Macroeconomics and Ideology

Jo Michell has a long post in which he enters in a debate between Ann Pettifor and myself about the role of mainstream macroeconomics in austerity. Ann wanted to pin a large part of the blame for austerity on mainstream macroeconomics, and Jo largely sides with her. Now I have great respect for Jo’s attempts to bridge the divide between mainstream and heterodox economics, but here he is both wrong about austerity and also paints a rather distorted picture of the history of macroeconomic thought.

Let’s start with austerity. I think he would agree that the consensus model of the business cycle among mainstream Keynesians for the last decade or two is the New Keynesian (NK) model. That model is absolutely clear about austerity. At the zero lower bound (ZLB) you do not cut government spending. It will reduce output. No ifs or buts.

So to argue that mainstream macro was pushing for austerity you would have to argue that mainstream economists thought the NK model was deficient in some important and rather fundamental respect. This was just not happening. One of, if not the, leading macroeconomist of the last decade or two is Michael Woodford. His book is something of a bible for those using the New Keynesian model. In June 2010 he wrote “Simple Analytics of the Government Expenditure Multiplier”, showing that increases in government spending could be particularly effective at the ZLB. The interest in that paper for those working in this area was not in that this form of fiscal policy would have some effect - that was obvious to those like myself working on monetary and fiscal policy using the NK model - but that it could generate very large multipliers.

This consensus that austerity would be damaging and fiscal stimulus useful was a major reason why we had fiscal stimulus in the UK and US in 2009, and why even the IMF backed fiscal stimulus in 2009. There were some from Chicago in particular who argued against that stimulus, but as bloggers like DeLong, Krugman and myself pointed out, they simply showed up their ignorance of the NK model. Krugman in particular was very familiar with ZLB macro, having done some important work on Japan’s lost decade.

What changed this policy consensus in 2010 was not agitation from the majority of mainstream academic macroeconomists, but two other events: the Eurozone crisis and the election of right wing governments in the UK and US Congress.

Jo tries to argue that because discussion of the ZLB was not in the macroeconomic textbooks, it was not part of the consensus. But textbooks are notorious for being about 30 years out of date, and most still base their teaching around IS/LM rather than the NK model. Now it might just be possible that right wing policy makers were misled by the consensus assignment taught in these textbooks, and that it was just a coincidence that these policy makers chose spending cuts rather than tax increases (and later tax cuts!), but that seems rather unlikely. You do not have to be working in the field to realise that the pre-financial crisis consensus for using changes in interest rates as the stabilisation tool of choice kind of depended on being able to change interest rates!

Moving on from austerity, Jo’s post also tries to argue that mainstream macroeconomics has always been heavily influenced by neoliberal ideology. To do that he gives a short account of the post-war history of macroeconomic thought that has Friedman, well known member of the Mont Pelerin society, as its guiding light, at least before New Classical economics came along. There is so much that could be said here, but let me limit myself to two points.

First, the idea that Keynesian economics was about short term periods of excess or deficient demand rather than permanent stagnation pre-dated Friedman, and goes back to the earliest attempts to formalise Keynesian economics. It was called the neoclassical consensus. It was why the Keynesian Bob Solow could give an account of growth theory that assumed full employment.

Second, the debates around monetarism in the 1970s were not about the validity of that Keynesian model, but about its parameters and policy activism. Friedman’s own contributions to macroeconomic theory, such as the permanent income hypothesis and the expectations augmented Phillips curve, did not obviously steer theory in a neoliberal direction. His main policy proposal, targeting the money supply, lost out to policy activism using changes to interest rates. And Friedman certainly did not approve of New Classical views on macroeconomic policy.

Jo may be on firmer ground when he argues that the neoliberal spirit of the 1980s might have had something to do with the success of New Classical economics, but I do not think it was at all central. As I have argued many times, the New Classical revolution was successful because rational expectations made sense to economists used to applying rationality in their microeconomics, and once you accept rational expectations then there were serious problems with the then dominant Keynesian consensus. I suppose you could try to argue a link between the appeal of microfoundations as a methodology and neoliberalism, but I think it would be a bit of a stretch.

This brings me to my final point. Jo notes that I have suggested an ideological influence behind the development of Real Business Cycle (RBC) theory, but asks why I stop there. He then writes

“It’s therefore odd that when Simon discusses the relationship between ideology and economics he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. The beliefs of the latter group are, Simon suggests, ideological, while those of the former group are based on ideology-free science. This strikes me as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable.”

This misses a crucial distinction. The whole rationale of RBC theory was to show that business cycles were just an optimal response to technology shocks in a market clearing world. This would always deny an essential feature of business cycles, which is involuntary unemployment (IU). It is absurd to argue that NK theory denies all the things on Jo’s list. Abstraction is different from denial. The Solow model does not deny the existence of business cycles, but just assumes (rightly or wrongly) that they are not essential in looking at aspects of long term economic growth. Jo is right that the very basic NK model does not include IU, but there is nothing in the NK model that denies its possibility. Indeed it is fairly easy to elaborate the model to include it.

Why does the very basic NK model not include IU? The best thing to read on this is Woodford’s bible, but the basic idea is to focus on a model that allows variations in aggregate demand to be the driving force behind business cycles. I happen to think that is right: that is what drives these cycles, and IU is a consequence. Or to put it another way, you could still get business cycles even if the labour market always cleared.

To suggest, as Jo seems to, that the development of NK models had something to do with the Third Way politics of Blair and Bill Clinton is really far fetched. It was the inevitable response to RBC theory and its refusal to incorporate rigid prices, for which there is again strong evidence, and its inability to allow for IU.

That’s all. I do not want to talk about globalisation and trade theory partly because it is not my field, but also because I suspect there is some culpability there. I would also never want to suggest, as Jo implies I would, that ideological influence is confined to the New Classical part of macroeconomics. But just as it is absurd to deny any such influence, it is also wrong to imagine that the discipline and ideology are inextricably entwined. 2010 austerity is a proof of that.

Will the financial crisis lead to another revolution in macroeconomics?

This question was prompted both by an earlier post, and by reading Martin Wolf’s excellent 2013 Wincott Memorial lecture. (The response by Robert Skidelsky is also worth reading.) In the lecture he in characteristic style tries to demolish the idea that we have permanently lost a large amount of productive potential, and also argues that we need to fundamentally rethink the role of the financial sector. Bravo to that. He also says that the financial crisis “calls for an intellectual upheaval reminiscent of the response to depression in 1930s and then to inflation in the 1970s.” It is this last idea that I want to explore here.

That the depression led to Keynesian economics, and that this revolutionised macroeconomics, cannot be disputed. If the great inflation of the 1970s did a similar thing, then we might indeed expect something similar to follow from the financial crisis of 2007-9. Yet it is far from clear to me that it did. It greatly increased, for a while, the popularity of monetarism, but in theoretical terms that was hardly revolutionary (it used IS-LM), and its popularity died out pretty quickly. The adoption of monetary policy as the stabilisation tool of choice owed something to monetarism, but it probably owed much more to the move to flexible exchange rates when Bretton Woods collapsed. Friedman’s reinterpretation of the Phillips curve was important, but it was not revolutionary.

There was a revolution in macroeconomics in the 1970s and 1980s, but it was a counter revolution, as the name New Classical implies. It was essentially a revolution inspired by theory (rational expectations, and microfoundations more generally), rather than external events. There is no obvious link with the great inflation of the 1970s. Indeed, the RBC model that embodied most of the ideas of that revolution had essentially nothing to say about inflation.

So, in this straightforward sense, the great inflation of the 1970s did not lead to a revolution in macroeconomic thought. This suggests that there is no inevitability that the financial crisis will lead to any revolution in macroeconomics. Everyone admits that mainstream macro analysis took finance for granted before the crash, and those economists that did worry about such things were marginalised. (I would want to add Greenwald and Stiglitz to the usual list.) But now ‘financial frictions modelling’ is the growth area within the discipline. However this explosion of work does not appear revolutionary, but just another example of adding particular ‘frictions’ or ‘market imperfections’ to standard models.

As yet there is no sign that the financial crisis is about to lead to any paradigm shift in macro, even if some might wish it so. I can think of three ways the reaction to the financial crisis could lead to major evolutionary changes over time. First, it may end the tyranny of the consumption Euler equation, and finally give agent’s asset positions the key role they deserve in understanding their behaviour. (See this earlier post of mine, or this more recently from Noah.) Second, the need to incorporate financial frictions, and other balance sheet effects for households and firms, while retaining the many essential features of the macroeconomy (e.g. labour market search, sticky prices) may require (for tractability) a gradual softening of the microfoundations methodology. I doubt that this will involve any sudden change, but just the increasing use of tricks like Calvo contracts that allow modellers to use aggregate equations that work empirically. Third, and most speculatively, I suspect we will see real attempts to model in a behavioural way changing attitudes to risk.

So, just as the great inflation of the 1970s in itself led to an evolution rather than a revolution in macro, we might see something similar following the Great Recession. However, to be a little controversial, perhaps there is a more indirect link between the great inflation and the New Classical revolution, which involves ideology. I think you could argue that the events of the 1970s led to an intellectual revolution in the sense of promoting neoliberalism and questioning the value of collective action in the form of both state intervention and trade unionism. That did not require any revolution in economics, because it came from (a selective reading of) the existing economics playbook. However you could argue (in a rather functionalist way) that Keynesian economics was too great a counterexample to the neoliberal view of the world, and therefore had to be overturned. A counterrevolution was required. I’m not sure how important this is, because I still think the main reason New Classical ideas won out against traditional Keynesian theory was that they won the intellectual argument. However I have also learnt in the last few years not to underestimate the role of ideology in economics. 

If you think this argument has some merit, then you might continue as follows. Although the financial crisis may not have exposed fundamental flaws in macroeconomics (just fundamental gaps), it should have exposed the failure of neoliberalism as an ideology. Finance was the poster boy of neoliberalism, where unfettered rewards and deregulation would generate innovation that helped fuel economic growth. The financial crisis led to the complete collapse of that story, with the whole sector having to be rescued by the state, and causing a prolonged recession. Yet the growing rewards continue regardless. It is now clear that these excessive rewards come not from innovative dynamism but either from rent seeking, or from risk taking supported by an implicit state subsidy (pdf). While the political forces that benefited from neoliberalism are strong, the bankruptcy of that ideology, and the harm done by the inequality it generated, are too great a truth to be resisted for long.

If that turns out to be true, then there may be some implications for macro. Theories that find support not from evidence but from the neoliberal positions they help justify may begin to be seen as the unacceptable face of the discipline. Conformity with most rather than just some of the evidence may start to matter more than conformity with a simple microeconomics that idealises the market. But this sounds too much like wishful thinking, so I suspect there is something wrong with the argument!

Misinterpreting the history of macroeconomic thought

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 behaviour in terms of optimisation 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.