Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 11 July 2014

Rereading Lucas and Sargent 1979

Mainly for macroeconomists and those interested in macroeconomic thought

Following this little interchange (me, Mark Thoma, Paul Krugman, Noah Smith, Robert Waldman, Arnold Kling), I reread what could be regarded as the New Classical manifesto: Lucas and Sargent’s ‘After Keynesian Economics’ (hereafter LS). It deserves to be cited as a classic, both for the quality of ideas and the persuasiveness of the writing. It does not seem like something written 35 ago, which is perhaps an indication of how influential its ideas still are.

What I want to explore is whether this manifesto for the New Classical counter revolution was mainly about stagflation, or whether it was mainly about methodology. LS kick off their article with references to stagflation and the failure of Keynesian theory. A fundamental rethink is required. What follows next is I think crucial. If the counter revolution is all about stagflation, we might expect an account of why conventional theory failed to predict stagflation - the equivalent, perhaps, to the discussion of classical theory in the General Theory. Instead we get something much more general - a discussion of why identification restrictions typically imposed in the structural econometric models (SEMs) of the time are incredible from a theoretical point of view, and an outline of the Lucas critique.

In other words, the essential criticism in LS is methodological: the way empirical macroeconomics has been done since Keynes is flawed. SEMs cannot be trusted as a guide for policy. In only one paragraph do LS try to link this general critique to stagflation:

“Though not, of course, designed as such by anyone, macroeconometric models were subjected to a decisive test in the 1970s. A key element in all Keynesian models is a trade-off between inflation and real output: the higher is the inflation rate, the higher is output (or equivalently, the lower is the rate of unemployment). For example, the models of the late 1960s predicted a sustained U.S. unemployment rate of 4% as consistent with a 4% annual rate of inflation. Based on this prediction, many economists at that time urged a deliberate policy of inflation. Certainly the erratic ‘fits and starts’ character of actual U.S. policy in the 1970s cannot be attributed to recommendations based on Keynesian models, but the inflationary bias on average of monetary and fiscal policy in this period should, according to all of these models, have produced the lowest unemployment rates for any decade since the 1940s. In fact, as we know, they produced the highest unemployment rates since the 1930s. This was econometric failure on a grand scale.”

There is no attempt to link this stagflation failure to the identification problems discussed earlier. Indeed, they go on to say that they recognise that particular empirical failures (by inference, like stagflation) might be solved by changes to particular equations within SEMs. Of course that is exactly what mainstream macroeconomics was doing at the time, with the expectations augmented Phillips curve.

In the schema due to Lakatos, a failing mainstream theory may still be able to explain previously anomalous results, but only in such a contrived way that it makes the programme degenerate. Yet, as Jesse Zinn argues in this paper, the changes to the Phillips curve suggested by Friedman and Phelps appear progressive rather than degenerate. True, this innovation came from thinking about microeconomic theory, but innovations in SEMs had always come from a mixture of microeconomic theory and evidence. 

This is why LS go on to say: “We have couched our criticisms in such general terms precisely to emphasise their generic character and hence the futility of pursuing minor variations within this general framework.” The rest of the article is about how, given additions like a Lucas supply curve, classical ‘equilibrium’ analysis may be able to explain the ‘facts’ about output and unemployment that Keynes thought classical economics was incapable of doing. It is not about how these models are, or even might be, better able to explain the particular problem of stagflation than SEMs.

In their conclusion, LS summarise their argument. They say:

“First, and most important, existing Keynesian macroeconometric models are incapable of providing reliable guidance in formulating monetary, fiscal and other types of policy. This conclusion is based in part on the spectacular recent failures of these models, and in part on their lack of a sound theoretical or econometric basis.”

Reading the paper as a whole, I think it would be fair to say that these two parts were not equal. The focus of the paper is about the lack of a sound theoretical or econometric basis for SEMs, rather than the failure to predict or explain stagflation. As I will argue in a subsequent post, it was this methodological critique, rather than any superior empirical ability, that led to the success of this manifesto.



16 comments:

  1. I feel like these 1 paragraph comments on recent events happen quite often. Most economic theory is fairly esoteric. These references are maybe more to interest readers than to fit with the whole paper.

    I wonder how many papers in recent years read something like "Since the financial crisis..." and barely deal with anything about the crisis?

    ReplyDelete
  2. Here are some more Krugman blogs on the same topic:

    1. December 13, 2013 Rudi Dornbusch and the Salvation of International Macroeconomics (Wonkish)
    2. October 16, 2013 Fallacies of Immaculate Causation
    3. January 18, 2012 Currencies, Prices, and Mike Mussa (A Bit Wonkish)
    4. January 2, 2012 Hermetic Economic Cults (Wonkish)
    5. December 24, 2011 Exchange Rates and Wages
    6. December 23, 2011 New Frontiers in Economic Barbarism
    7. September 28, 2011 History Roolz

    ReplyDelete
    Replies
    1. Good links:

      "I suspect that evidence like this is one reason international macroeconomists have been less likely than domestic macro types to march off into the dreamworld of real business cycles and all that."

      But basically LS don't believe in stick prices and that activist Keynesian policy causes stagflation?

      Delete
    2. Krugman "I don’t mean to argue that this is the only good way to think about these issues; old-fashioned IS-LM is actually a surprisingly powerful tool of analysis, and it’s by no means clear that fancier models are an improvement. But O-R was a model with all the eyes crossed and teas dotted, and it showed that even so fiscal policy could affect demand. No economist who had read Obstfeld-Rogoff, or was even vaguely aware of what they and many others working in the New Keynesian domain had been doing, could have said what Fama, Cochrane, and Lucas did."

      Doesn't this sort of argue against the heterodox who say New Keynesians downplays the role of fiscal policy in favor of monetary policy?

      http://www.thomaspalley.com/docs/research/milton-friedman-062014.pdf

      Delete
  3. “First, and most important, existing Keynesian macroeconometric models are incapable of providing reliable guidance in formulating monetary, fiscal and other types of policy. This conclusion is based in part on the spectacular recent failures of these model..."

    Surely, now, 30 years lager we should change "Keynesian macroeconometric models" in the above paragraph to "Dynamic Stochastic General Equilibrium" models"?

    And this -

    "...and in part on their lack of a sound theoretical or econometric basis.”

    People should be asking, now, at last, what does this really mean?

    ReplyDelete
  4. The justifications that Lucas and Sargent gave may not be the reasons that the general mass of economists accepted the New Classical revolution as necessary.

    ReplyDelete
    Replies
    1. Of course, but by the mid 1980s traditional macro had a model that incorporated stagflation, and New Classical/microfounded macro was still a work in progress. So why did everyone start doing microfounded macro? I think if you asked the typical macro PhD at the time, they would have been more likely to say the Lucas critique than stagflation.

      Delete
  5. L&S weren't just critical of the "Keynesian" models, they mock the General Theory's mere "'talk' about economic activity," and look forward to a scientific economics built around mathematical models that are clear, logically consistent, and testable by means of econometric techniques.

    What would Keynes have said in reply? Something like this. King Ptolemy gathered seventy scholars together and gave each one an ancient Hebrew text. He placed them in separate rooms and told them, one-at-a-time, to translate the Hebrew text into Greek. And, lo and behold, they emerged with seventy identical translations.

    Now let's suppose we put seventy econometricians into separate rooms, each one with the same model and the same data, and each one of these econometricians having “a different economist perched on his a priori.” Would we expect the same miracle of consistency?

    ReplyDelete
  6. It's as if there was an impetus for "positive" economics stripped of "normative" considerations and presenting itself as "objective."

    http://www.interfluidity.com/v2/5486.html

    ReplyDelete
  7. All of this discussion assumes to too great an extent that the battleground is entirely or primarily the realm of ideas. I was on the faculty of the University of Minnesota for almost two decades, hence very well acquainted with the nature of the graduate program there, although not a participant on the macro side. Whatever one may think about the main tenets of Keynesian economics, the dominant perception (and I never saw much reason to doubt this) was that Keynesian economics had run out of steam as a mode of training for certifying new Ph.D.'s who could join the academy at a high level as researchers and instructors of macroeconomics. Even if you think that the scientific value of the Minnesota methodology is slight at best, the people who worked in that mode had to confront significant technical challenges, the best were better than the others in ways that were easy to discern, and they could go on to respectable (both for themselves and the institutions that hired them) careers of doing more of it.

    With that sort of pipeline into the profession, shouldn't you expect macroeconomics to be increasingly dominated by people who were, due to some combination of self selection and self interest, positively disposed towards the views of their intellectual leaders?

    A lot of freshwater silliness (Lucas islands, all unemployment is voluntary, business cycle fluctuations are primarily due to shocks that have us sometimes forgetting 2% of our technical knowledge year-over-year, etc.) derived from a desire to promote a research program that couldn't possibly work otherwise. Most would now agree that the facts don't support these ideas, but actually that was pretty obvious back then, it's just that the pure power of ideas wasn't all that was at work. And it's no coincidence that a large fraction of the people who we now call macroeconomists apply this methodology to issues unrelated to business cycles.

    Stepping back a bit, it's important to bear in mind that while contemporary Keynesians are absolutely correct that fresh water business cycle theory is a scientific failure, their main recent positive contribution (adding frictions to a DSGE model, a la Smet and Wouters) is an obvious kludge. The work of Truman Bewley, and, more dramatically, 25% unemployment in Spain and Greece that persists for years on end, should convince the scientifically minded that our understanding of the labor market is hopelessly inadequate as a foundation for business cycle theorizing. This point is insufficiently stressed, perhaps because on the Keynesian side as well the selection process that leads some people to become macroeconomists is strongly biased in favor of those who think we already have some sort of solid or reliable knowledge.

    ReplyDelete
  8. So their argument was that
    1. Keynes was wrong because there was stagflation.
    2. The simple Phillips curve mechanism of "unemployment avoids inflation" wasn't true.
    3. Microfoundations are necessary because only then do we get a world of inflation and unemployment

    In my opinion, it's a pretty weak argument to throw away 40 years of Keynesianism, since the simultaneity of unemplyoment and inflation could also be explained by the oil supply shock and adaptive inflation expectations. They make a good argument for expanding the Keynesian framework, but the Neoclassical (Counter-)Revolution was unnecessary.
    Anyway, didn't Volcker's disinflation policy prove the general correctness of the Phillips curve?

    ReplyDelete
  9. I think PHDs in economics, especially macroeconomics, are routes for applied mathematicians into high paying jobs in the finance industry - such as in derivatives trading. The more the graduate student body looks like this, the more they will make it look like a PHD in applied mathematics. New Classical economics provides the perfect working framework for such people. They can use maths without really understanding the first thing about any economy anywhere. Long books, wordy discussions painfully reconstructing all the factors behind what caused the financial crisis, building up a comprehensive narrative, and how to deal with it? Forget it.

    Of course macro needs quantitative models. You need to estimate the effect of tax rises on the economy to formulate national budgets. But before the construction of such a model, you need well and widely informed qualitative analysis.

    ReplyDelete
  10. I remember reading a snarky comment by a mathematician to the effect that the reason for the existence of economics departments was so that second-rate mathematicians could be professors and have tenure too.

    I personally note that although it's great snark (not without a grain of truth) I would be willing to bet that whoever said that would have had no more success advancing our knowledge of how the economy works than anyone else, and probably less. Math is indispensable by not sufficient.

    ReplyDelete
  11. It is not counter-revolution in theory; it represents reaction in politics.

    ReplyDelete
  12. You have structure and you have trends and relationships in structure. The risks are three fold..
    1: the trend and relationships may be changing at one level while remaining constant at another which makes regression analysis of stationary relationships difficult.
    2 Points in time are not wholly independent and are likely, in a decaying way, dependent which makes a prob distribution analysis of the distribution of outcomes non sensical and gives rise to the "shifting distribution risk".
    3. There are very real changes and events that while a product of the structure cannot be forecast by the structure and hence have no basis other than in their randomness in the data.

    We need to get closer to the structure, understand the trends and relationships and how this may or may not impact statistical structures and adjust for dynamics within our modelling. We need models but we need to get close to structure and structural risks insteaed of assumung these away with a dependence on gen eq and independent randomness

    ReplyDelete

Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.