The UK Budget and the Political Dangers of Inequality

                The symbolic centre piece of the UK budget was cutting the top rate of income tax. There has been and will be plenty written on the merits or otherwise of this (see Chris Dillow for example), but I want to raise a broader point about political influence. To do that I will start with the UK and US, but then move to Uzbekistan and Nepal, before returning to the US and finally back to the UK.

                Let us start with trends in inequality.

The distribution of income in the UK has been getting steadily more unequal over the last two decades. As this chart makes clear, we are following in the footsteps of the US in this respect. There has been a great deal written about this trend. Is there a similar trend in inequality of opportunity, and are they linked? Just how many measures of health and social wellbeing are negatively correlated with inequality? But rather than discussing this, I want to move to Uzbekistan, Sierra Leone and Nepal.

                In a fascinating series of blog posts (trailing a book just published called Why Nations Fail), Daron Acemoglu and James Robinson tell stories about why these economies failed to develop over long periods of time. The common theme is that an economic and political elite (a dictator, a tribe) had established a system of extracting the surplus from an economy, and either that system prevented development (children spent a large amount of school time picking cotton in Uzbekistan) or development threatened this extractive system (the caste system in Nepal).

                Now move back to the US, and Larry Bartels’ book published a few years ago called ‘Unequal Democracy: The Political Economy of the New Guided Age’. Although Bartels notes that technology and globalization have contributed to growing inequality over the past 35 years, he finds that Republican policies on macroeconomics, taxes, and social spending have produced substantial increases in inequality, while Democratic policies have produced relatively equal income growth across the economic spectrum. The real incomes of working poor families have increased six times as fast under Democratic presidents as they have under Republican presidents. The corollary, of course, is that the wealthy have gained under Republican presidents – the Bush tax cuts, for example.

                However the causation runs both ways. Money buys votes in the US, which means it also buys politicians. Acemoglu and Robinson, in a recent Huffington Post article, make similar arguments about the US as they do about failing nations. They write: “Money matters much more in politics today than it did in the 1960s, and we are currently witnessing its import rising.” This matters because: “The problem is that economic inequality often comes bundled with inequality of opportunity and political inequality. Prosperity depends on innovation, and we waste our innovative potential if we do not provide a level playing field for all: we don't know where the next Microsoft, Google, or Facebook will come from, and if the person who will make this happen goes to a failing school and cannot get into a good university, the chances that it will become a reality are much diminished.”

                So finally back to the UK. The influence of money on politics here is perhaps more discrete. Take the major reform of the National Health Service (NHS) that has just been passed into law. This was not part of the government’s pre-election manifesto: in fact the prime minister appeared to rule out such a reorganisation in the campaign. The reform is opposed by nearly every professional association involved in the NHS. It is supposed to give more power to local doctors, yet the Royal College of GPs suggest it will "cause irreparable damage to patient care and jeopardise the NHS". A former NHS chief executive describes the bill as a mess that will set the NHS back. With the reorganisation happening at the same time as fiscal austerity, the political pay-off for the next general election is almost certainly negative. So why pursue it? Well, one group that will benefit are the private companies that will do a lot of extra business as a result of the reforms. These companies are - how can I put it - well connected in various ways.

                When business sees more profit in rent seeking and manipulating the state compared to investment and innovation, economic growth suffers. Which brings us finally back to the Budget and the 50p tax rate. The campaign to get rid of the 50p rate has been well organised, and has signed up many business leaders for support. The evidence that it will have a noticeable effect on UK growth in the next few years is non-existent. What UK business should have been lobbying for were changes in monetary and fiscal policies, but this has not happened in the UK or US. That the key 2012 Budget measure is a cut in the top tax rate, at a time when unemployment is rising because of demand deficiency, represents a specific macroeconomic policy failure. That the business community appears to be backing this stance perhaps represents a more general political problem.

The optimal speed of debt correction

                This month’s Economic Journal sees the publication of a paper by Tatiana Kirsanova and myself that asks how quickly fiscal policy should respond to excess government debt. It is a very topical issue, but we started work on it back in 2004. It was Tanya’s idea so she deserves the credit for any foresight.

                The set up is both straightforward and not too unrealistic. We assume that monetary policy pursues an optimal policy, and that it has the credibility to commit. (We ignore the zero lower bound problem - it is not that topical!) In contrast, fiscal policy involves a simple feedback rule: following some shock, either government spending or taxes are adjusted by some proportion of the level of excess debt. The economic model is of a pretty standard New Keynesian variety. We also ignore the possibility of default on debt. Following various shocks, we look at how social welfare changes as the speed of fiscal feedback varies. The idea was not just to find out what the optimal degree of feedback is, but also to observe how much welfare suffers if we depart from this optimal speed.

                One extreme case is where there is no fiscal feedback – the fiscal authorities just ignore debt completely. The presumption might be that this would lead to an explosive debt spiral. In fact it does not, because monetary policy manages to control both debt and inflation. The way it does this is clever (remember policy is optimal, so it can be clever). Following a shock that raises debt, it first cuts interest rates, which helps get debt under control. It subsequently raises interest rates, which controls inflation. The reason this works is that the inflation process, unlike the government’s budget constraint, is very forward looking – the model is New Keynesian. With rational expectations, promises of higher interest rates in the future help control inflation today, while lower interest rates today keep debt under control. (Those who follow such things may detect an element of the Fiscal Theory of the Price Level here.) However, although the economy is stabilised, inflation is not controlled very efficiently, and so the welfare costs of the shock are high.

                At the other extreme is where fiscal feedback is very rapid: government spending (say) is cut very quickly in response to a shock that raises debt. This does better in welfare terms, but it is not the best policy for two reasons. First, quickly cutting government spending has costs. Second, large changes in government spending mess with inflation. If a shock raises both debt and inflation, you might think this is a good thing, but in this type of model monetary policy is better at controlling inflation than fiscal policy. Having both fiscal and monetary policy control inflation actually reduces welfare.

                The best amount of fiscal feedback turns out to involve pretty slow correction of debt. Although this is an important result, it was not unexpected or very new. This is because the ideal fiscal policy (when both monetary and fiscal policy are jointly determined in an optimal manner under commitment) in this type of model would not eliminate excess debt at all. It is better to allow debt to change permanently as a result of a shock: although this means either government spending or taxes will have to change permanently to finance this debt, the discounted costs of this are less than the large short term changes in fiscal policy required to eliminate all excess debt. (This is an implication of Barro’s famous tax smoothing result.) A simple feedback rule cannot duplicate this ideal policy exactly, but it can get pretty close by not reacting very much to excess debt.

                The result that it is best to correct debt very slowly is neither surprising nor unusual – a similar conclusion is reached by most papers that look at this issue. In that sense it is a robust result. In more recent work that I have done with Campbell Leith and Ioana Moldovan, where the ideal policy is no longer to accommodate shocks to debt, we still get very slow adjustment. The more interesting result in the paper is quantifying the degree to which welfare deteriorates when we try and correct debt too quickly. Controlling debt too quickly is never as bad as not controlling it at all, but it is significantly worse than more gradual adjustment. Trying to correct debt too rapidly is costly, and should be avoided if possible, even when we are not at the zero lower bound.

                One interesting result that surprised me at the time was how well the simple feedback rule for fiscal policy did compared to the ideal fiscal policy (i.e. a joint optimisation benchmark). I now know that this reflects a fundamental property of this basic New Keynesian model, which is that in many cases, and in the absence of the zero lower bound, monetary policy is all you need for stabilisation of output and inflation. (This is well known for demand shocks, but it turns out to be more general than that.) With the help of Fabian Eser and Campbell Leith, we show this analytically here. Of course if monetary policy is compromised by hitting a zero lower bound for nominal interest rates, this result no longer holds. In this case you would want fiscal policy to help out on output stabilisation, as Gauti Eggertsson has examined in a number of papers. The position is similar to that of an individual economy in a monetary union. Tanya and I showed in joint work with Mathan Satchi and David Vines that the simple feedback rule on debt should be supplemented with additional terms reflecting this dual role in a monetary union.

                About two years ago, there was a debate via letters to newspapers over how quickly UK debt should be brought down. I’m told that when one of the economists who signed the ‘cut quickly’ letter saw Tanya present this paper, they said that they now understood why I had signed the ‘cut slowly’ alternative. And for those who would say ‘ah yes, but slow correction would not be credible’, read this. 

What should be in the 2012 Budget?

                The UK budget is presented on Wednesday 21^st March.  Speaking yesterday, the Chancellor said he had “secured the country’s economic stability”. He is absolutely right: in contrast to previous recoveries, when the economy grew, he has managed to stabilise output. GDP was 0.16% higher at the end of last year compared to the quarter after his first budget. Per capita GDP is over 5% below its peak at the end of 2007.

                Jonathan Portes, in a recent post/article, rightly condemns the current pessimism and inaction of the UK government about growth and unemployment. There is so much that could be done, even at this late stage, to start bringing unemployment down quickly. Jonathan suggests a fiscal stimulus (relative to current plans) involving

(1) A temporary cut in national insurance contributions for young and low-paid workers.

(2) Infrastructure investment. (No, it would not take time to find such projects – just reinstate those that were cancelled, like modernising run down school buildings.)

(3) Building more houses by helping social-housing providers to borrow and build. The UK, unlike some other countries, suffers from a structural shortage of housing supply.

I would add a fourth

(4) Reversing some of the changes about to take place in tax credits. This would go a little way towards correcting the fact that proposed budget changes are decidedly regressive in their impact, as I noted here. For more details see this discussion from the Resolution Foundation.

These four proposals would involve more borrowing in the short term. But what if the markets panic? The Chancellor could set in place two contingent policies to deal with this. First, authorise the Bank to undertake more Quantitative Easing if a risk premium on UK government debt begins to emerge. Such a program would be entirely consistent with the Bank’s mandate. Second, set out tax increases that would fully fund measures (1) to (4). This could involve bringing forward the tax increases that are pencilled in for later years, as suggested by the Social Market Foundation here. It could also involve raising taxes that will come largely out of savings, like increasing inheritance tax from the current 40% for example. These taxes would only be increased if the markets showed they could not stomach additional borrowing. They would diminish the expansionary impact of measures (1) to (4), but not by that much because of the balanced budget multiplier. Until now the majority party in the coalition has shown no interest in this way of expanding the economy without increasing debt, but we can always hope.

                The government has expressed concern about the evidence (see also Adam Posen here) that small and medium scale firms (SMEs) are being starved of (or priced out of) borrowing by excessively cautious banks. In the UK these firms are unusually dependent on borrowing from banks. Quantitative Easing by the Bank of England has focused on buying government debt, which may have eased the corporate bond market, but has done little for SMEs. The government has so far tried encouraging banks to lend more, with a predictable lack of success. Proposals are due to be announced in the budget, but one of the Bank of England’s leading thinkers suggests radical changes to the UK banking industry are required. Such changes are possible, because the public sector currently owns a good proportion of the banking sector.

                Last and not least, the Chancellor should instigate an immediate investigation into the possibility of replacing the inflation target by a nominal GDP target. There is a significant amount of evidence, from the Great Depression and more recently, that expectations of rising prices can provide a strong stimulus to demand. A nominal GDP target, suitably constructed, could help generate those expectations.

                If this strikes you as a bit too much, consider the following. In the highly unlikely event that the Chancellor took my advice and the economy started to expand too rapidly, we can cool things down very quickly by using monetary policy. In contrast, being stuck at the zero lower bound means monetary policy with the current inflation target is having little impact on rising unemployment. So for once being incautious is the sensible option.

                The unemployment rate among under 25s in the UK is currently 22.5% and rising, the highest since records began in 1992. This is no unfortunate accident beyond the government’s control:  over 100,000 public sector jobs were cut from education and the NHS in 2011. It is ironic that one of the positive things this government has done is to start publishing survey data on happiness. Alas at the same time its macroeconomic policies are leading to a substantial increase in unhappiness in the UK. 

Austerity and not wasting a crisis

                In the austerity versus stimulus debate, I argue from a macroeconomic point of view that this is a false choice if we are talking about economies where markets are eager to buy government debt i.e. pretty well everywhere apart from the Eurozone. In the short term we need stimulus, whereas fiscal discipline is a long term problem. We need to raise taxes and cut spending when times are good, not when times are bad. The Eurozone 2000-2007 is a clear example of when this should have happened.

                The response is often to concede the macroeconomic logic, but say that promises of austerity tomorrow cannot be trusted. It is easy to promise, but when tomorrow comes governments will break that promise. This resonates, but it is less clear what the underlying logic is. We can all agree that governments are subject to deficit bias. There are a number of reasons for this: the common pool problem, over optimistic forecasts, political impatience stemming from elections etc. (See Calmfors and Wren-Lewis, 2011, for a more complete account.) However bias stemming from these causes is fairly constant: it does not disappear when deficits are high and only materialize in good times.

                I sometimes put it this way. Suppose the government did go for fiscal stimulus today, and this helped lead to a macroeconomic recovery. Once the recovery was complete, the underlying fiscal position (i.e. the structural or cyclically adjusted deficit) would be a little worse than today, because the stimulus would have added to debt. So if a politician is prepared to undertake austerity today, they will be even more willing to undertake it tomorrow. Of course following a recovery the actual (rather than structural) deficit may be smaller, but is our macroeconomic discourse that naive?

                In economics we are of course used to the optimal policy changing solely as the result of the passage of time (time inconsistency). A central bank may promise to keep interest rates high for some time to reduce inflation today, but come tomorrow when the policy has done its job it becomes optimal to reduce interest rates. However when it comes to fiscal policy and deficit bias, the role of time inconsistency seems less central. The problem is not that we have a benevolent policy maker that is subject to a time inconsistency temptation; it is that we do not have a benevolent policy maker.

                Having said this, I think many feel that, when governments are prepared to act ‘out of character’ and impose restraints on themselves, this chance should be grabbed before it disappears. It is often possible, when looking at countries where government debt is not a major problem, to trace this back to changes made following a fiscal crisis. Lars Calmfors has a nice account of the Swedish case here. So can we rationalise this idea? Perhaps a crisis, and therefore the chance to act, is not governed by the level of debt (funding problems aside), but by its rate of change. So governments became prepared to impose austerity when debt started rising rapidly following the recession, but if nothing was done and debt remained high, the political imperative would gradually disappear. Higher debt would become the new normal.

                However I still have problems with this line of reasoning. As Lars emphasises, Sweden was successful because it instituted a comprehensive set of reforms following the crisis, including a fiscal target to be achieved over the course of the cycle. It was also successful because a large nominal depreciation boosted output growth, more than offsetting the deflationary impact of fiscal consolidation. The world as a whole cannot use this trick, so an important condition for successful global fiscal consolidation is missing. However countries could establish rules today that were designed to only begin operating when the economy has recovered. Use the current crisis to get the rules established, but recognise that their implementation needs to be delayed because of the recession.

                It is often said that instituting rules that only operate once the recovery is complete will ‘not be credible’. Here is the time inconsistency analogy again, and (funding crisis aside) it seems equally inappropriate. We just need to ask: credible to whom? Is a government that commits to future austerity that begins tomorrow, any more likely to renege in the future than that same government that commits to long term austerity and starts it today? We could argue the opposite: an austerity plan in conjunction with a recession is more likely to come unstuck.

                I think a mistake we can make here is to imagine we are trying to discover the preferences of two different governments. In that case, a government that just promises future austerity tells us very little, because it could just be cheap talk. If a government undertakes austerity now, we know more through its actions. However that is not what the current debate is about. In practice we have governments that are prepared to undertake austerity now. They have demonstrated that they take the debt problem seriously. Are these preferences going to change if we delay austerity until after the recovery?

                So let us, by all means, not waste a fiscal crisis. Use it to set out a combination of rules and institutional changes that avoid deficit bias in the future. However I do not see why it is politically impossible to delay the implementation of those rules until after the recession is over. But maybe I’m just displaying my ignorance of political science.

Time for Europe to enter the Econ blogosphere

                The new Bruegel blog has a provocative post entitled ‘Europeans can’t blog’. What they mean is that there is no equivalent in Europe to the US economics blogosphere. To quote: “It is striking to note that the online debate about European economic issues mostly takes place on American blogs.” European blogs exist, but Bruegel suggest that they tend not to link to each other, so debate is not encouraged. This is partly a language issue of course, with many blogs directed at a national audience written in their own language. But the language of economics is English, and there are already some good European blogs written partly or totally in English.

                Bruegel thinks it would be good if there was a more interactive European economics blogosphere, and I very much agree.  I know I’m not the only person who wants to understand more about the economic debate in other European economies, particularly at the moment. Discussion through blogs might even improve the quality of national economic debate. But what I really wanted to say is that it need not take long to achieve this. At the end of their post Bruegel kindly say that the “UK already has an impressive blogosphere that is tightly integrated with the American one”. The Palgrave Econolog ranks economics blogs mainly by the number of incoming links from other indexed economics blogs i.e. a bit like Google. Of their current top 20, 15 are US based, one is Canadian, one is the IMF, and 3 are from the UK. But of these three UK blogs, only Chris Dillow’s Stumbling and Mumbling was around six months ago. When I and Jonathan started blogging, Chris linked to some of our posts, which meant Mark Thoma read them etc. 

                Bruegel shows one way a new and interesting blog can be created, based around an internationally orientated economics think tank, research center or academic department. Alternatively, I’m sure I’m not the only economics professor who would find they had things to say. There are some really good US blogs by current or recent grad students, like Noahpinion for example. Once the critical mass is there, Bruegel's post and my own experience emphasise the importance of interacting with other blogs.

The inflation floodgates

                Mark Thoma bemoans the attitude of inflation hawks on the FOMC (the US equivalent of the Bank’s Monetary Policy Committee). He writes “Unfortunately, the hawks on the committee seem to be afraid that if they allow inflation to creep up even a little bit over their long-run target, the inflation flood gates will open and they won’t be able to help themselves from a repeat of the 1970s.” From this profile by Roger Lowenstein, the floodgates view may not be confined to the hawks (HT Karl Smith). It occurred to me that we have just had a little experiment in the UK to test this floodgates view, and it looks like being completely rejected.

                The first chart shows the basics on inflation. 

UK Inflation

The inflation target is 2%. Before 2005 the Monetary Policy Committee (MPC) of the Bank of England had done pretty well : since getting independence inflation had been close to the target. (The target measure of inflation was different at the start, but we do not need to get into these complications.) Since 2005 inflation has been consistently above target, and seriously so over the last two years, hitting a peak of 5.2%.

                What have been the consequences? The figure below, from the Bank’s latest inflation report, showed what happened to one year ahead inflation expectations.

The first point to note (see the green line) is that the Bank did expect to exceed its target (it opened the floodgates!), but the extent of the inflation overshoot was not foreseen. The second is that inflation expectations, as measured by surveys of households, did rise to somewhere between the Bank’s forecast and what actually happened. Similar surveys asking about longer term inflation expectations give numbers between 3% and 4%, which even after allowing for definitional issues is well ahead of the inflation target. Market measures based on swaps show a similar story for longer term inflation expectations. (There are lots of caveats that I’m ignoring, for reasons I hope will become clear. The limitations of these surveys, and others, are discussed in detail by MPC member Adam Posen here.) This is despite the Bank’s forecast, backed up by most other forecasters, which sees inflation coming back to target during this year.

                So in a sense this seems to confirm some of the hawks’ fears. Inflation expectations are now above target, and they are not coming down in line with forecaster’s projections. Has this started a wage-price spiral, with inflation out of control?

                In a word, no. From the peak of 5.2% in September, inflation has fallen rapidly, and was 3.6% in January. The OECD expects year on year inflation to be 2.7% in 2012, and only 1.3% in 2013. What we have seen is a classic and temporary cost push or supply shock caused by a VAT increase and rising commodity prices.

                The reason why all the talk of inflation out of control was nonsense can be seen in the other line from the first chart, which is average earnings inflation. Before the recession, wage inflation was always above price inflation, which is what we would expect because of underlying productivity growth. Since the recession, wage inflation has been invariably below price inflation, which is a consequence of rising UK unemployment. The latest figure for January, released yesterday, gives a year on year increase in earnings of only 1.4%.

                So, despite a significant inflation overshoot (part planned, part unplanned), a (modest) rise in inflation expectations, and a huge increase in the monetary base as a result of quantitative easing, there is absolutely no sign of a take-off in inflation.  This should not be a surprise. Sustained increases in inflation involve wage-price spirals, and given high and rising unemployment we are not seeing the wage part of this process. However, this does not prevent inflation hawks being inflation hawks, and others getting cold feet. In the spring of last year, 3 out of 9 members of the MPC voted to tighten monetary policy. That did not make sense in terms of the standard way we think about monetary policy (see my earlier post here), but it did make sense if you believed in a floodgates kind of world.

                You might think this does not matter too much, because the hawks are in a minority. However the floodgates view makes it much more difficult to have a sensible public discussion about using promises of higher future inflation to mitigate the zero bound constraint. (This could involve temporarily raising the inflation target, or switching to a price level or nominal GDP target.) As I noted here, there is very little discussion of this option in the UK (although this is a notable exception). I do not think such a monetary policy is an alternative to fiscal stimulus – in fact the two policies can complement each other, as Brad DeLong points out here. However, if a significant proportion of the monetary policy making community view inflation above 2% as the equivalent of just one drink for an alcoholic, then using inflation as a tool rather than just a target will not happen. Of course this UK episode is not the same as raising inflation above 2% when the real economy is no longer depressed, as would occur under a nominal GDP target, but I think it does require those who oppose this policy change to explain why things would be very different in that case.

                I would draw one other lesson from this experience. When thinking about inflation, it is a mistake to focus on consumer price inflation alone. We can try and take out various things from the consumer price index to get some ‘core’ measure, but there are two alternative inflation measures already published: output prices (the GDP deflator) and average earnings. We should look at these more often. At the very least this would help avoid silly panics caused by commodity price and other shocks. However there are also good theoretical reasons for looking at these alternative inflation measures, but that has to be for a later post. 

Microfoundations – is there an alternative?

                In previous posts I have given two arguments for looking at aggregate macroeconomic models without explicitly specifying their microfoundations. (I subsequently got distracted into defending microfoundations against attacks that I thought went too far – as I said here, I do not think seeing this as a two sided debate is helpful.) In this post I want to examine a much more radical, and yet old fashioned idea, which is that aggregate models could use relationships which are justified empirically rather than through microfoundations.  This argument will mirror similar points made in an excellent post by Richard Serlin in the context of finance. Richard also reflected on my earlier posts here. For an very good summary and commentary on recent posts on this issue see the Bruegel blog.

                Before doing this, let me recap on the two previous arguments. The first was that an aggregate model might have a number of microfoundations, and so all that was required was a reference to at least one of those. Thanks to comments, I now know that a similar point was made by Ekkehart Schlicht in Isolation and Aggregation in Economics (1985), Berlin, Heidelberg: Springer Verlag.  (I said at the time that this seemed to me a fairly weak claim, but Noah Smith was not impressed, I think because he felt you should be able to figure out which microfoundation represents reality. Unfortunately I think reality is often too complex to be well represented by just one microfoundation – think of the many good reasons for price rigidity, for example. In these circumstances robustness is important.)

                The second is more controversial. Because microfoundations takes time, an aggregate relationship may not as yet have a clear microfoundation, but it might in the future. If there is strong empirical evidence for it now, academic research should investigate its implications. So, for example, there is some evidence for ‘inflation inertia’: the presence of lagged as well as expected inflation in a Phillips curve. The theoretical reasons (microfoundation) for this are not that clear, but it is both important and interesting to investigate what the macroeconomic consequences of inflation inertia might be.

                This second argument could justify a very limited departure from microfoundations. A macro model might be entirely microfounded except for this one ‘ad hoc’ element. I can think of a few papers in good journals that take this approach. I have also heard macroeconomists object to papers of this kind: to quote one ‘microfoundations must be respected’. It was reflecting on this that led me to use the term ‘microfoundations purist’.

Suppose we deny the microfoundations purist position, and agree that it is a valid to explore ad hoc relationships within the context of an otherwise microfounded model. By valid, I mean that these papers should not automatically be disqualified from appearing in the top journals. If we take this position, then there seems to be no reason in principle why departures from microfoundations of this type should be so limited. Why not justify a large number of aggregate relationships using empirical evidence rather than microfoundations?

                This used to be done back in my youth. An aggregate model would be postulated relationship by relationship, and each equation would be justified by reference to both empirical and theoretical evidence in the literature. Let us call this an empirically based aggregate model. You do not find macroeconomic papers like this in the better journals nowadays. Even if papers like this were submitted, I suspect they would be rejected. Why has this style of macro analysis died out?

                I want to suggest two reasons, without implying that either is a sufficient justification. The first is that such models cannot claim to be internally consistent. Even if each aggregate relationship can be found in some theoretical paper in the literature, we have no reason to believe that these theoretical justifications are consistent with each other. The only way of ensuring consistency is to do the theory within the paper – as a microfounded model does. A second reason this style of modelling has disappeared is a loss of faith in time series econometrics. Sims (1980) argued that standard identification restrictions were ‘incredible’, and introduced us to the VAR. (For an earlier attempt of mine to apply a similar argument to the demise of what used to be called Structural Econometric Models, see here.)

                In some ways I think this second attack was more damaging, because it undercut the obvious methodological defence of empirically based aggregate models. It is tempting to link microfounded models and empirically based aggregate models with two methodological approaches: a deductivist approach that Hausmann ascribes to microeconomics, and a more inductive approach that Marc Blaug has advocated. Those familiar with these terms can skip the next two paragraphs.

                Microeconomics is built up in a deductive manner from a small number of basic axioms of human behaviour. How these axioms are validated is controversial, as are the implications when they are rejected. Many economists act as if they are self evident. We build up theory by adding certain primitives to these axioms (e.g. in trade, that there exist transport costs), and exploring their consequences. This body of theory will explain many features of the world, but not all. Those it does not explain are defined as puzzles. Puzzles are challenges for future theoretical work, but they are rarely enough to reject the existing body of theory. Under this methodology, the internal consistency of the model is all important.

                An inductivist methodology is generally associated with Karl Popper. Here incompatibility with empirical evidence is fatal for a theory. Evidence can never prove a theory to be true (the ‘problem of induction’), but it can disprove it. Seeing one black swan disproves the theory that all swans are white, but seeing many white swans does nothing to prove the theory. This methodology was important in influencing the LSE econometric school, associated particularly with David Hendry. (Adrian Pagan has a nice comparative account.) Here evidence, which we can call external consistency, is all important.

I think the deductivist methodology fits for microfounded models. Internal consistency is the solid rock on which microfounded macromodels stand. That does not of course make it immune from criticism, but its practitioners know where they stand. There are clear rules by which their activities can be judged. To use a term due I think to Lakatos, the microfoundations research programme has a well defined positive heuristic. Microfoundations researchers know what they are doing, and it does bring positive results.

The trouble with applying an inductivist methodology to empirically based aggregate macromodels is that the rock of external consistency looks more like sand. Evidence in macroeconomics is hardly ever of the black swan type, where one observation/regression is enough to disprove a theory. Philosophers of science have queried the validity of the Popperian ideal even in the context of the physical sciences, and these difficulties become much more acute in something as messy as macro.

So I end with a whole set of questions. Is it possible to construct a clear methodology for empirically based aggregate models in macro? If not, does this matter? If there is no correct methodology (we cannot have both complete internal and external consistency at the same time), should good models in fact be eclectic from a methodological point of view? Does the methodological clarity of microfounded macro help explain its total dominance in academia today, or are there other explanations? If this dominance is not healthy, how does it change?