Why Wren-Lewis can’t get it right on macroeconomics

30 Jun, 2012 at 00:13 | Posted in Economics, Statistics & Econometrics | Comments Off on Why Wren-Lewis can’t get it right on macroeconomics

In a new piece on the ongoing discussion of macroeconomics, professor Wren-Lewis yesterday wrote:

What I want to say in summary is this. Microeconomists are right in many of their criticisms, but what they often fail to see is the root cause of the problem. This is that macroeconomic policy is highly political, with strong ideological implications. Ideology and politics distort macroeconomics as a science. Yet despite this, there is – and for many years has been – a substantial body of analysis that most macroeconomics would sign up to, and which has sound empirical backing.
   What is this substantial body of analysis? It is what used to be called the new neoclassical synthesis … For a closed economy, its details are well represented in Romer’s graduate textbook, for example. This body of analysis has important gaps and omissions, of course, such as a naive and simplistic view of the financial sector. However … the financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis. Indeed, events since the crisis have provided significant empirical support for the Keynesian elements of that synthesis.

“[T]he financial crisis itself showed up this incompleteness, but did not invalidate most of what was in the synthesis.” Really?

The financial crisis of 2007-08 hit most laymen and economists with surprise. What was it that went wrong with our macroeconomic models, since they obviously did not foresee the collapse or even make it conceivable?

The root of our problem ultimately goes back to how we look upon the data we are handling. In modern neoclassical macroeconomics – dynamic stochastic general equilibrium, new synthesis, new-classical and new-Keynesian – variables are treated as if drawn from a known “data-generating process” that unfolds over time and on which we therefore have access to heaps of historical time-series. If we do not assume that we know the “data-generating process” – if we do not have the “true” model – the whole edifice collapses.

Modern macroeconomics obviously did not anticipate the enormity of the problems that unregulated “efficient” financial markets created. Why? Because it builds on the myth of us knowing the “data-generating process” and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

After thoroughly neglecting anything resembling a real-world finance system, one can’t just go on as if nothing has happened and simply append financial considerations to  neoclassical macromodels where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds.”

Both ontologically and epistemologically founded uncertainty makes any hopes of being able to consistently integrate financial crises into neoclassical macroeconomic models totally unfounded, since those models are based on assumptions of rational expectations, representative actors and dynamically stochastic general equilibrium – assumptions that convey the view that markets – give or take a few rigidities – are efficient!

Finance has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies, and – as Johan Åkerman used to say – acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterwards, just isn’t enough.

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