More on the problems with macroeconomics

Since Paul Krugman's NY Times piece dissecting what went wrong with the macroeconomics profession, some misinformation has bounced around the blogosphere about the role of rational expectations in all this. Justin Fox, for example, argues:

3) Macroeconomists actually have been making progress over the past couple of decades:

But the standard policy prescription of economists in the rational expectations tradition is that government shouldn't try to do anything about macroeconomic fluctuations. While I think that may be the right course (albeit one that is never really followed) in reaction to a garden-variety recession, I'm not so sure in the case of a potential global depression caused by a huge financial shock. And here's the thing: As best I can tell, modern macro models of almost all stripes don't really take the financial sector and its influence into account. Which is why Krugman and many others find themselves grasping back to Keynes.

Fox's first point is wrong, his second point is right. Back in the 1970s proponents of rational expectations were arguing that policymakers should do nothing about the business cycle. There are still those who peddle that line. But the mainstream of macroeconomic theory, New Keynesian economics, has incorporated rational expecations into models with sticky prices, with the implication that activist monetary policy can help stabilize the economy. This type of model, epitomized by the work of Michael Woodford, has been tremendously influential. It has informed the Fed's policy of "flexible inflation targeting," it justifies the use of various versions of the Taylor rule.

The problem is not in the use of rational expectations, it is in the modeling of the financial system. While there are plenty of models out there that incorporate "financial frictions" into New Keynesian models, the linearity of the models seems to be a fatal flaw. Linearity means that if a financial collapse can cause a recession and deflation, then a boom can cause an equivalent expansion and inflation. Then the proper response to an asset bubble is to lean against the wind only when the effects are visible on GDP and inflation. This reasoning underlies the Fed's policy of not trying to prick asset bubbles (Bernanke and Gertler established this as the conventional wisdom in a couple of papers a decade ago). Unfortunately, it appears that the real world is nonlinear. Asset bubbles may have modest macroeconomic effects on the upside but devastating effects on the downside.

Don't blame rational expectations for this particular shortcoming of macroeconomics - blame the propensity of macroeconomists to favor linear over nonlinear models (I'm looking at you, Blanchard and Khan!).