(Bloomberg View) -- There’s no question that mainstream academic macroeconomics failed pretty spectacularly in 2008. It didn’t just fail to predict the crisis -- most models, including Nobel Prize-winning ones, didn't even admit the possibility of a crisis. The vast majority of theories didn’t even include a financial sector.
And in the deep, long recession that followed, mainstream macro theory failed to give policymakers any consistent guidance as to how to respond -- some models recommended fiscal stimulus, some favored forward guidance by the central bank, and others said there was simply nothing at all to be done.
Because of this dismal record, many people have looked around for an alternative paradigm -- a new way of thinking about macroeconomics that would have allowed us to avoid the pitfalls of the Great Recession. That’s a natural reaction. And it was also inevitable that many people who felt shut out of the mainstream would rush to fill this demand for alternatives. These folks who call themselves “heterodox” economists.
Many among the heterodox would have us believe that their paradigm worked perfectly well in 2008 and after. As an example, take a recent blog post by British economics writer Frances Coppola.
Coppola likens mainstream macro to classical music, which walled itself off from the innovations of rock, jazz and other innovations. Like the musical innovators of the 20th century, she claims, the heterodox have found something that works better than the ossified old ways of the elite: Heterodox economists working in the real economy –- many of them untrained in formal economics –- not only predicted it but correctly identified the causes …
The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete.
This is dramatically overselling the product. First, heterodox models didn’t “predict” the crisis in the sense of an actual quantitative forecast.
This is because much of heterodox theory is non-quantitative. Basically, people write down English words explaining their conceptual ideas about how the economy works. This describes the ideas of mid-20th-century economist Hyman Minsky, who wrote books and essays about the instability of the financial system. Minsky, though trained in math, chose not to use equations to model the economy -- instead, he sketched broad ideas in plain English.
Broad idea-sketching is certainly a valuable activity. If theorists get lost in the specifics of their models, they can blind themselves to truly new hypotheses and mechanisms that would let them make big, radical changes. I do think this has happened to some degree in mainstream macro, where most modern models are variants of an old workhorse -- the Real Business Cycle model -- that was probably broken to begin with. But that doesn’t mean that broad idea-sketching is a replacement for formal models.
It’s not an apples-to-apples comparison. At the end of the day, policymakers and investors need to make quantitative decisions -- how much to raise or lower interest rates, how big of a deficit to run, or how much wealth to allocate to Treasury bonds.
If you had read Minsky in 2007, you might have known that a financial crisis and recession was conceivable, and had some general idea about the mechanisms that might be involved. But you wouldn’t have any concrete idea of the risk of experiencing a crisis or recession in 2008. For that, you need numbers.
Also, vague ideas can’t easily be tested against data and rejected. The heart of science is throwing away models that don’t work.
One of mainstream macro’s biggest failings is that theories that don’t fit the data continue to be regarded as good and useful models. But ideas like Minsky’s, with no equations or quantitative predictions, are almost impossible to reject -- if they seem not to fit with events, they can simply be reinterpreted. People will forever argue about what Minsky meant, or John Maynard Keynes, or Friedrich Hayek.
Some heterodox macroeconomists, it's true, do have quantitative theories. One is “stock-flow consistent” models (a confusing name, since mainstream models also maintain consistency between stocks and flows). These models, developed mainly by researchers at the Levy Economics Institute of Bard College, are large systems of many equations, usually linear equations -- for an example, see this paper by Levy economists Dimitri B. Papadimitriou, Gennaro Zezza, and Michalis Nikiforos.
However, these models have some serious flaws that make it very difficult to test them empirically. They have so many parameters that existing macroeconomic data has essentially no hope of identifying them all. This also tends to make them very vulnerable to so-called overfitting, meaning that they will fail to predict the future even if they appear to “predict” the past.
In addition, because they don’t take human behavior into account -- the equations are typically all in terms of macroeconomic aggregates -- there’s a good chance that the models could fail if policy changes make consumers and companies act differently than expected. In fact, the Federal Reserve Board already has this general type of model on hand, and tries harder than most heterodox researchers to address the pitfalls I mentioned, but it’s an uphill battle.
A second class of quantitative heterodox models, called “agent-based models,” have gained some attention, but so far no robust, reliable results have emerged from the research program.
So heterodox economics hasn’t really produced a replacement for mainstream macro. It remains an important source of new concepts and hypotheses -- and in fact, mainstream academics probably make use of those outside ideas more than they would like to admit. But there is currently no alternative macroeconomics waiting in the wings, denied its shot at glory only by the closed-mindedness of the academy. That is a myth.
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