I’ve said that, I should clarify that Eichengreen has obviously observed carefully and thought deeply and to good effect, with the result that Eichengreen’s essay is very much worth reading.  In each of these ways his essay is very nearly the exact opposite of Smiley’s.

But Keynes name-dropping aside, Krugman and Eichengreen share much: both urge more attention to behavioral economics and particularly behavioral finance; both urge more attention to the real economy at the expense of elegant mathematical models.  As Eichengreen points out, both efforts are already well on there way.

The shifts do not guarantee that economists won’t get it wrong again someday, but at least we can hope not to repeat the same mistakes.