Methodological seduction

Mainly for macroeconomists or those interested in economic methodology. I first summarise my discussion in two earlier posts (here and here), and then address why this matters.

If there is such a thing as the standard account of scientific revolutions, it goes like this:

1) Theory A explains body of evidence X

2) Important additional evidence Y comes to light (or just happens)

3) Theory A cannot explain Y, or can only explain it by means which seem contrived or ‘degenerate’. (All swans are white, and the black swans you saw in New Zealand are just white swans after a mud bath.)

4) Theory B can explain X and Y

5) After a struggle, theory B replaces A.

For a more detailed schema due to Lakatos, which talks about a theory’s ‘core’ and ‘protective belt’ and tries to distinguish between theoretical evolution and revolution, see this paper by Zinn which also considers the New Classical counterrevolution.

The Keynesian revolution fits this standard account: ‘A’ is classical theory, Y is the Great Depression, ‘B’ is Keynesian theory. Does the New Classical counterrevolution (NCCR) also fit, with Y being stagflation?

My argument is that it does not. Arnold Kling makes the point clearly. In his stage one, Keynesian/Monetarist theory adapts to stagflation, using the Friedman/Phelps accelerationist Phillips curve. Stage two involves rational expectations, the Lucas supply curve and other New Classical ideas. As Kling says, “there was no empirical event that drove the stage two conversion.” I think from this that Paul Krugman also agrees, although perhaps with an odd quibble.

Now of course the counter revolutionaries do talk about the stagflation failure, and there is no dispute that stagflation left the Keynesian/Monetarist framework vulnerable. The key question, however, is whether points (3) and (4) are correct. On (3) Zinn argues that changes to Keynesian theory to account for stagflation were progressive rather than contrived, and I agree. I also agree with John Cochrane that this adaptation was still empirically inadequate, and that further progress needed rational expectations (see this separate thread), but as I note below the old methodology could (and did) incorporate this particular New Classical innovation.

More critically, (4) did not happen: New Classical models were not able to explain the behaviour of output and inflation in the 1970s and 1980s, or in my view the Great Depression either. Yet the NCCR was successful. So why did (5) happen, without (3) and (4)?

The new theoretical ideas New Classical economists brought to the table were impressive, particularly to those just schooled in graduate micro. Rational expectations is the clearest example. Ironically the innovation that had allowed conventional macro to explain stagflation, the accelerationist Phillips curve, also made it appear unable to adapt to rational expectations. But if that was all, then you need to ask why New Classical ideas could have been gradually assimilated into the mainstream. Many of the counter revolutionaries did not want this (as this note from Judy Klein via Mark Thoma makes clear), because they had an (ideological?) agenda which required the destruction of Keynesian ideas. However, once the basics of New Keynesian theory had been established, it was quite possible to incorporate concepts like rational expectations or Ricardian Eqivalence into a traditional structural econometric model (SEM), which is what I spent a lot of time in the 1990s doing.

The real problem with any attempt at synthesis is that a SEM is always going to be vulnerable to the key criticism in Lucas and Sargent, 1979: without a completely consistent microfounded theoretical base, there was the near certainty of inconsistency brought about by inappropriate identification restrictions. How serious this problem was, relative to the alternative of being theoretically consistent but empirically wide of the mark, was seldom asked.   

So why does this matter? For those who are critical of the total dominance of current macro microfoundations methodology, it is important to understand its appeal. I do not think this comes from macroeconomics being dominated by a ‘self-perpetuating clique that cared very little about evidence and regarded the assumption of perfect rationality as sacrosanct’, although I do think that the ideological preoccupations of many New Classical economists has an impact on what is regarded as de rigueur in model building even today. Nor do I think most macroeconomists are ‘seduced by the vision of a perfect, frictionless market system.’ As with economics more generally, the game is to explore imperfections rather than ignore them. The more critical question is whether the starting point of a ‘frictionless’ world constrains realistic model building in practice.

If mainstream academic macroeconomists were seduced by anything, it was a methodology - a way of doing the subject which appeared closer to what at least some of their microeconomic colleagues were doing at the time, and which was very different to the methodology of macroeconomics before the NCCR. The old methodology was eclectic and messy, juggling the competing claims of data and theory. The new methodology was rigorous! 

Noah Smith, who does believe stagflation was important in the NCCR, says at the end of his post: “this raises the question of how the 2008 crisis and Great Recession are going to affect the field”. However, if you think as I do that stagflation was not critical to the success of the NCCR, the question you might ask instead is whether there is anything in the Great Recession that challenges the methodology established by that revolution. The answer that I, and most academics, would give is absolutely not – instead it has provided the motivation for a burgeoning literature on financial frictions. To speak in the language of Lakatos, the paradigm is far from degenerate.  

Is there a chance of the older methodology making a comeback? I suspect the place to look is not in academia but in central banks. John Cochrane says that after the New Classical revolution there was a split, with the old style way of doing things surviving among policymakers. I think this was initially true, but over the last decade or so DSGE models have become standard in many central banks. At the Bank of England, their main model used to be a SEM, was replaced by a hybrid DSGE/SEM, and was replaced in turn by a DSGE model. The Fed operates both a DSGE model and a more old-fashioned SEM. It is in central banks that the limitations of DSGE analysis may be felt most acutely, as I suggested here. But central bank economists are trained by academics. Perhaps those that are seduced are bound to remain smitten.