Understanding Irregular Economics

Paul Krugman has written a post that encapsulates his thinking on macroeconomics - how he thinks other people do it, and how he thinks it should be done. His post is a comment on Barro's WSJ article that I discussed here.



Let's take this apart. First paragraph:

As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did three and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.

We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can't say what a "better policy" is. Again, for that we need a model.



Second paragraph:

More generally, the existence of business cycles is hardly a trivial feature of real economies. You can try to explain those cycles in terms of “regular economics” — that’s what real business cycle theory is all about — but that effort has been a dismal failure, even if the practitioners refuse to admit it. The desperate efforts to find something Obama has done that explains why the economy plunged are in effect a demonstration of the hollowness of that whole approach.

Yes, real business cycle theory uses regular economics. But so does all of modern Keynesian theory. The people who worked on coordination failures - Bryant, Diamond, Cooper, Farmer, Benhabib - all used regular economics. So do the New Keynesians - Woodford, Gali, Gertler, etc. Krugman himself uses regular economics. But what was the "dismal failure" of real business cycle theory? Kydland and Prescott introduced a quantitative methodology that is still in wide use. The basic theoretical framework (due as much to Solow, Cass, Koopmans, Brock and Mirman, as to Kydland and Prescott) was expanded upon and used widely in the study of optimal taxation, time consistency, and other things. Further, Woodford adapted it to produce New Keynesian theory. Seems there is plenty of success in there.



Third paragraph:

But I want to add something more: why, exactly, are we supposed to have such faith in “regular economics”? What is the compelling evidence that the vision of a competitive, efficient economy allocating resources to the right uses is actually a good description of the world we live in?

Regular economics is not restricted to the study of competitive and efficient economies. Much of modern macroeconomics deals with externalities and the distortions caused by taxation and information frictions, among other things. The study of efficient economies is only a tiny part of what macroeconomists actually do.



Fourth paragraph:

I mean, it’s a lovely model, and one I, like everyone else in economics, use a lot. But I would not have said that it’s a model backed by lots of evidence. We do know that demand curves generally slope down; it’s a lot harder to give good examples of supply curves that slope up (as a textbook author, believe me, I’ve looked); and it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics. Realistically, imperfect competition, market failure, and more are everywhere.

1. "It's a lovely model" clearly means basic RBC, e.g. Kydland and Prescott. Why the focus on this particular model? Even if we focus on that model in particular, you can't say it's not backed by evidence. That was the whole idea. Go back and read Kydland and Prescott.

2. "it’s a very long way from there to the vision of Pareto efficiency and all that which Barro wants us to take as the true economics." Where does Barro say in his piece that everything is Pareto efficient?

3. Yes, we can find plenty of imperfect competition, market failure, and more. But regular economics can and does deal with all of that stuff. What is the problem here?



Fifth paragraph:

Meanwhile, there’s actually a lot of evidence for a broadly Keynesian view of the world. Not, to be fair, for fiscal policy, mainly because clean fiscal experiments are rare. But there’s huge evidence for sticky prices, lots of evidence that monetary shocks have real effects — and it’s hard to produce a coherent model in which that’s true that doesn’t also leave room for fiscal policy.

We have a fairly good characterization now of how prices behave - the frequency of price changes for particular goods and services. That evidence does not entirely square with modern Keynesian models, and we have search models which can deliver the features of price behavior we observe, but where money is in fact neutral. It does not follow obviously from the observed behavior of prices that the short run non-neutralities of money actually result from the pricing behavior of firms. The big gap in Keynesian theory is that it does not deliver on the elements that are key to how it works: Why are contracts set in nominal terms? Why are prices changed infrequently for some goods and services? What would make a firm unwilling to change its price but more than willing to incur the costs of changing output and employment?



Last paragraph:

In short, there’s no reason at all to consider microeconomics the “real” economics and macroeconomics some kind of flaky impostor. Yes, micro is a lot more rigorous — but if it’s rigorously wrong, who cares?

Note how he uses "macroeconomics." He means the macroeconomics that is spooned out to poor unsuspecting undergraduates in many undergraduate principles and intermediate macro books, which is indeed flaky. This is not the macroeconomics of most practicing macroeconomic researchers, the macroeconomics taught in PhD programs or the macroeconomics of the economists who advise many policymakers. It's not too much to expect that macroeconomists be rigorous - just like everyone else.