Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 19 April 2018

Did macroeconomics give up on explaining recent economic history?

The debate that continues about whether a Phillips curve still exists partly reflects the situation in various countries where unemployment has fallen to levels that had previously led to rising inflation but this time wage inflation seems pretty static. In all probability this reflects two things: the existence of hidden unemployment, and that the NAIRU has fallen. See Bell and Blanchflower on both for the UK.

The idea that the NAIRU can move gradually over time leads many to argue that the Phillips curve itself becomes suspect. In this post I tried to argue this is a mistake. It is also a mistake to think that estimating the position of the NAIRU is a mugs game. It is what central banks have to do if they take a structural approach to modelling inflation (and what other reasonable approaches are there?). Which raises the question as to why analysis of how the NAIRU moves is not a more prominent part of macro.

The following account may be way off, but I want to set it down because I am not aware of seeing it outlined elsewhere. I want to start with my account of why modern macro left the financial sector out of their models before the crisis. To cut a long story short, a focus on business cycle dynamics meant that medium term shifts in the relationship between consumption and income were largely ignored. Those who did study these shifts convincingly related them to changes in financial sector behaviour. Had more attention been paid to this, we might have seen much more analysis and more understanding of finance to real linkages.

Could the same story be told about the NAIRU? As with medium term trends in consumption, there is a literature on medium term movements in the NAIRU (or structural unemployment), but it does not tend to get into the top journals. One of the reasons, as with consumption, is that such analysis tends to be what modern macroeconomists would call ad hoc: it uses lots of theoretical ideas, none of which are carefully microfounded within the same paper. That is not a choice by those who do this kind of empirical work, but a necessity.

Much the same could apply to other key macro aggregates like investment. When economists ask whether investment is currently unusually high or low, they typically draw graphs and calculate trends and averages. We should be able to do much better than that. We should instead be looking at the equation that best captures the past 30 odd years of investment data, and asking whether it currently over or under predicts. The same is true for equilibrium exchange rates.

It was not just the New Classical Counter Revolution in macro that led to this downgrading of what we might call structural time series analysis of key macro relationships. Equally responsible was Sims famous paper 1980 ‘Macroeconomics and Reality’, that attacked the type of identification restrictions used in time series analysis and which proposed instead VAR methods. This perfect storm relegated the time series analysis that had been the bread and butter of macroeconomics to the minor journals.

I do not think it is too grandiose to claim that as a consequence macroeconomics gave up on trying to explain recent macroeconomic history: what could be called the medium term behaviour of macroeconomic aggregates, or why the economy did what it did over the last 30 or 40 years. Macro focused on the details of how business cycles worked, instead of how business cycles linked together.

Leading macroeconomists involved in policy see the same gaps, but express this dissatisfaction in a different way (with the important exception of Olivier Blanchard). For example John Williams, who has just been appointed to run the New York Fed, calls here for the next generation of DSGE models to focus on three areas. First they need to have a greater focus on modelling the labour market and the degree of slack, which I think amounts to the same thing as how the NAIRU changes over time. Second, he talks about a greater focus on medium- or long- run developments to both the ‘supply’ and ‘demand’ sides of the economy. The third of course involves incorporating the financial sector.

Perhaps one day DSGE models will do all this, although I suspect the macroeconomy is so complex that there will always be important gaps in what can be microfounded. But if it does happen, it will not come anytime soon. It is time that macroeconomics revisited the decisions it made around 1980, and realise that the deficiencies with traditional time series analysis that it highlighted were not as great as future generations have subsequently imagined. Macroeconomics needs to start trying to explain recent macroeconomic history once again.


  1. Slavery and low wages both prove the phillips curve is nonsense! if full employment increased wages then slavery would have abolished itself,that may sound silly and is! but only because of the very limited way slavery and therefore low wage economies people can act on the economy itself! the fact is what is more important is the values placed on work that gives the worker access to the marketplace and even the freedom to choose in the marketplace! it is the price of employment not the amount of employment that dictates whether through the cycle unemployment will be high or low the more people who have access to a dynamic market only increases the dynamism of that market!full employment ,no employment wouldn't matter as long as they actually have access to act within the market! and inequality and the false valuation are the cause! the difference between the value given to anything and it true value to economy is the damage it does to the economy!(that includes both over and under valuations) and they can be measured by the damage it does do to the economy! and taxation is the quickest although not the only way to alleviate that damage,markets will and never have given up any privilege it has add! that is why unregulated markets are very inefficient!

  2. Simon about NAIRU I hope you will read this argument that it need not exist i.e. that lower unemployment would mean higher, but steady, inflation, without acceleration at any point.

  3. It is good that during and after his transcendence to emeritus our blogger is expressing less obliquely his dissatisfaction with the "state of the art" and the imaginative quest for "internal consistency" at the expense of the external variety; maybe in 5 years time he will feel in retrospect even less satisfied with post-1980 Economics.

    As to the Phillips curve/NAIRU I found most persuasive the paper thatwhows that in retrospect there is a relationship between wages and inflation in soem periods of time but not in others, and that which period will or won't have a relationship cannot be determined in advance. Put another way, policy cannot be based on pushing down just wages to limit inflation.
    Nut the real goal of policy seems to have been not inflation, but wages (push them down) and asset prices (push them up via lower inflation than targeted and thus very low interest rates). The usual quotes from G Osborne, D Cameron, M King:

    «Osborne admitted that the darkening international economic outlook would have repercussions for the UK but insisted that he had no intention of amending his tough deficit reduction plans. It was up to the Bank of England, he added, to support demand over the coming months.
    "A credible fiscal plan allows you to have a looser monetary policy than would otherwise be the case. My approach is to be fiscally conservative but monetarily active."»

    ««It is hard to overstate the fundamental importance of low interest rates for an economy as indebted as ours… …and the unthinkable damage that a sharp rise in interest rates would do. When you’ve got a mountain of private sector debt, built up during the boom… …low interest rates mean indebted businesses and families don’t have to spend every spare pound just paying their interest bills. In this way, low interest rates mean more money to spare to invest for the future. A sharp rise in interest rates – as has happened in other countries which lost the world’s confidence – would put all this at risk… …with more businesses going bust and more families losing their homes.»

    «While other countries were phasing in entry from eastern Europe into their labour forces, Tony Blair was urged by Bank of England governor Mervyn King “to open the labour market without transition on the grounds that it would help lower wage growth and inflation”.»

  4. «what could be called the medium term behaviour of macroeconomic aggregates, or why the economy did what it did over the last 30 or 40 years»

    JM Keynes IIRC in his comment on J Tinbergen's econometrics pointed out that there are structural changes that happen, what some people call changes of "regime", for which different models have to be written, and these happen rather more often than every 30-40 years. As Steve Keen has shown for the UK, there was a dramatic regime change manifest in the trend line for UK private debt:

    That would be 38 years ago, but there have been other big regime changes in between, some of them aimed at preventing reversion to the previous regime in the 1990s and then in the 2000s. P Wales of the ONS as reported by F Coppola has spotted some time ago a huge change in productivity in the extractive and energy industries of the UK, and in the period 1982-2007 the UK was a net oil exporter, and the beginning and end of that were other huge regime changes:

    There is huge secular regime change for UK GDP per head around 1955 here:

    and clear bumps ones also in 1980, 1990, and 2008. In the graphs of electricity consumption per head of major first-world economies there is another clear regime change starting 2003-2005 (post China entry in the WTO):

    Looking at several financial indicators it is clear (and several "unaligned" people have seen it too) that there is a significant regime change in the USA in 1980 and a huge one in 1995 and again in 2001.

    All these are clearly related to enormous changes in the policy landscape, not necessarily economic policy changes, but changes in the regulatory environment and the geopolitical situation. They tend to happen every 10-15 years or sometimes even more often... Which makes M Friendman's suggestion to keep monetary (credit) policy braodly constant somewhat attractive however much I consider M Friedmand a "voodoo Economics" fantasist.

    1. The broader trend has been toward free lunch economics.

      Instead of increasing labor costs to put money in worker pockets, cost cuts put more money in your pockets.

      Before 1980, "more money in your pocket" meant higher wages (and higher prices), but since has meant cutting labor costs while keeping prices the same, except for asset prices which inflate in price as fast as the assets depreciate.

  5. Macro-economists today are very happy when they see Model. The same applies with the Phillips Curve - whether it seems that there is a relationship between unemployment inflation or not is purely one of chance. You are not really going to get very close to understanding what is actually going on by looking at things this way. This is another example of the excessive faith in formalism, and the costs this has in terms of our understanding, which of course, ultimately means we have poorer policy. What is needed is more engagement with other disciplines for a better understanding of human and social behaviour and doing the actual fieldwork -talking to, and going through the archives of, banks and business.

    Continual tweaking of models will just continue to take us in circles.


  6. Why does NAIRU seem to be low now and ditto in the 1950s and 60s? How about this? In the 50s and 60s most people had memories of the 30s and were thus grateful for a job and didn't risk it by making excessive wage demands. Likewise right now, people have memories of the recession that started around 2008. So they're not making big wage demands.....yet.

    1. Your gray hair seems to be premature. Born in 1947, I grew up when workers were striking and doing other things, voting in pols who hiked minimum wages, to get what were always described as "excessive wages".

      I read many columns by Milton Friedman about the horrors of "excessive wages" resulting from big government industrial policy. Like inflation from excessive consumption from excessive wages.

      I'm shocked by the passivity today of workers compared to workers in the 50s, 60s, and even 70s, or to mention the stand off between workers and Reagan, a former union leader fighting for "excessive wages" for actors.

      Worker passivity has only made more Trump voters who feel they have been cheated, but they seem to be active supporters of Trump, who promises workers will get paid more so they can consume more, but pay lower prices for everything, by cutting taxes, costly regulations requiring paying workers, cheaper health care (but not killing jobs in health care which has been a strong job sector), ....

      I note conservative pols think worker strikes are purely about winning excessive wages, and they seem shocked when teachers aren't placated by wage hikes, but instead demand overall higher spending and taxes to pay to buy books and fix classrooms, which means paying more to workers who are not teachers.

      Passively accepting lower wages did not help the economies where teachers are now striking. Cutting costs and taxes did not help those economies.

      Economics are zero sum. Wages stagnate or fall and the economy stagnates or declines.

  7. "Perhaps one day DSGE models will do all this.."

    Dynamic - the main reason these models are called "dynamic" is that their construction is ever in a process of modification. Despite the grand allusions to a consistent body of logic supporting these models, there really is none. D should really stand for "deficient".

    Stochastic - sounds too much like sarcastic to have any credibility.

    General Equilibrium - where? If anything these models look like twisted/stilted partial equilibrium constructions, with the presumption that an equilibrium exists somewhere.

    Model - in the end they are a melange of theory and mathematical techniques - optimization, calibration, estimation, which results in a grandiose curve fitting exercise.

    Henry Rech.

  8. It will be very interesting to see the kind of work done to better-estimate the degree of slack in the labor market.

    It seems to me that much of the uncertainty is likely caused by discouraged workers: modeling the conditions under which they return to the labor force seems to me to be a very challenging task (especially as it depends upon the ways in which society hinders or aids the return to the workforce).

  9. Using the acronym “NAIRU” is not advisable: it causes apoplexy among the merry band of “NAIRU haters”. What I do is to refer to something like “the maximum level of employment which is consistent with acceptable” inflation. That comes to the same thing as NAIRU, but I find NAIRU haters are perfectly happy with the latter “consistent” form of words, whereas they go beserk when the letters N,A,I,R and U are strung together....:-)

    1. Not really, since there is a difference beween accelerating inflation, and higher but steady inflation.

  10. Macroeconomics: self-delusion and empty promises
    Comment on Simon Wren-Lewis on ‘Did macroeconomics give up on explaining recent economic history?’

    Simon Wren-Lewis summarizes: “… John Williams … calls here for the next generation of DSGE models to focus on three areas. First they need to have a greater focus on modelling the labour market and the degree of slack, which I think amounts to the same thing as how the NAIRU changes over time. Second, he talks about a greater focus on medium- or long-run developments to both the ‘supply’ and ‘demand’ sides of the economy. The third of course involves incorporating the financial sector. Perhaps one day DSGE models will do all this, although I suspect the macroeconomy is so complex that there will always be important gaps in what can be microfounded. But if it does happen, it will not come anytime soon.”

    It will NEVER come, for the simple reason that the microfoundations approach is methodologically dead. The problem is that the present generation of economists is in the state of manifest self-delusion. The point to grasp is that economics has to be macrofounded.

    For more detail see
    NAIRU and the scientific incompetence of Orthodoxy and Heterodoxy

    Infantile model bricolage, or, How many economists can dance on a non-existing pinpoint?

    DSGE and profit―forget it! MMT and profit―forget it!

    Because the axiomatic foundations of economics are false the whole of economics is false. Economic policy guidance has no sound scientific foundations since Adam Smith/Karl Marx.

    Egmont Kakarot-Handtke

  11. "To cut a long story short, a focus on business cycle dynamics meant that medium term shifts in the relationship between consumption and income were largely ignored."

    I come from physics and engineering where one hard and fast rule is "zero sum". To have a bigger result, you need a bigger input.

    Economics before the 70s clearly assumed zero sum. The economy was modeled like the environment, a closed cycle. In nature waste becomes food, and food becomes waste. Zero sum. Can't have more food without more waste as both product and input.

    Thus consumption and income were zero sum, and given income is cost to the producer, and consumption is income to the producer, increasing consumption requires increasing costs, and cutting costs cuts consumption, and producer income.

    Since circa 1980, I see the rise in free lunch economics where cutting costs increases consumption because free lunch economics rejects the zero sum rule.

    Ie, in free lunch economics, cutting costs, firing workers, paying workers less, will increase consumption, and thus GDP. For every dollar cut in costs, a dollar increase in consumption follows.

    Basically, since the 80s, workers are not consumers, and consumers are not workers. Ie, the economy is not zero sum, and the ideal economy has 0% workers and 100% consumers. A free lunch economy: Consumers consume more without working, business have more income with no costs.

    Savings and debt timeshift individual and firm incomes and consumption, but do not change the economy wide zero sum rule.

    "It is time that macroeconomics revisited the decisions it made around 1980,..." yep, tanstaafl.

    Let's simply go back to Keynes circa 1935. His prescription is dismal science to the free lunch economists who want high profits and capital gains, aka inflating prices of depreciating assets.

  12. NAIRU explains the concept of excess inflation and stagflation

    there are two components to NAIRU

    structural/frictional unemployment which are longer term problems and are not what causes excess inflation

    and involuntary unemployment

    it is only the involuntary unemployment component that plays the role in excess inflation

    there are two factors in excess inflation

    decreased involuntary unemployment increases workers bargaining power leading to increased wage

    the extent of firms monopoly power allows them to increase prices to preserve economic rents

    anything that increase bargaining power at higher levels of unemployment affects the level of NAIRU

    anything that affects firms monopoly power affects the level of NAIRU

    although structural frictional unemployment are important, as far as excess inflation and stagflation go, it is the involuntary unemployment contribution to NAIRU that counts


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