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Black Box Macro

My EconTalk conversation with Guillermo Calvo has me thinking the tendency of macroeconomists to see the economy as a black box. In black box macro, we don’t have to worry about the complexity of what’s going on inside, not because it’s too complicated but because it’s unnecessary.

In this mainstream view, the opacity of the box is a feature, not a bug. It simplifies everything. It’s Occam’s Razor meets the Gordian Knot. We can just cut through the complexity and unravel the mystery of the economy. Unfortunately for macroeconomics, we can’t figure out which razor to use for cutting the knot.

Keynesians think all we have to worry about is aggregate demand–and the magic lever for solving any problem is government spending. Economy in the doldrums? No problem. Just spend more. The Keynesian solution assumes that this spending occurs in a world where everything else is held constant. So I have a lever to move the world–government spending, G. The lever is connected to the economy via the multiplier. If I want to adjust the size of the economy, all I have to worry about is G. So if the government increases spending and the economy remains troubled, I obviously didn’t increase G enough. The problem isn’t my assumption about how the black box works, it’s just a question of the setting of the lever.

Then there are the monetarists. To repair the economy, I just have to adjust the money supply enough. Everything else is irrelevant and stays constant when I move the money lever. It’s magic. Just get the money supply back on track and everything will be OK. We don’t have to worry about how the money supply achieves its magic. The economy is a black box. Again–it’s a feature not a bug. Just fix this one thing.

I know it’s a little more complicated than this. The monetarists are really Keynesians in that they too worry about aggregate spending. And they both can tell stories about what’s going on inside the box–how spending creates demand or how increases in the supply of money increases demand. But I think the most important thing they really have in common is a willingness to advance the virtues of one thing–government spending or money creation as an all-powerful elixir that cures all diseases.

I understand the appeal of simplicity. (And of course each side believes that it’s not just simple–it’s right. All the data say so after all!) It’s so exciting when you find the lever that moves the world. And we oh so want such a lever to exist. That desire for simplicity is so powerful. Finally there’s a tool that explains everything. Unfortunately, that leads to the narrative fallacy, the view that after the fact, I can connect the dots to create the picture that confirms my view. As Cafe Hayek reader Sam Thomsen once wrote in a comment:

The Universe is full of dots. Connect the right ones and you can draw anything. The important question is not whether the dots you picked are really there, but why you chose to ignore all the others.

This leads to Keynesians saying that they’re right because surveys show that businesses list inadequate sales as their number one concern. But to say that disappointing sales is the cause of economic troubles is to say nothing at all. It’s a tautology. It ignores the possibility that there is something else going on outside the levers that you want to pull, a factor outside the model that causes spending to be low. A factor that can’t be fixed by more spending by one part of the economy using borrowed money. Something real going on inside the black box that you can’t see and messes up the simple plan of “move lever, fix the economy.”

Or the monetarists who say that well sure, money didn’t do its magic this time, because we used the wrong measure of money or velocity jumped around so we had to take that into account and we didn’t, or the Fed paid interest so the banks didn’t use their reserves.

And of course either side might be right. But what I’ve been thinking is how confident each side is in its views, how disdainful each side is of other factors and how the world is actually a complicated place and that maybe, just maybe, we are all prone to the pretense of knowledge.

One reason I’ve been thinking about this is that the British economy seems to be on the rise (HT: Marginal Revolution). That is awkward for the Nobel Laureate who said of British “austerity”:

The shadow won’t just be cast on the present, but on the longer term…[Britain] will be a weaker economy ten years or even 15 years from now because [it has] failed to provide adequate demand now.

And then there’s this recent paper (HT: Marginal Revolution) on the effect of extending unemployment compensation:

Our estimates imply that most of the persistent increase in unemployment during the Great Recession can be accounted for by the unprecedented extensions of unemployment benefit eligibility.

I don’t know if that paper is right. But it does remind us of the possibility that there are real things going on in the economy that are not amenable to the cures of increased government spending or increases in the supply of money.

The Bard understood something profound:

There are more things in heaven and earth, Horatio,
Than are dreamt of in your philosophy.