Updated July 28 at 1:28pm

Wall Street skips economics class for old school

Guest Column:
Noah Smith
If you care at all about what academic macroeconomists are cooking up (or if you do any macro investing), you might want to check out the latest economics blog discussion about the big change that happened in the late ’70s and early ’80s. Here’s a post by the University of Chicago ecnomist John Cochrane, and here’s one by Oxford’s Simon Wren-Lewis that includes links to most of the other contributions.

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Wall Street skips economics class for old school

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If you care at all about what academic macroeconomists are cooking up (or if you do any macro investing), you might want to check out the latest economics blog discussion about the big change that happened in the late ’70s and early ’80s. Here’s a post by the University of Chicago ecnomist John Cochrane, and here’s one by Oxford’s Simon Wren-Lewis that includes links to most of the other contributions.

In case you don’t know the background, here’s the short version: Around 1980, macroeconomists abandoned the models they had been using and switched to something very different. The old kind of model was called structural econometric modeling (SEM), based on equations for economic aggregates – investment in office buildings, consumption of cars, etc. These models were also called “Keynesian,” because they usually included some assumptions that were loosely based on the writings of economist John Maynard Keynes. The new type of model was called dynamic stochastic general equilibrium (DSGE), and it tried to account for the individual decisions of consumers and producers. Everyone, and I mean everyone in academia, abandoned SEMs in a very short period of time, and many switched over to DSGEs.

Why did DSGE models take over? Two reasons. The first was the stagflation of the 1970s. The Keynesian SEMs predicted that when the Federal Reserve lowered interest rates, it should have given the economy a boost; instead, all it did was create useless, harmful inflation. This made a big impression on economists. About a year ago I asked a group of economists whether the Fed should temporarily adopt a higher inflation target. Robert Lucas, who probably has more claim than anyone to being the father of modern macroeconomics, thundered: “We tried [stupid] inflation! It didn’t [dang] work!”

Now, it was possible to tweak the old Keynesian SEM models to explain why inflation didn’t boost the economy. But at the same time, the aforementioned Lucas and some other heavyweights such as Tom Sargent were revealing that there was a very deep reason why those SEM’s shouldn’t work. It boils down to the famous saying that “correlation doesn’t equal causation.” Suppose economists noticed that businesses where people wear Star Trek T-shirts are more productive than others. Simple – just have everyone wear a Star Trek T-shirt, and you’ll boost national productivity, right? Wrong.

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