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Modern Economists Failed at Disaster Recovery

By    |   Friday, 12 November 2010 08:44 AM

When a recent Nobel Laureate in Economics, a current Federal Reserve Board president, and MIT economist with the National Bureau of Economics (NBER) agree — take serious note: It is quite rare.

"I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world,” Dr. Narayana Kocherlakota, President of the Minneapolis Federal Reserve Bank, wrote this past May.

He went on to say, “In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policymakers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown."

Dr. Kocherlakota is referring to the modern economists, who have been employing dynamic stochastic general equilibrium (DSGE) models over the past few decades.

Appearing before the House Committee on Science and Technology Subcommittee on Investigations and Oversight on July 20, 2010, Dr. Robert Solow, professor emeritus at MIT and the 1987 Nobel Laureate in Economics, said: "But the basic story (referring to DSGE) always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This cannot be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on."

Dr. Ricardo J. Caballero, an MIT economist with the NBER, states the following in a Sept. 27, 2010, paper: “"In this paper I argue that the current core of macroeconomics — by which I mainly mean the so-called dynamic stochastic general equilibrium (DSGE) approach — has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one.”

He suggests we focus on the ”broad-exploration” mode rather than the “fine-tuning” mode, since “we are too far from the absolute truth.”

Moreover, Dr. Kocherlakota suggests "the modernization of macroeconomics took place rapidly in academia. By the mid-1990s, virtually anyone getting a Ph.D. in macroeconomics in the United States was using modern macro models."

"Second, macroeconomists have to be more responsive to the needs of policymakers. During 2007–09, macroeconomists undertook relatively little model-based analysis of policy. Any discussions of policy tended to be based on purely verbal intuitions or crude correlations as opposed to tight modeling."

Economic analysis and the policy implications remain a function of human behavior and the decision-making process. Robust, elegant assessments require the incorporation of many dimensions, which include, but are not limited to, emotion, psychology, sociology, history, and politics.

The prudent approach demands a prescient understanding of changing dynamics within many spheres and how these impact practical and realistic decision making.

In the coming weeks, I will illuminate how this methodology (DSGE) was insufficient in identifying the underlying cause and effect relationships with respect to the following: excess risk-taking by financial institutions, unwarranted financialization of the economy, and quantitative easing (QE1 and QE2) by the Federal Reserve Board.

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When a recent Nobel Laureate in Economics, a current Federal Reserve Board president, and MIT economist with the National Bureau of Economics (NBER) agree take serious note: It is quite rare. I believe that during the last financial crisis, macroeconomists (and I...
Friday, 12 November 2010 08:44 AM
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