Models
Leon Walras, a 19th-century French economist, was adamant that one could not explain anything in an economy until one had explained everything. Each market — for goods, labor and capital — was connected to every other. Faster car sales in Texas result in an increase in grocery shopping in Detroit, the home of America’s “big three” carmakers. Steep prices for oil lead to lower American interest rates, because the money the Saudis and the Russians make from crude is spent on American Treasury bonds.
Politicians slap tariffs on steel imports to save jobs in Pittsburgh, only to find this costs more jobs in the domestic industries that use the metal. Or they keep zombie companies alive — rolling over their loans, and preserving their employees on the payroll — only to discover they have starved new firms of manpower and credit.
In 1941 Wassily Leontief published The Structure of American Economy, which included a table showing the flow of commodities and services back and forth among America’s households, trading partners and 41 national industries. In Leontief’s blueprint, each industry is represented by an equation. The inputs to the industry are entered on one side of the equation, the industry’s output appears on the other. Since the output of one industry (steel, for example) serves as an input for another (construction), one cannot solve any equation without solving them all simultaneously.
In 1958, William Phillips showed that for long stretches of British history, high unemployment coincided with low wage inflation, and vice versa. Many macroeconomic models therefore featured a trade-off between the two.
But in the 1970s these trusted relationships broke down. And in 1976 Robert Lucas explained why. Unanticipated inflation would erode the real value of wages, making workers cheaper to hire. But if central bankers tried to engineer such a result, by systematically loosening monetary policy, then forward-looking workers would pre-empt them, raising their wage claims in anticipation of higher inflation to come. Cheap money would result in higher prices, leaving unemployment unchanged.
One could not judge how the macroeconomy would respond to a new policy based on its behavior under the old regime.
Timothy Kehoe, in a paper published last year, argued that the models “drastically underestimated” NAFTA’s impact on trade flows (if not on jobs). The modellers assumed the trade pact would allow people to buy more of the goods for which they had already shown some appetite. In fact, the agreement set off an explosion in the exports of many products Mexico had scarcely traded before. Cars, for example, amounted to less than 1% of Mexico’s exports to Canada before the agreement. By 1999, however, they accounted for more than 15%.