The 2008 financial crisis and the deep recession that followed taught the world to be more skeptical of macroeconomic theories. In the years leading up to that crisis, many leading macroeconomists displayed a startling amount of complacency, bordering on hubris. The defining quote came in a 2003 essay, when Nobel-winning macroeconomist Robert Lucas made a startling declaration:
Macroeconomics in [its] original sense has succeeded: Its central problem of depression prevention has been solved…and has in fact been solved for many decades.
Lucas believed, like so many others did, that the Federal Reserve and other central banks had learned how to use monetary policy to fine-tune the economy and smooth out recessions. And part of the reason for his belief was an overreliance on the modern macroeconomic theories that he himself had helped create. Indeed, those theories completely failed to see the Great Recession coming.
Why did the theories fail in 2008? One reason was that most of them omitted a critical piece of the economy — the financial industry. Macroeconomic models are, by necessity, highly simplified pictures of the economy; they have to choose which sectors, agents and institutions to include and which to gloss over, and in this case they chose wrong. Another reason is that the models were designed to cope with normal conditions and modest economic fluctuations — a very large recession was outside the scope of the theories, and so they stopped working just when they were needed most.
A third reason macro models failed in 2008 was that even the parts of the economy they did try to describe were modeled incorrectly. These models are chock full of unrealistic assumptions about how consumers, workers and firms behave. Since even a small departure from realism can potentially make a macroeconomic model’s results go completely haywire, this is probably a vain hope most of the time.
Thus, macroeconomic models have little hope of matching the quantitative accuracy of theories in the natural sciences, or even in microeconomics. They can’t forecast the economy, and whether they can be used to offer any sort of precise, quantitative policy guidance is doubtful. Instead, policy makers tend to use them as heuristics.
But using theories like stories introduces another problem — how to tell which story to use. Policy makers have a vast number of different models sitting on their bookshelves, with very little in the way of a road map for which to pay attention to and which to ignore. It all comes down to judgment. If that judgment is wrong, there can be serious unintended consequences. For example, many central banks have kept interest rates at very low levels ever since the financial crisis, on the assumption that inflation was the only possible danger. But a few economists have suggested that low rates distort the economy in other ways, such as encouraging monopolies or reducing productivity.
For this reason, many have called on macroeconomists to show more humility. Brash, confident declarations like Lucas’s should be avoided, in favour of an eclectic, circumspect approach that acknowledges how little really can be known. Policy makers should generally avoid making huge changes to the way the economy is managed, except in an emergency like the 1930s or after 2008.
The people who run the Fed definitely have recognised the need for humility and caution. Academic macroeconomists have been chastened somewhat, too. But outside of mainstream, there are thinkers and activists advancing new kinds of macroeconomic theories with unchecked confidence, and calling for dramatic changes to US macroeconomic policy.
Chief among these theories is so-called modern monetary theory, or MMT. This theory, promulgated by a handful of heterodox thinkers and recently embraced by some activists on the left, purports to overturn the standard understanding of how money, government spending and taxation work. The theory lies at the center of the Green New Deal, an ambitious proposal put forth by Representative Alexandria Ocasio-Cortez to address climate change and economic inequality.
Because MMT holds that government spending isn’t funded by taxes, the Green New Deal doesn’t include any measures to finance the very large, open-ended fiscal commitments it would undertake. According to MMT economists, the only possible danger from the resultant government debt would be inflation, which can usually be controlled with tools other than raising taxes. In other words, deficits almost never matter. So confident are they of their theory’s universal applicability that MMT proponents often respond to their critics with scorn.
This incredible confidence can make even Lucas’s precrisis pronouncements seem humble by comparison. MMT economists and their activist believers would have the US dramatically change its whole approach to macroeconomic policy, on the strength of a theory that has undergone much less empirical examination and logical interrogation than the theories that failed so spectacularly in 2008. Even after watching the Great Recession take the economy into uncharted territory that mainstream theories had no hope of describing, MMT fans assume that their own doctrine will continue to hold absolutely true no matter what huge policy changes they make.
This is hubris. Economies are so complex that there is no such thing as a perfect macroeconomic theory. They all make simplifications, and they all have limits beyond which the theories stop applying. For MMT, there’s now very little general understanding of what those simplifications and limits might be. Until the picture clears up, a lot more humility from MMT theorists is in order.
Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion