New Classical Economics as Modeling Strategy

Judy Klein emails a response to a recent post of mine based upon Simon Wren Lewis's post “Rereading Lucas and Sargent 1979”:

Lucas and Sargent’s, “After Keynesian Macroeconomics,” was presented at the 1978 Boston Federal Reserve Conference on “After the Phillips Curve: Persistence of High Inflation and High Unemployment.” Although the title of the conference dealt with stagflation, the rational expectations theorists saw themselves countering one technical revolution with another.

The Keynesian Revolution was, in the form in which it succeeded in the United States, a revolution in method. This was not Keynes’s intent, nor is it the view of all of his most eminent followers. Yet if one does not view the revolution in this way, it is impossible to account for some of its most important features: the evolution of macroeconomics into a quantitative, scientific discipline, the development of explicit statistical descriptions of economic behavior, the increasing reliance of government officials on technical economic expertise, and the introduction of the use of mathematical control theory to manage an economy. [Lucas and Sargent, 1979, pg. 50]

The Lucas papers at the Economists' Papers Project at the University of Duke reveal the preliminary planning for the 1978 presentation. Lucas and Sargent decided that it would be a “rhetorical piece… to convince others that the old-fashioned macro game is up…in a way which makes it clear that the difficulties are fatal”; it’s theme would be the “death of macroeconomics” and the desirability of replacing it with an “Aggregative Economics” whose foundation was “equilibrium theory.” (Lucas letter to Sargent February 9, 1978). Their 1978 presentation was replete, as their discussant Bob Solow pointed out, with the planned rhetorical barbs against Keynesian economics of “wildly incorrect," "fundamentally flawed," "wreckage," "failure," "fatal," "of no value," "dire implications," "failure on a grand scale," "spectacular recent failure," "no hope." The empirical backdrop to Lucas and Sargent’s death decree on Keynesian economics was evident in the subtitle of the conference: “Persistence of High Inflation and High Unemployment.”

Although they seized the opportunity to comment on policy failure and the high misery-index economy, Lucas and Sargent shifted the macroeconomic court of judgment from the economy to microeconomics. They fought a technical battle over the types of restrictions used by modelers to identify their structural models. Identification-rendering restrictions were essential to making both the Keynesian and rational expectations models “work” in policy applications, but Lucas and Sargent defined the ultimate terms of success not with regard to a model’s capacity for empirical explanation or achievement of a desirable policy outcome, but rather with regard to the model’s capacity to incorporate optimization and equilibrium – to aggregate consistently rational individuals and cleared markets.

In the macroeconomic history written by the victors, the Keynesian revolution and the rational expectations revolution were both technical revolutions, and one could delineate the sides of the battle line in the second revolution by the nature of the restricting assumptions that enabled the model identification that licensed policy prescription. The rational expectations revolution, however, was also a revolution in the prime referential framework for judging macroeconomic model fitness for going forth and multiplying; the consistency of the assumptions – the equation restrictions - with optimizing microeconomics and mathematical statistical theory, rather than end uses of explaining the economy and empirical statistics, constituted the new paramount selection criteria.

Some of the new classical macroeconomists have been explicit about the narrowness of their revolution. For example, Sargent noted in 2008, “While rational expectations is often thought of as a school of economic thought, it is better regarded as a ubiquitous modeling technique used widely throughout economics.” In an interview with Arjo Klamer in 1983, Robert Townsend asserted that “New classical economics means a modeling strategy.”

It is no coincidence, however, that in this modeling narrative of economic equilibrium crafted in the Cold War era, Adam Smith’s invisible hand morphs into a welfare-maximizing “hypothetical ‘benevolent social planner’” (Lucas, Prescott, Stokey 1989) enforcing a “communism of models” (Sargent 2007) and decreeing to individual agents the mutually consistent rules of action that become the equilibrating driving force. Indeed, a long-term Office of Naval Research grant for “Planning & Control of Industrial Operations” awarded to the Carnegie Institutes of Technology’s Graduate School of Industrial Administration had funded Herbert Simon’s articulation of his certainty equivalence theorem and John Muth’s study of rational expectations. It is ironic that a decade-long government planning contract employing Carnegie professors and graduate students underwrote the two key modeling strategies for the Nobel-prize winning demonstration that the rationality of consumers renders government intervention to increase employment unnecessary and harmful.