Evan Soltas
May 14, 2015

Macro Mysteries and Non-Mysteries

There has been an interesting, if rather theoretical, debate between Roger Farmer, Brad DeLongPaul Krugman, and John Cochrane. The gist of it is simple enough: Is the current standard toolkit of macroeconomic models enough to explain the 2008 recession and limp recovery?

So that all blog-readers are on the same page, Keynesian macroeconomics has rallied around a certain framework since the 1980s. You start with a very classical model of the economy -- an economy that is always at potential, always has the right prices, and always has efficient allocations of resources -- and add some frictions, usually sticky prices or some sort of borrowing constraint. The result is a model where business cycles happen (and can be very severe) but where, eventually, the economy returns to potential. Krugman largely defends this theoretical tradition or, more precisely, a more primitive version of it.

This is not what Roger Farmer wants. Instead, Farmer wants economists to be thinking about models in which "potential" is not well defined -- that is, where it is very much possible for the economy to find equilibrium at many different levels of production. In short, Farmer wants ideas like multiple equilibria, nonlinearity, and self-fulfilling expectations back on the theoretical agenda. And, on the empirical side, Farmer has been trying to show empirically that we see this phenomena in key economic variables like unemployment and output.

In moderating the debate, DeLong faults Krugman's defense of the standard toolkit and argues that Farmer deserves some credit. The standard toolkit, DeLong contends, doesn't get the size of the recession right:

When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause... To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple--or a continuous set of--equilibria. And so Roger seems to me to be more-or-less on the right track.
I do not think DeLong is correct when he says that the magnitudes come out wrong. My sense has been that the standard toolkit -- with the financial accelerator and sticky prices -- actually does get it right. It follows that, at the moment, we do not have compelling evidence that the stuff Farmer wants to put into macroeconomic models is needed.

Matteo Iacoviello, for instance, showed back in 2005 that textbook financial-accelerator models match what we see in the data. There's no mystery to be solved about why declines in home prices have such severe, protracted effects on economic growth. More recently, Atif Mian and Amir Sufi have put forward a lot of evidence that the hit to household balance sheets during the 2008 recession explains the decline in employment. On my part, I am doing some work to extend this line of inquiry to Spain's housing bubble, with some initial results showing that the boom and bust in mortgage lending, driven by wholesale finance, fully explains the boom and bust in housing prices.

Simon Gilchrist and Egon Zakrajšek have shown something similar is true in corporate bonds -- a financial market that, when hit with an adverse shock, propagates the shock into corporate investment and employment. Daniel Leigh and an army of economists at the International Monetary Fund have shown that, across the set of developed economies, the drop and sluggish recovery in business investment also lines up with the predictions of the textbook model.

Another approach is to put these financial frictions into a more developed model of the economy's structure, as in some recent work by Marco Del Negro, Marc Giannoni, and Frank Schorfheide. When you hit that model economy with the the kind of shocks that preceded the 2008 recession, the downturn that pops out of the model looks quite a lot like the 2008 recession.

I am not trying to say here that the 2008 recession raises no interesting questions. It does. But I think that a review of the empirical research would suggest that "why was the downturn so severe?" and "why has the recovery been so weak?" are not among them. When DeLong and Farmer say that our theoretical framework is insufficient to explain the evidence, I do not know what evidence they have in mind.

Farmer does some informal statistical work to try to show that real output drifts rather than returns to a trend. The problem with this argument is that, when you separate out permanent and transient shocks -- something Farmer doesn't do -- the transient ones look like shocks to demand, the permanent ones to supply. (Cochrane's post has a lot more to say on these statistical issues.)

Farmer might find some stronger evidence for his view that "potential" is a nebulous concept in some fascinating new work by Larry Ball, which compares the revision of estimates of potential output to the actual downturn in output. Where the downturn was worse, Ball shows, the loss of potential has been worse. However, there's some (very different) evidence from the bombings of Japan and Vietnam showing that long-run economic potential is almost indestructible.

Trying to find solid footing on this issue will be a challenge. It's terribly difficult, from the standpoint of research, to show that short-run fluctuations transmit into long-run catastrophes. "Permanent" is hard to distinguish from "long-lasting."

My feeling then, is that the heat in this debate is pretty misplaced. We have a mountain of evidence showing that financial shocks can generate long-lasting, deep recessions -- and yet, we are only at the beginning when it comes to understanding whether recessions do permanent damage, let alone how much. Why don't we start there?