The dangers of pluralism in economics: the case of MMT

MMT (Modern Monetary Theory) is a ‘school of thought’ in economics, by which I mean that it deliberately sets itself apart from the mainstream. I like a lot about MMT as a set of ideas. On the key issue of whether monetary or fiscal policy should be used as the main stabilising tool, although I go with the mainstream in looking to monetary policy outwith the lower bound, I think that issue should always be kept open, and too many mainstream economists just presume that monetary policy must be better. I am also attracted to the idea of some version of a Job Guarantee type scheme, and the mainstream has often failed to recognise the amount of autonomy the banking system has to create demand. I could go on but you get the idea. As I result, I have tried probably more than most mainstream economists to engage with MMT ideas.

As far as I can see there is nothing in MMT that cannot be presented using standard mainstream tools. But I also know that the microfoundations hegemony in mainstream macro excludes many, like MMT economists, who would prefer to do macro in different ways. I dislike the microfoundations hegemony for reasons I have set out elsewhere. For that reason I cannot argue that MMT, or any other school of thought, should be part of the mainstream, because right now it would be impossible because of the microfoundations hegemony. [1]

Having said all that, I think MMT sometimes demonstrates many of the dangers of a school of thought. It tends to be antagonistic to the mainstream, and some (not all) of its leading lights give their followers the idea that the only truth is to be found within MMT, and everything the mainstream says has to be wrong. That proposition is so absurd but I can understand why it can be believed. It was a long time ago, but I was told as a student that neoclassical economics was fundamentally flawed, and would soon be replaced in some kind of Kuhnian revolution. I know how easy it is to follow your political instincts and thereby miss out on so much important and useful knowledge.

It is very difficult not to come across MMT followers (MMTers) if you write a blog on macroeconomics. Most recently this happened when I wrote this on Trump’s tax cuts. Now unusually this post examined how to discuss these tax cuts split into two parts: one which followed the mainstream view where monetary policy controlled inflation, and another that described an MMT view where fiscal policy controls inflation.

My post was criticised by some MMTers on twitter. Not because I had got the MMT part wrong, but because I had argued in the mainstream part that a deficit generated by a tax cut could alter the intergenerational distribution of income. Now this idea is standard, but it can confuse, because you cannot transfer real resources (output) through time in a closed economy. I show how it can be done in an overlapping generations framework here. It is much easier to see how it can happen in an individual open economy, because a generation can consume overseas goods as well as domestically produced goods.

If that all seems a bit abstract, it is also important. I have argued in the past that one of Margaret Thatcher’s failures was to give taxes from the North Sea back to consumers (who spent rather than saved them) instead of following Norway in creating a sovereign wealth fund. Subsequent generations have therefore been deprived of the benefits of North Sea oil. By giving tax cuts funded by borrowing, governments can do the opposite of creating a sovereign wealth fund: future generations inherit more government debt which they have to service.

Those MMTers criticising my blog said such intergenerational transfer was impossible. I tried the best I could to explain why it was possible, but the responses I got ranged from intelligent denialism to simple insults along the lines that I was neoliberal, I didn’t care about the working class and so on.

I’m used to that kind of interchange as a result of Brexit. But there was an important difference here. I was not attacking MMT, but outlining how things work in a mainstream view. So I was not attacking their school or their politics. They had no reason to be defensive. But it was clear to some that I was the enemy simply because I was not an MMTer. This very tribal attitude reflects one of the dangers of plurality in economics. Another is language. MMTers have their own way of describing things, so if you say something like a ‘tax financed increase in government spending’ you are jumped on: according to MMT tax never finances spending, but follows it, or something like that. I don’t mean to make fun, and I can see what they are trying to do, but talking separate languages is a key problem when you have different schools of thought, particularly if you insist that only your language is the right language.

Another problem is that schools of thought also tend to be political. As a result, to use Paul Romer’s phrase, all too often scientific discourse is replaced by political discourse. To some of these MMTers because I was a mainstream economist I had to be neoliberal, as if those two things had to go together. The idea that deficits could redistribute income between generations moved from being an economic statement to a political one. Presenting models that showed how it could happen meant those models had to be unrealistic, without specifying why that lack of realism mattered to the issue in hand.

It is a shame, because these MMTers are clearly interested in economics because of their political interest, so I would love them to be discussing both mainstream as well as MMT ideas. I probably spent too much time on twitter with them as a result. Those that tell them the mainstream is neoliberal and a waste of time are in my view almost criminal because that attitude leads to such a waste of enthusiasm and interest.

It does not have to be like this. I have had plenty of good discussions with MMT academics and some supporters which I have found interesting. They have been courteous and not aggressive. But not all the leading lights in MMT encourage these things. Such as those who write

“Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff.”

He wrote that, and worse still which I will not repeat, because he is angry that Labour have adopted a fiscal rule based on my own work with Jonathan Portes rather than MMT’s ideas. Actually I didn’t enjoy the conversations he is referring to at all, and I should have stopped much earlier because it was a waste of time, but as I said above it is a shame to see people who have closed themselves off to so much interesting and, for them, politically useful knowledge.

As I said, I do not blame anyone being in a macroeconomic school of thought because the current mainstream is exclusionary. Many MMTers are open and my discussions with them have been interesting for me at least. But unfortunately some in MMT appear to want to make it a kind of cult, where only MMT sees the truth and everything in the mainstream is neoliberal and wrong. They attract followers because of their politics, but then they turn their followers into converts with closed minds. Which I think is a real shame and completely unnecessary, because MMT is strong enough to stand on its own feet and encourage open minded thinking, not dogma.

[1] I do not think that is the only aspect of the mainstream that excludes other schools. There is too little room in mainstream journals to discuss policy or history in a discursive, holistic way. I happen to like the way most mainstream economists use models to discuss issues, but sometimes it is useful to make sure we are not abstracting from what is really important.

MMT and mainstream macro

There were a lot of interesting and useful comments on my last post on MMT, plus helpful (for me) follow-up conversations. Many thanks to everyone concerned for taking the time. Before I say anything more let me make it clear where I am coming from. I’m on the same page as far as policy’s current obsession with debt is concerned. Where I seem to differ from some who comment on my blog, people who say they are following MMT, is whether you need to be concerned about debt when monetary policy is not constrained by the Zero Lower Bound. I say yes, they say no, but for reasons I could not easily understand.

This was the point of the ‘nothing new’ comment. It was not meant to be a put down. It was meant to suggest that a mainstream economist like myself could come to some of the same conclusions as MMT writers, and more to the point, just because I was a mainstream economist does not mean I misunderstood how government financing works. It was because I was getting comments from MMT followers that seemed nonsensical to me, but which should not have been nonsensical because the basics of MMT are understandable using mainstream theory.

One comment on that earlier post provided a link to a very useful Nick Rowe post, who as ever has been there before me. This suggested that MMT assumed a vertical IS curve (there is no impact of interest rates on aggregate demand). If the IS curve is vertical, then it explains the puzzle I have. In the thought experiment I outlined in my previous post, if the government started swapping debt for money the decline in interest rates that would follow [1] would have no impact on demand, so there would be no rise in inflation. Indeed what else could it be besides an assumption of a vertical IS curve, as MMT does not deny that excess demand would lead to inflation at full employment.

I now think that is putting it too strongly. The view that many MMT writers have is that interest rates have an unreliable impact on demand relative to fiscal instruments. In that case of course you would have to use fiscal policy to control demand and inflation. That would be the focus of the fiscal rule. It is a similar regime to one I suggest would be appropriate for individual Eurozone countries. Inflation would be a discipline on deficit bias. [2]

What about a world where monetary policy did successfully control demand and inflation, which is the world I’m writing about? Evidence suggests you then need a fiscal rule stopping deficit bias (a gradual rise in the debt to GDP ratio over successive cycles). In a country with its own central bank (so no concern about forced default) and where all debt is owned domestically, the standard reasons why you would be concerned about deficit bias are intergenerational equity, crowding out of capital, and having to raise distortionary taxes to pay the higher debt interest bill.

There is a lot you can say on all three, but the point I want to make is simple. Being in that world means you do not need to worry about other sector balances because of their impact on demand. By being in that world at no point am I misunderstanding how government financing works, or ignoring the role of money. It does not mean I read the government budget constraint from left to right or vice versa! Yet I still get comments like this one left on a more recent post.

“Your political yourself Simon. One thing more than anything really annoys me. Why do you never announce or go public and say that taxes do not fund government spending?”

Comments like the one above, taken without context from some MMT paper, just appear stupid. By all means criticise my view that monetary policy is effective, or that rising debt has costs, but in future comments like that will just be ignored.

Let me make the same point using another example. Alex Douglas in a post argues that MMT does make an original contribution to political economy. He looks at a Warren Mosler claim that the state creates unemployment, and this is the only reason unemployment exists. It seems to me (with some additional help from Alex) that this involves two elements. The first sounds like a combination of points that mainstream economists might make: deficient demand exists because we are in a monetary economy, and some combination of monetary and fiscal policy can always get rid of deficient demand. The second is that money exists because the state requires taxes to be paid with it. Now I’m less sure about that second argument, but the point is that I can unpick what I agree with and what I do not using perfectly standard economic ideas. Yet if he had simply sent me a comment which said “the state currency is fundamentally a device for coercing labour” I wouldn’t have had a clue what he was talking about.

Now you might ask at this point why is it so important to be able to put MMT arguments in the language of standard macro. MMT is a coherent school of thought, using a language that those who have read the important texts understand. [3] Someone like me should just take the time out to read those texts. Well I have read some MMT papers, but I can assure you I have read many more than pretty well every mainstream macroeconomist I know. So what you may say. But it is a fact, and you may think it is an unfortunate fact, that mainstream macroeconomics is pretty dominant in both academic and policy circles. And it will stay that way: heterodox economists have been predicting the downfall of mainstream economics for longer than I have been an economist. [4] So if MMT is to have any influence, it will be through changing how mainstream macroeconomists think.

You gain that influence by properly understanding the mainstream. Bill Mitchell, writing in 2013, lambasts economists like me who try to suggest that the fixation with debt since 2010 does not come from mainstream macro. He does not believe it, and writes

“Why is there mass unemployment if government officials understood all our claims? It would be the ultimate example of venal dysfunctional politics to hold that that everybody knows all this stuff but are deliberately disregarding it – for what?”

But that is the tragedy of what has happened since 2010. Politicians, either out of panic or with ulterior motives, decided in countries with their own currencies that we should start worrying about the market no longer buying government debt, and austerity was the result. In this they were supported by a media that thought the government was like a household, and economists from the financial sector who had their own reasons for promulgating this myth. True, they did find support from some mainstream academic macroeconomists, but that support was never based on mainstream theory.

What mainstream theory says is that some combination of monetary and fiscal policy can always end a recession caused by demand deficiency. Full stop: no ifs or buts. That is why we had fiscal expansion in 2009 in the US, UK, Germany, China and elsewhere. The contribution of some influential mainstream economists to this switch from fiscal stimulus to austerity in 2010 was minor at most, and to imagine otherwise does nobody any favours. The fact that policymakers went against basic macro theory tells us important things about the transmission mechanism of economic knowledge, which all economists have to address.

[1] Bill Mitchell appears to suggest that in this case the central bank could maintain its interest rate by selling its stock of government debt. However pretty soon it would run out of assets to sell. This is exactly why some central bankers are reluctant to undertake helicopter money. One solution with helicopter money is to get the government to recapitalise the central bank, but of course to do that would involve creating more government debt. The central bank could start creating its own debt, but if governments stopped creating their own debt and asked the central bank to do it for them, nothing has really changed. 

[2] It is not clear to me that in such a world debt would always be tied down. A government that used an effective (in multiplier terms) fiscal instrument in booms (e.g. government spending) but an ineffective one in depressions (tax breaks for the wealthy) might experience an upward drift in debt. But what is clear is that in such a regime, concern about the debt stock should never justify significant departures from demand and inflation stabilisation.

[3] Although, as the range of comments to my earlier posts showed, what people understand MMT to mean varies quite a lot.

[4] I personally would not welcome the disintegration of macro back into separate schools of thought. Economists should be like doctors, and I do not want to have to ask my doctor what medical school of thought they belong to. I have relied on doctors using the same language and being able to understand each other. However I also realise that the unwise fixation of the current mainstream with microfoundations methodology can act as an exclusion mechanism, which encourages the formation of alternative schools of thought. This is yet another reason to be very critical of this methodological hegemony.  

Is mainstream academic macroeconomics eclectic?

For economists, and those interested in macroeconomics as a discipline

Eric Lonergan has a short little post that is well worth reading. Not because it is particularly deep or profound, but because it makes an important point in a clear and simple way that cuts through a lot of the nonsense written on macroeconomics nowadays. The big models/schools of thought are not right or wrong, they are just more or less applicable to different situations. You need New Keynesian models in recessions, but Real Business Cycle models may describe some inflation free booms. You need Minsky in a financial crisis, and in order to prevent the next one. As Dani Rodrik says, there are many models, and the key questions are about their applicability.

If we take that as given, the question I want to ask is whether current mainstream academic macroeconomics is also eclectic. (My original title for this post was can DSGE models be eclectic, but that got sidetracked into definitional issues, but from the way I tend to define things it is the same question.) My answer is yes and no.

Let’s take the five ‘schools’ that Eric talks about. We clearly already have three: New Keynesian, Classical, and Rational Expectations. (Rational Expectations is not normally thought of in the same terms, but I understand why Eric wanted to single it out.) There is currently a huge research programme which aims to incorporate the financial sector, and (sometimes) the potential for financial crises, into DSGE analysis, so soon we may have Minsky too. Indeed the variety of models that academic macro currently uses is far wider than this.

Does this mean academic macroeconomics is fragmented into lots of cliques, some big and some small? Not really, in the following important sense. I think that any of this huge range of models could be presented at an academic seminar, and the audience would have some idea of what was going on, and be able raise issues and make criticisms about the model on its own terms. This is because these models (unlike those of 40+ years ago) use a common language. The idea that the academic ranking of economists like Lucas should reflect events like the financial crisis seems misconceived from this point of view.

It means that the range of assumptions that models (DSGE models if you like) can make is huge. There is nothing formally that says every model must contain perfectly competitive labour markets where the simple marginal product theory of distribution holds, or even where there is no involuntary unemployment, as some heterodox economists sometimes assert. Most of the time individuals in these models are optimising, but I know of papers in the top journals that incorporate some non-optimising agents into DSGE models. So there is no reason in principle why behavioural economics could not be incorporated. If too many academic models do appear otherwise, I think this reflects the sociology of macroeconomics and the history of macroeconomic thought more than anything (see below).

It also means that the range of issues that models (DSGE models) can address is also huge. To take just one example: the idea that the financial crisis was caused by growing inequality which led to too much borrowing by less wealthy individuals. This is the theme of a 2013 paper by Michael Kumhof and colleagues. Yet the model they use to address this issue is a standard DSGE model with some twists. There is nothing fundamentally non-mainstream about it.

So why is the popular perception so different? Why do people talk about schools of thought? I think there are two reasons. First, while the above is true in the realm of academic understanding and discourse, it does not carry over into policy. When it comes to policy, we get to learn which models academic think are applicable to particular policy problems, and here divisions can be sharp. Second, there are plenty of people outside academia who have a public voice about economics (and generally a policy orientation), and they often do see themselves as school followers.

In terms of working practice rather than the hot end of macro policy decisions, most academic macroeconomists would regard themselves as eclectic in terms of the kind of work they are prepared to spend an hour or two seeing presented. But this view, and the common language that mainstream academics use, leads me to the No part of the answer to my original question. The common theme of the work I have talked about so far is that it is microfounded. Models are built up from individual behaviour.

You may have noted that I have so far missed out one of Eric’s schools: Marxian theory. What Eric want to point out here is clear in his first sentence. “Although economists are notorious for modelling individuals as self-interested, most macroeconomists ignore the likelihood that groups also act in their self-interest.” Here I think we do have to say that mainstream macro is not eclectic. Microfoundations is all about grounding macro behaviour in the aggregate of individual behaviour.

I have many posts where I argue that this non-eclecticism in terms of excluding non-microfounded work is deeply problematic. Not so much for an inability to handle Marxian theory (I plead agnosticism on that), but in excluding the investigation of other parts of the real macroeconomic world. (Start here, or type microfoundations into this blog’s search box and work backwards in time.) But for me at least this as a methodological point, rather than anything associated with any school of thought. Attempts to link the two, which I think many people including myself have been guilty of, just confuses.

The confusion goes right back, as I will argue in a forthcoming paper, to the New Classical Counter Revolution of the 1970s and 1980s. That revolution, like most revolutions, was not eclectic! It was primarily a revolution about methodology, about arguing that all models should be microfounded, and in terms of mainstream macro it was completely successful. It also tried to link this to a revolution about policy, about overthrowing Keynesian economics, and this ultimately failed. But perhaps as a result, methodology and policy get confused. Mainstream academic macro is very eclectic in the range of policy questions it can address, and conclusions it can arrive at, but in terms of methodology it is quite the opposite.

Speaking as an Old New Keynesian …

Labels are fun, and get attention. They can be a useful shorthand to capture an idea, or related set of ideas. But is there really a New Old Keynesian school of thought? I don’t think so. Here are a couple of bold assertions, which I think I believe, and which I will try to justify. First, in academic research terms there is only one meaningful division, between mainstream and heterodox. (Of course the heterodox divide themselves up into various ‘schools’, but their size is small and their influence is also small.) Second, in macroeconomic policy terms I think there is only one meaningful significant division, between mainstream and anti-Keynesians.

But before trying to justify these statements, I want to defend being a killjoy. As I said, putting people into categories can be fun - why spoil it by taking the exercise seriously? Two reasons. First, I want to make some points which do not get said often enough on economics blogs. Second, labels can lead to confusion or worse. Just think about the label Keynesian. Any sensible definition would involve the words sticky prices and aggregate demand. Yet there are still some economists (generally not academics) who think Keynesian means believing fiscal rather than monetary policy should be used to stabilise demand. Fifty years ago maybe, but no longer. Even worse are non-economists who think being a Keynesian means believing in market imperfections, government intervention in general and a mixed economy. (If you do not believe this happens, look at the definition in Wikipedia.)

So what do I mean by a meaningful division in academic research terms? I mean speaking a different language. Thanks to the microfoundations revolution in macro, mainstream macroeconomists speak the same language. I can go to a seminar that involves an RBC model with flexible prices and no involuntary unemployment and still contribute and possibly learn something. Equally an economist like John Cochrane can and does engage in meaningful discussions of New Keynesian theory (pdf). [1]

Of course all academic macroeconomists have their own idea of how the world actually works and will probably do research using models that roughly conform to that. Yet I think you would be hard put to draw meaningful boundaries here. Take John Quiggin’s Old/New Keynesian post, for example (which followed this from Tyler Cowen). He characterises New New Keynesians as those still working with DSGE models who are now attempting to add financial frictions. He wants to argue (and labels New Old Keynesian) the idea that following this recession, there “is no unique long-run equilibrium growth path, determined by technology and preferences, to which the economy is bound to return. In particular, the loss of productive capacity, skills and so on in the current depression is, for all practical purposes, permanent.” Now listening with my mainstream ears, this sounds like a combination of hysteresis effects and endogenous growth, which sounds interesting. Yet I also think we can learn a lot from adding financial frictions to DSGE models. Does this make me a middle aged Keynesian?

What I suspect Quiggin is getting at here is that New New Keynesians are still following a microfoundations research programme (using DSGE), whereas he would not. Now many mainstream macroeconomists, myself included, can be pretty critical of the limitations that this programme can place on economic thinking, particularly if it is taken too literally by microfoundations purists. But like it or not, that is how most macro research is done nowadays in the mainstream, and I see no sign of this changing anytime soon. (Paul Krugman discusses some reasons why here.) My own view is that I would like to see more tolerance and a greater variety of modelling approaches, but a pragmatic microfoundations macro will and should remain the major academic research paradigm.

When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term. [2] Why do I use the term anti-Keynesian rather than, say, New Classical? Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.

What is incoherent about believing in pretty flexible prices, you might ask? Two things. First, as I have argued before, with the demise of the Pigou effect flexible prices do not get you out of a deficient demand problem at the zero lower bound when there are inflation targets. Second, the evidence that prices are not flexible is so overwhelming that you need something else to drive you to ignore this evidence. Or to put it another way, you need something pretty strong for politicians or economists to make the ‘schoolboy error’ that is Says Law, which is why I think the basis of the anti-Keynesian view is essentially ideological.

Of course there are a huge number of policy debates in macroeconomics, and you can attach labels to those if you like. Should we use fiscal stimulus at the zero lower bound, for example. Was austerity a good idea? However, anti-Keynesians aside, I don’t think these debates reveal large fault lines in economic thinking. Economists do not rigidly line up on one side or another, and some even change their mind over time as the facts change. It is possible to have serious discussions about the effectiveness of monetary policy, the dangers of high debt etc. The only group where a discussion can fail to get off the ground is with those who contend that aggregate demand is always irrelevant.

[1] Heterodox economists might argue that they have to be bilingual - they are able to speak mainstream, even if they prefer not to among friends. Those more critical might detect a reluctance to get past certain words.

[2] An alternative, and more positive, way to define the anti-Keynesian group is that they believe macroeconomic outcomes are essentially efficient, and so intervention by a government (or central bank, beyond providing a nominal anchor) is not required. This difference might be important in placing someone like Roger Farmer (who I’m glad to see now has a blog), who is not an anti-Keynesian under this positive definition, but might be using my more negative criteria.

More on Schools of Thought

                The main task of this post is to try and answer the following question: why do schools of thought seem to fragment mainstream macroeconomics but not microeconomics? However before tackling that issue, I need to clear some ground raised by some interesting comments on my earlier posts on this issue.

                One point I did not make clear enough in my earlier discussion is a distinction between mainstream and heterodox economics. The latter might include neo-Marxists, post Keynesians, Austrians and others. My concern was about mainstream macroeconomics becoming fragmented into schools of thought. I can see why those challenging the mainstream might find schools of thought both convenient and useful. I also think it is very important that the mainstream should be continually challenged.

                I also may not have emphasised enough the downside of the microfoundations project. I do worry that it may help to exclude good ideas, as James Galbraith suggests, and have written about how this could be dangerous for policymakers who rely on the mainstream. However I still believe that microfoundations, if interpreted flexibly, bring net benefits. But that is not the focus of what I wanted to say on schools of thought.

                The success of the microfoundations project is also why I agree with Steve Williamson that academic work in macro is probably not as fragmented as it was in the 1970s. (I was not an academic at the time, so I cannot be sure.) In that sense, academic macroeconomists when doing academic work can still locate what they do within a common, mainstream framework. We all use models that abstract from many things to focus on what we think is important for some particular issue, and we receive criticism about whether those abstractions are valid or not. My concern about schools was more with the interface between academia and policy, which includes the advice academics give, what economic journalists write, and what politicians pick up.

                The kind of thing I had in mind here include politicians thinking that austerity would not increase unemployment, because those that worried that it would were from the same misguided Keynesian school that opposed Margaret Thatcher’s monetarism in 1981. Journalists who find it easier to slot every debate into one between schools rather than address issues on their merits. And academics who attempt to argue that certain views are not worthy of consideration because they were confined to the dustbin 30 years earlier. Jonathan Portes gave similar examples in his post.

                One of the interesting things about schools of thought in mainstream macroeconomics is that there does not seem to be anything similar in microeconomics. Now such a generalisation invites counterexamples. Some might point to the debate over the methodology of behavioural economics, for example. However most of my academic colleagues who I have road tested this idea on do agree that macroeconomics seems more prone to schools fragmentation than microeconomics. If this is true today, it is strange, because macroeconomics has become microfounded.

                One simple answer to this paradox is that schools of thought are associated with macroeconomic crises, and macro synthesis follows periods of calm. Keynesian theory itself was born out of the Great Depression. The first Neoclassical Synthesis arose from the period of strong growth and low inflation in the post-war period. Monetarism gained strength from the rapid inflation of the 1970s. The more recent synthesis may be a child of the Great Moderation, and now we have the Great Recession, schools of thought have returned. Because these crises are macroeconomic, and there are no equivalent crises involving microeconomic behaviour or policy, then fragmentation of the mainstream into schools will be a macro, not micro, phenomenon.

                Attractive though this account seems, I think it misses some important points. As one of the comments on my original post pointed out, the New Neo-classical Synthesis was in many ways a celebration of New Keynesian theory which was not shared by many freshwater departments in the US. Now I think there are good reasons why New Keynesian economists might have imagined that their analysis was an uncontested part of the mainstream. As I noted here, it is used in nearly all central banks as their main tool in carrying out monetary policy. With monetary policy somewhat depoliticised through central bank independence, the Great Moderation allowed this division among academic departments to remain dormant.

                On the other side, there was a belief that New Classical economics had been revolutionary: a successful counter-revolution against Keynesian ideas.  Once again there were good reasons to support this belief. Nick Rowe in his comment on my Anti-Keynesian School post noted how many Monetarist ideas, opposed at the time by many Keynesians, were now part of the mainstream. We could do the same for the battles between New Classical and Keynesian economists: on consumption, rational expectations, the Lucas critique and more, traditional Keynesians had unsuccessfully opposed New Classical ideas. Furthermore, many of the leaders of New Classical thought did not want to update Keynesian thinking, they wanted to destroy it.

                There is a lot more that could be said here, but it would lead me to the conclusion that this counter-revolution failed. It led to fundamental and largely progressive changes in Keynesian analysis, and macroeconomics more generally, and Keynesian analysis survived and prospered. Yet, for many reasons including ideological ones, the would-be counterrevolutionaries did not want to give up their counterrevolution.

                So, perhaps unlike the first (post-war) neoclassical synthesis, the New Neoclassical Synthesis was partial in terms of its coverage among academics. This incompleteness was not apparent during the Great Moderation, because the synthesis was applied in nearly every central bank. The fault lines only became apparent when monetary policy became relatively impotent at the zero bound after the Great Recession, and fiscal stimulus was used both in the US and UK. Once that happened, what I called the Anti-Keynesian school re-emerged.

                This back story is important, because it raises the possibility of an optimistic (from a Keynesian point of view) way forward. This is that the New Neo-Classical synthesis becomes complete. (For possible signs that this has already begun, see here.) The microfoundation of macroeconomics does logically imply that mainstream macro should be as free from alternative schools as microeconomics. This would require freshwater macroeconomists to recognise that New Keynesian models are essentially RBC models plus sticky prices, and that the addition of price rigidity was not that offensive. All would recognise that the conditions in which fiscal policy was a major stabilisation tool were either rather unusual (the zero bound), or geographically remote (monetary union), and so not something to get so worked up about. Freshwater economists would come to realise that demand denial  just did not make academic sense.

                I fear a more realistic conclusion is that the Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention. (For some supporting evidence, see here.) That divide occurs all the time in microeconomics, but because it involves arguing about many different externalities or imperfections it does not lend itself to fragmentation into schools. In macro, however, there is one critical externality to do with price rigidity, and so disagreements about policy can easily be mapped into differences about theory. Demand denial is attractive because it gives a non-ideological justification for what is essentially an ideological position about economic policy.

The Anti-Keynesian school

                Some comments on this recent post about Schools of Thought macro have raised interesting issues which I had not thought enough about, and which I want to come back to later if I can. Here I want to put forward an idea suggested by this from Jonathan Portes. We wrote these posts simultaneously and independently, and although I think Jonathan’s is consistent and complementary with what I had written, rereading it made me think a bit more about what I was really annoyed about.

Jonathan describes his puzzlement at being labelled a Keynesian when he thought he was just following mainstream macroeconomic theory and evidence. It discusses how misleading it can be to associate views about how the economy works with policy positions which may be rather specific in time, place and circumstance. Now I think these types of criticism, which I made in my original post, apply to at least some other schools of thought in macro. For example the label monetarist has many layers of meaning, from the very specific and policy related (money supply targeting) to the much more general and theoretical (money matters). These layers may be related, but they do not have to be.

Having said that, I think it is worth saying a bit more about the use of the specific term Keynesian, which both our posts focused on. It seems to me slightly unusual when used to denote a school of thought today, because it appears to be invoked more by those who disagree with it than those who agree. Jonathan’s post gave some clear examples of this. To caricature: we do not need to think too much about fiscal stimulus, because it’s a Keynesian policy. It is true that this kind of statement is more often made by politicians, journalists or bloggers than academics, but academics are not blameless here, and others often take their cue from them.

The source for dismissive statements of this kind probably goes back to the 1980s. At the academic level, it reflects the defeat of the Keynesians at the hands of New Classical economists, without noting that things have moved on rather a lot since then. At the level of policy in the UK, it may also reflect a perception on the right of past battles won.   

In contrast, those economists who use (New) Keynesian theory generally think they are just applying standard macroeconomic analysis. They are using the synthesis (e.g. the New Neoclassical Synthesis of Goodfriend and King) that I talked about in that earlier post. They do not think of themselves as members of a school of thought – they thought they were part of the mainstream.

                Is that just arrogance on their part? There are two reasons for thinking it is not. First, it is this synthesis model that is used by pretty well every central bank as the main tool for doing monetary policy. That does not make it right, but it does give it a pretty good claim to being mainstream macro. After all, it is mainly in central banks where macroeconomics is applied to the real world. Second, as the evidence that prices are sticky seems overwhelming (as Paul Krugman points out, the evidence from real exchange movements is clear), and it follows almost automatically that aggregate demand then matters, it is difficult to see how Keynesian analysis can either be controversial or ignored. (Furthermore, even if prices are pretty flexible, demand will still be important in determining output after a severe negative demand shock that takes us to the zero lower bound, as I argued here.)

                So I want to abolish the Keynesian school. Keynesian analysis should be part of the mainstream, and does not need to be embodied in a school of thought. However, for those that like schools of thought, I will replace it with a new one: the anti-Keynesian school of thought. It covers all those who attempt to dismiss Keynesian ideas like fiscal stimulus at the zero bound, or countercyclical fiscal policy in a monetary union, not through reasoned analysis, but by just labelling it Keynesian.

The Return of Schools of Thought Macro

When I first studied macro, it was all about ‘schools of thought’. Keynesians, Monetarists, New Classicals, and probably many more I cannot remember. Macroeconomists tended to take sides. Antagonists often talked across each other, and anyone not already on one side just got totally confused. I recall reading one textbook on international macro where each chapter represented an alternative ‘view’, with no clear idea of how each view or school was related to another. One thing that was pretty clear, however, was that most schools of thought could be identified with a particular ideological position.

                But then things began to change. The discipline appeared to become much more unified. It would be going much too far to suggest that there was a general consensus, but to use a tired cliché, most macroeconomists started talking the same language, even if they were not saying the same thing. I think there were two main reasons for this. The first was microfoundations: deriving the components of macro models from standard optimisation applied to representative agents. This gave macroeconomics the potential to achieve the same degree of unity as microeconomics. The second was the development of New Keynesian theory, which allowed an analysis of aggregate demand within a microfounded framework, and which integrated ideas like rational expectations and consumption smoothing into Keynesian analysis. To use the jargon, all models were now DSGE models.

                Goodfriend and King coined the term ‘New Neoclassical Synthesis’ (call it ‘synthesis’ for short), and other authors wrote along similar lines. So, even as recently as five years ago, I told masters students starting a macro course to forget anything they might have been told about alternative schools of thought: they were going to learn a unified framework that most macroeconomists – the mainstream – would sign up to. It was like the first half of David Romer’s popular textbook: start with Solow, but quickly replace a fixed savings propensity by an optimising intertemporal consumer to get the basic Ramsey model. Add endogenous labour supply to get RBC. Probably talk a bit about overlapping generations. Hopefully add to what was in Romer by doing some open economy stuff. Then add New Keynesian theory built around sticky prices. If the student went on to work in a central bank, they would probably encounter this framework as a central part of that institution’s forecasting and policy analysis.

I think this synthesis and the reasons behind it may have had one or two unintended and unfortunate consequences. Sometimes the emphasis on microfoundations became a bit of a fetish. (I have written about the shaky methodological grounds on which ‘microfoundations purists’ sometimes stand here.) Some have suggested that the emphasis on microfoundations meant too much time was devoted to elements that were easy to model within that framework rather than the things that really mattered. But I personally thought this synthesis had many more positive than negative consequences. I would not wish for every single macroeconomist to sign up to the synthesis: there is an important role for heterodox economists. However I liked the fact that the majority of macroeconomists used the same analytical framework.

                Just five years later and it seems rather different. I’ve encountered a much larger range of economics blogs in the last week or two (you can guess why), and it does feel like going back in time. Schools of thought in macro are definitely back. Since the recession it has become clear that the synthesis had not been adopted everywhere. In particular, in sections of the profession there remained a suspicion (to put it mildly) of New Keynesian theory, and partly as a consequence of this the amount of this theory that was taught to graduates differed widely.

                It is true that for some, schools of thought can be quite fun. Some students find the idea that academic macroeconomics consists of opposing forces locked in combat adds a degree of interest and motivation that might otherwise be lacking. However I am not persuaded that this spice was sufficient to offset misunderstanding. Personally when I was a student I found all the motivation I needed from socially destructive inflation, and widespread unemployment should do the same today. I do think that the schools of thought approach leads to an inexactness which can be misleading and annoying.

                Take the label Keynesian. Look up Wikipedia, and in the third paragraph you will find ‘Keynesian economics advocates a mixed economy — predominantly private sector, but with a significant role of government and public sector...’. Now I have a much more limited idea of what Keynesian economics is. For me, Keynesian macro is business cycle analysis based on aggregate demand and sticky prices. By this definition, the only ‘significant role for the public sector’ required is a central bank. Even in the rather unusual (I hope) times of a zero lower bound, Keynesian advocacy of fiscal stimulus implies is that the government brings forward its bridge building, and not that it permanently build more bridges. Does my preferred definition make me narrow-minded?

 Keynesian analysis as I define it implies that you need monetary policy, and occasionally countercyclical fiscal policy, to stabilise the economy, but that is not what is generally meant by a mixed economy! The extent of the public sector’s involvement in the economy will depend on microeconomics, not macro. Now it is true that those who tend to be antagonistic to state intervention may be uncomfortable with monetary and fiscal stabilisation policy, as I have suggested, but I am against ideology clouding economics, and I certainly do not want this connection hard wired as a school of thought.

                School of thought thinking also tends to bracket ways of looking at the economy with policy prescriptions, even when they are not inextricably linked. Take countercyclical fiscal policy, for example. Is that an intrinsic part of Keynesian thinking? For some time there has been general agreement among most macroeconomists that monetary policy was the stabilisation tool of choice, because of issues like implementation lags. This view has been strengthened by analysis over the last ten years that explicitly looks at welfare derived from a representative agent’s utility: the analysis of a simple basic case is contained in the Woodford paper I referenced here, and some of my own collaborative work has shown this result is surprisingly robust. So linking the routine use of countercyclical fiscal policy to what I think of as Keynesian theory is just misleading.

                  This sort of bundling together of ideas under one label at the very least causes confusion. (Here Jonathan Portes gives one recent example.) Worse still, it leads people to take sides on issues not because of the merits of the case, but because that case is associated with a school of thought whose other elements they do or do not like. I also miss the synthesis. I very much liked the idea that disagreements could be clearly located within a common framework. With the synthesis, I felt macroeconomics began to look more like a unified discipline - more like micro, and dare I say it, more like a science than a belief system.