Steve Williamson writes “It takes a model to beat a model. You can say that you don’t like [modern macroeconomics], but what’s your model? Show me how it works.” Well, I’m going to take up that challenge, because I wrote that model.
In my view, the challenge is not to write a model that works, but to write a model that the macroeconomic establishment will find “convincing.” And that generally requires writing a model that comes to conclusions that are closely related to the existing literature and therefore “make sense” to the establishment. The problem, however, is that many of the implications of the existing literature are batshit insane. (My personal pet peeve is explained in detail below, but there are others … ) The choice faced by a young economist is often to join the insanity or leave the profession. (This is actually a conversation that a lot of graduate students have with each other. Many compromise “temporarily” — with the goal of doing real research when they are established.)
Williamson’s own area of macro, new monetarism, which is the area that I was working in a decade ago too, illustrates the gravitational pull of conformity that characterizes the macroeconomics profession, and that interferes with the development of a genuine understanding by economists of the models they work with.
Williamson acknowledges, as every theorist does, that the models are wrong. The problem with macro (and micro and finance) is that even as economists acknowledge that formally there is a lot to criticize in the market clearing assumptions that underlie far too much of economic theory, they often dismiss the practical importance of these critiques — and this dismissal is not based on anything akin to science, but instead brings to mind a certain Upton Sinclair quote. (Note that there are sub-fields of economics devoted to these critiques — but the whole point is that these researchers are separated into sub-fields — in order to allow a “mainstream” segment of the profession to collectively agree to ignore the true implications of their models.)
Let’s, however, get to the meat of this post: Williamson wants a model to beat a model. I have one right here. For non-economists let me, however, give the blog version of the model and its implications.
(i) The model fixes the basic error of the neo-classical framework that prevents it from having a meaningful role for money. I divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability.
Note that because the model is designed to fix a well-recognized flaw in the neo-classical framework, it’s just silly to ask me to provide micro-foundations for my fix. The whole point is that the existing “market clearing” assumptions are not just micro–un–founded, but they interfere with the neo-classical model having any relationship whatsoever to the reality of the world we live in. Thus, when I adjust the market clearing process by inserting into it my intra-period friction, I am improving the market-clearing mechanism by making it more micro-founded than it was before.
Unsurprisingly, I wasn’t comfortable voicing this view to my referees, and so you will see in the paper that I was required to provide micro-foundations to my micro-foundations. The resulting structural assumptions on endowments and preferences make the model appear much less relevant as a critique of the neo-classical model, since suddenly it “only applies” to environment with odd assumptions on endowments and preferences. Thus, does the macroeconomics profession trivialize efforts to improve it.
(ii) An implication of this model in an environment with heterogeneous agents is that (a) money in the form of Milton Friedman’s “M” cannot solve the monetary problem, but that instead (b) a monetary form of short-term credit is needed to solve the monetary friction. To be more precise, in order to support a good outcome using “M” in an environment with heterogeneous agents the monetary authority needs to impose different lump-sum taxes for every type of agent (otherwise either some agents face a binding cash-constraint or the transversality condition that keeps agents from forever holding and never spending increasing amounts of money is violated). Thus, technically “M” can solve the monetary problem but only if an all-knowing monetary authority is constantly tweaking the amount of money that each member of the economy holds — that is, only if “M” does not have the anonymous properties that we associate with money.
In short, when the neo-classical model is corrected for its obvious flaws, we learn that the basic premise of monetarism, that there is some “M” which is clearly distinguishable from credit and which can solve the monetary problem, has no logical foundations. This whole approach to money is a pure artifact of the neo-classical model’s fatally flawed market-clearing assumptions.
These issues with “M” are actually well-established in the new monetarist literature. (See, e.g. here or here.) The problem is that this motivated changes in the literature, discussed below, that protect the concept of “M.” (Moral: if you want to get published be careful to rock the boat with a gentle lulling motion that preserves the comfort of senior members of the profession — they don’t like swimming in unfamiliar waters.)
(iii) I interpret (ii)(b) as a wholesale rejection of the concept of “M.” The fact that the fundamental monetary problem can only be fully addressed by credit points directly to the importance of the banking system. We need the transactional credit that banking systems have long provided — not incidentally starting at the dawn of modern growth trends — in order to solve the monetary problem.
This is where, in terms of modern macroeconomics, I go completely off the rails. Correctly viewed, however, this is where modern macroeconomics goes completely off the rails. Every modern macroeconomist, whether of the salt- or of the fresh-water school was trained to ignore the banking system. They are persuaded that it doesn’t matter, because if banking is a fundamental determinant of economic performance, then the whole of their understanding of how the economy works is fundamentally flawed. (See Upton Sinclair above.)
So we have the development of a sub-field of macroeconomics, new monetarism, and the implications of this literature should be understood as a direct challenge to the concept of “M.” What, in fact, happened to this literature? The basic model was tweaked, so the workhorse model in this area is now the Lagos-Wright model. What does this model do? After every trading period with frictions it introduces a frictionless stage in which money balances, “M,” can be reallocated using standard neo-classical market clearing assumptions. (To make this work the axioms of preference are also relaxed with respect to one good, but that’s another issue.) That is, it guts the basic intuition that economists should derive from the older new monetarist literature. Why does it do this? Because it turns the model into something that simply tweaks the traditional understanding of “M” and makes it easier for economists to continue to ignore the fundamental monetary role of the banking system — carefully lulling the macroeconomic boat.
To conclude, the models Williamson has been working with for years should tell him to reject the monetarist view of money. While he and other researchers in this area have explored bank money and its benefits, they do so in a tentative manner without in fact directly challenging the conceptual foundations of “M.” In short, the problem with macroeconomics today is not the models we have, but the illogical, emotionally-tied manner in which economists choose to interpret them.