There were three posts yesterday. The first was “Jean Tirole and the Triumph of Calculated Silliness:”
I’m late coming in on the Tirole Nobel – busy with real life – and many people have already weighed in on his contribution. But I though I might still have something useful to say about what the New Industrial Organization, of which he was the most important figure, actually did – namely, it made it safe to be strategically silly, to the great benefit of economics.
What do I mean by that? Before the new IO, economists wrote about perfect competition and monopoly, then acknowledged (if they were honest) that most of the real economy seemed to consist of oligopoly – competition among the few – but did little there except some hand-waving. Why? Because there was no general model of oligopoly.
And there still isn’t. When you have a small number of players, each able to have a significant effect on prices, lots of things can happen. They can collude – maybe implicitly, if there is an effectively enforced antitrust law; but what are the limits of collusion, and why and when does it sometimes break down? We like to assume that firms maximize profits, but what does that even mean when there are small-group interactions that create prisoners’-dilemma-type situations?
And yet you do want to model the economy, to think about stuff – and sometimes that stuff can’t be modeled without addressing imperfect competition. That was very much the case in my home field of trade, where even trying to model the role of increasing returns meant dealing with the fact that increasing returns internal to firms must cause perfect competition to break down.
Before the new IO came along, the way economics dealt with such issues was to assume them away. Increasing returns as a cause of trade? Hey, you can’t deal with that because we don’t have a theory of imperfect competition, so we have to assume that it’s all comparative advantage. (Harry Johnson once wrote a more or less triumphant paper to that effect.) Investment in R&D, and the temporary market power that results, as a source of technological progress? No can do.
What new IO brought was not so much a solution as an attitude. No, we don’t have a general model of oligopoly – but why not tell some stories and see where they lead? We can simply assume noncooperative price (or quantity) setting; yes, real firms are probably going to find ways to collude, but we might learn interesting things by working through the case where they don’t. We can make absurd assumptions about tastes and technology that lead to a tractable version of monopolistic competition; no, real markets don’t look like that, but why not use this funny version to think about increasing returns in trade and growth?
Basically, the new IO made it OK to tell stories rather than proving theorems, and thereby made it possible to talk about and model issues that had been ruled out by the limits of perfect competition. It was, I can tell you from experience, profoundly liberating.
Of course, there came a later phase when things were too liberated – when a smart grad student could produce a model to justify anything. Time for empirical work! But by then a lot had been achieved.
Yesterday’s second post was “The State of Macro, Six Years Later:”
Olivier Blanchard has gotten a lot of ribbing, from me among others, for his 2008 paper proclaiming that “the state of macro is good.” My critique was that Olivier was in a state of denial about the Dark Age of macroeconomics; when crisis struck and action became necessary, it became all too clear that freshwater macro had unlearned everything Keynes and Hicks had taught – and also that the desperate New Keynesian attempt to appease the rational expectations crowd had not only failed in that purpose, but arguably hobbled efforts to think clearly about anything that didn’t fit easily into a model where everything except price stickiness reflected maximization..
I would argue that Olivier’s latest version, which concedes that there are “dark corners” where the rational expectations approach doesn’t work, is still trying too hard to appease the unappeasable. But Arnold Kling offers a different critique: he thinks that Blanchard is demonstrating “modeling hubris.” And that, I’d argue, is all wrong.
First of all, whenever somebody claims to have a deeper understanding of economics (or actually anything) that transcends the insights of simple models, my reaction is that this is self-delusion. Any time you make any kind of causal statement about economics, you are at least implicitly using a model of how the economy works. And when you refuse to be explicit about that model, you almost always end up – whether you know it or not – de facto using models that are much more simplistic than the crossing curves or whatever your intellectual opponents are using.
Think, in particular, of all the Austrians declaring that the economy is too complicated for any simple model – and then confidently declaring that the Fed’s monetary expansion would cause runaway inflation. Whatever they may have imagined, they were in practice using a crude quantity-theory model of the price level.
And as I have often tried to explain, the experience of the past six years has actually been a great vindication for those who relied on a simple but explicit model, Hicksian IS-LM, which made predictions very much at odds with what a lot of people who didn’t use explicit models were sure would happen.
Suppose that you didn’t know about IS-LM and the concept of the liquidity trap. You would (and many did) look at the growth of the monetary base, and predict huge inflation:
And you could (and many did) look at government borrowing, and predict soaring interest rates:
But if you understood IS-LM, you realized that both the relationship between money and inflation and the relationship between borrowing and interest rates break down at the zero lower bound; and so they did.
If you don’t think these successful predictions are a big deal, go back and read the dismissive, vituperative comments those of us who predicted low inflation and interest rates faced back in 2009.
And a somewhat related point: when people claim to have a sophisticated understanding that transcends models, what, exactly, would they ever regard as evidence that their sophisticated understanding is, you know, wrong?
The last post yesterday was “Nobody Understands the Liquidity Trap: Cliff Asness Edition:”
Cliff Asness, one of the signers of the infamous open letter warning Ben Bernanke that his policies risked debasing the dollar, weighs in with a complaint that I am being a big meanie. As Brad DeLong immediately notes, what Asness mainly ends up doing is showing that he doesn’t at all get the whole notion of the liquidity trap, and the resulting irrelevance of monetary expansion to both prices and output.
Clearly, Asness has never read anything at all on the subject — not what I’ve written, not what Mike Woodford has written, not what Ben Bernanke has written. And he seems to view the failure of inflation to follow from quantitative easing as some sort of weird coincidence, not what anyone who applied basic macroeconomics to the situation predicted.
Now, I understand that busy people can’t keep track of everything, and even that you can sometimes be a successful money manager without reading up on monetary economics. But if you’re one of those people who don’t have time to understand the monetary debate, I have a simple piece of advice: Don’t lecture the chairman of the Fed on monetary policy.