Was the neoclassical synthesis unstable?

This post presents a very simple story of the development of macroeconomic thought from Keynes until today. It is related to a recent post from Brad DeLong on ‘economic theology’ and the neoclassical synthesis. (See also a response from Robert Waldmann.) 

Economics as a science that studies markets is ideologically neutral. Economic theory can be used to support ‘unfettered’ markets, or it can be used to justify interventions to avoid various kinds of market failure. The former means that it will inevitably be used by some to support a laissez-faire ideological position. There are two checks against this one-sided presentation of economic theory: economists presenting alternative theories that embody imperfections, and the use of evidence to show that a particular theory works, either in terms of its assumptions or results.

Before considering macroeconomics, take an example from labour economics: the minimum wage. Standard competitive theory suggests a minimum wage will reduce employment and raise unemployment. Card and Krueger undertook a famous study suggesting that in one particular example where the minimum wage was increased there was no reduction in employment. That led to a substantial amount of additional research, much (but by no means all) backing up the result that the impact of moderate increases in the minimum wage on employment was either non-existent or very small. For similar developments in the UK, see this account by Alan Manning. This empirical evidence was sufficient to encourage the development of alternative theoretical models: principally but not only monopsony.

So here we see theory and evidence interacting in a Popperian type way, hopefully leading to better theory. [1] Yet with economics there will always be ideological resistance, so there will always be those who want to stick to the basic model and who select those empirical studies that support it. For the discipline to survive, those ideologues have to be a minority. But even if this condition is met, a healthy discipline has to recognise the influence of that minority, rather than try and pretend it does not exist or does not matter.

There is a slight twist for macroeconomics. As governments are the monopoly providers of cash, and provide a backstop to the financial system, they are involved in the ‘market’ whether they like it or not. Complete non-intervention is not an option: instead the next best thing (from a laissez-faire point of view) is some kind of ‘neutral’ default policy rule, like keeping the stock of money constant.

The Great Depression was the empirical wake-up call (the equivalent of the Card and Krueger study) for macroeconomics. So profound was the impact of this empirical event that it led to a whole new way of doing the subject. Keynesian economics was methodologically different from much of microeconomics: it put much more weight on aggregate evidence (through time series econometrics), and much less on microeconomic theory. One way of putting this is that in the 1960s, general equilibrium theory of the Arrow-Debreu-McKenzie type seemed a complete contrast to what macroeconomists were doing. That an event as powerful as the Great Depression should have had such a profound methodological impact is not really surprising.

The Great Depression also meant that those advocating non-intervention had to make an exception of macroeconomics. It was for the generation after the Great Depression abundantly clear that here was a colossal market failure. This is one sense in which the term neo-classical synthesis can be used: to allow the state to combat the market failure represented by Keynesian unemployment (albeit, in the case of Friedman, in as rule like way as possible), but to maintain advocacy of non-intervention elsewhere. Note however that this is a synthesis servicing a particular ideological point of view, rather than being anything inherent within economics as a discipline.

Was this ‘ideological synthesis’ tenable among those supporting the ideology? There were two natural tensions. First, the position that macro intervention should be rule based and minimal was contestable. Second and more importantly, as the memory of the Great Depression faded (and neoliberalism spread), the temptation grew to ask ‘do we really have to accept the need for state intervention at the macro level’. However I’m not sure the latter would have become critical had it not been for another tension within macroeconomics itself. 

What was not tenable from a methodological point of view was the distance between the very empirical orientation of macroeconomics, and the more axiomatic foundation of much of microeconomics. What was required here was a different kind of synthesis, one which allowed for a healthy dialogue between theory and evidence. My impression is that in many areas of microeconomics this happened: that is partly why I gave the minimum wage example, but it is also worth noting that general equilibrium theory lost the primacy that it might once had among microeconomists. But these are impressions, and I’ll happily be corrected.

I think the same thing could have happened in macroeconomics. Heterodox economists (and Robert Waldmann) would almost certainly disagree, but I think macroeconomics has gained a great deal from the project to add microfoundations. Where I hope heterodox economists would agree is that a dialogue where theorists engaged with macroeconomics and tried to persuade macroeconomists of the importance of following particular theories would have been healthy. But that was not the way it turned out. What could have been a dialogue of the Popperian kind became instead a theoretical and methodological counter revolution. Instead of asking ‘what can we do to get better microfoundations for sticky prices’, the assertion became ‘without good microfoundations we should ignore sticky prices’.

Why was there a counter revolution in macro rather than a Popperian dialogue? I think it is here that the second tension in the ‘ideological synthesis’ I identified above is important. Those who wanted to dispute the need for macro intervention realised that the microfoundations for macro market failures that existed at the time were poor (adaptive expectations in a traditional Phillips curve), and so any macroeconomics based on ‘rigorous’ (textbook, imperfection free) microfoundations would not be Keynesian. They also realised that they could produce models which generated real business cycles which were entirely efficient. These models assumed all unemployment was voluntary, which in any normal science would lead to their rejection, but in an axiomatic based approach where some evidence can be ignored it was acceptable.

New Classical economics did not want to improve Keynesian economics, but to overthrow it. It is very difficult to believe this motivation was not ideological. Does the fact that this counter revolution was largely successful among academic macroeconomists imply that the majority of macroeconomists shared this ideological outlook? I suspect not. What New Classical economists succeeded in doing was framing the issue as one where a choice had to be made, between an eclectic empirically orientated approach where theory was weak and empirical methods shaky, and an alternative whose methodological foundations were solidly based within the discipline of economics. So we moved from a position where macroeconomics and Arrow-Debreu-McKenzie seemed worlds apart, to one where at least some see the former arising naturally from the latter. Ironically this happened at the same time as many microeconomists saw Arrow-Debreu-McKenzie as less relevant to what they did.

Of course we have moved on from the 1980s. Yet in some respects we have not moved very far. With the counter revolution we swung from one methodological extreme to the other, and we have not moved much since. The admissibility of models still depends on their theoretical consistency rather than consistency with evidence. It is still seen as more important when building models of the business cycle to allow for the endogeneity of labour supply than to allow for involuntary unemployment. What this means is that many macroeconomists who think they are just ‘taking theory seriously’ are in fact applying a particular theoretical view which happens to suit the ideology of the counter revolutionaries. The key to changing that is to first accept it.

[1] By Popperian type, I just mean that a theory proves inconsistent with data and so a better theory is developed. The Popperian ideal where one piece of evidence (one black swan) is enough on its own to disprove a theory is never going to apply in economics (if it applies anywhere), because evidence is probabilistic and fragile. There are no black swans in economics.