New Classical macroeconomics — elegant fantasies

28 Sep, 2016 at 12:46 | Posted in Economics | 1 Comment

65974000The crucial issue of macroeconomic theory today is the same as it was sixty years ago when John Maynard Keynes revolted against what he called the “classical” orthodoxy of his day. It is a shame that there are still “schools” of economic doctrine, but perhaps controversies are inevitable when the issues involve policy, politics, and ideology and elude decisive controlled experiments. As a lifelong Keynesian, I am quite dismayed by the prevalence in my profession today, in a particularly virulent form, of the macroeconomic doctrines against which I as a student enlisted in the Keynesian revolution. Their high priests call themselves New Classicals and refer to their explanation of fluctuations in economic activity as Real Business Cycle Theory. I guess “Real” is intended to mean “not monetary” rather than “not false,” but maybe both.

I am going to discuss the issues of theory, Keynesian versus Classical, both then and now … The doctrinal differences stand out most clearly in opposing diagnoses of the fluctuations in output and employment to which democratic capitalist societies like our own are subject, and in what remedies, if any, are prescribed. Keynesian theory regards recessions as lapses from full-employment equilibrium, massive economy-wide market failures resulting from shortages of aggregate demand for goods and services and for the labor to produce them. Modern “real business cycle theory” interprets fluctuations a moving equilibrium, individually and socially rational responses to unavoidable exogenous shocks. The Keynesian logic leads its adherents to advocate active fiscal and monetary policies to restore and maintain full employment. From real business cycle models, and other theories in the New Classical spirit, the logical implication is that no policy interventions are necessary or desirable …

Keynesians believe that the economy is sometimes in one regime, sometimes in the other. New Classicals model the economy as always supply-constrained and in supply-equals-demand equilibrium. In their real business cycle models, the shocks that move economic activity up and down are essentially supply shocks, changes in technology and productivity or in the bounty of nature or in the costs and supplies of imported products. Although external forces of those kinds, for example weather, harvests, natural catastrophes, have been the main sources of fluctuating fortunes for most of human history, and although events continually remind us that they still occur, Keynesians do not agree that they are the main source of fluctuations in business activity in modern capitalist societies …

Fancy econometrics is not needed to mobilize evidence against the real business cycle theory view that observed fluctuations in output and employment are movements in priced-cleared equilibrium. Here are a number of regularities of US business cycles which falsify that hypothesis:

1. Unemployment itself. If people are voluntarily choosing not to work at prevailing wages, why do they report themselves as unemployed, rather than as ‘not in the labour force’? Real business cycle theory explains fluctuatiuons of unemployment as intertemporal choice between work and leisure. Workers drop out when the real wages, the opportunity costs of leisure, are temporarily low relative to what they expect later …

2. Unemployment and vacancies. New classicals ask us to believe that the labour market is in equilibrium at 9 per cent unemployment just as truly as it is at 5 per cent. If so, there would be no reason to expect the balance between unemployment and job vacancies to differ. Both unemployment and vacancies would be higher in recession. However, a strong negative association between unemployment and vacancies  — as would be expected in Keynesian theory — is obvious in the U.S. and other market capitalist economies.

3. Quits and layoffs. If recessions and prosperities are both supply-equals-demand equilibria, there is no reason to expect the relative frequencies of voluntary quits of jobs and involuntary ‘separations’ from jobs to vary over the business cycle. But of course there are regularly many more layoffs, relative to quits, when unemployment is high and vacancies are scarce. There are many more ‘job losers’ relative to ‘job leavers’ in recessions.

4. Excess capacity. Utilization of plant and equipment varies cyclically, parallel to utilization of labour. Presumably machines do not choose leisure voluntarily.

5. Unfilled orders and delays. These move pro-cyclically, again suggesting strongly that demand is much higher relative to supply in prosperities than in recessions.

6. Monetary effects on output. According to the ‘classical dichotomy,’ monetary events and policies should affect only nominal prices. Real outcomes should be independent of them. The evidence that this is not true is overwhelming.

The list could go on. Why do so many talented economic theorists believe and teach elegant fantasies so obviously refutable by plainly evident facts?

James Tobin

1 Comment

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