Saturday, 28 June 2014

Understanding the New Classical revolution

In the account of the history of macroeconomic thought I gave here, the New Classical counter revolution was both methodological and ideological in nature. It was successful, I suggested, because too many economists were unhappy with the gulf between the methodology used in much of microeconomics, and the methodology of macroeconomics at the time.

There is a much simpler reading. Just as the original Keynesian revolution was caused by massive empirical failure (the Great Depression), the New Classical revolution was caused by the Keynesian failure of the 1970s: stagflation. An example of this reading is in this piece by the philosopher Alex Rosenberg (HT Diane Coyle). He writes: “Back then it was the New Classical macrotheory that gave the right answers and explained what the matter with the Keynesian models was.”

I just do not think that is right. Stagflation is very easily explained: you just need an ‘accelerationist’ Phillips curve (i.e. where the coefficient on expected inflation is one), plus a period in which monetary policymakers systematically underestimate the natural rate of unemployment. You do not need rational expectations, or any of the other innovations introduced by New Classical economists.

No doubt the inflation of the 1970s made the macroeconomic status quo unattractive. But I do not think the basic appeal of New Classical ideas lay in their better predictive ability. The attraction of rational expectations was not that it explained actual expectations data better than some form of adaptive scheme. Instead it just seemed more consistent with the general idea of rationality that economists used all the time. Ricardian Equivalence was not successful because the data revealed that tax cuts had no impact on consumption - in fact study after study have shown that tax cuts do have a significant impact on consumption.

Stagflation did not kill IS-LM. In fact, because empirical validity was so central to the methodology of macroeconomics at the time, it adapted to stagflation very quickly. This gave a boost to the policy of monetarism, but this used the same IS-LM framework. If you want to find the decisive event that led to New Classical economists winning their counterrevolution, it was the theoretical realisation that if expectations were rational, but inflation was described by an accelerationist Phillips curve with expectations about current inflation on the right hand side, then deviations from the natural rate had to be random. The fatal flaw in the Keynesian/Monetarist theory of the 1970s was theoretical rather than empirical.


6 comments:

  1. Krugman blogs September 9, 2013, 'C’est La V No More', October 30, 2011 'A Volcker Moment Indeed (Slightly Wonkish)' and August 5, 2011 'Notes on the Un-recovery' answer this Rosenberg non-issue.

    The odd political reaction to stagflation seems more to come from, in the UK, silliness from some shop stewards, but more importantly, the OPEC I and II crises that reversed a little bit of that Empire-thinking which was slowly fading from the political toolkit of UK government.


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  2. A scathing attack on DSGE and the New Classical Revolution by Robert Gordon.

    http://faculty-web.at.northwestern.edu/economics/gordon/gru_combined_090909.pdf

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  3. I agree 99.9-100% with this excellent post (instead of the usual 99% plus narcissism of small differences). I am quite sure that old Keynesians didn't say stagflation was impossible, and that old Keynesian models were rapidly adjusted to fit the 1970s data.

    But I think there might be a semantic disagreement about the meaning of the word "stagflation". In the USA it was certainly used to refer to a combination of high unemployment and high inflation, without the additional implication that the high inflation was highly persistent. I recall the word appeared promptly in 1974 or 1975 at the latest when there was very little evidence related to the persistence of inflation.

    High inflation and high unemployment can occur together even if the coefficient on expected inflation in an augmented Phillips curve is less than one. The 70s certainly did not provide proof that it is one and not say 0.9999. They can also occur together in the non accelerationist model in which the coefficient on expected inflation is one but expected inflation is, say, a linear function of lagged inflation with coefficients which add up to less than one.

    Here I agree 100% with you, if by stagflation you mean permanently high inflation combined with stable unemployment (but note that we won't know if something is permanent in a million years or any finite amount of time).

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  4. Simon, I enjoyed this post as well as your old post that you linked to about the neo-classical synthesis. I like getting a flavor of the history of these various ideas, although I'm definitely an amateur and am not familiar with many of the details of some of the concepts you discuss. In terms of general equilibrium and ADM, by coincidence I just finished reading another series of posts looking at the subject from a completely different point of view. I can't say I grasped this series any better that your posts, but I do think I generally understand the author's conclusion. I'm curious about your reaction:

    "...I'm abandoning Arrow-Debreu-McKenzie equilibrium. Not because it is hard, but because it is likely meaningless for macroeconomics."

    http://informationtransfereconomics.blogspot.com/2014/06/towards-arrow-debreu-mckenzie_27.html

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  5. “Stagflation is very easily explained: you just need an ‘accelerationist’ Phillips curve . . . plus a period in which monetary policymakers systematically underestimate the natural rate of unemployment.”

    That strikes me as a contradiction in terms. That is, stagflation is by definition a combination of higher than usual unemployment and higher than usual inflation. And that’s a scenario in which “monetary policymakers” are almost certainly NOT UNDERESTIMATING the “natural rate”.

    Also, the “accelerationist” version of the Phillips curve (i.e. NAIRU or something like NAIRU) is not strictly necessary. That is, if the authorities are underestimating the natural rate of unemployment, then inflation will be on the high side regardless of whether the relationship between inflation and unemployment is a la Phillips or a la NAIRU.

    In short, there has to be some other explanation for the 1970s stagflation. And I agree with Anonymous’s suggestions (above) along these lines. To enlarge on Anon’s points, those who cite the oil price hike in the early 70s might have a point. Also, Anon’s point about shop stewards rings a bell with me. To enlarge on that….

    For the two decades or so after WWII most people had memories of the 1930s and were thus grateful for a job. They kept their noses to the grindstone. By the 1970s or thereabouts, most employees had no memories of the 1930s and adopted a more cavalier attitude to their jobs.

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  6. Brilliant post.

    The difference between the monetarist counterrevolution and the New Classical counterrevolution is too rarely overlooked, and you make the great point that stagflation alone cannot explain the latter.

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