Macroeconomics after the crisis

Ricardo J. Caballero has a new NBER working paper out entitled Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome. The abstract reads:

In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.

Caballero opens the paper by saying,

The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. To be honest, this inability to predict does not concern me much. It is almost tautological that severe crises are essentially unpredictable, for otherwise they would not cause such a high degree of distress. Of course, it is well-known that certain elements can increase the fragility of a financial system, such as high levels of leverage or mismatches between short-term liabilities and long-term assets, and that these issues may justify policy intervention. But knowing these mechanisms is quite different from arguing that a severe crisis can be predicted. Modern Cassandras will always claim to have seen the crisis coming. What they will not say is how many times they saw things coming that never materialized, or how the specific mechanisms behind the crisis are different from those on which their predictions were based. In my view, the conviction that one can foretell a severe crisis in advance is mostly a manifestation of pareidolia—the psychological phenomenon that makes people see faces and animals in clouds and the like.

There is a nice point here, severe crises are essentially unpredictable, for otherwise they would not cause a high degree of distress, that is, they wouldn't be severe. If we could predict severe crises we could take actions to mitigate the effects of the crisis thereby rendering it less severe. Policymakers should keep this in mind. There is only limited scope for policy that can in advance eliminate the risk or costs of a financial crisis.