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.
