Mainly for macroeconomists and those interested in macroeconomic thought
Following this little interchange (me, Mark Thoma, Paul Krugman, Noah Smith, Robert Waldman, Arnold Kling), I reread what could be regarded as the New Classical manifesto: Lucas and Sargent’s ‘After Keynesian Economics’ (hereafter LS). It deserves to be cited as a classic, both for the quality of ideas and the persuasiveness of the writing. It does not seem like something written 35 ago, which is perhaps an indication of how influential its ideas still are.
What I want to explore is whether this manifesto for the New Classical counter revolution was mainly about stagflation, or whether it was mainly about methodology. LS kick off their article with references to stagflation and the failure of Keynesian theory. A fundamental rethink is required. What follows next is I think crucial. If the counter revolution is all about stagflation, we might expect an account of why conventional theory failed to predict stagflation - the equivalent, perhaps, to the discussion of classical theory in the General Theory. Instead we get something much more general - a discussion of why identification restrictions typically imposed in the structural econometric models (SEMs) of the time are incredible from a theoretical point of view, and an outline of the Lucas critique.
In other words, the essential criticism in LS is methodological: the way empirical macroeconomics has been done since Keynes is flawed. SEMs cannot be trusted as a guide for policy. In only one paragraph do LS try to link this general critique to stagflation:
“Though not, of course, designed as such by anyone, macroeconometric models were subjected to a decisive test in the 1970s. A key element in all Keynesian models is a trade-off between inflation and real output: the higher is the inflation rate, the higher is output (or equivalently, the lower is the rate of unemployment). For example, the models of the late 1960s predicted a sustained U.S. unemployment rate of 4% as consistent with a 4% annual rate of inflation. Based on this prediction, many economists at that time urged a deliberate policy of inflation. Certainly the erratic ‘fits and starts’ character of actual U.S. policy in the 1970s cannot be attributed to recommendations based on Keynesian models, but the inflationary bias on average of monetary and fiscal policy in this period should, according to all of these models, have produced the lowest unemployment rates for any decade since the 1940s. In fact, as we know, they produced the highest unemployment rates since the 1930s. This was econometric failure on a grand scale.”
There is no attempt to link this stagflation failure to the identification problems discussed earlier. Indeed, they go on to say that they recognise that particular empirical failures (by inference, like stagflation) might be solved by changes to particular equations within SEMs. Of course that is exactly what mainstream macroeconomics was doing at the time, with the expectations augmented Phillips curve.
In the schema due to Lakatos, a failing mainstream theory may still be able to explain previously anomalous results, but only in such a contrived way that it makes the programme degenerate. Yet, as Jesse Zinn argues in this paper, the changes to the Phillips curve suggested by Friedman and Phelps appear progressive rather than degenerate. True, this innovation came from thinking about microeconomic theory, but innovations in SEMs had always come from a mixture of microeconomic theory and evidence.
This is why LS go on to say: “We have couched our criticisms in such general terms precisely to emphasise their generic character and hence the futility of pursuing minor variations within this general framework.” The rest of the article is about how, given additions like a Lucas supply curve, classical ‘equilibrium’ analysis may be able to explain the ‘facts’ about output and unemployment that Keynes thought classical economics was incapable of doing. It is not about how these models are, or even might be, better able to explain the particular problem of stagflation than SEMs.
In their conclusion, LS summarise their argument. They say:
“First, and most important, existing Keynesian macroeconometric models are incapable of providing reliable guidance in formulating monetary, fiscal and other types of policy. This conclusion is based in part on the spectacular recent failures of these models, and in part on their lack of a sound theoretical or econometric basis.”
Reading the paper as a whole, I think it would be fair to say that these two parts were not equal. The focus of the paper is about the lack of a sound theoretical or econometric basis for SEMs, rather than the failure to predict or explain stagflation. As I will argue in a subsequent post, it was this methodological critique, rather than any superior empirical ability, that led to the success of this manifesto.