"Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis?"
Robert Gordon argues that "modern macro neglects the basic sources of both impulses and propagation mechanisms of business cycles," and that we should return to "1978-era macroeconomics." Here's the introduction to his paper:
Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis?, by Robert Gordon: 1. Introduction For more than three decades since 1978 hundreds of U. S. macroeconomists have developed what is often called the "modern macroeconomics" of business cycle fluctuations. Until recently, there was evident self-satisfaction that macroeconomic truth had been discovered, that old errors had been buried, and that a long period of warfare between new classicals and new Keynesians had ended as a consensus had emerged based on Dynamic Stochastic General Equilibrium (DSGE) models that combined new-classical market clearing with the new-Keynesian contribution of sticky prices.
Along the way numerous modern macroeconomists concluded that the U. S. "Great Moderation" of macroeconomic volatility in the 1984-2007 period (as compared to higher volatility in the earlier 1947-84 postwar interval) was a side benefit of modern analysis. However since 2007 the world economy has entered a crisis of sub-prime mortgage defaults, excessive leveraging followed by deleveraging, output and employment meltdowns, and an enormous destruction of wealth. The Great Moderation is dead. Neither the proponents of modern macro nor the adherents of Keynesian ideas anticipated the crisis in advance. But even the most avid supporters of the modern macro camp have thus far failed to provide any intellectual links with their preferred explanations of business cycle downturns based on technology retardation, changes in preferences, or tightness in monetary policy.
This paper is not an endorsement of 1936-era Keynesian thought, but rather revives an alternative intellectual paradigm called "1978-era macroeconomics."
This incorporates all the rich underpinnings of Keynesian demand-side economics added in the postwar era by Baumol, Eisner, Friedman, Jorgenson, Modigliani, and Tobin and many others to the micro foundations of the economy's demand side. The 1978-era version of aggregate demand shocks in the fact of incomplete price adjustment has no trouble in tracing the links between yet another financial bubble in 2003-06 (as in 1927-1929 and 1997-1999) and the resulting massive downdraft on economic activity in a disequilibrium where markets fail to clear. Among the elements of 1978-era demand-side macro that are often neglected today are the dependence of current consumption on current income and wealth, and the accelerator theory of investment which makes investment depend on the rate of change of real output and income.
But 1978-era macro does not include the other intellectual baggage of the term "Keynesian economics", which has been forever tainted by association (in Lucas-Sargent 1978 and elsewhere) with the discredited 1960s-era Phillips Curve and its implication of an exploitable inflation-unemployment tradeoff. Instead this paper revives the supply-side invented in the mid-1970s that recognizes the co-existence of flexible auction-market prices for commodities like oil and sticky prices for the remaining non-oil economy. Adverse supply shocks coming not just from oil prices but also, as in the early 1970s from auction-market price shocks in food and exchange rates, boosted the expenditure share of commodities and forced nominal spending on non-shocked products to contract. Without flexible wages, a decline in real non-shocked output had to occur and did, leaving policymakers with the dilemma that any attempt to control inflation would create a recession, while any attempt to stabilize real GDP would lead to faster inflation.
As combined in 1978-era theories, empirical work, and pioneering intermediate macro textbooks, this merger of demand and supply resulted in a well-articulated dynamic aggregate demand-supply model that has stood the test of time in explaining both the multiplicity of links between the financial and real economies, as well as why inflation and unemployment can be both negatively and positively correlated. The achievement of 1978-era macro was to retain the best of Keynesian demand-side economics while dropping the negatively sloped inflation-unemployment tradeoff with its neglect of supply shocks. 1978-era macro recognizes that the correlation between inflation and unemployment can be either negative or positive, just as microeconomics has long predicted that the correlation between the price and quantity of wheat can be either negative or positive depending on the size of the shocks to demand and supply.
To understand the domestic macroeconomic environment of the 2007-09 worldwide crisis, we are best served by applying 1978-era macro. The adjective "business cycle" in front of the phrase "modern macro" represents an important qualification to the scope of this paper. Much of modern macro escapes its critical overview, including such broad areas of modern macro progress as growth theory, search and matching models of unemployment, theories of why prices and wages are only partial flexible, and attempts to use modern versions of production functions and factor input measurement to develop empirical counterparts to longstanding 1978-era macro constructs such as potential GDP growth and the GDP gap.
The world economic crisis started in the United States, and an understanding of its causes, possible prevention, and policy responses is most easily developed in the context of a hypothetically closed American economy. The economics literature of the last 50 years is dominated by American economists arguing over alternative theories of the domestic sources of American business cycles. Any suggestion in this paper that American business cycle macroeconomics has been going backwards in the past few decades does not extend to our colleagues who have greatly deepened our understanding of international imbalances and exchange rate adjustment.
The failings of modern American business fluctuations macro were evident long before the start of the world crisis in 2007. Yet so dominant have been the modern macroeconomists in the teaching of graduate economics education that few economists under the age of 45 are even aware that there is another macro that was well developed by 1978 and provides a more suitable intellectual framework for dealing with the current crisis. Even a distinguished senior economist, Olivier J. Blanchard (2008), recently joined in the orgy of self-congratulation by writing a survey paper on the state of macro which concluded "the state of macroeconomics is good." His sanguine paper was released as a NBER Working Paper only one month before the failure of Lehman Brothers in September, 2008, began the worldwide downward economic spiral.
The development of this paper by coincidence coincides with the recent cover of The Economist (July 18, 2009), which depicts a wax-like book titled Modern Economic Theory, shown melting into a puddle like the Wicked Witch of the West in the 1939 movie The Wizard of Oz.
The Economist derides the economics profession for (1) helping to cause the crisis, (2) failing to spot it, and (3) having no idea how to fix it. Our theme is different; there is no accusation here that economists of one school of thought or another "caused the crisis." Some did see it coming but almost none forecast the amplification of shocks that is its unique trait. Many have helped to fix it, starting with Chairman Bernanke of the Fed, perhaps the leading American academic expert on the Great Depression. Indeed, Bernanke in his own work and collaboration with Mark Gertler (1989) has made important contributions to macroeconomics but has steered clear of linking them to the market-clearing environment of DSGE models that are the subject of this paper.
The malaise of modern macroeconomics has recently been the subject of strikingly vitriolic accusations. The Economist (p. 70) quotes Paul Krugman's LSE Lionel Robbins Lecture of 10 June 2009 as stating "most macroeconomics of the past 30 years was spectacularly useless at best, and positively harmful at worst." More recently Krugman (2009) has amplified this criticism in a long and overly argumentative denunciation of modern macroeconomics. In notably similar language that might have inspired Krugman, Buiter (2009) wrote three months earlier that "the typical graduate macroeconomics. . . training received at Anglo-American universities during the past 30 years or so may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources."
This paper takes a more temperate view of what is wrong with modern macro. It looks back into the pre-crisis (pre-2007) intellectual history of macroeconomic theory and argues that modern macro neglects the basic sources of both impulses and propagation mechanisms of business cycles. The basic problem is that modern macro consists of too much micro and not enough macro. Focus on individual preferences and production functions misses the essence of macro fluctuations -- the coordination failures and macro externalities that convert interactions among individual choices into constraints that prevent workers from optimizing hours of work and firms from optimizing sales, production, and utilization. Also modern business-cycle macro has too narrow a view of the range of aggregate demand shocks that in the presence of sticky prices constrain the choices of workers and firms. Shocks that have little or nothing to do with technology, preferences, or monetary policy can interact and impose constraints on individual choices.
How does the contrast between domestic American "modern macro" and the alternative 1978 version illuminate the current world crisis? Modern business-cycle macroeconomics has little to say about the origins of the Great Depression of the 1930s and concludes that it must have resulted from a massive negative technology shock, a monumental bout of forgetfulness. In contrast 1978-era macro understands the Great Depression as the joint result of wealth, consumption, investment, and monetary policy shocks in the context of regulatory failure. No 1978-era macroeconomists predicted in advance the full sweep of the 2007-09 meltdown, but they were led by their studies of the Great Depression and postwar business cycles to regard as fundamental drivers of business cycles a wide variety of demand shocks, including the coordination failures evident in the financial and housing bubbles.
The paper begins in Part 2 with an account of the worldwide crisis, where the main novelty is a set of observations about similarities and differences between 2003-09 and 1927-32. Then in Part 3 the elements of 1978-era macroeconomics are established and are contrasted in Part 4 with the hybrid but inconsistent edifice built by modern macroeconomists in the form of Dynamic Stochastic General Equilbrium (DSGE) models.
1. The "modern macro of business cycle fluctuations" describes the set of models and strategies that have dominated graduate school and academic-conference business-cycle macroeconomics since the late 1970s. Developers of modern macro rarely use that phrase since they take for granted that all macro is "modern," while critics like Solow (2008) feel obliged to define "modern macro" as what they are criticizing.
2. The self-satisfaction of modern macro is often demonstrated by Blanchard's (2008) much-cited conclusion that "the state of macro is good." More on Blanchard below. A more measured and scholarly paper arrives at the same verdict as summarized in the title of Woodford (2009), "Convergence in Macroeconomics: Elements of a New Synthesis." Woodford among others conclude that New Classical and New Keynesian macro have converging on DSGE with price stickiness as a consensus model.
3. There is no need here to provide citations of the forms of modern macro that escape criticism here. The large literature on new endogenous growth theory is well known; search and matching models were developed by Diamond, Mortensen, and Pissarides and their followers, and the large "New Keynesian" literature on the micro foundations of wage and price adjustment was fully surveyed by Gordon (1990) among others. A recent source that brings together the modern production function approach to the measurement of potential real GDP and the GDP gap is Anderson (2009).4. There are a welcome set of exceptions, as always. The work of Bernanke (1983) and Bernanke-Gertler (1989) are notable examples of post-1978 attempts to link the financial collapse of the Great Depression with the real economy, although neither did so with the full apparatus of modern DSGE models. Eggertson-Woodford (2004) come closer to an attempt to merge modern macro with the zero lowerbound characteristic of nominal interest rates in the late 1930s and the 2008-09 period. Ongoing work by my colleagues Christiano and Eichenbaum (2009) on fiscal policy multipliers in the presence of a zero lower bound represent further progress in this direction.