There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions – the ones they were built to answer – and not so good at answering others…
But the New Keynesian model has its limits. It was built to capture “ordinary” business cycles driven by pricesluggishness of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.
I think that Mark is closer to being on track than are some folks like this fellow or this fellow. A model is not all-or-nothing, right-or-wrong. A model is like a pair of binoculars. It helps you see some things more clearly, at the expense of not seeing other things at all. If you do not have that understanding of the modeling process, then you are missing what I see as a fundamental methodological truth.
Some more comments:
1. In my estimate, the real-world usefulness of New Keynesian and DSGE models is close to zero. Even if it is a bit more positive than that, there is no way to justify the intensity with which those models were pursued. And as much as Paul Krugman wants to blame Minnesota, I keep coming back to the fact that it was Stan Fischer who turned out the grad students who captured probably 75 percent of the available top-tier academic macro posts available for a period of about 15 years, effectively over-running the entire ecosystem. To suggest instead that the profession caved into bullying from Prescott or Sargent or Lucas is to create a false narrative, offering what amounts to an intellectual bailout for MIT. Read my recent macro book to try to get a better sense of the history.
2. Mark Thoma may be optimistic in suggesting that there is a “right model” to use in every situation. It may be that there are important macroeconomic episodes that are beyond the scope of any model to truly capture.
3. If there is a “right model” for what I call the Financial Crisis Aftermath episode, then I think it will have to include a role for malinvestment. Not so much malinvestment because of the Fed’s misbehavior in 2004 (sorry, John Taylor), and even not so much malinvestment in housing. In the financial sector, I suspect that a lot of the malinvestment reflected poor judgment on the part of both private-sector executives and regulators. In the nonfinancial sector, I suspect that the malinvestment included poor choices on the part of people in terms of skill acquisition (a lot of college degrees in psychology and “____ studies” majors) and a lot of malinvestment on the part of firms that took too long to recognize that the Internet was blowing apart their business models.
4. The PSST story emphasizes the lengthy, trial-and-error process involved in finding new patterns of sustainable specialization and trade. It tends to defy the entire “model” genre, because modeling tends to involve solving for equilibrium, rather than describing what may be a laborious process of groping within a state of disequilibrium.
Interesting post. I agree on #2 but you’re being too generous. Apart from your PSST, the economy doesn’t swing from one flawed specification to another. Financial factors weren’t inconsequential prior to recent cycles; price rigidities aren’t inconsequential in the present cycle; and so on.
In other words, the relative importance of each dynamic varies, but you can’t boil each cycle down to a single dynamic. The very nature of macroeconomic volatility is that virtuous and vicious circles cut across both the financial and the “real” economy.
IMO, the “one model for every occasion approach” reeks of a self-preservation strategy for folks who’ve devoted their careers to modeling. It layers even more naivety on top of the naivety that’s built into the many faulty models that we’ve accumulated.
A technology explanation has been around for a long time, but applying it to the 30s when innovation was high would have to mean that it takes time for them to mature to the point where large scale investment is worthwhile. It is possible, but it is also possible a lack of funds and risk tolerance prevented them from being exploited sooner or with more failures there could have been more successes.
This shades into psychology which is probably the only permanency of the human condition. Patterns not looked for are not found. Whether you think you can or not, you are right.
The explanation has entrepreneurs groping about in the dark while disequilibrium is unmeasurable. So what drives them, how do they know when things are sustainable? They have no measure, no way forward.
The question of what drives entrepreneurs is not simple. Keynes answered “animal spirits.” The traditional economic answer is “profit opportunities.” Certainly it is profits that are the indicator of sustainability in a market system.
I would slightly alter that explanation. At the boundary of disequalibrium, entrepreneurs can measure slight equilibriating changes.