The state of macroeconomics: it all went wrong in 1958

Much of the recent discussion in the “state of macroeconomics” has concerned the question

* Is macroeconomics making progress?
* If not, when did it stop?

I’m not going to survey the whole debate, but I will point to a good contribution from Robert Gordon (linked by JW Mason in comments to a previous post). Gordon argues that 1978-era New Keynesian macro is better than the DSGE approach dominant today. That implies 30 years of retrogression.

My own view is even more pessimistic. On balance, I think macroeconomics has gone backwards since the discovery of the Phillips curve in 1958 [1][2]. The subsequent 50+ years has been a history of mistakes, overcorrection and partial countercorrections. To be sure, quite a lot has been learned, but as far as policy is concerned, even more has been forgotten. The result is that lots of economists are now making claims that would have been considered absurd, even by pre-Keynesian economists like Irving Fisher.

Phillips showed that there was a negative correlation between unemployment and inflation, a finding replicated for the US by Samuelson and Solow. The result was consistent with the then-dominant (Old) Keynesian models which taught that inflation (or deflation) arose in situations of excess (inadequate) aggregate demand and therefore low (or high) unemployment.

The first mistakes in interpreting the result were made by Keynesians, notably including Samuelson and Solow. Although their journal articles included lots of qualifications about expectations effects, these qualifications were downplayed in policy discussions, leading to the idea that policymakers had a menu of choices. In particular, appropriate use of fiscal and monetary policy could permanently reduce unemployment at the cost of somewhat higher inflation. This claim went along with the widespread belief that macroeconomics was now, for policy purposes, an exact science, which would allow “fine tuning” of the economy, in the unfortunate phrasing of Walter Heller, Kennedy’s head of the Council of Economic Advisers.

Taken together, the “menu” interpretation of the Phillips curve and the belief in fine tuning imparted an inflationary basis to policy, which was already evident by the time Milton Friedman gave his 1968 Presidential Address to the American Economic Association. Friedman argued that the trade-off in the Phillips curve was only temporary. Once firms and workers got used to higher inflation, they would build it into their expectations, and the initial reductions in unemployment would be lost. Friedman also argued against fine-tuning, pointing out the “long and variable lags” that made short-term fine-tuning impossible.

Friedman’s criticisms were broadly correct, and were validated by the inflationary explosion that began around the time of his address, but he pushed the point too far in several respects. First, at inflation rates near zero, there really is a trade-off, arising from the fact that interest rates can’t be negative. This point was implicit in Keynes’ discussion of the liquidity trap, but was reinforced by Krugman’s analysis of the Japanese experience in the 1990s, and is highly relevant today. Second, he took his critique of the Phillips curve to mean that there was a “natural rate” of unemployment, determined by labour market conditions (this is now usually called the NAIRU or non-accelerating inflation rate of unemployment). It’s turned out that long-periods of high unemployment have their own self-sustaining effects – Olivier Blanchard and Larry Summers christened this “hysteresis”. So, estimates of the natural rate tend to rise when unemployment is high, making the concept virtually useless as a guide to policy.

Third, Friedman used his critique of fine-tuning that macro policy should be confined to a rules-based monetary policy, with no role for fiscal policy. Although Friedman’s own prescription (a rule controlling the rate of growth of the money supply) was unsuccessful and quickly abandoned, these ideas were the basis of the policy regime, based on the use of interest rates as an instrument to meet inflation targets, that prevailed from the 1980s to the financial crisis, and to which central banks plan to return as soon as the crisis is over.

The real decline was in the 1970s and 1980s, as Friedman’s already overstated critique of Keynesianism was pushed to the limits of credibility and beyond. The big ideas of the period: Ricardian equivalence, Rational Expectations, Policy Ineffectiveness, Microfoundations, Real Business Cycle theory and the (strong-form) Efficient Markets Hypothesis were based on plausible (to economists, anyway) arguments. They didn’t have much empirical support but, given that Keynesian models weren’t working well either, this wasn’t enough to stop them taking over the debate.

The main response was New Keynesianism which showed that with plausible tweaks to the standard micro assumptions, some Keynesian results were still valid, at least in the short run. New Keynesianism gave a rationale for the countercyclical monetary policies pursued by central banks in the inflation targeting era, whereas the classical view implied that a purely passive policy, such as Friedman’s money supply growth rule, was superior. Broadly speaking the pre-crisis consensus consisted of New Keynesians accepting the classical position in the long run, and most of Friedman’s views on short-term macro issues, and abandoning advocacy of fiscal policy, while the New Classicals acquiesced in moderately active short-term monetary policy

How you evaluate this consensus depends on your view of the period from 1990 to the crisis. Noah Smith, quoting Simon Wren-Lewis says

macro did produce a policy consensus (basically interest rate targeting by the Fed, with a Taylor Rule type objective function balancing growth stability and price stability), and yes, that policy consensus did help the world, by giving us the Great Moderation, which wasn’t perfect but was better than what came before

Implicit in this view is the idea that the Great Moderation was a policy success and that the subsequent Great Recession was the result of unrelated failures in financial market regulation. My view is that the two can’t be separated. In the absence of tight financial repression, asset price bubbles are regularly and predictably[3] associated with low and stable inflation. Central banks considered and rejected the idea of using interest-rate policies to burst bubbles, and the policy framework of the Great Moderation was inconsistent with financial repression, so the same policies that gave us the moderation caused the recession.

To sum up, work done in macroeconomics since the discovery of the Phillips curve has offered an improved understanding of a wide range of issues. On the other hand, it has produced and sustained the dominance, in central banks and in much of the economics profession, of an empirically unsupportable position that is resolutely opposed to fiscal stimulus, or to any large-scale countercyclical policy. It has also diverted most of the intellectual energy of academic macroeconomists into a largely fruitless search for microfoundations, at the expense of an improved understanding of the various co-ordination failures that are at the heart of the macroeconomic problem.

I don’t suggest throwing out everything that’s been done since 1958 and starting all over from there. But, in many ways, that would be a better choice than continuing on the current path.

fn1. Phillips himself might agree. He is supposed to have remarked “If I’d known what they were going with the curve, I never would have drawn it”.

fn2. Macro covers a range of topics. In some other areas often classed as part of macro, such as growth theory and national accounting, progress has continued. And macro in 1958 was focused on the case of fixed exchange rates and limited capital flows. Mundell and Fleming in 1963 did the basic work on open-economy macro with floating rates and free capital movements.

fn3 No one predicted the timing of the crisis, or the details of the meltdown, with any great accuracy. But at least on this point, my 2006 paper with Stephen Bell, Asset price instability and policy responses: The legacy of liberalization got the analysis basically right, I think.

35 thoughts on “The state of macroeconomics: it all went wrong in 1958

  1. Bill Mitchell’s latest post on his blog starts out like this;

    “Two papers have come out in the first week of January that provide further evidential support for the argument that the majority of macroeconomics that is taught in standard university programs is worthless. The first (published January 3, 2013) – Growth Forecast Errors and Fiscal Multipliers – from the IMF attempts to explain why the planned fiscal austerity measures in advanced economies have been more damaging than mainstream economists predicted. It is an excruciating attempt at regaining credibility for the seriously wayward IMF. The problem is that its credibility is so far in deficit that it has a lot of consolidation to do before anyone should believe them again. The second paper (published January 2013) – A Boost in the Paycheck: Survey Evidence on Workers’ Response to the 2011 Payroll Tax Cuts – from researchers at the Federal Reserve Bank of New York “presents new survey evidences on workers’ response to the 2011 payroll tax cuts”. The results of the survey? Much higher estimates of the consumption propensities than were predicated from mainstream economic theory. Implication? The standard theory taught to students is wrong and should be disregarded.”

    To which I say,”Hear! Hear! Absolutely correct!”

    Mainstream economics (which is now neoclassical neocon) is 100% wrong on all the important points and demonstrably so from mountains of empirical evidence. There are none so blind as those who will not see.

  2. I might add that the whole Bill Mitchell article titled “The culpability lies elsewhere” is well worth reading. It addresses the failure of IMF predictions, the differences between forecasts being wrong for stochastic (chance) reasons and for systematic modelling error reasons, the failure of pro-cyclical austerity prescriptions from the IMF and elsewhere and the fallacy of composition which is central to so many of the mistakes made by neoclassical macroeconomics… and much, much more. So it’s well worth an attentive reading.

  3. @Ikonoclast

    Bill Mitchell sometimes exaggerated undergraduate economic studies a bit too far. I do not dispute it is full of neoclassical theories and models, but to my knowledge, universities in NSW at least, still teaches Neoclassical Synthesis models (Neo-Keynesian).

    In these courses, although it teaches IS-LM curve which suggests government expenditure “crowd out” investment, some units of the undergraduate courses also teaches New Keynesian IS-MP curve which suggests that fiscal policy does not inevitably lead to an increase in interest rate (thus “crowding out” does not necessarily apply). Most importantly, none of its units suggests that fiscal multiplier is zero (other than units that are related to New Classical side) or implied a figure that is lower than 1. Academic lecturers, usually uses figures estimated by Treasury or other economic related organisation rather than ricardian equivalence.

    Even though I personally have my disagreements with undergraduate economics, what they teach in universities (in NSW) is not as extreme in neoclassical as what Bill Mitchell suggests. The IMF? They have no excuses.

  4. Greg :

    Your making a very nice argument for a benevolent dictatorship

    This makes no sense – unless you view parliament and the courts as a form of;

    “benevolent dictatorship”

  5. @Tom

    Perhaps you are right on the academic side. But the baneful and seemingly all-pervasive influence of neoclassical economics (a badly bowdlerized version of academic economics) on public discourse and offical policy can scarcely be denied. The “zombie ideas” that won’t die as Prof. J.Q. terms them are everywhere and cannot be killed off despite being hit with great bludgeons of empirical data and historical experience. This suggest there is an enormous push coming from somewhere to debase economics to the cartoon fallacy of neoclassicism.

    This push has definitely debased economics education in Australia. Steve Keen writes of the great undergraduate fight to keep economics from being debased in Sydney in the 1970s / 80s. I walked through the UQ bookshop recently (admittedly a kind of strawpoll of what’s being studied by textbook display count). Vast shelves (and I mean vast relatively speaking) were devoted to Business, Management and Business Economics (whatever in heck that is). Virtually no or very little shelf space I could find was devoted to History (Economic history or otherwise), nor Philosophy, nor (strangely) Medicine nor Political Economy (nary a book by or about Keynes or Marx that I could see). Literature, science and computer science seemed to get a bit of a look-in. Now maybe I missed some sections but it seemed passing strange to me and a sea-change from say 35 to 40 years ago when I was an undergrad.

    Something very odd, very deleterious and deeply concerning has happened to the intellectual life of the West in the last 40 years. No wonder we are in such a mess.

  6. @Ikonoclast

    In my opinion, the change in the structure of the undergraduate economic course is due largely to the change in the mangement style of universities. I think Bill Mitchell and a fair number of academics also agree on this point.

    As much as I dislike the change in university economics, I don’t think non-ideological graduates in the current undergraduate programs will advocate fiscal austerity in EU or the US thinking the fiscal mutiplier is zero or negative from the models they have been taught. To conclude? If the EU even tries to follow the simple undergraduate textbook rather than the New Classical ideology, it won’t be in the mess its in right now.

  7. If the rot started with the discovery of the Phillips curve in 1958, the rot started much earlier. See THE EARLY HISTORY OF THE PHILLIPS CURVE by Thomas M. Humphrey 1985.

    Prototypal Phillips curve analysis is in the writings of David Hume (1752), Henry Thornton (1801), and John Stuart Mill

    Irving Fisher’s 1926 statistical analysis was republished as I discovered the Phillips curve in 1973. Jan Tinbergen estimated the wage-change version in 1936

    Phillips was seen as the discoverer because, Humphrey concluded, because “by providing a ready-made justification for discretionary intervention and activist fine tuning, this interpretation helped make the Phillips curve immensely popular among Keynesian policy advisors.”

    The 100-years stable Phillips curve trade-off disappeared for the reasons provided by Lucas. People anticipated the interventions.

  8. JQ, did you see that Krugman acknowledged your 1958 argument at the AEA meetings a few days ago, at a panel on the macroeconomics of recessions? There’s a transcript in DeLong’s blog.

  9. John, maybe Robert Gordon is right about pre-1978 Keynesian macroeconomics being better. Krugman may be well on the money too about pre-1978.

    Nelson and Schwartz specially addressed this point in their response to his carping at the time of Milton Friedman’s death.

    • Krugman (2007d) said: “The key thing is that good Keynesianism, as embodied even in undergrad textbooks of the time, was perfectly OK: Dornbusch and Fischer, 1978 edition, offered a description of what disinflation would look like that matches the experience of the ’80s reasonably well, and the textbook does not seem all that dated even now.”

    • Nelson and Schwartz going on to say that “a major reason why Dornbusch and Fischer (1978) “does not seem all that dated even now” is because it incorporates many monetarist ideas.” Dornbusch and Fisher (1978, p. 520) observe ‘Much of the analysis of this book would, a few years ago, have been considered monetarist.”

    See pp. 18-19.

    Tom Sargent also pointed out that Keynesians such as in the renditions of Berkley story of macroeconomics say that the natural rate hypothesis was well accepted in the very early 1970s.

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