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Friday, January 25, 2013

'Misinterpreting the History of Macroeconomic Thought'

Simon Wren-Lewis argues that the "crisis view" of change in macroeconomic theory is too simple

Misinterpreting the history of macroeconomic thought, mainly macro: An attractive way to give a broad sweep over the history of macroeconomic ideas is to talk about a series of reactions to crises (see Matthew Klein and Noah Smith). However it is too simple, and misleads as a result. The Great Depression led to Keynesian economics. So far so good. The inflation of the 1970s led to ? Monetarism - well maybe in terms of a few brief policy experiments in the early 1980s, but Monetarist-Keynesian debates were going strong before the 1970s. The New Classical revolution? Well rational expectations can be helpful in adapting the Phillips curve to explain what happened in the 1970s, but I’m not sure that was the main reason why the idea was so rapidly adopted. The New Classical revolution was much more than rational expectations.

The attempt gets really off beam if we try and suggest that the rise of RBC models was a response to the inflation of the 1970s. I guess you could argue that the policy failures of the 1970s were an example of the Lucas critique, and that to avoid similar mistakes macroeconomists needed to develop microfounded models. But if explaining the last crisis really was the prime motivation, would you develop models in which there was no Phillips curve, and which made no attempt to explain the inflation of the 1970s (or indeed, the previous crisis - the Great Depression)?

What the ‘macroeconomic ideas develop as a response to crises’ story leaves out is the rest of economics, and ideology. The Keynesian revolution (by which I mean macroeconomics after the second world war) can be seen as a methodological revolution. Models were informed by theory, but their equations were built to explain the data. Time series econometrics played an essential role. However this appeared to be different from how other areas of the discipline worked. In these other areas of economics, explaining behavior in terms of optimization by individual agents was all important. This created a tension, and a major divide within economics as a whole. Macro appeared quite different from micro.

A particular manifestation of this was the constant question: where is the source of the market failure that gives rise to the business cycle. Most macroeconomists replied sticky prices, but this prompted the follow up question: why do rational firms or workers choose not to change their prices? The way most macroeconomists at the time chose to answer this was that expectations were slow to adjust. It was a disastrous choice, but I suspect one that had very little to do with the nature of Keynesian theory, and rather more to do with the analytical convenience of adaptive expectations. Anyhow, that is another story.

The New Classical revolution was in part a response to that tension. In methodological terms it was a counter revolution, trying to take macroeconomics away from the econometricians, and bring it back to something microeconomists could understand. Of course it could point to policy in the 1970s as justification, but I doubt that was the driving force. I also think it is difficult to fully understand the New Classical revolution, and the development of RBC models, without adding in some ideology. 

Does this have anything to tell us about how macroeconomics will respond to the Great Recession? I think it does. If you bought the ‘responding to the last crisis’ narrative, you would expect to see some sea change, akin to Keynesian economics or the New Classical revolution. I suspect you would be disappointed. While I see plenty of financial frictions being added to DSGE models, I do not see any significant body of macroeconomists wanting to ply their trade in a radically different way. If this crisis is going to generate a new revolution in macroeconomics, where are the revolutionaries? However, if you read the history of macro thought the way I do, then macro crises are neither necessary nor sufficient for revolutions in macro thought. Perhaps there was only one real revolution, and we have been adjusting to the tensions that created ever since.  

Let me follow up on the ideological point with an example. Prior to the New Classical revolution in the 1970s (which, contra some recent descriptions, is different from DSGE models), the people who do not believe that government intervention is bad had a problem. It was very clear in the data that there was a positive correlation between changes in the money supply and changes in employment and real income. Further, though this is harder to establish, the relationship appeared causal. Money causes income, and this allowed government to stabilize the economy.

The (neo)classical model, with its vertical AS curve, could not explain the positive money-income correlation in the data. In the typical classical formulation, so long as prices are perfectly flexible and all markets clear at all points in time, the economy is always in long-run equilibrium. Thus, in these models the prediction is a zero correlation between money and income. But it wasn't zero.

However, a very clever idea from Robert Lucas in the 1970s allowed this correlation to be explained without admitting government can do good, i.e. without admitting that government can stabilize the economy using monetary policy. This is the ideological part -- a way to explain the data without acknowledging a role for government at the same time. I can't say that Lucas approached the problem in this way, i.e. that he started out with the ideological goal of explaining the money-income correlation without allowing a role for government. Maybe it arose in a flash of brilliance completely unconnected to ideological concerns, But I find it hard to explain why this model came about in the form it did without ideology, and the view of government the New Classical model supported surely didn't hurt its acceptance at places like the University of Chicago (as it existed then).

    Posted by on Friday, January 25, 2013 at 12:24 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (4)


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