Models matter

I’ve been turning this over in my head for weeks. Obviously, the economic/political problems in the US are one of biggest economic issues going, and I’ve not blogged about them. Part of the reason I haven’t is that it is very difficult to separate the political from the economic.

I should also say that I’m not a macroeconomist. I discussed this a bit here (p. 6), but I studied macro in the 1980s, and what I remember most is confusion. Our professors tried to teach us all the contemporaneous strands – Keynesian, neoclassical, monetary – but I didn’t understand until much later that they couldn’t all be true. Going into the problems of 2007, I didn’t have good models for thinking about what was going on. For example, I saw the huge build-up of the money supply, and thought it would bring inflation.

I have learned a lot about macro in the last few years. I have spent a fair amount of time reading articles and blogs, trying to make sense of what has been happening in the US. What I have found is that Krugman and DeLong have been right, and lots of other economists have not. That is, they have been able to say, ‘here is what we would expect to happen in this situation’, and they have been right.

Thus, it is also a distinct disappointment to find posts like this one from kiwiblog. He has the economics all wrong. The economic situation is what we would expect – given the correct model – from this type of recession and the tepid government response. The US is suffering from a lack of aggregate demand, and the government can currently borrow at zero percent to lift demand now. To quote Krugman:

By contrast, the Krugman/Thoma/DeLong axis (I still like it!) is basically using standard macroeconomics, applied to a nonstandard situation. The Hicks/Keynes model — in which demand drives output in the short run, interest rates are determined by the tradeoff between liquidity and yield, and extreme negative shocks push you into a liquidity trap in which conventional monetary policy loses traction and deficits don’t crowd out private spending — has worked very well in this crisis, which is why we keep using it with a few twiddles (such as emphasizing the role of private debt).

We are lucky, here. I shouldn’t say this too loudly, but I think NZ is probably well-placed to weather this storm without too much trouble. Government debt is low. Our main trading partners are Australia and China, both doing well. We export food, which people still need. We should take the opportunity to learn from other countries’ pain. We could learn which models fit the facts, and which ones don’t.