New Monetarists, scientists or engineers?

Back in 1994, when the New Keynesian (NK) label, if not the models, were relatively new, Ball and Mankiw argued that Milton Friedman was closer to the NK approach than the New Classical (NC)/Real Business Cycle (RBC) one. For them (see here, 1994, p. 9):

"although traditionalist are often called 'new Keynesians,' this label is a misnomer. They could just as easily be called 'new monetarists.'"

The whole point was that monetarists believed in the non-neutrality of money in the short run and in sticky prices, like NKs. Now there is an explicit New Monetarist model with sticky prices here, and a growing literature surveyed by Stephen Williamson and Randall Wright here. Williamson has a blog here.

New Monetarists seem to build on ideas developed by Thomas Sargent and Neil Wallace in the early 1980s (here, for example). A simple introductory presentation is given by Champ and Freeman (here). The theoretical framework is in general based on overlapping generations models, in which monetary policy can affect relative prices and, as a result, change the intertemporal consumption, labor supply, and investment decisions of rational maximizing agents.

As Williamson says:

"Monetary policy matters due to distortions in intertemporal prices, for example the anticipation of higher money growth and higher inflation acts as a tax on labor supply and reduces output."

Not sure if he thinks that the current slow growth is to be blamed on the expansion of the money supply after the recession, and higher inflationary expectations, leading to an increase in the demand for leisure time (a reduction on labor supply, that will be taxed by the higher inflation). That would explain why he thinks that the Fed should sell bonds, and raise the interest rate (not a joke!). At any rate, the whole New Monetarist approach is fundamentally, like New Classical authors in general, concerned with microfoundations. In this case, microfoundations in the money market.

This kind of approach reminds me of another Mankiw paper on the nature of macroeconomic research. For him macro, from the Keynesian Revolution until the rise of Lucas and the New Classical school, was dominated by what he calls engineers, that is problem solvers. From Lucas on it has been dominated by scientists, meaning those that search first principles.

So the first group was concerned with empirical regularities, like Okun's Law, while the latter emphasized rational intertemporal maximizing economic agent models, like in the Ramsey model. New Monetarists are clearly in the latter camp. So are we better off with the rise of the "scientific" macroeconomists? Here is why Mankiw's paper is so important. He candidly tells us (p. 19):

"The sad truth is that the macroeconomic research of the past three decades [the 'scientific' micro-founded stuff] has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering."

No kidding, great science that has nothing to say about the reality of how to solve actual economic problems. The rise of sci-fi macroeconomists. Welcome to the Twilight Zone!

Sims is not Sargent

Below Steve's comment on Sims. Worth a whole post.

Chris Sims' classic 1980 paper "Macroeconomics and Reality" still echoes, or should, among macro model builders and macro econometricians. He could not possibly be clearer about the "incredible" restrictions that models often impose, and proposed a way forward, the VAR in its many forms.

That method has evolved to the point where, for example, good econometricians can recast a DSGE model in VAR form and see if it survives the data. Often they don't, a recent example being Peter Ireland's DSGE so soundly rejected by Katarina Juselius.

The rub is in the qualifier good. This is not easy stuff to do correctly. But its power is worth the sweat. Sims has been homaged over his prize by Mark Thoma here, and by Jim Hamilton, the time series bible author here.

A very favorite story is when Sims, Robert Litterman, and Thomas Doan, all either at the Minneapolis Fed or U of Minnesota in the 80's, "took on" their big models with a small VAR and outforecast them by a bunch. They soon left, maybe excommunicated? But Sims and Litterman at least landed on their feet...Litterman just retired as head statistician at Goldman Sachs. So the Sims triumph validates a reality first approach, meaning data before theory, and with the tools we now have and careful work, this method will become ever more influential in applied macro. Sims has also contributed to Bayesian approaches to macro modeling.

I totally miss the logic of the pairing with Sargent, but such is academic politics.

I agree.

PS: Links are there in the two here in Steve's post, and in the title of Sim's paper and Juselius name.

Esther-Mirjam Sent on Sargent and more

As Kevin Gallagher noted, the contributions of Sargent and Sims are quite different and should be analyzed separately. Ester Mirjam-Sent is certainly the most qualified and discerning critic of Sargent's work, and anybody interested in understanding his (Sargent's) contributions to economics should read her extensive research on his ideas. A good start is her paper in the Cambridge Journal of 1997 (here).

Her concerns are more with the evolution of his thinking about rationality, from rational to bounded, which is a central pillar of neoclassical economics. She notes that Sargent's preoccupation with rationality (which should be contrasted with Simon's views) was to strengthen the theoretical foundations of neoclassical economics. I tend to be more concerned with the critique of those foundations, rather than with the question of how rational behavior leads (or not) to efficient market results.

One important area, in which I have done some research, is hyperinflation theory. Sargent basically is responsible for extending the Cagan model (his classic paper is here) and suggesting that beyond a monetary reform, a credible fiscal adjustment was essential for stabilization. In that sense, while Sargent maintained the fiscal fundamentals of hyperinflation, he suggested that expectations did have a role to play. As Carlos Bastos reminded me recently, here is a critique of Sargent's contribution published in the Economic Journal (subscription needed; portuguese version here). For an alternative discussion of inflation/hyperinflation go here, and for a survey of the literature here.

PS: Sent was one of the faculty members that left Notre Dame after the administration dismantled the heterodox program there. For more on that read here.

Re-writing history

By the way, in the middle of the several comments praising the winners of the Sveriges Riksbank Prize in Economics there will be a lot of misplaced acclaim. Here is one example from the Huffington Post:

"Sargent famously weighed in on the fight against inflation in the early 1980s. Many economists believed it would take years of high interest rates to bring inflation down. But Sargent believed that inflation could be tamed much faster if the Federal Reserve acted enough to break the public's expectations that prices would continue to rise rapidly. That is basically what happened: Then-Fed Chairman Paul Volcker raised interest rates so quickly and so much that inflation expectations were shattered."

So now, if you believe this report, Sargent and Lucas were right about the costless disinflation of the 1980s. Forget that disinflation had to do with falling commodity prices, caused by the hike in interest rates, and with the weakening of the labor force, which faced what was, in the US up to that point, the worse recession since the Great Depression. Unemployment in the US reached 11%, but it was inflationary expectations that mattered. And the Huff Post is a progressive site, isn't it?!