In the idealized world of economic modeling, the inhabitants of the models understand statistics. They make efficient decisions using information about relevant variables pertaining to their specific situations. The relevant data is immediately available. And people are presumed to understand perfectly the model that they inhabit, which has been created to explain the way things are.
If that all sounds ridiculous, you probably aren’t an economist. But then again, there are some very learned economists who agree with you.
“That’s a tremendous leap of faith. To a noneconomist, it sounds crazy,” says Marvin Goodfriend, professor of economics; chairman, The Gailliot Center for Public Policy.
In November, a prestigious group of economists followed tradition by breaking tradition. The Carnegie-Rochester Conference on Public Policy convened for its 78th semi-annual meeting to discuss ways to apply the latest academic theories to current public policy matters. Since its inception, the conference has convened at Carnegie Mellon in November and at the University of Rochester in April. Goodfriend is its current coeditor with Thomas Cooley, former Dean of New York University’s Stern School of Business, which played host to the Carnegie Rochester conference in April 2011.
“The conference was established to bring the latest neoclassical economics to bear on public policy matters, most often macroeconomic policy concerns involving inflation, unemployment, financial markets, and economic growth.” Goodfriend explains.
Founded during the early 1970s under the leadership of Allan Meltzer, The Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon, and the late Karl Brunner of the University of Rochester, conference attendance is relatively small – with 40 to 50 invitees – and is noted not only for challenging prevailing theories of the day and advancing applied macroeconomic policy, but also for the robust discussion of the six papers presented at the two-day affair.
“The conference is known for subjecting each paper to intense scrutiny---the author gets a half hour to present the paper and must respond to fifteen minutes of commentary by a designated discussant, and a half hour of questions from participants at large.” says Goodfriend. “Economic science advances by open debate and criticism.” The six papers are published with the discussant’s comments subsequently in a conference volume where they can be read and referenced more widely.
During the 1970s, a sequence of papers presented at the conference developed the idea that the “Great Inflation” of the 1960s and ‘70s was caused by excessive money growth produced by the Federal Reserve. That influential research encouraged Paul Volcker as chairman of the Fed to restrain monetary growth beginning in October 1979 to bring inflation down. The success, known as the Volcker disinflation, was the topic of a 2004 Carnegie Rochester conference paper Goodfriend wrote with co-author Robert King of Boston University entitled “The Incredible Volcker Disinflation.”*
The November 2011 Carnegie Rochester conference, organized by guest editors Stan Zin of New York University and Chris Sleet of Carnegie Mellon, explored economic models whose inhabitants are presumed to have an imperfect understanding of the structure of the model in which they live. This presumption is eminently reasonable, though technically demanding to model. The conference, entitled “Robust Macroeconomic Policy,” was about how to take this fundamental uncertainty into account in the design and implementation of macroeconomic stabilization policy.
Among the attendees in November were the two winners of the 2011 Nobel Prize in Economics, Christopher Sims of Princeton, who served as a discussant, and Thomas Sargent of NYU, who co-authored a conference paper with Lars Hansen of the University of Chicago. Sargent and Hansen’s recent research on policy robustness served as a starting point for the modeling strategies employed at the November conference; though such research had its origins in a paper “Robustness Properties of a Rule for Monetary Policy” written for a 1988 Carnegie Rochester conference by Bennett T. McCallum of Carnegie Mellon, a former co-editor of the conference.
By changing economic models to allow for individuals to have less-than-perfect understanding of how the world works, the conference pushed back the frontiers of modeling macroeconomic policy. Each paper offered a different version of the deficits in understanding: One presumed that people in the model are unsure about the structure of the world in which they live. Another modeled the potential for misunderstanding between the government and the public about the structure of the world.
“These papers are trying to get at reality in a fundamental way,” says Goodfriend, adding that the most recent economic crisis illustrated why it’s important to address these problems: “The economy is perhaps much more complex than economists had realized.”
Other papers presented in November examined uncertainty about the transmission of financial market conditions to the broader market economy; the control of inflation and problems related to the disparity between the private sector’s expectations of future inflation and those implied by the model actually used by the central bank; the effect of misunderstood model structure on credit default swap spreads and equity prices; and the international finance implications of model uncertainty.
The irony of the conference is that more than 30 years ago, it championed perfectly informed rational expectations models as a means of addressing policy problems; now, it is critiquing that very strategy.
“But that’s the point, in a way,” notes Goodfriend. “Science advances by building on previously productive abstractions.”
*To download a (pdf) version of the "The Incredible Volcker Disinflation," please use the (pdf) button located at the top left corner of the hosting webpage.
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