Archive for the 'New Classicals' Category

Krugman on the Volcker Disinflation

Earlier in the week, Paul Krugman wrote about the Volcker disinflation of the 1980s. Krugman’s annoyance at Stephen Moore (whom Krugman flatters by calling him an economist) and John Cochrane (whom Krugman disflatters by comparing him to Stephen Moore) is understandable, but he has less excuse for letting himself get carried away in an outburst of Keynesian triumphalism.

Right-wing economists like Stephen Moore and John Cochrane — it’s becoming ever harder to tell the difference — have some curious beliefs about history. One of those beliefs is that the experience of disinflation in the 1980s was a huge shock to Keynesians, refuting everything they believed. What makes this belief curious is that it’s the exact opposite of the truth. Keynesians came into the Volcker disinflation — yes, it was mainly the Fed’s doing, not Reagan’s — with a standard, indeed textbook, model of what should happen. And events matched their expectations almost precisely.

I’ve been cleaning out my library, and just unearthed my copy of Dornbusch and Fischer’s Macroeconomics, first edition, copyright 1978. Quite a lot of that book was concerned with inflation and disinflation, using an adaptive-expectations Phillips curve — that is, an assumed relationship in which the current inflation rate depends on the unemployment rate and on lagged inflation. Using that approach, they laid out at some length various scenarios for a strategy of reducing the rate of money growth, and hence eventually reducing inflation. Here’s one of their charts, with the top half showing inflation and the bottom half showing unemployment:




Not the cleanest dynamics in the world, but the basic point should be clear: cutting inflation would require a temporary surge in unemployment. Eventually, however, unemployment could come back down to more or less its original level; this temporary surge in unemployment would deliver a permanent reduction in the inflation rate, because it would change expectations.

And here’s what the Volcker disinflation actually looked like:


A temporary but huge surge in unemployment, with inflation coming down to a sustained lower level.

So were Keynesian economists feeling amazed and dismayed by the events of the 1980s? On the contrary, they were feeling pretty smug: disinflation had played out exactly the way the models in their textbooks said it should.

Well, this is true, but only up to a point. What Krugman neglects to mention, which is why the Volcker disinflation is not widely viewed as having enhanced the Keynesian forecasting record, is that most Keynesians had opposed the Reagan tax cuts, and one of their main arguments was that the tax cuts would be inflationary. However, in the Reagan-Volcker combination of loose fiscal policy and tight money, it was tight money that dominated. Score one for the Monetarists. The rapid drop in inflation, though accompanied by high unemployment, was viewed as a vindication of the Monetarist view that inflation is always and everywhere a monetary phenomenon, a view which now seems pretty commonplace, but in the 1970s and 1980s was hotly contested, including by Keynesians.

However, the (Friedmanian) Monetarist view was only partially vindicated, because the Volcker disinflation was achieved by way of high interest rates not by tightly controlling the money supply. As I have written before on this blog (here and here) and in chapter 10 of my book on free banking (especially, pp. 214-21), Volcker actually tried very hard to slow down the rate of growth in the money supply, but the attempt to implement a k-percent rule induced perverse dynamics, creating a precautionary demand for money whenever monetary growth overshot the target range, the anticipation of an imminent future tightening causing people, fearful that cash would soon be unavailable, to hoard cash by liquidating assets before the tightening. The scenario played itself out repeatedly in the 1981-82 period, when the most closely watched economic or financial statistic in the world was the Fed’s weekly report of growth in the money supply, with growth rates over the target range being associated with falling stock and commodities prices. Finally, in the summer of 1982, Volcker announced that the Fed would stop trying to achieve its money growth targets, and the great stock market rally of the 1980s took off, and economic recovery quickly followed.

So neither the old-line Keynesian dismissal of monetary policy as irrelevant to the control of inflation, nor the Monetarist obsession with controlling the monetary aggregates fared very well in the aftermath of the Volcker disinflation. The result was the New Keynesian focus on monetary policy as the key tool for macroeconomic stabilization, except that monetary policy no longer meant controlling a targeted monetary aggregate, but controlling a targeted interest rate (as in the Taylor rule).

But Krugman doesn’t mention any of this, focusing instead on the conflicts among  non-Keynesians.

Indeed, it was the other side of the macro divide that was left scrambling for answers. The models Chicago was promoting in the 1970s, based on the work of Robert Lucas and company, said that unemployment should have come down quickly, as soon as people realized that the Fed really was bringing down inflation.

Lucas came to Chicago in 1975, and he was the wave of the future at Chicago, but it’s not as if Friedman disappeared; after all, he did win the Nobel Prize in 1976. And although Friedman did not explicitly attack Lucas, it’s clear that, to his credit, Friedman never bought into the rational-expectations revolution. So although Friedman may have been surprised at the depth of the 1981-82 recession – in part attributable to the perverse effects of the money-supply targeting he had convinced the Fed to adopt – the adaptive-expectations model in the Dornbusch-Fischer macro textbook is as much Friedmanian as Keynesian. And by the way, Dornbush and Fischer were both at Chicago in the mid 1970s when the first edition of their macro text was written.

By a few years into the 80s it was obvious that those models were unsustainable in the face of the data. But rather than admit that their dismissal of Keynes was premature, most of those guys went into real business cycle theory — basically, denying that the Fed had anything to do with recessions. And from there they just kept digging ever deeper into the rabbit hole.

But anyway, what you need to know is that the 80s were actually a decade of Keynesian analysis triumphant.

I am just as appalled as Krugman by the real-business-cycle episode, but it was as much a rejection of Friedman, and of all other non-Keynesian monetary theory, as of Keynes. So the inspiring morality tale spun by Krugman in which the hardy band of true-blue Keynesians prevail against those nasty new classical barbarians is a bit overdone and vastly oversimplified.

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John Cochrane, Meet Richard Lipsey and Kenneth Carlaw

Paul Krugman wrote an uncharacteristically positive post today about John Cochrane’s latest post in which Cochrane dialed it down a bit after writing two rather heated posts (here and here) attacking Alan Blinder for a recent piece he wrote in the New York Review of Books in which Blinder wrote dismissively quoted Cochrane’s dismissive remark about Keynesian economics being fairy tales that haven’t been taught to graduate students since the 1960s. I don’t want to get into that fracas, but I was amused to read the following paragraphs at the end of Cochrane’s second post in the current series.

Thus, if you read Krugman’s columns, you will see him occasionally crowing about how Keynesian economics won, and how the disciples of Stan Fisher at MIT have spread out to run the world. He’s right. Then you see him complaining about how nobody in academia understands Keynesian economics. He’s right again.

Perhaps academic research ran off the rails for 40 years producing nothing of value. Social sciences can do that. Perhaps our policy makers are stuck with simple stories they learned as undergraduates; and, as has happened countless times before, new ideas will percolate up when the generation trained in the 1980s makes their way to to top of policy circles.

I think we can agree on something. If one wants to write about “what’s wrong with economics,” such a huge divide between academic research ideas and the ideas running our policy establishment is not a good situation.

The right way to address this is with models — written down, objective models, not pundit prognostications — and data. What accounts, quantitatively, for our experience?  I see old-fashioned Keynesianism losing because, having dramatically failed that test once, its advocates are unwilling to do so again, preferring a campaign of personal attack in the popular press. Models confront data in the pages of the AER, the JPE, the QJE, and Econometrica. If old-time Keynesianism really does account for the data, write it down and let’s see.

So Cochrane wants to take this bickering out of the realm of punditry and put the conflicting models to an objective test of how well they perform against the data. Sounds good to me, but I can’t help but wonder if Cochrane means to attribute the academic ascendancy of RBC/New Classical models to their having empirically outperformed competing models? If so, I am not aware that anyone else has made that claim, including Kartik Athreya who wrote the book on the subject. (Here’s my take on the book.) Again just wondering – I am not a macroeconometrician – but is there any study showing that RBC or DSGE models outperform old-fashioned Keynesian models in explaining macro-time-series data?

But I am aware of, and have previously written about, a paper by Kenneth Carlaw and Richard Lipsey (“Does History Matter?: Empirical Analysis of Evolutionary versus Stationary Equilibrium Views of the Economy”) in which they show that time-series data for six OECD countries provide no evidence of the stylized facts about inflation and unemployment implied by RBC and New Keynesian theory. Here is the abstract from the Carlaw-Lipsey paper.

The evolutionary vision in which history matters is of an evolving economy driven by bursts of technological change initiated by agents facing uncertainty and producing long term, path-dependent growth and shorter-term, non-random investment cycles. The alternative vision in which history does not matter is of a stationary, ergodic process driven by rational agents facing risk and producing stable trend growth and shorter term cycles caused by random disturbances. We use Carlaw and Lipsey’s simulation model of non-stationary, sustained growth driven by endogenous, path-dependent technological change under uncertainty to generate artificial macro data. We match these data to the New Classical stylized growth facts. The raw simulation data pass standard tests for trend and difference stationarity, exhibiting unit roots and cointegrating processes of order one. Thus, contrary to current belief, these tests do not establish that the real data are generated by a stationary process. Real data are then used to estimate time-varying NAIRU’s for six OECD countries. The estimates are shown to be highly sensitive to the time period over which they are made. They also fail to show any relation between the unemployment gap, actual unemployment minus estimated NAIRU and the acceleration of inflation. Thus there is no tendency for inflation to behave as required by the New Keynesian and earlier New Classical theory. We conclude by rejecting the existence of a well-defined a short-run, negatively sloped Philips curve, a NAIRU, a unique general equilibrium, short and long-run, a vertical long-run Phillips curve, and the long-run neutrality of money.

Cochrane, like other academic macroeconomists with a RBC/New Classical orientation seems inordinately self-satisfied with the current state of the modern macroeconomics, but curiously sensitive to, and defensive about, criticism from the unwashed masses. Rather than weigh in again with my own criticisms, let me close by quoting another abstract – this one from a paper (“Complexity Eonomics: A Different Framework for Economic Thought”) by Brian Arthur, certainly one of the smartest, and most technically capable, economists around.

This paper provides a logical framework for complexity economics. Complexity economics builds from the proposition that the economy is not necessarily in equilibrium: economic agents (firms, consumers, investors) constantly change their actions and strategies in response to the outcome they mutually create. This further changes the outcome, which requires them to adjust afresh. Agents thus live in a world where their beliefs and strategies are constantly being “tested” for survival within an outcome or “ecology” these beliefs and strategies together create. Economics has largely avoided this nonequilibrium view in the past, but if we allow it, we see patterns or phenomena not visible to equilibrium analysis. These emerge probabilistically, last for some time and dissipate, and they correspond to complex structures in other fields. We also see the economy not as something given and existing but forming from a constantly developing set of technological innovations, institutions, and arrangements that draw forth further innovations, institutions and arrangements.

Complexity economics sees the economy as in motion, perpetually “computing” itself — perpetually constructingitself anew. Where equilibrium economics emphasizes order, determinacy, deduction, and stasis, complexity economics emphasizes contingency, indeterminacy, sense-making, and openness to change. In this framework time, in the sense of real historical time, becomes important, and a solution is no longer necessarily a set of mathematical conditions but a pattern, a set of emergent phenomena, a set of changes that may induce further changes, a set of existing entities creating novel entities. Equilibrium economics is a special case of nonequilibrium and hence complexity economics, therefore complexity economics is economics done in a more general way. It shows us an economy perpetually inventing itself, creating novel structures and possibilities for exploitation, and perpetually open to response.

HT: Mike Norman

Explaining the Hegemony of New Classical Economics

Simon Wren-Lewis, Robert Waldmann, and Paul Krugman have all recently devoted additional space to explaining – ruefully, for the most part – how it came about that New Classical Economics took over mainstream macroeconomics just about half a century after the Keynesian Revolution. And Mark Thoma got them all started by a complaint about the sorry state of modern macroeconomics and its failure to prevent or to cure the Little Depression.

Wren-Lewis believes that the main problem with modern macro is too much of a good thing, the good thing being microfoundations. Those microfoundations, in Wren-Lewis’s rendering, filled certain gaps in the ad hoc Keynesian expenditure functions. Although the gaps were not as serious as the New Classical School believed, adding an explicit model of intertemporal expenditure plans derived from optimization conditions and rational expectations, was, in Wren-Lewis’s estimation, an improvement on the old Keynesian theory. The improvements could have been easily assimilated into the old Keynesian theory, but weren’t because New Classicals wanted to junk, not improve, the received Keynesian theory.

Wren-Lewis believes that it is actually possible for the progeny of Keynes and the progeny of Fisher to coexist harmoniously, and despite his discomfort with the anti-Keynesian bias of modern macroeconomics, he views the current macroeconomic research program as progressive. By progressive, I interpret him to mean that macroeconomics is still generating new theoretical problems to investigate, and that attempts to solve those problems are producing a stream of interesting and useful publications – interesting and useful, that is, to other economists doing macroeconomic research. Whether the problems and their solutions are useful to anyone else is perhaps not quite so clear. But even if interest in modern macroeconomics is largely confined to practitioners of modern macroeconomics, that fact alone would not conclusively show that the research program in which they are engaged is not progressive, the progressiveness of the research program requiring no more than a sufficient number of self-selecting econ grad students, and a willingness of university departments and sources of research funding to cater to the idiosyncratic tastes of modern macroeconomists.

Robert Waldmann, unsurprisingly, takes a rather less charitable view of modern macroeconomics, focusing on its failure to discover any new, previously unknown, empirical facts about macroeconomic, or to better explain known facts than do alternative models, e.g., by more accurately predicting observed macro time-series data. By that, admittedly, demanding criterion, Waldmann finds nothing progressive in the modern macroeconomics research program.

Paul Krugman weighed in by emphasizing not only the ideological agenda behind the New Classical Revolution, but the self-interest of those involved:

Well, while the explicit message of such manifestos is intellectual – this is the only valid way to do macroeconomics – there’s also an implicit message: from now on, only my students and disciples will get jobs at good schools and publish in major journals/ And that, to an important extent, is exactly what happened; Ken Rogoff wrote about the “scars of not being able to publish stick-price papers during the years of new classical repression.” As time went on and members of the clique made up an ever-growing share of senior faculty and journal editors, the clique’s dominance became self-perpetuating – and impervious to intellectual failure.

I don’t disagree that there has been intellectual repression, and that this has made professional advancement difficult for those who don’t subscribe to the reigning macroeconomic orthodoxy, but I think that the story is more complicated than Krugman suggests. The reason I say that is because I cannot believe that the top-ranking economics departments at schools like MIT, Harvard, UC Berkeley, Princeton, and Penn, and other supposed bastions of saltwater thinking have bought into the underlying New Classical ideology. Nevertheless, microfounded DSGE models have become de rigueur for any serious academic macroeconomic theorizing, not only in the Journal of Political Economy (Chicago), but in the Quarterly Journal of Economics (Harvard), the Review of Economics and Statistics (MIT), and the American Economic Review. New Keynesians, like Simon Wren-Lewis, have made their peace with the new order, and old Keynesians have been relegated to the periphery, unable to publish in the journals that matter without observing the generally accepted (even by those who don’t subscribe to New Classical ideology) conventions of proper macroeconomic discourse.

So I don’t think that Krugman’s ideology plus self-interest story fully explains how the New Classical hegemony was achieved. What I think is missing from his story is the spurious methodological requirement of microfoundations foisted on macroeconomists in the course of the 1970s. I have discussed microfoundations in a number of earlier posts (here, here, here, here, and here) so I will try, possibly in vain, not to repeat myself too much.

The importance and desirability of microfoundations were never questioned. What, after all, was the neoclassical synthesis, if not an attempt, partly successful and partly unsuccessful, to integrate monetary theory with value theory, or macroeconomics with microeconomics? But in the early 1970s the focus of attempts, notably in the 1970 Phelps volume, to provide microfoundations changed from embedding the Keynesian system in a general-equilibrium framework, as Patinkin had done, to providing an explicit microeconomic rationale for the Keynesian idea that the labor market could not be cleared via wage adjustments.

In chapter 19 of the General Theory, Keynes struggled to come up with a convincing general explanation for the failure of nominal-wage reductions to clear the labor market. Instead, he offered an assortment of seemingly ad hoc arguments about why nominal-wage adjustments would not succeed in reducing unemployment, enabling all workers willing to work at the prevailing wage to find employment at that wage. This forced Keynesians into the awkward position of relying on an argument — wages tend to be sticky, especially in the downward direction — that was not really different from one used by the “Classical Economists” excoriated by Keynes to explain high unemployment: that rigidities in the price system – often politically imposed rigidities – prevented wage and price adjustments from equilibrating demand with supply in the textbook fashion.

These early attempts at providing microfoundations were largely exercises in applied price theory, explaining why self-interested behavior by rational workers and employers lacking perfect information about all potential jobs and all potential workers would not result in immediate price adjustments that would enable all workers to find employment at a uniform market-clearing wage. Although these largely search-theoretic models led to a more sophisticated and nuanced understanding of labor-market dynamics than economists had previously had, the models ultimately did not provide a fully satisfactory account of cyclical unemployment. But the goal of microfoundations was to explain a certain set of phenomena in the labor market that had not been seriously investigated, in the hope that price and wage stickiness could be analyzed as an economic phenomenon rather than being arbitrarily introduced into models as an ad hoc, albeit seemingly plausible, assumption.

But instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of fully rational agents. Instead of trying to enrich and potentially transform the Keynesian model with a deeper analysis and understanding of the incentives and constraints under which workers and employers make decisions, the New Classicals used microfoundations as a methodological tool by which to delegitimize Keynesian models, those models being insufficiently or improperly microfounded. Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption, portraying it as nothing more than the consistent application of the rationality postulate underlying standard neoclassical price theory.

For the New Classicals, microfoundations became a reductionist crusade. There is only one kind of economics, and it is not macroeconomics. Even the idea that there could be a conceptual distinction between micro and macroeconomics was unacceptable to Robert Lucas, just as the idea that there is, or could be, a mind not reducible to the brain is unacceptable to some deranged neuroscientists. No science, not even chemistry, has been reduced to physics. Were it ever to be accomplished, the reduction of chemistry to physics would be a great scientific achievement. Some parts of chemistry have been reduced to physics, which is a good thing, especially when doing so actually enhances our understanding of the chemical process and results in an improved, or more exact, restatement of the relevant chemical laws. But it would be absurd and preposterous simply to reject, on supposed methodological principle, those parts of chemistry that have not been reduced to physics. And how much more absurd would it be to reject higher-level sciences, like biology and ecology, for no other reason than that they have not been reduced to physics.

But reductionism is what modern macroeconomics, under the New Classical hegemony, insists on. No exceptions allowed; don’t even ask. Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment.

UPDATE (11:43 AM EDST): I made some minor editorial revisions to eliminate some grammatical errors and misplaced or superfluous words.

John Cochrane on the Failure of Macroeconomics

The state of modern macroeconomics is not good; John Cochrane, professor of finance at the University of Chicago, senior fellow of the Hoover Institution, and adjunct scholar of the Cato Institute, writing in Thursday’s Wall Street Journal, thinks macroeconomics is a failure. Perhaps so, but he has trouble explaining why.

The problem that Cochrane is chiefly focused on is slow growth.

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Sclerotic growth trumps every other economic problem. Without strong growth, our children and grandchildren will not see the great rise in health and living standards that we enjoy relative to our parents and grandparents. Without growth, our government’s already questionable ability to pay for health care, retirement and its debt evaporate. Without growth, the lot of the unfortunate will not improve. Without growth, U.S. military strength and our influence abroad must fade.

Macroeconomists offer two possible explanations for slow growth: a) too little demand — correctable through monetary or fiscal stimulus — and b) structural rigidities and impediments to growth, for which stimulus is no remedy. Cochrane is not a fan of the demand explanation.

The “demand” side initially cited New Keynesian macroeconomic models. In this view, the economy requires a sharply negative real (after inflation) rate of interest. But inflation is only 2%, and the Federal Reserve cannot lower interest rates below zero. Thus the current negative 2% real rate is too high, inducing people to save too much and spend too little.

New Keynesian models have also produced attractively magical policy predictions. Government spending, even if financed by taxes, and even if completely wasted, raises GDP. Larry Summers and Berkeley’s Brad DeLong write of a multiplier so large that spending generates enough taxes to pay for itself. Paul Krugman writes that even the “broken windows fallacy ceases to be a fallacy,” because replacing windows “can stimulate spending and raise employment.”

If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile. There are many ways to generate the models’ predictions for GDP, employment and inflation from their underlying assumptions about how people behave. Some predict outsize multipliers and revive the broken-window fallacy. Others generate normal policy predictions—small multipliers and costly broken windows. None produces our steady low-inflation slump as a “demand” failure.

Cochrane’s characterization of what’s wrong with New Keynesian models is remarkably superficial. Slow growth, according to the New Keynesian model, is caused by the real interest rate being insufficiently negative, with the nominal rate at zero and inflation at (less than) 2%. So what is the problem? True, the nominal rate can’t go below zero, but where is it written that the upper bound on inflation is (or must be) 2%? Cochrane doesn’t say. Not only doesn’t he say, he doesn’t even seem interested. It might be that something really terrible would happen if the rate of inflation rose about 2%, but if so, Cochrane or somebody needs to explain why terrible calamities did not befall us during all those comparatively glorious bygone years when the rate of inflation consistently exceeded 2% while real economic growth was at least a percentage point higher than it is now. Perhaps, like Fischer Black, Cochrane believes that the rate of inflation has nothing to do with monetary or fiscal policy. But that is certainly not the standard interpretation of the New Keynesian model that he is using as the archetype for modern demand-management macroeconomic theories. And if Cochrane does believe that the rate of inflation is not determined by either monetary policy or fiscal policy, he ought to come out and say so.

Cochrane thinks that persistent low inflation and low growth together pose a problem for New Keynesian theories. Indeed it does, but it doesn’t seem that a radical revision of New Keynesian theory would be required to cope with that state of affairs. Cochrane thinks otherwise.

These problems [i.e., a steady low-inflation slump, aka “secular stagnation”] are recognized, and now academics such as Brown University’s Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them. Good. But models that someone might get to work in the future are not ready to drive trillions of dollars of public expenditure.

In other words, unless the economic model has already been worked out before a particular economic problem arises, no economic policy conclusions may be deduced from that economic model. May I call  this Cochrane’s rule?

Cochrane the proceeds to accuse those who look to traditional Keynesian ideas of rejecting science.

The reaction in policy circles to these problems is instead a full-on retreat, not just from the admirable rigor of New Keynesian modeling, but from the attempt to make economics scientific at all.

Messrs. DeLong and Summers and Johns Hopkins’s Laurence Ball capture this feeling well, writing in a recent paper that “the appropriate new thinking is largely old thinking: traditional Keynesian ideas of the 1930s to 1960s.” That is, from before the 1960s when Keynesian thinking was quantified, fed into computers and checked against data; and before the 1970s, when that check failed, and other economists built new and more coherent models. Paul Krugman likewise rails against “generations of economists” who are “viewing the world through a haze of equations.”

Well, maybe they’re right. Social sciences can go off the rails for 50 years. I think Keynesian economics did just that. But if economics is as ephemeral as philosophy or literature, then it cannot don the mantle of scientific expertise to demand trillions of public expenditure.

This is political rhetoric wrapped in a cloak of scientific objectivity. We don’t have the luxury of knowing in advance what the consequences of our actions will be. The United States has spent trillions of dollars on all kinds of stuff over the past dozen years or so. A lot of it has not worked out well at all. So it is altogether fitting and proper for us to be skeptical about whether we will get our money’s worth for whatever the government proposes to spend on our behalf. But Cochrane’s implicit demand that money only be spent if there is some sort of scientific certainty that the money will be well spent can never be met. However, as Larry Summers has pointed out, there are certainly many worthwhile infrastructure projects that could be undertaken, so the risk of committing the “broken windows fallacy” is small. With the government able to borrow at negative real interest rates, the present value of funding such projects is almost certainly positive. So one wonders what is the scientific basis for not funding those projects?

Cochrane compares macroeconomics to climate science:

The climate policy establishment also wants to spend trillions of dollars, and cites scientific literature, imperfect and contentious as that literature may be. Imagine how much less persuasive they would be if they instead denied published climate science since 1975 and bemoaned climate models’ “haze of equations”; if they told us to go back to the complex writings of a weather guru from the 1930s Dustbowl, as they interpret his writings. That’s the current argument for fiscal stimulus.

Cochrane writes as if there were some important scientific breakthrough made by modern macroeconomics — “the new and more coherent models,” either the New Keynesian version of New Classical macroeconomics or Real Business Cycle Theory — that rendered traditional Keynesian economics obsolete or outdated. I have never been a devote of Keynesian economics, but the fact is that modern macroeconomics has achieved its ascendancy in academic circles almost entirely by way of a misguided methodological preference for axiomatized intertemporal optimization models for which a unique equilibrium solution can be found by imposing the empirically risible assumption of rational expectations. These models, whether in their New Keynesian or Real Business Cycle versions, do not generate better empirical predictions than the old fashioned Keynesian models, and, as Noah Smith has usefully pointed out, these models have been consistently rejected by private forecasters in favor of the traditional Keynesian models. It is only the dominant clique of ivory-tower intellectuals that cultivate and nurture these models. The notion that such models are entitled to any special authority or scientific status is based on nothing but the exaggerated self-esteem that is characteristic of almost every intellectual clique, particularly dominant ones.

Having rejected inadequate demand as a cause of slow growth, Cochrane, relying on no model and no evidence, makes a pitch for uncertainty as the source of slow growth.

Where, instead, are the problems? John Taylor, Stanford’s Nick Bloom and Chicago Booth’s Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago’s Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.

Where, one wonders, is the science on which this sort of seat-of-the-pants speculation is based? Is there any evidence, for example, that the tax burden on businesses or individuals is greater now than it was let us say in 1983-85 when, under President Reagan, the economy, despite annual tax increases partially reversing the 1981 cuts enacted in Reagan’s first year, began recovering rapidly from the 1981-82 recession?

What Does “Keynesian” Mean?

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.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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