Central banks have been using DSGE macro models to guide monetary policy.
Robert Solow now acknowledges that these models are fundamentally flawed.
But what does it mean for the layman?
I believe it means that central bank monetary policy will be “too easy” in boom times, as in the run up to 2007, and “too tight” just before and during a crash, as in 2008-09. We can’t tell if policy is “just right” for now, but if the global economy weakens, monetary will still be too tight, and when it strengthens, monetary policies will again be too easy. The flawed macro model will therefore result in policy that does not dampen the business cycle, and may even feed it.
Questions: What next? Is there a “way out”?
My best conjecture or guess is as follows. What really matters is productivity. If it is increasing, policy “errors” will not be fatal. But if productivity is stagnating, then the business cycle will be there because no macro model can accurately anticipate what Keynes called “animal spirits.” Besides, productivity will increase again only after Schumpeter’s creative destruction is allowed to work its way through the economy.
But productivity increases cannot be forced or predicted. All that policy makers can do is set the stage for such increases through institutional arrangements that promote innovation and competition. A rent-seeking economy will not progress, which is why corruption is a bad thing, and education is a good thing. Humans will innovate if they know how to think, and will compete if basic rules of fair play are observed.
Hat tips to Arnold Kling and Greg Mankiw for pointing to Solow’s testimony in US Congress.