Flawed macroeconomic models

17 May, 2013 at 13:39 | Posted in Economics, Theory of Science & Methodology | 3 Comments

stiglitz3If we had begun our reform efforts with a focus on how to make our economy more efficient and more stable, there are other questions we would have naturally asked; other questions we would have posed. Interestingly, there is some correspondence between these deficiencies in our reform efforts and the deficiencies in the models that we as economists often use in macroeconomics.

•First, the importance of credit
We would, for instance, have asked what the fundamental roles of the financial sector are, and how we can get it to perform those roles better. Clearly, one of the key roles is the allocation of capital and the provision of credit, especially to small and medium-sized enterprises, a function which it did not perform well before the crisis, and which arguably it is still not fulfilling well.

This might seem obvious. But a focus on the provision of credit has neither been at the centre of policy discourse nor of the standard macro-models. We have to shift our focus from money to credit. In any balance sheet, the two sides are usually going to be very highly correlated. But that is not always the case, particularly in the context of large economic perturbations. In these, we ought to be focusing on credit. I find it remarkable the extent to which there has been an inadequate examination in standard macro models of the nature of the credit mechanism. There is, of course, a large microeconomic literature on banking and credit, but for the most part, the insights of this literature has not been taken on board in standard macro-models …

•Second, stability
As I have already noted, in the conventional models (and in the conventional wisdom) market economies were stable. And so it was perhaps not a surprise that fundamental questions about how to design more stable economic systems were seldom asked. We have already touched on several aspects of this: how to design economic systems that are less exposed to risk or that generate less volatility on their own.

One of the necessary reforms, but one not emphasised enough, is the need for more automatic stabilisers and fewer automatic destabilisers – not only in the financial sector, but throughout the economy. For instance, the movement from defined benefit to defined contribution systems may have led to a less stable economy …

•Third, distribution
Distribution matters as well – distribution among individuals, between households and firms, among households, and among firms. Traditionally, macroeconomics focused on certain aggregates, such as the average ratio of leverage to GDP. But that and other average numbers often don’t give a picture of the vulnerability of the economy.

In the case of the financial crisis, such numbers didn’t give us warning signs. Yet it was the fact that a large number of people at the bottom couldn’t make their debt payments that should have tipped us off that something was wrong …

•Fourth, policy frameworks
Flawed models not only lead to flawed policies, but also to flawed policy frameworks.

Should monetary policy focus just on short-term interest rates? In monetary policy, there is a tendency to think that the central bank should only intervene in the setting of the short-term interest rate. They believe ‘one intervention’ is better than many. Since at least eighty years ago, with the work of Frank Ramsey, we know that focusing on a single instrument is not generally the best approach.

The advocates of the ‘single intervention’ approach argue that it is best, because it least distorts the economy. Of course, the reason we have monetary policy in the first place – the reason why government acts to intervene in the economy – is that we don’t believe that markets on their own will set the right short-term interest rate. If we did, we would just let free markets determine that interest rate. The odd thing is that while just about every central banker would agree we should intervene in the determination of that price, not everyone is so convinced that we should strategically intervene in others, even though we know from the general theory of taxation and the general theory of market intervention that intervening in just one price is not optimal.

Once we shift the focus of our analysis to credit, and explicitly introduce risk into the analysis, we become aware that we need to use multiple instruments. Indeed, in general, we want to use all the instruments at our disposal. Monetary economists often draw a division between macro-prudential, micro-prudential, and conventional monetary policy instruments. In our book Towards a New Paradigm in Monetary Economics, Bruce Greenwald and I argue that this distinction is artificial. The government needs to draw upon all of these instruments, in a coordinated way …

Of course, we cannot ‘correct’ every market failure. The very large ones, however – the macroeconomic failures – will always require our intervention. Bruce Greenwald and I have pointed out that markets are never Pareto efficient if information is imperfect, if there are asymmetries of information, or if risk markets are imperfect. And since these conditions are always satisfied, markets are never Pareto efficient. Recent research has highlighted the importance of these and other related constraints for macroeconomics – though again, the insights of this important work have yet to be adequately integrated either into mainstream macroeconomic models or into mainstream policy discussions.

•Fifth, price versus quantitative interventions
These theoretical insights also help us to understand why the old presumption among some economists that price interventions are preferable to quantity interventions is wrong. There are many circumstances in which quantity interventions lead to better economic performance.

A policy framework that has become popular in some circles argues that so long as there are as many instruments as there are objectives, the economic system is controllable, and the best way of managing the economy in such circumstances is to have an institution responsible for one target and one instrument. (In this view, central banks have one instrument – the interest rate – and one objective – inflation. We have already explained why limiting monetary policy to one instrument is wrong.)

Drawing such a division may have advantages from an agency or bureaucratic perspective, but from the point of view of managing macroeconomic policy – focusing on growth, stability and distribution, in a world of uncertainty – it makes no sense. There has to be coordination across all the issues and among all the instruments that are at our disposal. There needs to be close coordination between monetary and fiscal policy. The natural equilibrium that would arise out of having different people controlling different instruments and focusing on different objectives is, in general, not anywhere near what is optimal in achieving overall societal objectives. Better coordination – and the use of more instruments – can, for instance, enhance economic stability.

Joseph Stiglitz


  1. I thought this a nice talk here you might appreciate https://rwer.wordpress.com/2013/05/18/paul-davidson-at-university-of-chicago-economics-department-seminar/

  2. Wow that’s a great list and his number one would have been my number one.

  3. Geldstone, an engineer, argues that there has never been a sound theory of economics because there has never been a sound definition of money. In short, money’s value is established by government decree based on a domestic labor unit (i.e. min wage). Money’s role serves to establish structured rigid wages (a purely domestic phenomenon based on Keynes relative wage observation), which in turn establishes rigid cost-of-production prices. A labor theory of value is necessary (unlike neo), because LTV is not micro but of a macro nature (classical’s mistake) in the sense that labor content must be measured in order to track productivity gains and induce NECESSARY short term instability (job loss–goodbye Walras). LTV becomes the heart of growth theory. The productivity gains result in consumers flush with cash who will spend it in other sectors providing long term employment for the newly unemployed. Worker mobility relies on wage rigidity and a common language (why the Euro will fail) to function properly. These factors in turn imply free trade theory is radically flawed too, since both language and mobility are lacking, nor can labor units be tracked properly either in an imported good. In short, a flawed definition of money, leads to a flawed definition of micro, which in turn leads to flawed macro and international economics. Game over says Geldstone. Like our protectionist Constitution and Lincoln, the Chinese get it. Maybe it is time we do too.

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