Friday, September 04, 2009

Krugman on the State of Macro

As a Nobel Laureate, Paul Krugman has earned the right to state his views on the state of macroeconomics. I wish that the New York Times had allowed a couple of the University of Chicago scholars, (Lucas, Cochrane, Fama, Mulligan) who are mentioned in the piece, the opportunity to respond.

Paul Krugman's piece does not mention the word "heterogeneity". He hints at this when he discusses the Shleifer and Vishney paper investigating the limits to arbitrage. But heterogeneity will be the future of macro.

In markets featuring mixtures of types (such as naive and "smart" actors), how do market outcomes evolve in the face of shocks? When a new market is opened up (such as zero interest ARM loans), who participates? What are the macro economic implications of who enters the market? After all, economics think at the margin --- who is this subset of people at the margin?

Applied micro economists have used partial equilibrium models to study the participation decisions in markets but we are not good general equilibrium modelers.

In a globalized economy, a macro guy is pretty ambitious. Does everyone have the same information for forming expectations? Does everyone have the same "model" in their head about how the economy evolves? Does everyone really act like a small price taker? Are there really no firms (think of Goldman Sachs) playing a strategic game with government? Add in heterogeneous expectations, market power, and strategic game playing and general equilibrium becomes pretty tough. Now add in non-stationary shocks to the system and things get even tougher.

Prof. Krugman's piece has some truth to it but if a 22 year old undergraduate reads it, I'm worried that she may not want to go to Princeton to study Macro in a Ph.D. program. In fact, today we need more macroeconomists.

Returning to the University of Chicago, their excellent economists should write a popular piece on what they have learned from this crisis. Do they think differently now about macro? If I went back to Chicago for another PHD, would my macro teachers still spend so much time on the one sector growth model with a representative consumer?