Ceteris not Paribus
Ajinkya Nene
SYBsc (2022-25)
Estimated reading time ~9 minutes
“Twenty years ago, it was easier being a student of macroeconomics”
This is the opening line of a rather well cited and well received paper by Prof. Gregory Mankiw. Yes, that Mankiw. For the uninitiated, this is the person who quite literally wrote the textbook on macroeconomics, the very same textbook that is used in GIPE’s introductory macroeconomics course.
The paper that I am quoting here is Mankiw’s ‘A Quick Refresher Course in Macroeconomics’, published in 1990. While the paper is neither quick nor really a refresher course in quite the way I was expecting it to be, it did prove immensely interesting. It is an examination of the general state of macroeconomics, a succinct summary of the leading breakthroughs at the time of the publishing and, most interestingly, it concludes with Mankiw’s views on the future of macroeconomics: in terms of both theory and application. As an aside, while this is truly a worthwhile read, I can attest from personal experience that reading it the day before a college exam is probably not an efficient allocation of resources.
Now, what did Mankiw mean when he said macroeconomics has gotten harder? Well, he likens the new economic theories coming through in 1990 to the Copernican revolution, meaning that the largely outdated macroeconomic models used in public policy will be substituted or improved over a long period of time to reflect what are fundamental shifts in economic thinking. Understandably, one of the effects of such a change at a basic level means that while the new models do explain the economy relatively better, they do so at the cost of greatly increased complexity.
The older models the paper is referring to are the IS-LM models and Phillips Curves and a whole host of other similar models which were used extensively since their inception starting in the late 1930s. They are in fact still used today, within a relatively limited scope. By the time the paper was published, the use of these long-standing models was on the decline but still persisted in practice. The ever widening rift between macroeconomic theory and its actual application has only ever grown since, definitely not helped by the perceived inability of economics to actually accomplish the goals it has set for itself.
As it happens, one of the breakthroughs that Mankiw addresses in his paper is the theory of rational expectations – it was revolutionary in the sense that it was one of the first to recognise that the assumptions economists make in their models are not always correct. Economic agents do not always have perfect information and they can, in fact, be wrong sometimes while still being rational or correct on average.
Economics is (in?)famous for what have been called ‘plain dumb’ assumptions baked into nearly all its theories that make the real life applications of those theories ill-fitting at best and plain wrong at worst. The rational expectations theory was the first tiny step in slowly breaking down the many assumptions that govern economic theory: the culmination of which is now the relatively brand-new field of behavioural economics.
Why does this matter?
Mankiw ends his paper with the following paragraph:
“Twenty years from now we shall know which of these developments has the power to survive the initial debate and to permeate economists’ conceptions of how the world works.”
Personally, I find it absolutely hilarious that just before the twenty years were over, we were in the midst of the worst economic crisis since the Great Depression, a crisis that macroeconomics effectively failed to predict or prevent. As it became apparent in the aftermath: the consumers were not rational, the firms sought to maximise profit but unfortunately so did their auditors, incentives were thoroughly exploited, checks failed to check and balances failed to balance and as a result, society paid a terrible cost.
The 2008 financial crisis. Image source
Earlier this year, I was attending classes for a finance exam that I was taking. Finance is, as you know, one of the practical, real-life applications of macroeconomics and as such, economics was one of the subjects. My instructor was excellent and quite enthusiastic when teaching all the subjects: except for certain topics of macroeconomics which, in his view, did not hold up to the rigours of practical application. Therefore, when IS-LM models were brought up, words such as “draconian” and “dreadful” featured rather prominently. Without the benefit of having yet completed the college macroeconomics course, I had no choice but to nod along as decades of economic thought were dismissed as having little to none real benefit.
Now, even with an introductory macroeconomics course under my belt, I have no real answer or comeback to the position that macroeconomics in particular has limited practical use. As Mankiw states in his paper, if perfectly good macroeconomic models remain unused by firms, that assumes a profit opportunity remains unexploited. This creates a unique catch-22, for one of the primary assumptions those models make is that firms seek to maximise profits, leaving no opportunity unexploited.
This is where my mind was when I discovered the Mankiw paper, a result of intense Googling before the finals. It reminded me of what is essentially at the core of the debate: that economics is not an exact science, unlike mathematics or physics.The fact that it is a social science does not detract from the research methodology it uses. The fact that macroeconomics is oftentimes wrong and that there is no scholarly consensus on any one theory is not a bug, it is a feature. Just like Mankiw wrote in 1990 about the improvement of the old models, so too will another researcher write about the improvements made twenty years hence, and so on it will go and never end.
Copernicus’s heliocentric model finally found its precious practical applications hundreds of years after it was conceptualised. It was not perfect, but it led us to a better future. Ultimately, that is the goal of all sciences, including economics.
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