Freshwater Macroeconomics Has Failed the Market Test

A blog about business and economics.
Dec. 18 2013 11:14 AM

Freshwater Macroeconomics Has Failed the Market Test

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Jan Hatzius, chief economist at Goldman Sachs

Tagespiegel/Goldman Sachs

One curiosity that economists seem too polite to note is that one important school of macroeconomic thought—"freshwater" macroeconomics that focuses heavily on the idea of a "real" business cycle and disparages the notion of either fiscal or monetary stimulus—has completely flopped in the marketplace. It lives, instead, sheltered from market forces at a variety of Midwestern nonprofit universities and sundry regional Federal Reserve banks.

Stephen Williamson, a proponent of freshwater views, reminded me of this recently when he contended that macroeconomics is divided into schools of thought primarily because there's no money at stake. In financial economics, according to Williamson, "All the Wall Street people care about is making money, so good science gets rewarded." But in macroeconomics you have all kinds of political entrepreneurs looking for hucksters who'll back their theory.

In general it seems very important to freshwater types to contend that their saltwater antagonists aren't just mistaken or even stupid but actually fraudulent in their views (see Robert Lucas on "schlock economics" or John Cochrane saying Robert Shiller is trying to take the science out of economics). So this view of saltwater macro as politically motivated cheap talk is appealing. But it doesn't make any sense. If you knew—really knew—how changes in federal budget policy or changes in the extent of Federal Reserve Quantitative Easing programs would impact the economy, you could make a lot of money with that knowledge. And for precisely that reason, investment banks do in fact do macroeconomic analysis. And specifically they do broadly Keynesian types of analysis even though it would be easy to hire people who have a different approach.

Now another important point about how banks deal with macroeconomic analysis is that they don't really spend all that much money on it relative to the size of the objective stakes. That's the market telling you that it doesn't think any macroeconomic modeling approach is all that fantastic, reliable, or informative. But to the extent that it is useful, we know what kind of approaches they use and they aren't freshwater ones.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.