Cyclicalists should start talking about structural issues too.

I could count on my fingers the number of times Paul Krugman has obviously been wrong about something, and still have enough fingers left to type 60 words per minute. But if there's one thing I've learned in my years of arguing with people, it's that if you're not in math or the natural sciences, being right on the merits is never good enough to win an argument. You have got to win hearts and minds.

Krugman has convinced a huge chunk of the populace that there is something seriously wrong with macroeconomics. That is good. But he seems not to have made much headway in garnering intellectual support for more active countercyclical policy. As an illustration of this, consider the recent push for "structural" explanations of our current high unemployment rate. Raghuram Rajan, David Brooks, and Tyler Cowen are all confidently asserting that our problems are structural, not cyclical. This point of view is seconded by Greg Mankiw and John Cochrane and echoes recent comments by Jim Bullard.

Now, it is true that these "structuralists" (to use Brooks' term) are in some sense just the usual suspects. For these people to support, say, quantitative easing would be to go against their political instincts. But in 2009 you did not hear these people arguing nearly as strongly or loudly that everything was structural, because in 2009 this point of view was far less credible. The fact that no one now feels ashamed of making structuralist claims shows that the winds of public opinion are starting to shift against Krugman and the "cyclicalists".

In response, Krugman has rebutted the structuralist argument with data (see here, here, and here). He is joined by Scott Sumner, Karl Smith, Mike Konczal, Ezra Klein, and other cyclicalists. On the merits, their case is very strong. It is much stronger than the case of the structuralists, which seems mostly based on assertion and repetition, and includes a fair bit of confusion (for example, Cowen claims that we have a drought of government investment, and then claims that there is somehow a tradeoff between government investment and fiscal stimulus; Cochrane seems to think that Keynesians believe that negative AD shocks move the economy to a slower long-term growth path). If economic policy arguments were settled on the basis of logic, the cyclicalists would be winning. 

And yet they are not winning. They are slowly losing. The battle for fiscal stimulus in America has been lost, the battle for more quantitative easing in America has been lost for now, and the battle against European austerity is not going well. My guess is that this coincides with an increasing acceptance of structuralist ideas on both sides of the Atlantic.

Why? I suggest several reasons:

1. People intuitively understand structuralist ideas, which is to say they intuitively understand long-run supply. They do not intuitively understand aggregate demand. Anyone who has taught undergrad macro knows this fact. And though intuition and common sense are not a good substitute for scientific expertise, it is not certain who constitutes an expert, and when trillions of dollars are on the line, people have a tendency to go with their gut rather than listen to some smart guy with a confusing theory.

2. Many people just don't care about business cycles, and assume that even without help, the economy will recover in a few years.

3. Many people want (quite reasonably!) to use the ongoing economic troubles as an opportunity to win political backing for their favorite structural reforms - as the saying goes, "never letting a good crisis go to waste".

4. Many people are worried about structural problems anyway, regardless of where we are in the business cycle.

5. Many people think that economists understand optimal structural policy much better than they understand optimal cyclical policy, and that we should focus on making suggestions that we understand better.

So if I'm right, Krugman and the cyclicalists can unload as many pretty graphs and impressive numbers and inventive models and carefully argued paragraphs as they like, and it will make very little difference to what most people think. A new rhetorical approach is needed.

For this new approach, I suggest that Krugman and others start talking about structural policy ideas.

I do not mean that cyclicalists should stop recommending things like quantitative easing. I mean that they should start also throwing out ideas about how to improve our economic performance in the long run. They should do this for two reasons. 

The first reason is that many policymakers and members of the public currently think that there is a tradeoff between cyclical policy and structural policy. In general, contra Tyler Cowen, this is not true. If you think that deregulation is what we need to grow more in the long run, then you should realize that there is no tradeoff between deregulation and quantitative easing, or deregulation and stimulus. Ditto for free trade. Ditto for corporate tax cuts (as long as income taxes are raised to keep revenue the same). Ditto for policies to improve education. Ditto for policies to improve labor search and matching. In the case of the government investment that Tyler Cowen says we need more of, good structural policy also makes good countercylical policy! In fact, the only "structuralist" policies - if you can call them that and keep a straight face - that conflict with countercyclical policy are austerity and hard money.

Krugman and some of the cyclicalists have focused the vast majority of their attention on cyclical issues. But this reinforces the (mistaken, misleading) claim of the structuralists that there is a tradeoff between the short term and the long term. One more Krugman blog post is not going to convince anyone to support stimulus, QE, etc. But one more Krugman blog post dedicated to discussing long-term issues will do a lot to convince readers that there is no policy trade-off. In other words, the marginal value of Krugman devoting more time to cyclical issues is negative.

The second reason for cyclicalists to discuss structural policy is political. The people advocating "structuralist" policies are, right now, mostly conservatives. Their ideas about long-term growth policy are basically more tax cuts and more deregulation. Only occasionally, if ever, do these "structuralists" call for repairs to our disintegrating infrastructure, or increased spending on research, or ending the dollar's reserve currency status. And the conservative "structuralists" have ideas about education, health care, and occasionally immigration that strongly diverge from what liberal "cyclicalists" would be promoting if they bothered to talk about structural policy more often. 

In other words, while liberals throw all their energy into a losing rearguard action against austerity, conservatives are winning the future.

This is why I call for a balance between discussions of cyclical policy and discussions of structural policy. Yes, it would still be good if we got more QE. Yes, European-style austerity is a real danger. But continuing to hammer home these points with logic and reason is yielding diminishing returns. Logic and reason are good things to have, but by themselves they do not win arguments. If I have a choice between proving I'm right and winning, I'll pick winning every time...


Update: Here is a good example of what I'm calling for!

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Leadership (or lack thereof) begins at the top

Yahoo! CEO (and liar) Scott Thompson.

On May 3, activist shareholder Dan Loeb pointed out that Yahoo! CEO Scott Thompson never obtained a degree in computer science, despite what his official Yahoo! bio claims. (The bio has since been altered.)

Apparently, Thompson has been lying about his credentials for at least ten years. When Thompson worked for eBay (as CTO of the PayPal division), his bio contained the statement: "Scott received a bachelor’s in accounting and computer science from Stonehill College." There's only one problem. Stonehill did not begin awarding computer-science degrees until four years after Thomspon graduated.

Thompson's bachelor's degree is actually in business administration.

Less-often reported is the fact that Yahoo! board member Patti Hart (who vetted Thompson's hiring) doctored her bio, also, to show a degree in "economics and marketing." In actual fact, Hart's degree (like Thompson's) is in business administration.

Yahoo! issued a statement calling Thompson's out-and-out lie "an inadvertent error." Which is, itself, a lie.

Yahoo! Board Member Patti Hart

So lying is endemic at the highest levels of Yahoo.Which ought to be quite demoralizing to Yahoo! employees. And apparently it is.

Interestingly, Yahoo's own code of ethics, which you can download here if you're interested, requires employees to (among other things) "Make sure information we disclose about our company is clear, truthful, and accurate." It also cautions employees to "avoid exaggerating."

Apparently, Yahoo's code of ethics means absolutely nothing, since board members and executive officers don't obey it.

Ordinary employees at Yahoo! now must come to grips with the fact that there are two standards of behavior at Yahoo!, one of which applies to them, the other of which applies to bigwigs at the top.If any ordinary employee did what Thompson and Hart have done, he or she would be fired in an instant. But CEO Thompson hasn't been fired. And even if he is, he'll leave with millions of dollars in severance.

The whole episode (including Yahoo's unbelievable lack of urgency in dealing with the situation) sends a bad message not only about Yahoo! but about corporate America. It says that corporate codes of ethics needn't mean anything, and lying (in both corporate bios and SEC statements) is 100% acceptable at the level of CEOs and board members.

We'll see, soon enough, if at also means you get paid big bucks on the way out the door.

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The macro Overton window

The "Overton window" is basically the range of positions on a certain question that are considered reasonable. In macroeconomic policy discussions in the United States, certain positions are, for whatever reason, outside the Overton window - Marxist ideas, mercantilist ideas, the gold standard, etc. Whatever your position is in an argument, you want it to be in the middle of the Overton window instead of at the edge. You do not want to be seen as someone who is on the borderline between serious and kook. 

In the debate over the causes of, and proper responses to, the current recession, the Overton window matters. If one edge of the window corresponds to Old Keynesianism and the other edge corresponds to the policy status quo, it's likely that what will end up happening will be something in between those two extremes, e.g. more quantitative easing. But if the rightmost edge of the window corresponds to the idea that demand shocks don't affect output at all, then what will end up happening will probably look more like the status quo.

Hence it makes practical sense for economists who favor less countercyclical policy to try to yank the Overton window toward the right, even if their objective analyses admit the possibility that Keynesians might be right. Or even if conservative economists don't do this intentionally, it certainly helps their cause when someone does it.

For example of arguments that shift the Overton window rightward, here is Garrett Jones suggesting that we pay attention to RBC models:

One of the major schools of thought in macroeconomics rarely makes it into mainstream discussions: Real Business Cycle Theory...[A]s long as big ideas come in waves, as long as energy supplies depend on the vagaries of global politics, and as long as politicians enact policies that weaken confidence in the health of a nation's economic institutions, RBC will matter. 

Notice that the "technology shock" that Jones hints is responsible for our current recession is just the supposed leftist policies of the Obama administration.

For another example, here's John Cochrane:

A logical possibility of course is that drawn-out recessions following financial crises...reflect particularly ham-handed policies followed by governments after financial crises.  Financial crises are followed by  bailouts, propping up zombie banks, stimulus, heavy regulation, generous unemployment and disability benefits, mortgage interventions, debt crises and high distortionary taxation (European "Austerity" consists largely of taxes that say "don't start a business here") and so on...It is certainly possible that these, rather than "financial crisis" are the cause of slow recovery, and thus that slow recovery is a self-inflicted wound rather than an inevitable fate.   

The similar policy mix in the Great Depression is now accused by a strand of scholarship as the prime cause of that depression's extraordinary length, not valiant but sadly insufficient fixes. (For example, see Lee Ohanian; for some more popular summaries see Jim Powell or Amity Shlaes.)

Amity Shlaes? Really?

Note that both Jones and Cochrane make almost explicit reference to the Overton window. Jones says RBC "rarely makes it into mainstream discussions," while Cochrane says "It's certainly possible" that Obama is behind the slow recovery. They aren't claiming that this extreme view is true. They merely wanted it included in the discussion. They want the Overton window to include it.

Is the idea - that Obama's policies have caused our slow recovery - plausible? Well, I guess so, in a generalized, I'm-open-minded-and-willing-to-consider-any-proposition sort of way. But by that standard, quite a lot of things are plausible that no one is talking about nowadays. If you're going to argue that aggregate demand doesn't affect output, you're going to have a very difficult time explaining the initial steep plunge of GDP in 2008-9, before Obama had had a chance to do anything (and you're going to have a very hard time explaining what happened to the price level during that time).

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What is a "financial crisis"? (reply to John Cochrane)

The conventional wisdom says that recessions that follow financial crises last longer than other recessions. In a recent blog post, John Cochrane challenges the conventional wisdom:

Financial crises certainly don't always and inevitably lead to long recessions, as the factoid suggests... 

In a nice article for the Atlanta Fed, Gerald Dwyer and James Lothian went back to the 1800s, and find no difference between recessions with financial crises and those without. Some, like the Great depression and now, last a long time. The others don't.   

Michael Bordo and Joseph Haubrich wrote a somewhat more detailed study of US history, (which I found through John Taylor's blog) concluding 

recessions associated with financial crises are generally followed by rapid recoveries. We find three exceptions to this pattern: the recovery from the Great Contraction in the 1930s; the recovery after the recession of the early 1990s and the present recovery. ... 

In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength 

This had pretty much been the "stylized facts" when I went to grad school: US output has (so far) returned to trend after recessions. The further it falls, the quicker it rises (growth). Financial crises give sharper and deeper recessions, followed by sharper recoveries, but not, on average, longer ones. This "recovery" is in fact quite unusual, looking more like the Great Depression but unlike the usual pattern.  

As I did minor searches for the facts however, it's clear there is an explosion of work on this subject, so it's hardly the last word.  

When I read this, the first question that popped into my mind was "OK, but how are they defining financial crises?" It turns out that the two sources Cochrane cites disagree on this point. The article by Dwyer and Lothian says:

No U.S. recession since World War II [other than the current recession] has been associated with a financial crisis. 

While the paper by Bordo and Haubrich says:

Consequently, the recessions we associate with a financial crisis are those that start in 1882, 1892, 1907, 1912, 1929, 1973, 1981, and 1990.

That's a big difference! Three post-WW2 financial crises versus zero?

The problem, of course, is that it's difficult to define a financial crisis. Many people seem to use the term to mean "a large drop in asset prices" (this is the definition that leads to the claims that economic models can't forecast financial crises). But there are other possible meanings of the term. For example, "financial crisis" could also mean:

• A large number of bank runs, leading to a liquidity crisis

• A solvency crisis, in which most large financial institutions are found to be insolvent

It seems to me that this third definition - the simultaneous insolvency of most large financial institutions - is the kind of "financial crisis" that most people would casually associate with long recessions and slow recoveries. Note that a steep fall in asset prices is neither necessary nor sufficient to generate a solvency crisis, since firms may have different degrees of leverage.

If we define financial crises as asset price drops, it seems pretty obvious that "financial crises" will be associated with most recessions. This is because asset prices are forward-looking and quick to react to events; any shock that will cause a recession over the next year will cause an asset price almost as soon as the shock is realized. I strongly suspect that Bordo and Haubrich are using this definition, since they claim that a financial crisis happened just before the 1981 recession. Stock prices would obviously fall in reaction to an interest rate hike by the Fed (which most people believe caused the recession in '81).

Dwyer and Lothian seem to be using a different definition of "financial crisis". I'm not sure what their definition is, but my guess is that it is a liquidity crisis or solvency crisis type of definition.

Now, both of Cochrane's sources reach the same conclusion, which is mainly based on pre-WW2 data. I don't know much about pre-WW2 economic history, so I'm not really qualified to evaluate their claims. But I think that the confusion over definitions merits a long hard look into exactly what happened in and before all of those pre-WW2 recessions.

Two more points:

1. Actually, my intuition says that financial crises are not the cause of slow recoveries. My intuition is basically the "balance sheet recession" story, which is about a sudden regime change in people's behavior toward debt and consumption after a long build-up in debt. My intuition says that people's sudden shift to a "balance sheet rebuilding" regime will tend to cause both a long recession and a financial crisis. But then again, this is just my intuition...As Cochrane says, there is lots of research being done on the subject.

2. Cochrane definitely does do a good job of rebutting a factoid tossed off by Bill Clinton, which is that recessions after financial crises last "5 to 10 years". Cochrane cites evidence from Reinhart and Rogoff that shows that the international average has been just under 5 years for recent crises. Although I'm not sure I believe the Reinhart/Rogoff numbers (the Great Depression lasted only 4 years??), it is definitely the case that countries such as Sweden, Finland, and Korea have managed quick recoveries after financial crises. I think we should look at what they did, and see if maybe we can replicate their best practices.

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Riled by the wrongness of Raghuram Rajan

Once more, it's time for me to take advantage of the large number of R's in Raghuram Rajan's name to create a catchy blog post title, for once more, the eminent finance professor has written an article that I believe to contain a substantial quantity of Wrong. Rajan's article in Foreign Affairs, titled "The True Lessons of the Recession," is a call for austerity, pro-growth structural reforms, and other Stuff Conservatives Like. The piece has already sparked controversy in the econ blogosphere - Tyler Cowen says "every paragraph of [the] piece is excellent", while Karl Smith calls it "nonsense on stilts". As you may guess, I agree more with the other Smith. Though Rajan gets some things right and some things wrong, I have three major problems with his analysis: 1. His reading of economic history appears to fall victim to several common misconceptions, 2. His focus on structural reform doesn't make a lot of sense for the U.S., and 3. His conclusion that "the West can't borrow and spend its way to recovery" seems to just come out of nowhere.

Much of Rajan's article is devoted to a sort of folk history of the global economy since World War 2. Most of this I have no problem with. But some of it is appallingly false. For example, how many times has this narrative been dissected and rejected?

[S]tarting in the early 1990s, U.S. leaders encouraged the financial sector to lend more to households, especially lower-middle class ones...Such policies helped money flow to lower-middle-class households and raised their spending...

Cynical as it may seem, easy credit was used as a palliative by successive administrations unable or unwilling to directly address the deeper problems with the economy or the anxieties of the middle class...

Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down. (emphasis mine)

The idea that U.S. housing policies caused the housing bubble and the financial crisis remains a part of the conventional wisdom only because Republicans keep saying it over and over. The evidence is strongly against this interpretation of events. I could rattle off a million links to back this up, but why bother? Everyone with two eyes can see that the rise in securitization, not any federal policy, is what increased the demand for risky housing loans. Rajan does not even mention securitization.

Or take this nugget of bad CW:

Some countries focused on making themselves more competitive. Fiscally conservative Germany, for example, reduced unemployment benefits even while reducing worker protections....[O]ther European countries, such as Greece and Italy, had little incentive to reform[.]

"Fiscally conservative" Germany? But Germany's government debt is 83% of GDP; for most of the period Rajan is discussing, Germany ran deficits as big or bigger than the countries Rajan castigates.

To sum up, it seems to me that ideological conservatives, Republican partisans, and European "austerians" have managed to repeat certain fictions long enough and vehemently enough that these fictions have seeped into the worldviews of conservative-leaning economists like Rajan. But fictions they are.

Now on to Rajan's prescriptions for improving the economic situation. Rajan says that "pro-growth" structural reforms are the answer for the South European states:

[T]he best short term policy response is to focus on long-term sustainable growth...Countries that don’t have the option of running higher deficits, such as Greece, Italy, and Spain,should shrink the size of their governments and improve their tax collection. They must allow freer entry into such professions as accounting, law, and pharmaceuticals, while exposing sectors such as transportation to more competition, and they should reduce employment protections...

OK, assume for the moment that Rajan is right - suppose these countries "don't have the option of running higher deficits", and suppose that these structural reforms are obviously good ideas, and that these reforms would make a big difference.

Now, what about the United States?

The United States, not being part of the EU or the euro, has plenty of scope to both borrow money and engage in looser monetary policy. But Rajan takes his prescription for South Europe and applies it to the United States in an almost cut-and-paste fashion:

The United States must improve the capabilities of its work force, preserve an environment for innovation, and regulate finance better so as to prevent excess.

He then lists a number of reforms that he thinks would benefit the U.S. Actually, I agree with most of these ideas! What I don't agree with is Rajan's conviction that such reforms would make a big difference.

See, back in the 80s, the U.S. already did a lot of the reforms that Rajan recommends for Europe. Rajan himself points this out. Therefore, the U.S., though it is now facing the same high unemployment levels suffered by Europe, has far less scope for easy reform. That's the problem with trying to use structural reform as countercyclical recession-fighting policy; eventually you run out of reforms!

Karl Smith puts this rather more colorfully:

Is this some kind of sick joke? 

Is there an area in which our policy initiatives have more consistently failed than in producing long term sustainable growth? Do we even have a consensus on how long term growth got started in the first place? Do we have a solid story to explain growth differentials today?... 

[E]fforts to increase TFP or educational effectiveness...[are] what folks have been desperate for my entire life. If we knew how to get it, we would.

Finally, let's talk about Rajan's big conclusion. The subheading of Rajan's article is "The West Can’t Borrow and Spend Its Way to Recovery". But Rajan seems to draw this conclusion out of thin air. He offers no reason why fiscal stimulus won't work in the United States. Maybe such reasons exist. Maybe Rajan has them in his head. But he doesn't say what they are; he just asserts this claim as if it follows from the rest of his article, when in fact he never makes the case. Even when talking about Europe, he just states that countries like Spain "don't have the option of running higher deficits", when in fact Spain has considerably less debt than Germany.

To sum up, this article is full of dubious or unsubstantiated claims. The claim that U.S. government housing policy caused the financial crisis is highly dubious. The claim that Germany is "fiscally conservative" is highly dubious. The claim that structural reform is the key to a U.S. recovery is highly dubious. And the claim that fiscal stimulus will not benefit the United States is unsubstantiated.

I don't like this. When well-respected people like Raghuram Rajan repeat these claims over and over in the popular press, they become a part of the conventional wisdom, and give ammunition to vested political groups (e.g. Republicans) looking for intellectual cover for their narrow interests.

And I just generally dislike this trend of substituting conservative harrumph-ing for thoughtful economic analysis. Harrumph, austerity is healthy and stimulus is waste! Harrumph, government attempts to help the poor must be at the root of any market failure! Harrumph, North Europeans work harder and save more than South Europeans! Etc. etc. Yes, I realize that macroeconomics is really hard, and that we just don't understand the vast majority of what is going on. But I think that makes it all the more important to ignore the sweet seductive siren song of one's own politico-cultural biases.

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Reasons for "apparent status quo" bias at the Fed

As a follow-up to my last post, I want to think out loud a little more about why the Fed should have a bias toward doing nothing. Warning: these thoughts just came off the top of my head, and may be crazy. But anyway...

For a doctor, status quo bias makes sense, because of the principle of "first do no harm". For a government, status-quo bias in the form of laissez-faire bias makes sense when you believe in free markets. But the Fed is different. Because for the Fed, "doing nothing" is not really doing nothing! Even when the Fed is keeping interest rates unchanged and refusing to engage in quantitative easing (as it is now), it is still printing money, and it is still managing expectations. (In fact, since silence affects expectations differently the longer you keep it up, Fed policy is always changing even if the Fed clams up completely!) What looks like the "status quo" is really only the apparent status quo.

So why would the Fed have a natural bias toward seeming to do nothing? I thought about it, and came up with the following reasons:

1. Internal politics bias. The Fed's decisions are probably dependent on some sort of internal decision-making procedure in which the opinion of the different governors are taken into account in some way. Current Fed actions reflect a balance between hawks and doves. As long as this balance is stable, the Fed will be biased away from taking any apparent actions. Only outside events or a change in the opinions or composition of the factions within the Fed will alter the balance of power.

2. Reputational bias. Anything the Fed does is going to make someone mad. People pay more attention to things that make them mad than to things that please them. And people pay more attention when the Fed is in the news (i.e. when it appears to do something) So any action that the Fed appears to take is going to result in negative attention directed at the Fed chairman. The Fed chairman, being human, probably doesn't enjoy negative attention. So this is a reason for the Fed chairman to keep a low profile by seeming to do nothing.

3. Credibility bias. Again, people tend only to pay attention to what the Fed seems to do, rather than what  the Fed actually does. And each time the Fed seems to do something, it makes people more uncertain as to what the Fed actually wants, what it knows, what it believes, and what it is planning to do. The Fed values credibility, so it will seek to minimize taking headline-grabbing actions that make people actively wonder what the Fed is going to do in the future.

4. Asymmetric model uncertainty. This applies specifically to the Fed's reluctance to engage in quantitative easing. Paul Krugman has discussed this before. To make a long story short, history has seen many changes in the Federal Funds rate, but not many instances of QE, so it's more difficult to select a model to give you guidance when contemplating QE than when contemplating routine open-market operations. Therefore, to do QE, you have to take a much bigger leap of modeling faith. This will bias the Fed toward apparent inactivity when short-term nominal interest rates are at the Zero Lower Bound, as they are now.

So these are some reasons why Fed policy might currently be "stuck". Hawks inside the Fed are not strong enough to make Bernanke raise interest rates, and this will probably be the case for the foreseeable future. But a combination of reputation bias, credibility bias, and model uncertainty make Bernanke very reluctant to engage in further QE. And a combination of reputation bias and credibility bias make Bernanke reluctant to make additional statements about future Fed policy.

So what can academic economists do to convince Bernanke to do more QE? Well, they can write papers about QE, thus reducing (slightly) model uncertainty. They can try to get the public to realize that Fed "inaction" is really just stealth action, by couching their public complaints in different terms ("Why is the Fed doing X" rather than "Why is the Fed doing nothing"). But these efforts are not likely to have huge success. Is there any other way to reduce "apparent status quo" bias? I'm not sure.

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Macro: intuition vs. theory

Two items regarding macro policy have caught my eye this past week. The first is Gideon Rachman arguing for fiscal austerity. The second is Paul Krugman's assertion that Ben Bernanke has been assimilated by the hard-money Borg.

Why are all these people arguing for things like hard money and austerity? Do they believe in some model - some RBC variant, perhaps - that tells them that now is not the time for quantitative easing and fiscal stimulus? If so, they aren't publicizing the fact. My guess is that it's not really about models and theories at all - policymakers and pundits basically don't buy into any macro model, and so are falling back on their own reflexive intuition.

First, take Rachman. His arguments for European austerity are far weaker than his typical logical perspicacity would lead one to expect.

First, he argues that infrastructure spending in Greece and Spain over the past 30 years failed to prevent the current crisis. But that is obviously irrelevant, since Greece and Spain grew robustly before the crisis, and no advocate of stimulus believes that infrastructure spending will prevent recessions in the future.

Second, Rachman points out that European debt levels are already high. But if you broke your arm and didn't have health insurance, it would be moronic to say "Well, I'm already deeply in debt, so I shouldn't borrow any more money to treat my broken arm." If austerity hurts growth - and there is strong evidence that it does - then existing debt levels are irrelevant.

Third, Rachman says that Europe's real task is structural reform. This opinion echoes that of economists like John Cochrane. But does the case for structural reform affect the case for countercyclical fiscal policy? No. Because unless you believe that bad business environments cause recessions, improving structural factors won't stop the business cycle.

So Rachman is making weak arguments (for a more constructive rebuttal, see Ryan Avent). Why? Rachman is a smart, reasonable guy. My guess is that he doesn't really believe in any model or theory of the macroeconomy, and he's just recommending austerity because it sort of seems prudent. After all, spending more than you earn is usually a bad idea, right? I mean, come on, everybody knows that, it's obvious. It's "common sense". Economic theories, like all scientific theories, are built to be counterintuitive - if our common sense was sufficient to allow us to understand the economy, we wouldn't need science. By chucking theory and saying "Come on, cut the crap, everyone knows that austerity is the sensible, responsible, prudent thing to do," Rachman is implicitly saying that economic science is crap and common sense is all you need.

Now, Ben Bernanke. Paul Krugman points out that as a professor, Bernanke wrote papers that advocated quantitative easing; now, as a policymaker, he's much more shy about doing it. Krugman's explanation is social; being around a bunch of hard-money Fed guys (who are obsessed with the Fed's inflation-fighting credibility but blase about the Fed's depression-fighting credibility) has swayed Bernanke by good old peer pressure.

I have a somewhat different hypothesis: I think Bernanke is dealing with a severe case of model uncertainty. Think about it. A professor's job is to say "Here is a way the world might work." A policymaker has to say "OK, I am going to act as if the world works this way." The latter requires a LOT more faith in the model's correctness than the former. It seems highly likely to me that Fed Chairman Bernanke does not believe in Professor Bernanke's theories enough to make big bets on them.

The more I read about monetary policy, the more convinced I become that humankind does not really understand it very well. With some assumptions - a certain kind of price stickiness, for example - you can derive an optimal monetary policy rule. But those assumptions are almost certainly crap, included for mathematical tractability (e.g. Calvo pricing), or capturing only one small piece of what's really going on. When you're a policymaker, you don't care about mathematical tractability, and you can't afford to focus only on one piece of what's going on.

The fact is, we just don't know what monetary policy is the best. Maybe QE is a good idea (I think it is!). Maybe a rule like NGDP level forecast targeting is a good idea (I am skeptical but it doesn't sound too bad). Or maybe the amount of QE needed to produce a noticeable movement in employment is so huge that it really would cause serious inflation. Maybe monetary policy operates with "long and variable lags," as Milton Friedman suggested, meaning that it's very difficult for the Fed to know the consequences of its actions. I am not economically illiterate. I can easily find, read, understand, and explain a paper supporting any of these contentions. But at the end of the day I'm willing to bet you that I won't really know how right the paper is. At best, my opinions will probably only have shifted slightly. I am guessing this because I've never read a monetary policy paper that convinced me that "OK, this has got to be how the world works."

So I think that Ben Bernanke has been paralyzed into inaction by the realization that, his academic papers aside, he doesn't really know if QE would be good or bad.

So the upshot of this blog post is this: People do not believe in macro models. Macroeconomics is not a science that has, as of May 2012, proven itself in the way that chemistry, biology, or various branches of microeconomics have proven themselves. And so when push comes to shove - as it has - people fall back on their gut reactions, going "Hrrrrrm, austerity, yes, prudent!" or "Hrrrrrm, inflation, yes, scary!" Do I disagree with this Hrrrrrrm-ing?? Sure! MY intuition says something different. And I think the academic literature supports my position more than that of the austerians and hard-money people. But I understand how model uncertainty makes the case for stimulus and QE less than a slam-dunk.

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