Macro Wars: Solow vs. Lucas: Re: Adam:
I don’t think that Solow, in particular, has ever tried to come to grips with any of these issues except by making jokes
Though, these exchanges are funny I think they reveal something deep and its why I tend to side with Mankiw-Solow camp. Lucas is essentially saying that Keynesian doesn’t make any sense. Solow is responding that Frictionless Markets don’t match reality. My take is that at its heart this is exchange is about whether economics is philosophy or science. For philosophy logical consistency is paramount. But, in science, empirical observation wins. I side with science. If the world doesn’t act like its described by Freshwater Models then all the elegance in the world can’t save you. If the only explanation anyone can think of that fits the data is that a Giant Purple Elephant did it. Then Giant Purple Elephants it is. That doesn’t mean we have to be satisfied with GPE model, but unless you got something better...
The Quotable Bob Solow: Rereading Greg Mankiw’s “The Macroeconomist as Scientist and Engineer” I came across this Bob Solow quote on why he doesn’t bother to seriously engage neoclassical economists:
Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon Bonaparte.
http://qed.econ.queensu.ca/pub/faculty/lloyd-ellis/econ815/papers/mankiw1.pdf: Neither scientists nor engineers have a claim to greater virtue. The story is also not one of deep thinkers and simple-minded plumbers. Science professors are typically no better at solving engineering problems than engineering professors are at solving scientific problems.... As a result of the three waves of new classical economics, the field of macroeconomics became increasingly rigorous and increasingly tied to the tools of microeconomics. The real business cycle models were specific, dynamic examples of Arrow-Debreu general equilibrium theory. Indeed, this was one of their main selling points.... [T]hese three waves of new Keynesian research added up to a coherent microeconomic theory for the failure of the invisible hand to work for short-run macroeconomic phenomena. We understand how markets interact when there are price rigidities, the role that expectations can play, and the incentives that price setters face as they choose whether or not to change prices. As a matter of science, there was much success in this research.... Was this work also successful as a matter of engineering? Did it help policymakers devise better policies to cope with the business cycle? The judgment here must be less positive.... Lucas seems to be complaining that Solow does not appreciate the greater analytic rigor that new classical macroeconomics can offer. Solow seems to be complaining the Lucas does not appreciate the patent lack of reality of his market-clearing assumptions. They each have a point. From the standpoint of science, the greater rigor that the new classicals offered has much appeal. But from the standpoint of engineering, the cost of this added rigor seems too much to bear...
Somehow, I think Greg misses the mark with his definition of "science" here...
Why do we have business cycles? Why do asset prices move around so much? At this stage, macroeconomics has little to offer by way of answer to these questions. The difficulty in macroeconomics is that virtually every variable is endogenous – but the macro-economy has to be hit by some kind of exogenously specified shocks if the endogenous variables are to move. The sources of disturbances in macroeconomic models are (to my taste) patently unrealistic. Perhaps most famously, most models in macroeconomics rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities). None of these disturbances seem compelling, to put it mildly. Macroeconomists use them only as convenient short-cuts to generate the requisite levels of volatility in endogenous variables.... It is not true that all macroeconomic models assume complete financial markets--quite the contrary.... However, few macroeconomic models capture an intermediate messy reality in which markets are incomplete but there are nonetheless many assets and/or asset trade is conducted through intermediaries. As a consequence, we don’t understand the sources (or costs/benefits) of large-scale daily (or even quarterly) financial asset re-allocation. In part, this omission reflects a belief among macroeconomists that this level of institutional detail was not essential for questions of interest. In part, it reflects the extreme difficulty in handling mathematical formalizations of these features of reality.... Again, recent events may well lead to a re-ordering of priorities...
And Robert Lucas again:
In order to get an output [and employment] effect... the exchange of money for goods takes place in some manner other than in a centralized Walrasian market.... [A] given price increase can [then] signal a supplier that the [unanticipated] money transfer x is large, in which case he wants to... not respond, or it can mean... a real shift in his favor [to which he should] respond by producing more [and hiring more]. The best the individual can do... is to hedge.... Equilibrium prices... move in proportion to [the anticipated monetary shock] m which is known to all traders, but increase less than proportionally with the [unanticipated monetary] transfer x.... Anticipated monetary expansions... [do not create misperceptions of real prices and] are not associated with the kind of stimulus to employment and production that Hume described. Unanticipated monetary expansions... [do create misperceptions of real prices and] stimulate production... unanticipated contractions... induce depression. The importance of this distinction between anticipated and unanticipated monetary changes is an implication of every one of the many different models, all using rational expectations... developed during the 1970s.... The discovery of the central role of the distinction between anticipated and unanticipated money shocks resulted from the attempts, on the part of many researchers, to formulate mathematically explicit models that were capable of addressing the issues raised by Hume.
But... none of the specific models... [is a] satisfactory theory of business cycles...
Earlier in his Nobel Prize Lecture Lucas explained why:
In the models... real effects of monetary policy need to work through movements in prices. The [favorable econometric] tests described in the last paragraph do not use data on prices and so do not test this prediction. Other econometric work that did require money shocks to be transmitted through price movements was much less favorable. Estimates in Sargent (1976) and in Leiderman (1979) indicated that only small fractions of output variability can be accounted for by unexpected price movements. Though the evidence seems to show that monetary surprises have real effects, they do not seem to be transmitted through price surprises...
And then he picks up the thread again:
Perhaps in part as a response to the difficulties with the monetary-based business cycle models of the 1970s, much recent research has followed the lead of Kydland and Prescott (1982) and emphasized the effects of purely real forces on employment and production. This research has shown how general equilibrium reasoning can add discipline to the study of an economy’s distributed lag response to shocks, as well as to the study of the nature of the shocks themselves. More recently, many have tried to re-introduce monetary features into these models, and I expect much future work in this direction. But who can say how the macroeconomic theory of the future will develop, any more than anyone in 1960 could have foreseen the developments I have described in this lecture? All one can be sure of is that progress will result from the continued effort to formulate explicit theories that fit the facts, and that the best and most practical macroeconomics will make use of developments in basic economic theory.
I will just remark that "discovery" is used in an unusual way here: Lucas "discovers" that anticipated monetary shocks don't and unanticipated monetary shocks do have real effects because anticipated monetary shocks don't and unanticipated monetary shocks do move relative prices in a way that is correlated with movements in employment and production. But they don't. This to me to be very different than Galileo's discovery of the moons of Jupiter, or Rutherford's discovery of the atomic nucleus, or Crick, Russell, and Watson's discovery of the structure of DNA.