Answering the Hardest Question in Economics

Xavier Gabaix, a New York University economist who gets far less attention than he should, has written what might prove to be the most interesting macroeconomic theory paper in years. The title, “A Behavioral New Keynesian Model,” isn’t exactly exciting and the paper is still incomplete, but it might help resolve the most important and difficult macroeconomic debate in academia today — whether low interest rates cause inflation, deflation or neither. And it might signal a sea change in the way macroeconomic theory gets done.

Traditionally, macroeconomists have believed that low interest rates encourage inflation. But first Japan, and now the U.S. and Europe have kept rates low for years now, and inflation has stayed stubbornly low. A radical group of macroeconomists, including Stephen Williamson of the Federal Reserve Bank of St. Louis and John Cochrane of the Hoover Institution, have introduced a new theory called Neo-Fisherism, which says that a long period of low interest rates actually holds prices down instead of pushing them up. Williamson and Cochrane have both repeatedly stressed that New Keynesian models — the most mainstream type of macroeconomic theory — can easily yield the Neo-Fisherian result instead of the traditional view. One problem is that the standard models are often ambiguous — they offer a number of possible, radically different outcomes for the economy, with no way to tell which will happen.

Gabaix tackles these problems with a simple, intuitive, yet bold step. Instead of assuming that people are perfectly rational, he theorizes that they have limited attention — what psychologist Herbert Simon called “bounded rationality.” When interest rates or gross domestic product change, people in Gabaix’s model don’t quite realize that things are different. Even more importantly, they’re short-sighted — they don’t think as much about the probability of a recession happening 10 years from now as they do about one occurring in the next six months.

Those ideas probably seem obvious to most people. When events are further in the future, you worry about them less, right? I know I do. But to macroeconomists, this is a pretty radical step. Most macroeconomic researchers are strict adherents to the cult of perfect rationality. If the economy looks like it’s being driven by behavior that isn’t quite rational, macroeconomists usually bend over backward to explain it as a failure of economic institutions, rather than a result of human psychology. Christopher House, my own teacher at the University of Michigan, thought behavioral economics was a fad, and would never have a big influence on macro theory.

Gabaix might just prove House wrong. Along with another recent paper by Mariana Garcia-Schmidt and Michael Woodford, Gabaix’s new theory is putting human limitations front and center, and slaughtering the sacred cow of Homo economicus.