Wren-Lewis on the New Classical Counter Revolution

2 Feb, 2016 at 18:19 | Posted in Economics | 5 Comments

Simon Wren-Lewis argues in a new paper — Unravelling the New Classical Counter Revolution — that it is essential to understand the success of the New Classical Counter Revolution (NCCR), if we are going to be able to position Keynes’s  General Theory today. Writes Wren-Lewis:

One other undoubted appeal that the NCCR had was that it allowed macroeconomics to be brought back under the microeconomics umbrella. New Keynesian economists can talk about how business cycles involve an externality (price rigidity reflecting the cost of adjusting individual prices also has an impact on overall demand), and this market failure requires state intervention. This is language their micro colleagues can relate to …

The theoretical insights that New Classical economists brought to the table were impressive: besides rational expectations, there was a rationalisation of permanent income and the life-cycle models using intertemporal optimisation, time inconsistency and more …

A new revolution, that replaces current methods with older ways of doing macroeconomics, seems unlikely and I would argue is also undesirable. The discipline does not need to advance one revolution at a time …

To understand modern academic macroeconomics, it is no longer essential that you start with The General Theory. It is far more important that you read Lucas and Sargent (1979), which is a central text in what is generally known as the New Classical Counter Revolution (NCCR). That gave birth to DSGE models and the microfoundations programme, which are central to mainstream macroeconomics today …

Hmm …

There’s something that just does not sit very well with this picture of modern macroeconomics.

‘Read Lucas and Sargent (1979)’. Yes, why not. One who has read it is Wren-Lewis’s ‘New Keynesian’ buddy Paul Krugman. And this is what he has to say on that reading experience:

Lucas and his school … went even further down the equilibrium rabbit hole, notably with real business cycle theory. And here is where the kind of willful obscurantism Romer is after became the norm. I wrote last year about the remarkable failure of RBC theorists ever to offer an intuitive explanation of how their models work, which I at least hinted was willful:

“But the RBC theorists never seem to go there; it’s right into calibration and statistical moments, with never a break for intuition. And because they never do the simple version, they don’t realize (or at any rate don’t admit to themselves) how fundamentally silly the whole thing sounds, how much it’s at odds with lived experience.”

Paul Krugman

Yours truly, of course, totally agrees with Paul on Lucas’ rabbit hole freshwater school.

And so does Truman F. Bewley:

Lucas and Rapping (1969) claim that cyclical increases in unemployment occur when workers quit their jobs because wages or salaries fall below expectations …

According to this explanation, when wages are unusually low, people become unemployed in order to enjoy free time, substituting leisure for income at a time when they lose the least income …

According to the theory, quits into unemployment increase during recessions, whereas historically quits decrease sharply and roughly half of unremployed workers become jobless because they are laid off … During the recession I studied, people were even afraid to change jobs because new ones might prove unstable and lead to unemployment …

If wages and salaries hardly ever fall, the intertemporal substitution theory is widely applicable only if the unemployed prefer jobless leisure to continued employment at their old pay. However, the attitude and circumstances of the unemployed are not consistent with their having made this choice …

In real business cycle theory, unemployment is interpreted as leisure optimally selected by workers, as in the Lucas-Rapping model. It has proved difficult to construct business cycle models consistent with this assumption and with real wage fluctuations as small as they are in reality, relative to fluctuations in employment.

This is, of course, only what you would expect of New Classical Chicago economists.

So, what’s the problem?

The problem is that sadly enough this extraterrestial view of unemployment is actually shared by Wren-Lewis and other so called ‘New Keynesians’ — a school whose microfounded dynamic stochastic general equilibrium models cannot even incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with microfunded representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility.

In the basic DSGE models used by most ‘New Keynesians’, the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

To Wren-Lewis is seems as though the ‘New Keynesian’ acceptance of rational expectations, representative agents and microfounded DSGE models is something more or less self-evidently good. Not all economists (yours truly included) share that view:

While one can understand that some of the elements in DSGE models seem to appeal to Keynesians at first sight, after closer examination, these models are in fundamental contradiction to Post-Keynesian and even traditional Keynesian thinking. The DSGE model is a model in which output is determined in the labour market as in New Classical models and in which aggregate demand plays only a very secondary role, even in the short run.

In addition, given the fundamental philosophical problems presented for the use of DSGE models for policy simulation, namely the fact that a number of parameters used have completely implausible magnitudes and that the degree of freedom for different parameters is so large that DSGE models with fundamentally different parametrization (and therefore different policy conclusions) equally well produce time series which fit the real-world data, it is also very hard to understand why DSGE models have reached such a prominence in economic science in general.

Sebastian Dullien

Neither New Classical nor ‘New Keynesian’ microfounded DSGE macro models have helped us foresee, understand or craft solutions to the problems of today’s economies.

Wren-Lewis ultimately falls back on the same kind of models that he criticize, and it would sure be interesting to once hear him explain how silly assumptions like ‘hyperrationality’ and ‘representative agents’ help him work out the fundamentals of a truly Keynesian macroeconomic analysis.

In a recent paper on modern macroeconomics, another of Wren-Lewis’s ‘New Keynesian’ buddies, macroeconomist Greg Mankiw, wrote:

The real world of macroeconomic policymaking can be disheartening for those of us who have spent most of our careers in academia. The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.’s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation’s top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering.

So, then what is the raison d’être of macroeconomics, if it has nothing to say about the real world and the economic problems out there?

If macoeconomic models – no matter of what ilk – assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Macroeconomic theorists – regardless of being ‘New Monetarist’, ‘New Classical’ or ‘New Keynesian’ – ought to do some ontological reflection and heed Keynes’ warnings on using thought-models in economics:

The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organized and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking. Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error.

 

So, these are some of my arguments for why I think that Simon Wren-Lewis ought to be even more critical of the present state of macroeconomics than he is. If macroeconomic models – no matter of what ilk –  build on microfoundational assumptions of representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Trying to represent real-world target systems with models flagrantly at odds with reality is futile. And if those models are New Classical or ‘New Keynesian’ makes very little difference.

Simon Wren-Lewis [writes]:

“It is hard to get academic macroeconomists trained since the 1980s to address [large scale Keynesian models] , because they have been taught that these models and techniques are fatally flawed because of the Lucas critique and identification problems … But DSGE models as a guide for policy are also fatally flawed because they are too simple. The unique property that DSGE models have is internal consistency … Take a DSGE model, and alter a few equations so that they fit the data much better, and you have what could be called a structural econometric model. It is internally inconsistent, but because it fits the data better it may be a better guide for policy.”

Nope! Not too simple. Just wrong!

I disagree with Simon. NK models are not too simple. They are simply wrong. There are no ‘frictions’. There is no Calvo Fairy. There are simply persistent nominal beliefs.

Period.

Roger Farmer

Yes indeed. There really is something about the way macroeconomists construct their models nowadays that obviously doesn’t sit right.

Fortunately — when you’ve got tired of the kind of macroeconomic apologetics produced by ‘New Keynesian’ macroeconomists like Wren-Lewis, Mankiw, and Krugman, there still are some real Keynesian macroeconomists to read. One of them — Axel Leijonhufvud — writes:

For many years now, the main alternative to Real Business Cycle Theory has been a somewhat loose cluster of models given the label of New Keynesian theory. New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of shortterm adjustment problems in the economy. The “New Keynesian” label refers back to the “rigid wages” brand of Keynesian theory of 40 or 50 years ago. Except for this stress on inflexibilities this brand of contemporary macroeconomic theory has basically nothing Keynesian about it …

I conclude that dynamic stochastic general equilibrium theory has shown itself an intellectually bankrupt enterprise. But this does not mean that we should revert to the old Keynesian theory that preceded it (or adopt the New Keynesian theory that has tried to compete with it). What we need to learn from Keynes … are about how to view our responsibilities and how to approach our subject.

No matter how brilliantly silly ‘New Keynesian’ DSGE models Wren-Lewis and his buddies come up with, they do not help us working with the fundamental issues of modern economies. Using that kind of models only confirms Robert Gordon‘s  dictum that today

rigor competes with relevance in macroeconomic and monetary theory, and in some lines of development macro and monetary theorists, like many of their colleagues in micro theory, seem to consider relevance to be more or less irrelevant.