Fiscal policy formalities (wonkish), by Paul Krugman: There seems to be an amazing amount of misunderstanding of the basics of fiscal policy, even among people who should know better. Leave on one side the remarkable parade of economists who think that the savings-investment identity proves that government action can’t increase spending; PGL points us to a higher-level fallacy: the widespread belief that Ricardian equivalence doesn’t just say that tax cuts have no effect — which it does — it also says that private consumption automatically offsets any rise in government spending, which is just wrong.
Justin Wolfers suggests that this is because economists just haven’t been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn’t true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.
And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.
What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don’t read anything that doesn’t come from their
cultcircle; they just weren’t aware of major bodies of work that didn’t happen to be in their preferred style.
This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They’ve been taught that there is one true faith, and have been carefully protected from heresy.
It’s a sad story.
It's even sadder. The two groups have lots to offer, New Keynesians can learn from RBC theorists, and the reverse is true as well, but ideological hard-headedness driven by a turf war among the leaders in each group, a war that is really about a quest for for professional fame has, I think, kept these two groups in opposition to the detriment of the profession.
A post from last August looked at this question:
There is currently a movement within the economics profession to [synthesize real business cycle and new Keynesian models]. Real business cycle models, i.e. supply-side models, are adequate models of the long-run but do not explain demand side short-run economic fluctuations very well. Because of this, they are limited in their applicability. Models with wage and price rigidities, New Keynesian models, do have the ability to explain such short-run fluctuations but pay scant attention to long-run issues. Combining these two models, a real business cycle model for the long-run and a New Keynesian model of wage and price rigidity for the short-run, is a promising avenue for explaining macroeconomic fluctuations.
Olivier Blanchard explores this idea in more detail in "The State of Macro." Here's a bit of the paper (I can't find an open link - Update: open link - click on "choose download location" at top of page):
The State of Macro, by Olivier J. Blanchard, NBER Working Paper No. 14259, August 2008: The editors of this new Journal asked me to write about "The Future of Macroeconomics". ...
The theme is that, after the explosion (in both the positive and negative meaning of the word) of the field in the 1970s, there has been enormous progress and substantial convergence. For a while - too long a while - the field looked like a battlefield. Researchers split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies. Over time however, largely because facts have a way of not going away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good. ...
1 A Brief Review of the Past
When they launched the "rational expectations revolution", Lucas and Sargent (1978) did not mince words:
That the predictions [of Keynesian economics] were wildly incorrect, and that the doctrine on which they were based was fundamentally flawed, are now simple matters of fact, involving no subtleties in economic theory. The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.
They predicted a long process of reconstruction:
Though it is far from clear what the outcome of this process will be, it is already evident that it will necessarily involve the reopening of basic issues in monetary economics which have been viewed since the thirties as "closed" and the reevaluation of every aspect of the institutional framework within which monetary and fiscal policy is formulated in the advanced countries. This paper is an early progress report on this process of reevaluation and reconstruction.
They were right. For the next fifteen years or so, the field exploded. Three groups dominated the news, the new-classicals, the new-Keynesians, and the new-growth theorists (no need to point out the PR role of "new" here), each pursuing a very different agenda:
The new-classicals embraced the Lucas-Sargent call for reconstruction. Soon, however, the Mencheviks gave way to the Bolcheviks, and the research agenda became even more extreme. Under Prescott's leadership, nominal rigidities, imperfect information, money, and the Phillips curve, all disappeared from the basic model, and researchers focused on the stochastic properties of the Ramsey model (equivalently, a representative agent Arrow-Debreu economy), rebaptized as the Real Business Cycle model, or RBC. Three principles guided the research:
Explicit micro foundations, defined as utility and profit maximization; general equilibrium; and the exploration of how far one could go with no or few imperfections.
The new-Keynesians embraced reform, not revolution. United in the belief that the previous vision of macroeconomics was basically right, they accepted the need for better foundations for the various imperfections underlying that approach.
The research program became one of examining, theoretically and empirically, the nature and the reality of various imperfections, from nominal rigidities, to efficiency wages, to credit market constraints. Models were partial equilibrium, or included a trivial general equilibrium closure: It seemed too soon to embody each one in a common general equilibrium structure.
The new-growth theorists simply abandoned the field (i.e. fluctuations). Lucas' remark that, once one thinks about growth, one can hardly think about something else, convinced many to focus on determinants of growth, rather than on fluctuations and their apparently small welfare implications. ...
Relations between the three groups - or, more specifically, the first two, called by Hall "fresh water" and "salt water" respectively (for the geographic location of most of the new-classicals and most of the new-Keynesians) - were tense, and often unpleasant. The first accused the second of being bad economists, clinging to obsolete beliefs and discredited theories. The second accused the first of ignoring basic facts, and, in their pursuit of a beautiful but irrelevant model, of falling prey to a "scientific illusion." (See the debate between Prescott and Summers (1986)). One could reasonably despair of the future of macro (and, indeed, some of us came close (Blanchard 1992)).
This is still the view many outsiders have of the field. But it no longer corresponds to reality. Facts have a way of eventually forcing irrelevant theory out (one wishes it happened faster). And good theory also has a way of eventually forcing bad theory out. The new tools developed by the new-classicals came to dominate.
The facts emphasized by the new-Keynesians forced imperfections back in the benchmark model. A largely common vision has emerged, which is the topic of the next section.
2 Convergence in Vision
2.1 The role of aggregate demand, and nominal rigidities
It is hard to ignore facts. One major macro fact is that shifts in the aggregate demand for goods affect output substantially more than we would expect in a perfectly competitive economy. More optimistic consumers buy more goods, and the increase in demand leads to more output and more employment. Changes in the federal funds rate have major effects on real asset prices, from bond to stock prices, and, in turn, on activity.
These facts are not easy to explain within a perfectly competitive flexible-price macro model. ...
Attempts to explain these effects through exotic preferences or exotic segmented-market effects of open market operations, while maintaining the assumption of perfectly competitive markets and flexible prices, have proven unconvincing at best. This has led even the most obstinate new-classicals to explore the possibility that nominal rigidities matter. ...
The study of nominal price and wage setting is one of the hot topics of research in macro today. ... The cast of characters involved ... nicely makes the point that the old fresh water/salt water distinction has become largely irrelevant: While research on the topic started with new-Keynesians, recent research has been largely triggered by an article by Golosov and Lucas (2007), itself building on earlier work on aggregation of state-dependent rules by Caplin and by Caballero, among others.
2.2 Technological shocks versus technological waves
One central tenet of the new-classical approach was that the main source of fluctuations is technological shocks. The notion that there are large quarter-to-quarter aggregate technological shocks flies however in the face of reason. Except in times of dramatic economic transition,... technological progress is about the diffusion and implementation of new ideas, and about institutional change, both of which are likely to be low-frequency movements. No amount of quarterly movement in the Solow residual will convince the skeptics: High frequency movements in measured aggregate TFP must be due to measurement error.
This does not imply, however, that technological progress does not play an important role in fluctuations. Though technological progress is smooth, it is certainly not constant. There are clear technological waves. ...
2.3 Towards a general picture, and three broad relations
The joint beliefs that technological progress goes through waves, that perceptions of the future affect the demand for goods today, and that, because of nominal rigidities, this demand for goods can affect output in the short run, nicely combine to give a picture of fluctuations which, I believe, many macroeconomists would endorse today.
Fifty years ago, Samuelson (1955) wrote:
In recent years, 90 per cent of American economists have stopped being "Keynesian economists" or "Anti-Keynesian economists." Instead, they have worked toward a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neo-classical economics and is accepted, in its broad outlines, by all but about five per cent of extreme left-wing and right-wing writers.
I would guess we are not yet at such a corresponding stage today. But we may be getting there. ...
When I first posted this, I agreed. The two sides seemed to be converging and I thought that was a good development. But the current crisis has reopened old debates, exposed divisions that have never been fully healed, and we seem as far apart as ever.
I want to end with this quote from Lucas:
The task which faces contemporary students of the business cycle is that of sorting through the wreckage, determining what features of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use, and which others must be discarded.
What's different this time, and it's a difference I hope will bring about some humility, is that the wreckage is not from the Keynesian model crashing, this time it is the Classical formulation of the world that is being called into question. Once the proponents of these models are willing to concede that point, something they are currently resisting, maybe we can come together and get somewhere useful.