“The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics”

Willem Buiter on “‘state of the art’ academic monetary economics”:

The unfortunate uselessness of most ’state of the art’ academic monetary economics, by Willem Buiter: The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member … contained, like its successor…, quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity.  Indeed, it may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding .  It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.  Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes  rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability.  So the economics profession was caught unprepared when the crisis struck.

Complete markets

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. …

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked. …

[M]arkets are inherently and hopelessly incomplete.  Live with it and start from that fact. … Perhaps we shall get somewhere this time.

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained.  This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.  Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. education.   But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance.  The influence of the heterodox approaches … was, however, strictly limited.

In financial markets, and in asset markets, real and financial, in general, today’s asset price depends on the view market participants take of the likely future behaviour of asset prices.  … Since there is no obvious finite terminal date for the universe…, most economic models with rational asset pricing imply that today’s price depend in part on today’s anticipation of the asset price in the infinitely remote future. …  But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right. …

The friendly auctioneer at the end of time, who ensures that the right terminal boundary conditions are imposed to preclude, for instance, rational speculative bubbles, is none other than the omniscient, omnipotent and benevolent central planner.  No wonder modern macroeconomics is in such bad shape. …  Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.

So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no Auctioneer at the end of time.

Linearize and trivialize

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave.  So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.  This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc.  will appreciate what is lost…  Threshold effects, non-linear accelerators – they are all out of the window.  Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.

Technically, the non-linear stochastic dynamic models were linearised (often log-linearised) at a deterministic (non-stochastic) steady state.  The analysis was further restricted by only considering forms of randomness that would become trivially small in the neigbourhood of the deterministic steady state.  Linear models with additive random shocks we can handle – almost !

Even this was not quite enough…  When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner.  … The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories.  What they were left with was something that, following an exogenous  random disturbance, would return to the deterministic steady state pretty smartly.  No L-shaped recessions.  No processes of cumulative causation and bounded but persistent decline or expansion.  Just nice V-shaped recessions.

There actually are approaches to economics that treat non-linearities seriously.  Much of this work is numerical – analytical results of a policy-relevant nature are few and far between – but at least it attempts to address the problems as they are, rather than as we would like them lest we be asked to venture outside the range of issued we can address with the existing toolkit.

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models … was a major step backwards.  I trust it has been relegated to the dustbin of history by now in those central banks that matter.


Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right.  It excludes everything relevant to the pursuit of financial stability.

The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard.  A drastic but chaotic re-education took place and is continuing. …

[Buiter has much more in the original article in support of his arguments.]

I think this is right, but I’d put it differently. Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.

The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice? Hopefully, it is the ability to answer questions that are the least important, so the modeling choices that are made reveal what the modelers though was most and least important.

The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment ,or when we found ourselves in mild, “normal” recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, where prices depart from fundamentals, or when markets are incomplete. When this crisis hit, I looked into our tool bag of models and policy recommendations and came up empty for the most part. It was disappointing. There was really no choice but to go back to older Keynesian style models for insight.

The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades,  did not even envision that this could happen, let alone build it into their models. Markets work, they don’t break down, so why waste time thinking about those possibilities.

So it’s not the math, the modeling choices that were made and the inevitable sacrifices to reality that entails reflected the importance those making the choices gave to various questions. We weren’t forced to this end by the mathematics, we asked the wrong questions and built the wrong models.

New Keynesians have been trying to answer: Can we, using equilibrium models with rational agents and complete markets, add frictions to the model – e.g. sluggish wage and price adjustment – you’ll see this called “Calvo pricing” – in a way that allows us to approximate the actual movements in key macroeconomic variables of the last 40 or 50 years.

Real Business Cycle theorists also use equilibrium models with rational agents and complete markets, and they look at whether supply-side shocks such as shocks to productivity or labor supply can, by themselves, explain movements in the economy. They largely reject demand-side explanations for movements in macro variables.

The fight – and main question in academics – has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it’s been a fairly brutal fight at times – you’ve seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.

What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important (some don’t even believe that policy can help the economy, so why put effort into studying it?).

I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.

When asked if what Buiter says is true, Brad DeLong says:

Brad DeLong: Yes, it is true. That is all.

Well, actually, that is not all. Buiter is a little bit too mean to us “new Keynesians”, who were trying to solve the problem of why it is that markets seem to work very well as social planning, incentivizing, and coordination mechanisms across a range of activities and yet appear to do relatively badly in the things we put under the label of “business cycle.” I, at least, always regarded Shiller, Akerlof, and Stiglitz as being fellow “New Keynesians.” As Larry Summers put it to a bunch of us graduate students l around the end of 1983, Milton Friedman’s prediction in 1966 that the post-WWII economic policy order would break down in inflation had come true and that that had given the Chicago School an enormous boost, but that now they had gone too far and were vulnerable, and that our collective intellectual task if we wanted to add to knowledge, do good for the world, and have productive and prominent academic careers was to “math up the General Theory”: to take the conclusions reached by John Maynard Keynes in his General Theory of Employment, Interest and Money, and explain how or demonstrate to what degree they survived the genuine insights into expectations formation and asset pricing that the Chicago School had produced. In fact, Buiter’s column I read as a commentary on General Theory chapter 12: “The State of Long-Term Expectation.” Collectively, I think we made a compelling intellectual case–but we were completely ignored and dismissed by Chicago.

But, yes, on the big things Buiter is right.

Originally published at the Economist’s View and reproduced here with the author’s permission.

One Response to "“The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics”"

  1. Jon Cloke   March 7, 2009 at 5:42 am

    This argument struggles towards the core truth but turns away at the last fence: “Models are built to answer questions…. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.” How can models which have been so ‘stripped’ be built to answer questions, except in rare instances where reality occasionally collides with the way such models were constructed to perceive reaality?This is a post hoc ergo propter hoc situation; all such models were devised with the basic perceptions that markets are efficient, that they self-balance. In other words, the reason that they were ‘stripped’ is because that which was stripped contradicted the prevailing ideological mindset about markets, namely that they be efficient and that equilibrium is the norm, rather than a fortuitous and unstable outcome.It is this ideological component that is missing from the analysis; how else, after all, to explain the musings of a Friedman, someone who had to ‘strip’ out credit in his theorizing to make monetarism work? Or Walt Rostow, who later on in life admitted that he’d developed his infamous Take-Off theory mainly as a response to the perceived threat of communism?