WSJ suggests abandoning economic models

Simon Nixon has a provocative article in the WSJ where he argues that the current generation of New Keynesian models are useless because of their poor forecast performance. He proposes looking solely at the rate of debt reduction when forecasting economic performance:

[The] dismal science’s [forecasting] record suggests is that there is something profoundly wrong with the mainstream economics profession’s understanding of how modern economies work. The models on which its forecasts are built are clearly badly flawed.

It is true that forecasting performance is poor, but that is largely because forecasting is very, very difficult. The DSGE models Nixon refers to are important in modern macroeconomics but they were originally designed to estimate the impact of monetary policy, not to forecast the future. In fact, until very recently, most forecasting was not done with structural DSGE models but with statistical models that take their structure from the data. They provided better forecast performance and so were preferred by professional forecasters. These days, the best forecasts tend to be made by estimated DSGE models that outperform the best statistical models because they incorporate some of our understanding about how the economy works. No doubt they will be improved over time but it is incorrect to suggest that forecasters are too constrained by theory to forecast accurately. In fact, economists’ understanding of the economy helps them to provide better predictions about the future than simply using statistical relationships.

Nixon then discusses a paper by Claudio Borio at the BIS, which suggests building models that describe not only business cycles but also ‘financial cycles’. Borio’s paper highlights the monetary nature of the current recession and recommends that the next generation of macro models give serious consideration to the slow buildup of disequilibrium forces in financial booms, which then trigger deep recessions. Whether or not you agree with that diagnosis, the question he tackles is crucial: how do crises endogenously develop? Part of the reason forecasting is so difficult is that turning points are hard to pick because we don’t really understand all of the mechanisms that lead to recessions. Nixon uses that paper to claim that…

…[for] investors, the sensible response is surely to disregard all short-term forecasts based on out-dated models. They should focus instead on identifying those economies most likely to deliver a medium-term recovery by aggressively addressing their stock of debt. In the European context, it is the euro zone where the process of debt reduction and restructuring seems likely to proceed most rapidly, not least because the greater independence of the European Central Bank means there is less prospect of loose monetary policy being used to defer tough decisions.

I don’t think that is what Borio’s paper claims. Can Nixon really be advising you to ignore expert forecasters and instead put your money into EU countries, many of whom are currently facing the possibility of further recession in 2013? He has good company in suggesting that current economic models have problems and could be improved; however, the chances that they can be improved upon by following a simple heuristic like ‘less debt equals more growth’ are exceedingly slim. Indeed, there is considerable public debate among economists over the impact of debt on growth. Reinhart and Rogoff’s work has generated a lot of discussion, and there is a paper entitled ‘Macroeconomic Risk and Debt Overhang’ being presented at the ASSA conference. It’s hardly a matter that has been neglected by the profession!

Of course, it’s very difficult to diagnose and fix a problem with a single newspaper article: witness Paul Krugman’s repeated attacks on the current state of macroeconomics and the heated responses that they’ve generated, for instance. When even Nobel prize-winners can’t agree on whether there is a problem it is a sign that we don’t really understand what needs to be done. It’s great that Nixon is bringing interesting papers like Borio’s to public attention and airing the debate that’s going on in the profession. Unfortunately, in this case I don’t think his diagnosis or proposed solution are quite right.

Where are we with the Eurozone at the moment

It’s been a while since I’ve written down my impression of what is going on and what is happening with New Zealand – because things are just not changing.  The events in Europe continue to have a significant impact on what is going on in New Zealand, both by lowering businesses willingness to invest in staff and other forms of capital and by lowering the returns to exporters (more than its reduced the price of our imports).

However, we are currently in the middle of a fascinating example of political economy – something I am poorly versed in, and so will instead just link to.

The Eurozone needs a lender of last restort, a credible lender of last resort.  The weird actions going on in Europe are indicative of some institutions recognising this, while other groups who have to take on any perceived risk (eg Germany) are less than willing to do so.

Of course, the belief that the Eurozone needs a lender of last resort depends on the “multiple equilibrium” view of credit markets in Europe – are these banks truly insolvent, or do they just look insolvent because of liquidity/expectations.  If you are in the first camp there is a burden that must be shared in some way, if you are in the second camp there is much less of a real burden – and a strong requirement of a lender of last resort.  The different things being said by different people inside and outside of Europe are not just a result of a normative belief in what is a “fair distribution of the burden”, but also a different implicit model which implies different costs and benefits from different policy actions.

No wonder agreement has been so difficult.

A great explanation of the issues in Europe

Crooked Timber has a great “pick your own adventure” style post on solving the European debt crisis (ht Eric Crampton).  Give it a go.

Eric and my work colleague here both hit option 52, while I hit option 54.  To see what 54 is I’ll repeat it below:

Maynard is staring at his legal pad. “This looks like a mess to me. Greece has defaulted, left the euro, and had a tax commissioner appointed – how many more humiliations can you heap on them? Economically it has a certain internal logic but politically it is all over the place and I think that kills the chance of the transfer payments which you need if you’re going to achieve primary balance after the default without massively contractionary domestic fiscal policy. We can type it up and submit it, but I think it’s only going to be looked at as an example of the kind of idea that an economist might come up with”.

The kind of an idea an economist might come up with – I’m taking that as a compliment even though I suspect it isn’t meant to be …

Crisis over before Christmas?

With bond yields collapsing in Europe the implied “bank run” on the periphery appears to be over.  This is due to the ECB backstopping European banks for the next three years – in some sense they have taken on the lender of last resort role, just in a confusing, seemingly temporary, and poorly communicated way. Note:  Whether this is really “happening” is still an open question – we won’t have confirmation of this, or its impact on CDS’s, until tomorrow at the earliest.

This in no way means that the fundamental issues in Europe are over – in fact, it makes focus on the structural problems in Europe an essential part of what people should now be doing.

However, if the bank run really is over, and credit markets really are unfreezing (something we will know in the next couple of days), it is a positive for the short-term for a little country like NZ.  But lets not forget a few things:

  1. Japan, and now Europe, have shown us the vulnerability of public and private finances to changes in demographic structure – we ignore these issues at our peril, and with plenty of warning.
  2. Europe still has massive structural issues.  These still need to be solved, or we will merely have another crisis down the line.
  3. If Europe isn’t going to sort itself out, hopefully the rest of the world will see the risk and reduce their implied exposure to Europe.

Incompetence in Europe

I fully endorse Krugman’s point here:

These alleged technocrats have in fact systematically ignored both textbook macroeconomics and the lessons of history in favor of fantasies. The European Central Bank has placed its faith in the confidence fairy, while imagining that it can run policy in a way that has never worked in several centuries of central bank experience. Meanwhile, the European policy elite has simply wished away the clear evidence that the euro zone needs to make an adjustment that is virtually impossible unless inflation targets are raised.

Not only are we seeing why the Euro was a silly idea in technical terms – we are seeing how endemic policy failure can be in places like Europe.

Seriously, the vast majority of economists knew that we just needed the ECB to act as a lender of last resort, and for the default in Greece (and policy changes in the rest of the PIIGS) to be determined in a reasonable amount of time – instead we’ve seen failure from both monetary and fiscal authorities around the region.  Embarrassing failure.