Tyler Cowen on the State of Macroeconomics
The Curious Case of Macroeconomics Today

Sketch of a Talk on the History of Macroeconomic Thought since 1960...

Mark Thoma says that we would have better economists if young economists did not imitate Robert Lucas and sit in the back and giggle when people like Mike Mussa are talking:

Ask the right questions: [T]he important question is why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model?... And... why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed? It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession...? It wasn't the tools, and it wasn't lack of imagination.... [T]he voices were there... Michael Mussa for one.... Nobody listened even though some people....

And here I think that thought leaders such as Robert Lucas and others... have questions they should ask themselves (e.g. Mr Lucas saying: "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another"...).... [That] influences whole generations of economists away from asking certain types of questions, some of which turned out to be important. Why was it necessary for the major leaders in macroeconomics to shut down alternative lines of inquiry...?...

People will always be passionate in defense of their life's work, so it's not the rhetoric itself that is of concern, the problem comes when factors such as ideology or control of journals... stand in the way of promising alternative lines of inquiry...

I must confess that I am puzzled. The way I was taught macroeconomics back at the start of the 1980s was that the emergence of stagflation over 1969-1974 was a major intellectual challenge to the Okun-Samuelson-Solow-Tobin view that:

Samuelson and Solow: "Analytical Aspects of Anti-Inflation Policy": price stability... involve[s] about 5% per cent unemployment; whereas... 3 per cent unemployment... involve[s] a price rise of about 4% per cent per annum.... It would be wrong... to think that our... menu... will maintain its same shape.... [P]olicy... during the next few years might cause it to shift.... [A] low-pressure economy... might... so act upon wage and other expectations as to shift the curve downward... so that over a decade, the economy might enjoy higher employment with price stability than our present-day estimate would indicate. But also the opposite is conceivable. A low-pressure economy might build up within itself over the years larger and larger amounts of structural unemployment.... The result would be an upward shift of our menu of choice, with more and more unemployment being needed just to keep prices stable. Since we have no conclusive or suggestive evidence on these conflicting issues, we shall not attempt to give judgment on them...

and led to a great deal of soul-searching and agonized reappraisal. One piece of that reappraisal was made up of Robert Lucas's hypotheses that:

  1. Households and firms have rational expectations.
  2. Shocks to the money stock that are rationally anticipated affect all prices equally and have no effect on perceived or actual real wages, real interest rates, production, and employment.
  3. Shocks to the money stock that are unanticipated--that cannot have been rationally forecast beforehand--do affect some prices more than others, lead to confusion about what relative prices are, and affect levels of production and employment until that confusion is cleared up.

The interesting thing I thought back at the time was that the Volcker Deflation of 1979-1984 posed as great an intellectual challenge to Lucas's point of view as the emergence of stagflation had to Okun-Samuelson-Solow-Tobin a decade before. And here let me turn the mike over to Paul Krugman:

The lessons of 1979-82: [T]he experience of stagflation... disprove[d] was the naive Phillips curve... stable tradeoff between unemployment and inflation.... [M]acroeconomists... accepted... the Friedman/Phelps natural rate... sustained inflation gets built into price-setting... inflation... persist[s] for a while even in the face of high unemployment. But that’s very far from rejecting the basic Keynesian insight that demand matters....

What’s odd, though, is... [tht] the way the 70s ended... [was] a huge vindication of Keynesianism.... [T]he Fed decided to squeeze inflation out of the system through a monetary contraction... [which] in Lucas-type rational expectations... should have caused [only] a [short] rise in unemployment... to the extent... people didn’t realize what the Fed was doing; once the policy shift was clear... the economy should have returned to the natural rate. [And i]f you believed in real business cycle theory, the Fed’s policies should have had no real effect at all. What actually happened was a terrible, three-year slump, which eased only when the Fed relented. It was 79-82 that made me a convinced saltwater economist. And nothing that has happened since--certainly not the current crisis--has dented that conviction...

Indeed, one way to view the 1980s is that both of the Samuelson-Solow predictions of the long-run consequences of a deflation--of the deliberate creation of a low-pressure economy by the Federal Reserve--came true but in different places. In the U.S. the Volcker Deflation caused a vicious recession, but a decade later unemployment was moderate and inflation was low as the long-run effects of the deflation on expectations improved the short-run inflation-unemployment tradeoff in the United States. By contrast, in western Europe the Thatcher Deflation and its continental cousins produced over a decade a huge rise in structural unemployment and a deterioration in the terms of the short-run inflation-unemployment tradeoff.

But while stagflation led to a serious rethinking of its visualization of the Cosmic All on the part of Cambridge, the Volcker Deflation did not lead to any similar rethinking on the part of Chicago. "I'm not interested in studying the latest residual..." was a not-atypical seminar parry.

And as in any dynamic Markov system subject to shocks in which one state is absorbing, over time that absorbing state will grow in mass and importance--whether or not it is in some sense true. There is a good sociological model of fundamentalism in there somewhere...

Comments