On the rotten state of macroeconomics

6 January, 2013 at 12:25 | Posted in Economics | 1 Comment

The classical position may be restated as saying that the fiscal multiplier is zero. The core of New Classical economics is the reassertion of this claim. If workers are unemployed it was either because they are unwilling to work at the going wage or because some artificial barrier (unions or minimum wages) stops wages from adjusting to their equilibrium level. To the extent that Keynesian policies worked, New Classical economists like Lucas argued, it was by generating unanticipated inflation and tricking workers into accepting wages that were higher in nominal terms but lower in real terms.

Before the current crisis, New Keynesians conceded a fair bit of ground to the classical view, but argued for a positive multiplier, though not necessarily greater than 1. One way of putting this is that public expenditure partially “crowds out” private spending. But most NK advocates thought fiscal policy unnecessary, since monetary policy had the same effects and was easier to manage.

I criticized the New Classical view last time, but the dominant idea in European and many US policy circles is even worse. It’s, the theory of expansionary austerity put forward by Alesina and various co-authors that the fiscal multiplier is substantial and negative. That is, cutting public expenditure will increase output.

This claim has no real theoretical basis and almost no empirical support, being based largely on anecdotal evidence and on a few studies that have not stood up to criticism …

To sum up, despite the thousands of papers published every year in the field, macroeconomic theory is incapable of giving even a qualitative answer to the most basic questions about fiscal policy … Worse, public policy decisions to impose austerity policies are being made on the basis of a magical theory, with almost no empirical support.

This is an appalling situation, made worse by the complacency of (the dominant group of) academic macroeconomic specialists, who seem to think that everything in the garden is rosy … It really is hard for me to see how the economics profession can recover from its current rotten state, at least as regards macro (and, even worse, finance).

…

On balance, I think macroeconomics has gone backwards since the discovery of the Phillips curve in 1958 … To be sure, quite a lot has been learned, but as far as policy is concerned, even more has been forgotten. The result is that lots of economists are now making claims that would have been considered absurd, even by pre-Keynesian economists like Irving Fisher …

The real decline was in the 1970s and 1980s, as Friedman’s already overstated critique of Keynesianism was pushed to the limits of credibility and beyond. The big ideas of the period: Ricardian equivalence, Rational Expectations, Policy Ineffectiveness, Microfoundations, Real Business Cycle theory and the (strong-form) Efficient Markets Hypothesis were based on plausible (to economists, anyway) arguments. They didn’t have much empirical support but, given that Keynesian models weren’t working well either, this wasn’t enough to stop them taking over the debate.

The main response was New Keynesianism which showed that with plausible tweaks to the standard micro assumptions, some Keynesian results were still valid, at least in the short run. New Keynesianism gave a rationale for the countercyclical monetary policies pursued by central banks in the inflation targeting era, whereas the classical view implied that a purely passive policy, such as Friedman’s money supply growth rule, was superior. Broadly speaking the pre-crisis consensus consisted of New Keynesians accepting the classical position in the long run, and most of Friedman’s views on short-term macro issues, and abandoning advocacy of fiscal policy, while the New Classicals acquiesced in moderately active short-term monetary policy …

To sum up, work done in macroeconomics since the discovery of the Phillips curve has offered an improved understanding of a wide range of issues. On the other hand, it has produced and sustained the dominance, in central banks and in much of the economics profession, of an empirically unsupportable position that is resolutely opposed to fiscal stimulus, or to any large-scale countercyclical policy. It has also diverted most of the intellectual energy of academic macroeconomists into a largely fruitless search for microfoundations, at the expense of an improved understanding of the various co-ordination failures that are at the heart of the macroeconomic problem.

I don’t suggest throwing out everything that’s been done since 1958 and starting all over from there. But, in many ways, that would be a better choice than continuing on the current path.

John Quiggin

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