LSE Lecture February 2011

1. Macroeconomics In The Era Edward Hugh
Of The Internet London: February
2011

2. Why Didn’t Mainstream Economists See The
Crisis Coming?
Three Hypotheses
•Over-reliance on consensus
•Excessive Belief That Markets Can Never Fail
•They Were Mesmerised By Their Own Models

3. The Case Of The IMF
For a long while after the explosion of macroeconomics
in the 1970s, the field looked like a battlefield. Over
time however, largely because facts do not go away, a
largely shared vision both of fluctuations and of
methodology has emerged. Not everything is fine. Like
all revolutions, this one has come with the destruction
of some knowledge, and suffers from extremism and
herding. None of this deadly however. The state of
macro is good............ there has been broad
convergence in vision.
Oliver Blanchard , Chief Economist at the IMF

4. "Part of the problem was the similar mindset of many
mainstream economists working at the Fund, with similar
background and training and who were not open to
dissenting views. Both in and outside the Fund, there were
other economists and policy makers with contrarian views.
But their views were not encouraged or closely examined
within the Fund.“
IMF Performance in the Run-Up to the Financial and Economic
Crisis: IMF Surveillance in 2004-07
Background Paper: Summary of Views of the Advisory Group
The IEO View
(IMF Independent Evaluation Office)

5. The Heart of the Problem
Excess of Confidence – “Feel-good” Effect
Too Much Consensus – Inability To Listen
The “Storks on the Wire” – false correlation – effect,
years of apparent economic stability and a new
generation of macro theories (the era of the so-called
Great Moderation) lead to the idea that sound application
of consenually grounded theory had had something to do
with the apparent stability. This later turned out to have
been a mistake.

6. As I see it, the economics profession went astray because economists,
as a group, mistook beauty, clad in impressive-looking mathematics,
for truth.
Paul Krugman
This is a widely shared view, and is certainly the case. But
Krugman goes further, the world of economics as he sees it is
divided between those who believe the economic system
regulates itself, and those that don’t. In Krugman’s terminology,
freshwater economists are, essentially, market purists. They
believe that all worthwhile economic analysis starts from the
premise that people are rational and markets work. My question
is: are these very strong, and scarcely credible, assumptions
really needed to get the game of doing useful macroeconomics
started?
The Freshwater and Saltwater Approach

7. On the other hand there are those who believe economic systems
don’t run smoothly on their own: “Where the freshwater economists
were purists, saltwater economists were pragmatists. ... they found
the evidence that recessions are, in fact, demand-driven too
compelling to reject. So they were willing to deviate from the
assumption of perfect markets or perfect rationality, or both, adding
enough imperfections to accommodate a more or less Keynesian
view of recessions. And in the saltwater view, active policy to fight
recessions remained desirable”.
Demand Driven Recessions
This argument seems more plausible , since levels of
consumer and investment demand do fluctuate, but it
still leaves us with the underlying issue as to why such
shifts in demand occur. In other words, what drives
these movements in demand. Is there any identifiable
underlying process?

8. "What does concern me about my discipline, however, is
that its current core —by which I mainly mean the so-called
dynamic stochastic general equilibrium approach — has
become so mesmerized with its own internal logic that it
has
begun to confuse the precision it has achieved about its
own world with the precision that it has about the real one”.
Ricardo Cabellero - Macroeconomics after the Crisis:
Time to Deal with the Pretense-of-Knowledge Syndrome
The “Core” Versus “Periphery” Argument

9. At this level Caballero’s approach seems similar to
Krugman’s statement above, but rather than put the line in
the sand between “laissez-faire” and interventionist
economists, he tries to differentiate between an
increasingly unreal (he uses the word “surreal”) core and a
series of “real-world” plug-ins which have been created to in
an make the models work by making their assumptions
more realistic. As Caballero notes, in fact integration of the
plug-ins increasingly poses a threat to the coherence of the
models they were meant to rescue.
Realism vs Coherence?

10. But Before Going Further: What Was The Last Crisis About?
The recent
financial crisis
was basically
about debt, and
about how
heavily indebted
societies were
going to claw
their way back to
economic growth.
In fact mainstream neo-classical economists have
often found it extremely difficult to incorporate this
deep structural component into their cyclically based
models.

11. But Then: Just Why Was There So Much Debt?
This is a key part of the puzzle. One of
the key parts of the problem is to explain
why some societies got into debt, while
others didn’t. Spain’s households, for
example, contracted a lot of debt.
German households didn’t.
Why the difference? One theory is
that a failure of single-size monetary
policy. But is that enough to explain
such massive structural divergence?

12. Then There Were Those Famous “Global Imbalances” –
But Just Why Did The Imbalances Build Up?
Japan, Germany and
China – the usual
suspects – had their
massive current
account surpluses.
While that other group
- the debtors, like the
UK, the US and Spain
– ran substantial
deficits.
So with such mundane macro processes like these as the backdrop,
do we really need to start by talking about rare phenomena and “fat
tail” events here?

13. So What Really Are The Problems With
Macroeconomics?
Surely comprehensive macro theory should be able to
handle and explain such general global phenomena.
Ricardo Caballero in his paper “Macroeconomics
after the Crisis: Time to Deal with the Pretense-of-
Knowledge Syndrome” makes some strong
assertions, which I think macroeconomics needs to
challenge and give a response to.
• Complexity Implies Uncertainty
• Events Cannot Be Foreseen
• Something Is Rotten In The Core of Neo-
Classical Theory

14. "The idea is to place at the center of the analysis the
fact that the complexity of macroeconomic interactions
limits the knowledge we can ever attain. In thinking
about analytical tools and macroeconomic policies, we
should seek those that are robust to the enormous
uncertainty to which we are confined, and we should
consider what this complexity does to the actions and
reactions of the economic agents whose behaviour we
are supposed to be capturing".
Does Complexity Really Imply Uncertainty?

15. Really there is uncertainty, and uncertainty. I may be able to
identify a housing bubble, but I cannot tell when exactly it will
burst (although “x” months after the central bank starts raising
interest rates would be a good rule-of-thumb approach - think
China now).
Multi year GDP forecasts may be the next best thing to
useless, but is it completely impossible to identify the level of
trend growth for an economy at any given moment in time.
Spain’s economy was growing at about 4% a year for the best
part of a decade, but would anyone like to bet me we will see
average growth rates of over 1% annually between now and
2020?
Is The World Really So Uncertain As Caballero
Claims?

16. Really there is uncertainty, and uncertainty. I may be able to
identify a housing bubble, but I cannot tell when exactly it will
burst (although “x” months after the central bank starts raising
interest rates would be a good rule-of-thumb approach - think
China now).
Multi year GDP forecasts may be the next best thing to
useless, but is it completely impossible to identify the level of
trend growth for an economy at any given moment in time.
Spain’s economy was growing at about 4% a year for the best
part of a decade, but would anyone like to bet me we will see
average growth rates of over 1% annually between now and
2020?
Is The World Really So Uncertain As Caballero
Claims?

17. "In my view, the conviction that one can foretell a severe
crisis in advance is mostly a manifestation of pareidolia—the
psychological phenomenon. That makes people see faces
and animals in clouds and the like.“
Ricardo Caballero
Knowing What You Might Know, And What
You Almost Certainly Don’t Know
In a manner which is extraordinarily reminiscent of the way
scholastics treated the move from the closed to the infinite
universe, Caballero ridicules attempts to give a predictive
edge to economic theory. In Newton’s day appeal to non
material forces of attraction (like gravity) was ridiculed as
being no better than mere astrological quackery. Today we
are faced with a transition in the way we think about things
which is every bit as profound as the shift from Newtonian to
Einsteinian physics.

18. But Then What Really Is The Problems With Modern
Macroeconomics?
"The core approach to macroeconomics, as it is taught in
most graduate programs and as it appears in leading
journals, begins with a neoclassical growth model. This
model is then developed into a stochastic form....“
Ricardo Caballero
The Neo-Classical Core
So at the heart of modern macroeconomics lies the neo-classical
growth model, and the assumption of some form or other of –
hard to define – steady state growth. Some notion of this kind
has to lie behind all those weird and wonderful RBC models, or
the game could never commence. But just how reasonable are
the premises which lie behind this assumption?

19. "All theory depends on assumptions which are not quite true.
That is what makes it theory. The art of successful theorizing
is to make the inevitable simplifying assumptions in such a
way that the final results are not very sensitive.' A "crucial"
assumption is one on which the conclusions do depend sensitively,
and it is important that crucial assumptions be reasonably realistic.
When the results of a theory seem to flow specifically from a
special crucial assumption, then if the assumption is dubious,
the results are suspect.“
Solow, R. M. (1956). A contribution to the theory of economic growth.
Quarterly Journal of Economics 70(February):65-94.
Solow’s Simplifying Assumption
Now one of those simplifying assumptions for Solow, and
the whole neo classical growth approach is based on this
is that POPULATION IS AN EXOGENOUS VARIABLE.
Just how realistic is this assumption?

20. What Happens If We Make Population Endogenous?
Instead of treating the relative rate of population increase as
a constant, we can more classically make it an endogenous
variable of the system. Suppose, for example, that for very
low levels of income per head or the real wage population
tends to decrease; for higher levels of income it begins
to increase; and that for still higher levels of income the
rate of population growth levels off and starts to decline.
Solow: Homogenisis & Steady State Dynamics

21. What Happens If We Make Population Endogenous?
Instead of treating the relative rate of population increase as
a constant, we can more classically make it an endogenous
variable of the system. Suppose, for example, that for very
low levels of income per head or the real wage population
tends to decrease; for higher levels of income it begins
to increase; and that for still higher levels of income the
rate of population growth levels off and starts to decline.
Solow: Homogenisis & Steady State Dynamics

22. But Do We Really See Homogenisis In Reality?
Is there a self correcting “”hidden
hand” type mechanism at work
here?
Do societies converge towards a
common steady state income per
capita growth rate as they age?

23. One Size To Fit Them All – Median Population Age
Could it really all be as
simple as this?

24. A Simple Model Of Current Account Dynamics
Using Demography and Median Age
Claus Vistesen
If Lions Could Speak, Would We Really Be Able To Understand Them?

25. The Role Of The Internet I –
The Arrival of the Sell Side Analyst
Nikkei Peak, and Japan Dependents
Ratios
From The Golden To The Grey Age,
Deutsche Bank Special Report.
Can Greece Really Pay All That
Debt?

26. The Role Of The Internet II – New Media
Universities won't survive. The future
is outside the traditional campus, outside
the traditional classroom.
Distance learning is coming on fast
Peter Drucker - I got my degree though e-mail

27. The Role Of The Internet III – Social Networks

28. The Role Of The Internet IV – Access To High Volume Data

29. The Role Of The Internet V – Qualitatative Data
Despite the
obsession with
building robust
quantitative models.
In real world economics,
at the empirical level,
Quantitative data – like PMI
& Labour Force Surveys –
ProvesTo Be Incredibly
Useful.

30. The Role Of The Internet VI –
Sharing Information & Perspectives
The new information technology..
Internet and e-mail..
have practically eliminated
the physical costs of communications.
Peter Drucker
Are There Positive Externalities
Associated With Sharing Information?

31. So What Does The Future Look Like?
I’ve seen it, but does it work? The Japanese Case

32. And What About Spain?
And That “Horrid”
European Sovereign Debt Crisis?

33. According to the World Bank, the nine
countries that have been attracting the bulk of
capital flows since the crisis are Brazil, China,
India, Indonesia, Malaysia, Mexico, South
Africa, Thailand and Turkey. - World Bank‘:
Global Economic Prospects 2011.
Can We Really See Nothing In Advance?

34. Monetary Policy In the Age of A Global Economy
Ben Bernanke’s Latest Statement
“With regards to commodities inflation in developing economies,
Ben Bernanke asserted that central banks there were equipped
to deal with it. They could raise interest to quash price pressures
and also allow the exchange rates of their currencies to appreciate
to counter imported inflation””.
Globalization is an ecosystem in which economic potential is
no longer defined or contained by political and geographic
boundaries. Economic activity knows no bounds in a globalized
economy. A globalized world is one where goods, services, financial
capital,machinery, money, workers and ideas migrate to wherever
they are most valued and can work together most efficiently,flexibly
and securely.
Richard Fisher , President of the Federal Reserve Bank of Dallas

35. Thank You Very Much For Your Attention
Economists set themselves too easy, too
useless a task if in tempestuous seasons they
can only tell us that when the storm is long
past, the ocean is flat again.
John Maynard Keynes