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Unlearning economic paradigms

What’s at stake: Both the crisis, its aftermath, and the empirical econ revolution have changed our understanding of economics. Conventional wisdoms a

Publishing date
30 November 2015

Unlearning macroeconomics

Adam Posen writes that a lot of economists have spoken about the need to fundamentally rethink major parts of macroeconomics following the global financial crisis.

Paul Krugman writes that what hasn’t worked nearly as well is our understanding of aggregate supply. One big problem has been the absence of deflation. The “accelerationist” Phillips curve that used to be standard — inflation depends on unemployment and lagged inflation — seemed consistent with the experience from previous big slumps, which were associated with large declines in the rate of inflation. Specifically, we used to cite the “clockwise spirals” one saw in unemployment-inflation space as evidence for something like the Friedman-Phelps theory of the natural rate. The other big problem is the dramatic drop in estimates of potential output, which is clearly correlated with the depth of cyclical slumps.

Robert Waldmann writes that that the reason Krugman was surprised by the failure of the supply side is that he didn’t pay enough attention to the European unemployment problem. The natural unemployment rate hypothesis failed spectacularly in Europe in the 1980s. Extremely high unemployment did not lead to deflation — rather it coexisted with moderate inflation for a long time, then with low inflation. By 2008, the flat Phillips curve was already very clear to anyone who read Italian newspapers.

Brad DeLong writes that Hicksian-inclined economists misunderstood the length of the short run. It was supposed to be a small multiple of typical contract duration in the economy – perhaps six years in an economy characterized by three-year labor contracts, and perhaps three years in an economy in which workers and employers made decisions on an annual cycle. After that time, nominal prices and wages were supposed to have adjusted enough to nominal aggregates that the economy either would be at or would be well on the road to its long-run full-employment configuration.

Lawrence Summers writes that it is pretty hard indeed to escape the conclusion that – contrary to the implication of simple textbook macroeconomic models – when a recession happens in 2020, a sensible person’s view is the GDP in 2028 will be significantly lower than it would have been without that recession.

In a recent speech at the Clausen center, Benoit Coeure writes that recent theoretical and empirical research has started deconstructing three important assumptions about our understanding of the international macroeconomic adjustment process: that the reallocation of aggregate demand across economies would sustain an appropriate pace of global growth; that freely floating exchange rates would support such demand and act as shock absorbers; and that cross border capital flows make international adjustment smoother and improve the global allocation of capital.

Unlearning microeconomics

Noah Smith writes that again and again, standard ideas – the stuff that most of the undergrad kiddos learn in their Econ 101 classes – are being smacked down by the heavy hand of new data. A ton of standard, common theories are just not matching reality very well. For example:

  1. If you slap some quick supply-and-demand graphs on the board, it looks like minimum wages should harm employment in the short term. But the data shows that they probably don't.
  2. If there's any sort of limits to mobility, then simple labor demand theory says that a big influx of immigrants should depress the wages of native-born workers of comparable skill. But the data shows that in many cases, especially in the U.S., the effect is very small.
  3. A simple theory of labor-leisure choice predicts that welfare should make recipients work less. But a raft of new studies shows that in countries around the world, welfare programs barely reduce observable work effort.
  4. Most standard econ theory doesn't assume the existence of social norms. But experiments consistently show that social norms (or morals, broadly conceived) matter to people.

Noah Smith writes that we shouldn't train tomorrow's business elite to have faith in theories that have only a small amount of empirical success. The simple theories we teach in Econ 101 classes (for example on the impact of minimum wage hikes and welfare policies) work once in a while, but in many important cases they fail. This is what we have learned from the empirical revolution in economics. We now have an academic economics profession focused on examining evidence and an Econ 101 curriculum that focuses on telling pleasant but often useless fables. This has big political implications. If economics majors leave their classes thinking that the theories they learned are mostly correct, they will make bad decisions in both business and politics.

Noah Smith writes that the problem is that by emphasizing theory so much, and by relegating evidence to some brief asides, Econ 101 textbooks (and classes) will tend to trick kids into thinking that the theories have better fit than they do. When you make people learn a theory in detail, I think they naturally tend to believe that the theory has strong empirical fit unless they see evidence to the contrary.

About the authors

  • Jérémie Cohen-Setton

    Jérémie Cohen-Setton is a Research Fellow at the Peterson Institute for International Economics. Jérémie received his PhD in Economics from U.C. Berkeley and worked previously with Goldman Sachs Global Economic Research, HM Treasury, and Bruegel. At Bruegel, he was Research Assistant to Director Jean Pisani-Ferry and President Mario Monti. He also shaped and developed the Bruegel Economic Blogs Review.

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