Last week Simon Wren-Lewis wrote a really interesting post on his blog trying to find the right labels with which to identify macroeconomists. Simon, rather disarmingly, starts by admitting the ultimate futility of assigning people labels; reality is just too complicated to conform to the labels that we invent to help ourselves make sense of reality. A good label can provide us with a handle with which to gain a better grasp on a messy set of observations, but it is not the reality. And if you come up with one label, I may counter with a different one. Who’s to say which label is better?
At any rate, as I read through Simon’s post I found myself alternately nodding my head in agreement and shaking my head in disagreement. So staying in the spirit of fun in which Simon wrote his post, I will provide a commentary on his labels and other pronouncements. If the comments are weighted on the side of disagreement, well, that’s what makes blogging fun, n’est-ce pas?
Simon divides academic researchers into two groups (mainstream and heterodox) and macroeconomic policy into two approaches (Keynesian and anti-Keynesian). He then offers the following comment on the meaning of the label Keynesian.
Just think about the label Keynesian. Any sensible definition would involve the words sticky prices and aggregate demand. Yet there are still some economists (generally not academics) who think Keynesian means believing fiscal rather than monetary policy should be used to stabilise demand. Fifty years ago maybe, but no longer. Even worse are non-economists who think being a Keynesian means believing in market imperfections, government intervention in general and a mixed economy. (If you do not believe this happens, look at the definition in Wikipedia.)
Well, as I pointed out in a recent post, there is nothing peculiarly Keynesian about the assumption of sticky prices, especially not as a necessary condition for an output gap and involuntary unemployment. So if Simon is going to have to work harder to justify his distinction between Keynesian and anti-Keynesian. In a comment on Simon’s blog, Nick Rowe pointed out just this problem, asking in particular why Simon could not substitute a Monetarist/anti-Monetarist dichotomy for the Keynesian/anti-Keynesian one.
The story gets more complicated in Simon’s next paragraph in which he describes his dichotomy of academic research into mainstream and heterodox.
Thanks to the microfoundations revolution in macro, mainstream macroeconomists speak the same language. I can go to a seminar that involves an RBC model with flexible prices and no involuntary unemployment and still contribute and possibly learn something. Equally an economist like John Cochrane can and does engage in meaningful discussions of New Keynesian theory (pdf).
In other words, the range of acceptable macroeconomic models has been drastically narrowed. Unless it is microfounded in a dynamic stochastic general equilibrium model, a model does not qualify as “mainstream.” This notion of microfoundation is certainly not what Edmund Phelps meant by “microeconomic foundations” when he edited his famous volume Microeconomic Foundations of Employment and Inflation Theory, which contained, among others, Alchian’s classic paper on search costs and unemployment and a paper by the then not so well-known Robert Lucas and his early collaborator Leonard Rapping. Nevertheless, in the current consensus, it is apparently the New Classicals that determine what kind of model is acceptable, while New Keynesians are allowed to make whatever adjustments, mainly sticky wages, they need to derive Keynesian policy recommendations. Anyone who doesn’t go along with this bargain is excluded from the mainstream. Simon may not be happy with this state of affairs, but he seems to have made peace with it without undue discomfort.
Now many mainstream macroeconomists, myself included, can be pretty critical of the limitations that this programme can place on economic thinking, particularly if it is taken too literally by microfoundations purists. But like it or not, that is how most macro research is done nowadays in the mainstream, and I see no sign of this changing anytime soon. (Paul Krugman discusses some reasons why here.) My own view is that I would like to see more tolerance and a greater variety of modelling approaches, but a pragmatic microfoundations macro will and should remain the major academic research paradigm.
Thus, within the mainstream, there is no basic difference in how to create a macroeconomic model. The difference is just in how to tweak the model in order to derive the desired policy implication.
When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term.
So, even though New Keynesians have learned how to speak the language of New Classicals, New Keynesians can console themselves in retaining the upper hand in policy discussions. Which is why in policy terms, Simon chooses a label that is at least suggestive of a certain Keynesian primacy, the other side being defined in terms of their opposition to Keynesian policy. Half apologetically, Simon then asks: “Why do I use the term anti-Keynesian rather than, say, New Classical?” After all, it’s the New Classical model that’s being tweaked. Simon responds:
Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.
This explanation really annoyed Steve Williamson who commented on Simon’s blog as follows:
Part of what defines a Keynesian (new or old), is that a Keynesian thinks that his or her views are “mainstream,” and that the rest of macroeconomic thought is defined relative to what Keynesians think – Keynesians reside at the center of the universe, and everything else revolves around them.
Simon goes on to explain what he means by the incoherence of the anti-Keynesian view of the world, pointing out that the Pigou Effect, which supposedly invalidated Keynes’s argument that perfect wage and price flexibility would not eventually restore full employment to an economy operating at less than full employment, has itself been shown not to be valid. And then Simon invokes that old standby Say’s Law.
Second, the evidence that prices are not flexible is so overwhelming that you need something else to drive you to ignore this evidence. Or to put it another way, you need something pretty strong for politicians or economists to make the ‘schoolboy error’ that is Says Law, which is why I think the basis of the anti-Keynesian view is essentially ideological.
Here, I think, Simon is missing something important. It was a mistake on Keynes’s part to focus on Say’s Law as the epitome of everything wrong with “classical economics.” Actually Say’s Law is a description of what happens in an economy when trading takes place at disequilibrium prices. At disequilibrium prices, potential gains from trade are left on the table. Not only are they left on the table, but the effects can be cumulative, because the failure to supply implies a further failure to demand. The Keynesian spending multiplier is the other side of the coin of the supply-side contraction envisioned by Say. Even infinite wage and price flexibility may not help an economy in which a lot of trade is occurring at disequilibrium prices.
The microeconomic theory of price adjustment is a theory of price adjustment in a single market. It is a theory in which, implicitly, all prices and quantities, but a single price-quantity pair are in equilibrium. Equilibrium in that single market is rapidly restored by price and quantity adjustment in that single market. That is why I have said that microeconomics rests on a macroeconomic foundation, and that is why it is illusory to imagine that macroeconomics can be logically derived from microfoundations. Microfoundations, insofar as they explain how prices adjust, are themselves founded on the existence of a macroeconomic equilibrium. Founding macroeconomics on microfoundations is just a form of bootstrapping.
If there is widespread unemployment, it may indeed be that wages are too high, and that a reduction in wages would restore equilibrium. But there is no general presumption that unemployment will be cured by a reduction in wages. Unemployment may be the result of a more general dysfunction in which all prices are away from their equilibrium levels, in which case no adjustment of the wage would solve the problem, so that there is no presumption that the current wage exceeds the full-equilibrium wage. This, by the way, seems to me to be nothing more than a straightforward implication of the Lipsey-Lancaster theory of second best.