Tuesday, September 20, 2016

Romer on Macro

I am teaching Principles of Macro this semester as I frequently do.  What to make of Paul Romer's broadside against Macroeconomics?

I believe it was Williamson who said that what is taught in undergraduate macroeconomics has nothing to do with what real macroeconomists do.    So, I suppose I shouldn't worry too much that Romer believes that these "real" macroeconomists have gone off the rails.  

Still, I think Romer goes to far.

Romer calls out several famous economists by name.   His strongest criticism is for Prescott, though Lucas and Sargeant get some heavy criticism too.    What is Romer's problem with Prescott and the rest?   It seems mostly aimed at real business cycle theory.

I think real business cycle theory is a bit of an oxymoron.   Of course, if business cycle theory is supposed to explain fluctuations in real output around trend, then what I would prefer to call "supply-side" shocks must be taken into account.     From that perspective, real business cycle theory has done a service in correcting a view that potential output is on a continuous three percent growth path and any deviation of real output from that growth path should be understood as being due to shifts in aggregate demand--spending on output--imperfectly accommodated by changes in inflation of money prices and wages.

When the obvious is recognized, that there is little reason to expect potential output to always grow at a constant rate and that resource availability and productivity should be expected to at least grow at somewhat variable rates, then the problem of macroeconomic coordination is better understood--real output should grow not at three percent or some other "target" but rather at a rate that varies with potential output.

While slower than three percent growth in real output is entirely plausible, "supply-side" explanations of recessions--decreases in real output--are a more of a stretch.   However, it is actually quite easy to think of disasters that would have that consequence.   Natural disasters or man-made disasters like civil war would be examples.   And there are public policies that could also result in reductions in production.   These could be just foolish anti-capitalist policies.   But efficient policies could have that effect as well.   For example, even an efficient institution for protecting the environment could result in decreases in measured real output if starting from a highly polluted condition.   I think that a reduction in the production of various goods and services would be highly significant and worth measuring even if some more inclusive measure of human welfare increased on net.

The reason I think of real business cycle theory as an oxymoron is not that "real" recessions are impossible, it is rather that they are not interesting.   After a country suffers a major nuclear attack, it will produce less output.  Yes.   And aside from trying to make sure that doesn't happen, why is that interesting?

Now, I will grant that having slower growth in resource productivity cause reductions in output rather than just slower growth is interesting, though I doubt that it is at all likely.

The puzzle of recession is that even though we live in a word of scarcity, there are occasional periods where there is widespread idleness of scarce resources resulting in reduced production of many types of scarce goods and services.   These recessions are nearly always associated in broad-based reductions in sales of goods and services.   That is, many firms in many industries report what they perceive as weak sales and respond by curtailing production.   In other words, the problem to be explained is fluctuations in aggregate demand as well as the reason why these do not simply result in changes in money prices and wages so that scarce resources remain employed producing scarce goods and services.

What are sometimes called "growth recessions" would be a similar phenomenon.   Sales grow too slowly for firms to use all of their scarce resources to produce scarce goods and services, though the amount they do produce is greater than what they did before.   Real output grows, but less than potential output.   Since it is quite possible for potential output to grow more slowly, it is difficult to distinguish a failure of output to grow as fast as potential with a situation where real output remains equal to a more slowly growing potential output.

However, the real problem with real business cycle theory isn't that it has nothing interesting to say.   It is rather the research program of seeking to show that aggregate demand does not matter at all and that real output is always equal to potential output.   This is closely associated with the "new classical" emphasis on "market clearing."   Prices and wages are assumed to be sufficiently flexible that any shift in aggregate demand results in changes in prices and wages so that all scarce resources remain fully employed producing scarce goods.    Observed fluctuations in real output, employment, and unemployment around trend therefore must be due to optimal responses to real, or supply side, shocks.    Potential output?   Why have a special term for that?   Real output is potential output.  Or do you just mean trend?   It is that view that is the problem.

Romer's focus then is on the opaque methods real business cycle theorists have used in pursuit of this program.    In particular, their empirical work hides assumptions that makes unobserved real factors supposedly cause general fluctuations in output and employment.

One problem with Romer's essay is that the leading macroeconomists today are not the followers of Prescott but rather Woodford.   Where are the leading new Keynesians in his story?    They most definitely recognize the importance of aggregate demand and monetary policy.

Perhaps one issue is that the real business cycle approach has not been sufficiently stamped out.   I guess that there are still PhD dissertations accepted and papers published in major journals in this vein.   Romer seems to be arguing that this should be treated as so much trash.   Less of it should be published and it should be treated less seriously.

But I also think Romer believes that the bad technique generated by that wrongheaded approach has infiltrated into the mainstream of new Keynesian macroeconomics.    If an idea cannot be characterized within a rigorous and calculable DSGE model using rational expectations, then it isn't worthwhile.    The mechanism for sticky prices (or wages) must be sufficiently rigorous and allow for a calculation of results in a rigorous model.   Why?   Because that is the standard insisted upon by Prescott and company, when really, according to Romer, their approach was fundamentally fraudulent.

Further, if the model implies that aggregate demand has only small and transitory effects on real output, then real business cycle theory must be mostly correct and monetary policy really doesn't matter.   I think Romer's point is if the Calvo model of price-stickiness doesn't result in large fluctuations in output, then the problem is in the Calvo model and not a reason to think that monetary policy doesn't matter much in the real world.

Market Monetarists favor a stable growth path for spending on output.    If this were accomplished perfectly, then there would be no problem with fluctuations of aggregate demand.   That doesn't mean that there would be no fluctuations in real output.    The fluctuations would be due to supply side factors.   In such a world, researches would hopefully find that all fluctuations in real output were caused by "real" factors.   Would that mean that aggregate demand and monetary policy does not matter?   Not at all.   It would rather be that monetary policy was perfect and stabilized aggregate demand.  

Further, what would researches discover about the quantity theory of money?   Well, it is likely that the quantity of money would grow as would nominal income over the long run.   However, a careful consideration of short run fluctuations would show appreciably no relationship between the quantity of money and inflation.   Instead, the quantity of money would be inversely related to velocity and systematically related to anything that causes changes in velocity--perhaps real interest rates.  Changes in inflation, on the other hand, would be almost entirely shown to be determined by the same real factors causing fluctuations in real output.     But to conclude from such evidence that a new monetary institution that involved rapid exogenous growth in the quantity of money would not generate more rapid inflation would be foolhardy.

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