Never Let a Serious Crisis Go to Waste
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If there had been a sophisticated outside observer, they might have insisted that all the brouhaha about jettisoning the DSGE model was a weary sideshow, since the gnawing problem the economic orthodoxy was intent on avoiding was gauging to what extent the crisis had voided the legitimacy of neoclassical microeconomics. Legions of macroeconomists were mobilized into action by the crisis not to address its dire consequences, but instead to obscure this threatening conclusion through smoke, mirrors, and legerdemain. No one who wanted to maintain their position in academia would countenance the possibility that amputation of the DSGE would result in the patient bleeding to death. So instead they promoted endless expensive consultations over the health of the DSGE—and even Congress was snookered into the pointless game.
This argument would begin by characterizing the two options promoted after the crisis hit by economists who thought of themselves as orthodox macroeconomists. The first was to insist that all that ridicule of the DSGE model was simply ignorant: all those aspects of the crisis that critics said couldn’t be accommodated by the model had in fact been fully taken into account somewhere in the journal literature.95 You want heterogeneity of agents—we’ve already done it. We’ve got models with frictions galore, and we have even coquetted with bounded irrationality. You claim there are big political divisions within macro, and that DSGE describes only neoliberal fantasies of self-regulating markets; but the “freshwater/saltwater” divide is just an illusion. The orthodoxy comes equipped with DSGE models to conform to all ideologies. We even have some versions of the model here and there that mention banks and credit.96 All those carping complaints are baseless, and mired in an outdated impression of real business-cycle theory back in the 1980s.
This option, while commonplace, is utterly unavailing. Some of the orthodox are beginning to notice this.97 A philosophically grounded economist would point out that the canonical DSGE assumes its canonical outlandish format in order to “save” its microfoundations, viz., the nonnegotiable prescription that macro and neoclassical microeconomics constitute one big unified theory. All these current fragmentary amendments to render the DSGE model more “realistic,” or perhaps more politically acceptable to the New Keynesians, turn out to be self-contradictory, since they attempt to mitigate or “undo” the microfoundations that had been imposed from the outset. It ends up being yet one more instance of economists blithely asserting both A and not-A simultaneously. By thrusting the rabbit into the hat, then pulling it back out with a different hand, the economist merely creates a model more awkward, arbitrary, and unprepossessing than if he had just started out explicitly to model confused heterogeneous agents, dodgy banks, consciously duplicitous CDOs, informationally challenged markets, and all the rest of the usual suspects for the crisis, minus the neoclassical window dressing and professions of fealty to “equilibrium.” If you allowed freedom of amendment to the DSGE in this manner, you would end up with models that violated the Lucas critique in a more egregious fashion than the earlier Keynesian models these macroeconomists love to hate. And there are the nagging worries that, as in the case of undermining existence of equilibria and welfare indicies, one ends up driving the formalism into Bedlam. Thus, a “more realistic DSGE” ends up a contradiction in terms.
The second option, the one favored by the high-profile economists dismissive of the DSGE tradition such as Robert Solow and Paul Krugman, was to roll back the clock to 1969, and pretend like the whole sequence of sordid developments leading up to DSGE never happened. Sometimes this was bruited about as a “return to Keynes,” although a historian might aver that the American profession was never all that enamored of the actual Keynes and his writings.98 Nevertheless, this latter group was extrapolating from the heady days of late 2008, when all thoughts of DSGE were nowhere to be found. As the economic historian Greg Clark put it, “The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ I. What is the multiplier from government spending? Does government spending crowd out private spending? . . . If you got an A in college Econ I, you are an expert in this debate: fully an equal of Summers and Geithner.”99
This proposal was, if anything, even more implausible than the revision of the DSGE. Most macroeconomists would rather abandon the field than admit all their technical sophistication was superfluous, and forget the lessons they learned at the feet of Robert Lucas and Thomas Sargent. The entire field was populated by people drilled in contempt for reading Keynes, and confirmed in their convictions that those 1960s-era models, like the old-fashioned IS-LM and Phillips Curve, fully deserved to be tossed on the trash heap of history. Yet, even if some magic wand waved away generations of inertia, there was no guarantee that if you reran the tape of history one more time, starting in 1969, the neoclassical orthodoxy wouldn’t just end up rejecting all those 1960s-era models all over again. For Lucas and Sargent had a point: the earlier “Keynesian” macroeconomics as it existed back then was logically incompatible with neoclassical microeconomic theory; and if something had to give, it would be Keynes, and not the theory of general equilibrium, at least in America. Hence, by a circuitous route we arrive once more at the lesson of this section: the real bone of contention is not the DSGE model per se, but rather the preeminence of legitimacy of neoclassical microeconomics.
One of the places where the 2010 congressional hearing missed an opportunity at gaining an understanding of the true character of the path to dominance of the DSGE was in not inviting a historian/methodologist to provide metacommentary upon the curious testimony offered by the invited participants. Not only would the missing ghost witness have provided some context for the seemingly orthogonal positions voiced by Solow, Chari, Page, and Winter, and pointed out it was no accident that no substantial alternative to neoclassical theory had a place at the table; but she might have also suggested that the Congress (or its delegated agencies) itself deserved its own fair share of the blame for the rise to intellectual monopoly of the DSGE. To suggest where such testimony might have ventured, we here cite another occasion of testimony before the same House committee dating back to March 1981. Then the issue was a Reagan administration drive to cut the funding of economic research from the National Science Foundation. The speaker was the Harvard economist Zvi Griliches:
It is ironic and sad that whoever came up with these cuts does not even recognize that most of the recent “conservative” ideas in economics—the importance of “rational expectations” and the impotency of conventional macroeconomic policy, the disincentive effects of various income-support programs, the magnitude of the regulatory burden, and the arguments for deregulation—all originated in, or were provided with quantitative backing by NSF supported studies.100
Griliches was merely stating the obvious: “legitimate” economists produce the sorts of knowledge that their patrons desire, within the trajectory of their accumulated intellectual heritage; that list of patrons includes neoliberal elements within the government, with their allies in selected ranked economics departments and think tanks. Congressmen today should not act as though the DSGE model and its precursors were somehow foisted upon unsuspecting regulators and an innocent public by imperious economists. Mostly, Americans just got what they paid for.
High Theory to the Rescue
So perhaps all those attempts to “fix” orthodox neoclassical theory that were trumpeted by journalists after the crisis really didn’t actually amount to much. Whether or not it was intentional, its effect was to foster the mistaken impression in the general populace that neoclassical economists were dutifully atoning for their sins by rethinking their past premises, even though no such thing was happening. Given the very notion that Nobel winners in economics were especially or ideally primed to fundamentally transform economic thinking once they had been anointed by the glittering prize bordered on delusional, and since those very same Nobel winners loomed large in journalists’ accounts for reasons already discussed, this abortive outcome was more or less a foreordained
conclusion. Behavioral economics, divestment of the EMH, and tinkering with the DSGE have all been abysmal failures. Yet something agnotological was achieved: the blogosphere was set all a-twitter on irrelevant pointless topics, while journalists were set off on wild goose chases. However, I expect that readers familiar with recent economics will tend to object: How about the best and brightest of the orthodox profession who are perched a bit lower down in the hierarchy, and therefore escape the public eye? What about their ideas?
One must concede it is at least more likely that any revitalization of the neoclassical tradition would come from below, a younger and less lionized cohort, if it were to happen at all. Journalists have been misled, barking up the wrong cedar. This, I believe, is also the current attitude of the effective leaders of the orthodox profession. Hence the dance card both lengthens and becomes a bit more obscure, with numerous potential candidates for the title of Prophet of the Reformation put forth from different corners. Indeed, there are already starting to appear dedicated surveys in the form of laundry lists that simply array any “cause” someone, somewhere managed to publish; and more pertinent to current concerns, surveys of all the different ways casts of hundreds have sought to stuff finance and “failure” into orthodox macroeconomic models.101 Fear not, dear reader; I will not attempt anything remotely approaching that here, for the following reason.
Eric Maskin, whom we have encountered previously insisting that the orthodoxy was robust, convened a “Summer School” in Jerusalem in June 2011 to showcase what he considered to be the finest exemplars of orthodox explanations of the crisis. I would ask the reader to glance at the video online;102 and if her patience is tried by the technical lectures, just sample the roundtable identified in the footnote. What you will quickly learn from the experience is that when these Princes of Theory were forced to summarize in ten minutes their take on the causes of the crisis, all the subtle models and technical details were soon left behind, and those economists reverted to fairly simple explanations already found in the more popular press. Nobel winners generally come off comparably worse than people who actually have had some relevant experience. There are moments of clarity, when someone realizes that generalizations turn out to be much less valid and more rare than theorists often presume. Furthermore, in the period of give-and-take, one august economist bemoaned that “we” really do not know the true causes of the crisis, and another counseled humility, since five participants there were seen to proffer eight or more different causes.103
I believe that particular panel gets to the heart of something important about the profession: building neoclassical mathematical models in the twenty-first century is a pursuit attuned to appeal to a narrow coterie of refined tastes; one should never confuse it with providing explanations of economic events. Indeed, more often than not, it tends to appear as a post-hoc rationalization for positions/explanations often arrived at elsewhere, and by alternative avenues. That doesn’t mean the models are utterly superfluous; but mostly, what they manage to demonstrate is that it is nearly impossible to shoehorn vernacular conceptions of cause into legitimate neoclassical models, and at the same time obey the orthodox “norm of closure,” which means you must demonstrate existence of an equilibrium, and preferably, a unique equilibrium. Since the vernacular causes of crisis sometimes championed by these orthodox economists are themselves interesting and potentially illuminating, it might repay some brief consideration of one or two of these cases, so as not to seem that the neoclassical project is being dismissed out of hand.
A) The Leverage Cycle of John Geanakoplos
Once we realize that numerous high-status academic economists enjoy a shadow life on Wall Street, then the question presents itself: Doesn’t direct hands-on experience count for anything in the economics profession? While many such economists prize theoretical fidelity over practical acuity, there are a few more venturesome souls. One such person is John Geanakoplos, James Tobin Professor of Economics at Yale. Geanakoplos is known for his broad tastes in theory, having spent substantial intervals at the Santa Fe Institute, which was at one time a stomping ground for the avant-garde in mathematical economics. But more pertinently, he has enjoyed a long stint on Wall Street as well, serving first as a managing director at Kidder Peabody from 1990 to 1995, and then as one of the founding partners of the hedge fund Ellington Capital Management from 1995 to the present. (Again we observe the tight coupling of finance and the commanding heights of the economic profession described in chapter 4.) Ellington Capital is a hedge fund that specialized in mortgage-backed securities, so it seems safe to say Geanakoplos had a ringside seat at the grand defalcation that led to the current crisis. And indeed, when he talks in the vernacular about what has gone wrong in the financial industry, he tends to sound a bit like Hyman Minsky, which means he makes a fair bit of sense.104 However, his academic persona is one of the elite among general-equilibrium theorists of the purest water: so the aspect of his personality that draws our attention is—how does he manage to reconcile the two?
Geanakoplos had a leg up on other economists because he did notice some pathologies of the mortgage market earlier on, and therefore had begun to concoct models well before the debacle of Bear Stearns and Lehman. Indeed, his Street connections were so good that when the crisis broke, the Wall Street Journal was quick off the blocks to anoint him with the title of New Orthodox Seer. Mostly, he did not tread the well-worn paths we have already summarized, such as awkward representative agent models, or retread neoclassical synthesis models. Interestingly, he eschews much of existing finance theory: “I don’t believe in fundamental value; I think different people may have different views about the value of an asset.” As we might expect from a consistent neoclassical, he also repudiates his Yale colleague Robert Shiller’s appeals to irrational exuberance and the madness of crowds, suggesting Shiller did not avail himself of exploration of what was going on “beneath” the mortgage bubble. What this means is he is willing to consider market structure as a candidate causal mechanism; this is combined with a penchant for having heterogeneous agents in his models, which sometimes just means the old trick of inserting “noise traders” to jostle the über-rational neoclassical agents, but in other work, agents that have substantially different utility functions.105 Because the models are still of the “general equilibrium” genus, tractability is imposed in all sorts of arbitrary fashions: there is only one “consumption good” but many “financial assets,” time is finite but ticked off in discrete periods with “information” arriving between the ticks, news is either “good” or ‘“bad,” expectations are old-fashioned von Neumann-Morgenstern expected utility . . . These are the sorts of jury-rigged assumptions we have come to expect to make the jerry-built neoclassical model give determinate results. What renders his models of the so-called leverage cycle of some passing interest is his explicit attempt to render both the interest rate and the degree of leverage as endogenous to the model, such that leverage degree and asset prices exhibit positive covariance.106 This permits him to tell a story where control of the interest rate turns out to be insufficient to control the aggregate magnitude of borrowing in an economy, much less the degree of financial fragility, obviating the usual simplistic neoclassical models of savings and investment. The reason that prices go up when leverage goes up in the Geanakoplos model is that “optimists” always borrow up to the hilt, so in the eventuality they can increase their leverage, they will unreservedly use it to purchase more assets. In his model, “the leverage cycle simply asserts there is too much leverage in normal times and therefore too high asset prices and there is too little leverage in crisis times and therefore too low asset prices. The cycle recurs over and over again.”107 In his view the mortgage bubble was only half the story; the rise of shadow banking provides the necessary other half. Geanakoplos believes this permits him to reconcile the ahistorical laws of Walras with the historical specificities of the last few decades.
While the focus on procyclical movement of le
verage and asset prices is an important departure from much of orthodox models, the commitment to Walrasian general equilibrium so hampers the formalism that good intentions ended up in Bedlam. Geanakoplos likes to phrase his commentary in terms of “cycles,” but in fact, general equilibrium forces him to posit separate and unconnected sequential states of equilibrium, driven in a Rube Goldberg fashion by the arbitrarily sequenced arrival of asset issuance→“news”→valuation. Each state along the way is in “equilibrium,” as defined by constrained optimization and market clearing. Because everything is always already in equilibrium, the only reason anything changes is the deus ex machina imposed from outside by the model builder. Worse, the sequence itself is completely arbitrary, dictated more by the math than by anything that happens in the world: for instance, each player has only one chance to issue assets, is proscribed from trading them on secondary markets, and consumption can happen only at the initial issuance and at the end of time.108
It seems that, however proud he may be of hewing to Walrasian heuristics, the suite of models he has constructed rarely do much to actually illuminate the actual crisis and aftermath. After all, if the different configurations of leverage and asset prices are each in “equilibrium,” then there is no warrant for recourse to the language of prices and leverage being “too high” or “too low.” At each Goldilocks state of the world, they are “just right” for all participants. Geanakoplos seems to have forgotten that there is no “unemployment,” no unused resources, and no distress in Walrasian general equilibrium. The market always perfectly reflects the desires of all the agents; the only reason anything ever changes is that the godlike puppetmaster forces parameter alterations from another astral plane. Further, at least Minsky proposed a reason why leverage would increase over time: big players tend to shade or violate previous rules. Nobody ever breaks a rule in a Geanakoplos model. The closest he ever gets to realizing this is when he moves his comments outside the formalism to discuss actual institutional events in the history of the crisis: “the market engineered its own negative shock by creating credit default swaps, which started [MBS] prices down. Had the CDS been actively traded from the beginning, prices might never have got so high.”109 In effect, he finally defaults to the hoary old Arrow-Debreu excuse for “market failures”: markets were unaccountably incomplete, and then they suddenly weren’t. With a full complement of high-tech financial wizardry, the crisis would presumably never have happened, or so he seems to suggest.