Rational expectations, New Classicals, and Real Business Cycles Schools

  

A video conversation with LP Rochon and my co-author Bill McColloch on our chapter for the forthcoming book on the history of ideas. Many topics, including Friedman vs Lucas relevance, the Lucas critique, the empirical turn in the profession, and more. More info on the book soon.

Simon Wren-Lewis on New Classical Economics and the Financial Crisis

New paper by Wren-Lewis titled "Unravelling the New Classical Counter Revolution." It provides a strong New Keynesian critique of the New Classical/Real Business Cycle schools. He argues, correctly in my view, that the problem is the abandoning of the Keynesian method of analysis. I'm less keen on microfoundations. Or at least on marginalist microfoundations. But it is important to understand how much the fundamentalist views of Lucas and Prescott have affected the profession.

From the abstract:

To understand the position of Keynes's The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the New Classical Counter Revolution (NCCR), and why it was so successful. This revolution can be seen as having two strands. The first, which attempted to replace Keynesian policy, failed. The second, which was to change the way academic macroeconomics was done, was successful. Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. 

As a result, most academic macroeconomists today would see the foundation of their discipline as not coming from The General Theory, but as coming from basic microeconomic theory – arguably the ‘classical theory’ that Keynes was so keen to cast aside. Students are also taught that pre-NCCR methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong. The problem with the NCCR was not the emergence of microfoundations modelling, which is a progressive research programme, but that it discouraged the methods of analysis that had flourished after The General Theory. I argue that, had there been more academic interest in these alternative forms of analysis, the discipline would have been better prepared ahead of the financial crisis.

Read the whole paper here. 

Who is the real revolutionary figure in modern macro, Friedman or Lucas?

 

Who's your daddy?

Just finished my summer macro class (last Friday actually; grades were due Monday). One of the things that always becomes important in the course is how to define the break between Keynes, or at least Keynes and the Old Neoclassical Synthesis, on the one hand, and Friedman and Lucas, in the case of the latter both the New Classical models (monetary misperception) and Real Business Cycle (RBC) models, on the other. Many authors suggest that Lucas should be considered, after Keynes himself, the great scientific revolutionary, and that Friedman's break is incomplete. It is the implicit view in Alessandro Vercelli's book  Methodological Foundations of Macroeconomics: Keynes After Lucas or explicitly in the more recent book by Michel De Vroey's Keynes, Lucas, d'une macroéconomie à l'autre.

The reasons adduced are associated to Friedman's model, which remains in many respects similar to the Neoclassical Synthesis one, that is, an ISLM with a Phillips Curve (PC) with gradual adjustment to the equilibrium position. In one sense it is true that in Lucas' equilibrium model endogenous variables are determined on the basis of real phenomenon, technology, preferences, and factor endowments. The model, which was further developed by RBC authors, emphasizes the intertemporal choices of between leisure and consumption, and the fact that production takes time, and requires inputs over several periods, and has led many to label it Walrasian, in contrast to the supposedly Marshallian model used by Friedman and the Neoclassical Synthesis Keynesians. The other significant difference is that stochastic processes, rather than deterministic ones, become relevant, and Dynamic Stochastic General Equilibrium (DSGE) became dominant [more on that in another post; issues have been dealt to some extent here].

Traditionally a Walrasian model is a General Equilibrium (GE) one, while a Marshallian model represents partial equilibrium. In that sense, the label is a bit of a misnomer, since the ISLM cum Phillips Curve model behind the Friedman’s aggregate demand and aggregate supply model is also a GE model. The Neoclassical Synthesis model solves for the simultaneous equilibrium of the goods, labor, money and bond markets. What Friedman added explicitly is the natural rate. The supply constraint.

The difference between Friedman and Lucas is really that in the Neoclassical Synthesis and Monetarist models some behavior is not derived from intertemporal maximization of individual agents, while that is not true in the RBC models. That should be seen not as a Walrasian feature, but as a result of the abandonment of the Principle of Effective Demand (PED), and the use of a Ramsey Intertemporal model to determine consumption. That is, a dynamic version of Say's Law. In that sense, like the New Classical School, the fundamental change, in this context, is that the equilibration between savings and investment is done by changes in the rate of interest, not income, and that only rigidities would deviate investment from full employment savings.

On the basis of these changes, it is hard to say that Lucas is the more revolutionary figure in modern macro. True, in Lucas framework, the main Monetarist conclusions are less effective or irrelevant. Only unanticipated monetary shocks have effects, and those are strange things to conceive. When shocks are anticipated, monetary shocks have no effects. However, when forced to discuss the Great Depression, Lucas admits that there is little evidence for the RBC view.

Lucas asks: “where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn’t we be able to see it in the data?”* Lucas, even though he has accepted that most cycles are explained by productivity shocks remains convinced that the Great Depression resulted from a monetary contraction by the Fed, as in the Monetarist views of Friedman. And one wonders why that monetary contraction was unanticipated.

Also, even if more extreme, the results do not change the situation in the long run. That is, for Friedman too in the long run (anticipated or not) monetary shocks have no effects. The crucial theoretical variable is the natural rate.

In this sense, it seems that Friedman, and the return of the natural rate of unemployment, and implicitly the interest and output ones too, is crucial for explaining the return of the pre-Keynesian Wicksellian framework that is dominant with the New Macroeconomics Consensus (NMC). Even if Friedman had exogenous money, and a quantitative rule, rather than an interest one, and even if he believed in monetary shocks, rather than the real ones that Wicksell and modern macroeconomists emphasize. Modern macro is neo-Wicksellian, but it owes that to Friedman, more than to Lucas.

* Cited in DeVroey and Pensieroso here.

The rise of vulgar economics and the end of dissent

Funny thing, the rise of vulgar economics, which I discussed before (here, here, and here; see also this and this papers for more on the topic) didn't just lead to the ostracism of heterodox approaches to economics. It also led to a significant decrease in the debate within the mainstream. Or at least is what the figure below, from the interesting blog post by Joe Francis, seems to indicate. At some point in the 1960s, more than 20% of the papers in the main journals were a reply, a comment or a rejoinder to the work of someone else. Not anymore.

It is clear that the Great Depression and the Keynesian Revolution seemed to increase debate within the mainstream, and that, as Joe says, the: "decline in debate... appears to have been associated with the emergence of a ‘neoliberal’ hegemony from the 1970s onwards." That's essentially correct.

And the decline in debate explains why Lucas could say in the early 1980s that: "at research seminars, people don't take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another." And also why if you wanted to publish you basically had to accept the crazy New Classical models. Krugman admitted to that before, as I've already noticed. He argued that: “the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable.” You must remember, you don't publish, you don't get tenure. So crazy models became the norm.

Not only heterodox economists were kicked out of mainstream departments, and had to create their own journals in the 1970s, but also the pressure within the mainstream to conform and silence dissent was strong indeed. Note that many, like Blanchard and Woodford for example, in the mainstream continue to suggest that there is a lot of consensus between New Keynesians, and Real Business Cycles types. In fact, they say there is more agreement now than in the 1970s. How is the consensus methodology in macroeconomics, you ask. From Blanchard's paper above:

"To caricature, but only slightly: A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment."

And yes that is also the basis of New Keynesian models. The haiku basically describes the crazy models in which reasonable results must be disguised if you're to be taken seriously in academia. When everybody agrees, there is little need for debate. And you get stuck with crazy models. The lack of debate within the mainstream to this day is also, in part, what provides support for austerity policies around the globe, even when it is clear that they have failed.

Notes on the Policy Implications of the New Macroeconomic Consensus

The New Macroeconomic Consensus (NMC) model is based on three simple equations. An IS equation that, contrary to what most discussions within the heterodoxy suggest, is based on a Ramsey model intertemporal approach to savings and investment, a Phillips curve (PC) equation, normally with rational expectations, and a monetary policy (MP) rule, typically Taylor’s rule. From the IS and the MP an aggregate demand (AD) curve is derived, while the PC provides an aggregate supply (AS) curve, similar to Lucas’ supply curve. Business cycles are seen as being determined by shocks, either monetary, that affect the AD curve, or real, which impact the AS curve.

A few things are important to note with respect to the NMC model. First, the IS curve now is not based on the traditional Keynesian multiplier process, by which savings adjust to investment (or in more sophisticated models with endogenous investment, to autonomous demand) as a result of variations to the income level. Agents make intertemporal decisions on consumption and savings, and investment adjusts, in the absence of imperfections, to full employment savings as in the pre-Keynesian models. That is the reason why in order to stimulate the economy it is often suggested that what is needed is higher inflationary expectations (which in this framework could be caused by the central bank announcing a higher inflation target), which would in turn lead to an increase in current consumption (since inflation would reduce future consumption possibilities; see my critique of this view, which I refer to as the inflation expectations fairy, here).

Second, both the New Keynesian Phillips Curve and the Taylor rule presuppose the existence of a natural rate of unemployment, in line with Milton Friedman. Further, stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level, a result sometimes referred to as the ‘Divine Coincidence.’ Thus, inflation is always the result of a level of unemployment that is below its natural level, or in other words caused by demand-pull. Supply-side shocks may eventually cause inflation too, but those are seen, at least by most New Keynesians as being of secondary importance. Even Lucas, who has accepted for the most part the Real Business Cycle story, admits that one cannot explain the Great Depression and other such crises with real shocks.

Third, the MP rule implies that money is endogenous, and that central banks control the rate of interest and NOT the quantity of money. In other words, the old Monetarist rules about the rate of growth of money supply are out, since actual central banks very rarely have behaved in that way. This ‘innovation’ (not much of an invention since Wicksell used more than a century ago) within the mainstream took place without ever acknowledging the contributions of Kaldor (accomodationist tradition to endogenous money), Minsky (financial innovation tradition to endogenous money), Moore and other post-Keynesian authors.

Finally, it is rather clear that the NMC is essentially a neo-Wicksellian model (for a simple description go here), rather than Keynesian (New or otherwise). Not only the multiplier model was abandoned (and with it even the basis for fiscal policy activism, since the logic of Barro’s Ricardian Equivalence has been incorporated; see Wren-Lewis here), but also the concept of the natural rate that Keynes at least tried to get rid of has become central for policy analysis. And here is the Achilles’ heel of the NMC model.

Note that if the natural rate is not fixed, and in particular if it presents hysteresis or path dependence, and moves with the actual level of unemployment, then the basis of the NMC model falls apart. In other words, expanding demand might reduce the natural rate of unemployment and would not trigger inflation, and as a result would not require the central bank to hike the rate of interest to lean against the wind. That was, in a sense, the rationale for not hiking the rate of interest when unemployment fell below 6%, which many identified as the natural rate, during the Clinton boom. Greenspan suggested that productivity was going up (note that he didn’t necessarily say that productivity went up, and the natural rate down, as a result of the expansion of demand).

There are good logical reasons for not believing the natural rate story, as we know, associated to the limitations of the marginalist theory (see here). However, there are also reasonably well-established empirical problems with the natural rate hypothesis. The Real Business Cycles authors, in particular Nelson and Plosser in their classic paper (here), have long ago shown that output follows a random walk. In other words, changes in output are permanent, and there is no tendency for output to revert to its former trend following a shock, contradicting the natural rate hypothesis, or suggesting if one prefers that the natural rate moves with supply-side shocks and that the business cycle is the result of agents adjusting their behavior to the change in the natural rate.

As I noted before (here), the actual measure of productivity (Total Factor Productivity, TFP) used by RBC authors does NOT measure productivity, and most of their conclusions are irrelevant really. Also, as suggested above, it would be impossible to pin down the real shock that caused the Great Depression or the Great Recession, that have structural causes that are profound (in the patterns of consumption, private indebtedness and inequality) and that were triggered by financial shocks. However, the notion that the natural rate is not fixed, and that it changes significantly is actually quite important, since as we indicated, it suggests that policies that try to lean against the wind hiking the rate of interest when the economy is below the natural rate of unemployment are without foundation.

Heterodox authors would add to the RBC empirical observation about the fact that output is not mean reverting, that the supply or capacity limit of the economy is endogenously determined by autonomous spending (the supermultiplier that extends Keynes’ effective demand to explain potential output; for more go here). This does NOT mean that one can expand the economy without limits, since if the expansion of demand is faster than the movement of the capacity limit, eventually full employment would be reached and inflation (demand-pull inflation) might follow. Note, however, than since the 1930s in the US unemployment was below 4% (to say a relatively low number) only for four short periods, during the mid-40s, early 50s, late 60s and late 90s, with inflation occurring in the first three periods. Also, it suggests that the main barrier to the use of demand policies to achieve full employment, at least in developed countries with no balance of payments problems, is political. As Kalecki noted long ago, sound finance would be the political instrument to keep workers’ demands for higher wages in line. The NMC model is the modern incarnation of what Kalecki’s referred to as sound finance. So who is really surprised with the dominance of austerity policies?

More on wages and employment

So my last post has led to a few comments on the relation between changes in real wages and employment. As my students are probably tired to hear real wages tend to be pro-cyclical, a well established empirical regularity. This poses a problem, not only for mainstream accounts of the labor market (and hence for the conventional views on the minimum wage), but also for Keynes' own views.

Keynes was forced to deal with those issues early on, as a result of the empirical research by Dunlop and Tarshis, and his answer in his famous 1939 paper (often published together with the General Theory, GT) "Relative Movements of Real Wages and Output." He said then:

"The only solution was offered by Dr Kalecki in the brilliant article which has been published in Econometrica. Dr Kalecki here employs a highly original technique of analysis into the distributional problem between the factors of production in conditions of imperfect competition, which may prove to be an important piece of pioneer work."

In other words, he suggests that some sort of constant returns, or increasing returns to scale, and, hence a mildly positively sloped labor demand curve could possibly explain the empirical regularity. Note also that Keynes had already in chapter 2 of the GT argued that the labor supply curve made no sense (two reasons one fundamental, and the other non-fundamental; see here). He says:

"the contention that the unemployment which characterises a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts... A fall in real wages due to a rise in prices, with money-wages unaltered, does not, as a rule, cause the supply of available labour on offer at the current wage to fall below the amount actually employed prior to the rise of prices."

However, even if one gets rid of the labor supply curve, and determines employment in the market for goods, as a function of demand, as Keynes does, as it is clear from his reply to Dunlop and Tarshis the real problem with the conventional marginalist story (and Keynes' own) is on the acceptance of the marginal productivity of labor (MPL) as the source for labor demand.

One possible neoclassical response would be to suggest that real (supply side) shocks, which change the MPL upwards and downwards, is the main cause of fluctuations in output and employment. So Real Business Cycles (RBC) is the solution. In this case, pro-cylcial real wages can be explained by the mainstream. The main critique coming from other mainstream authors about this possibility, is that, since the real wages are only mildly pro-cyclical, a shock to the MPL would lead to small changes in the real wage only if labor supply is very elastic. In other words, workers labor supply would have to be very sensitive to changes in real wages, and, yet, the empirical evidence is that the number of hours worked does not change much with variations of the real wage.

Besides, there is the question of whether one can really assume that business cycles are explained by real shocks. Note that Lucas, who has for the most accepted the RBC interpretation of the working of the economy, still argues that the Great Depression is most likely explained by a demand shock (for him a monetary contraction a la Friedman).

That is why the capital debates, which undermine the rationale for the marginalist labor demand curve, is relevant for solving the pro-cyclicality of real wages conundrum. The capital controversies suggest that there is no reason to expect that firms buy more of a relatively cheap 'factor of production,' implying an inverse relation between remuneration and intensity of use. Once this notion is rejected, the problem of pro-cyclicality is easy to explain.

Classical (not neoclassical, but the old classical political economists and Marx) presumed that the real wage was determined by the relative bargaining power of workers and capitalists, and it is expected that in a boom, with low unemployment, workers would have the upper hand, and would be able to demand higher wages. So there is no need to resort to real shocks to explain this empirical regularity.

What can we learn from the Depression?

Free Exchange has discussed in a recent post the academic views on the Great Depression. They suggest that recent research (say the last 20 years or so) has produced a different view, and "that many traditional views about the causes of the Depression have been overturned by academics in recent decades." In particular, they suggest that neither protectionism nor the financial crash are seen as central anymore. They correctly note that the dominant view, associated to Barry Eichengreen and Peter Temin,* now puts an emphasis on the effects of the Gold Standard (note that Keynes also emphasized the role of the Gold Standard, to which he referred to as a 'barbarous relic'). 

And by the way that means that the consensus is that a demand shock caused the Depression. Note that a few authors have pushed the Real Business Cycle (RBC) story in recent times. For example, Prescott argues that:

“In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment.”

In other words, the changes in incentives led to less supply of labor and less demand for investment goods by firms. Same ideas have been put forward by Cole and Ohanian, and by popularizers like Amity Shlaes in her The Forgotten Man. However, most of the New Deal regulations that the revisionists abhor, actually came to late to have caused the Depression. They generally try to explain the 'slow' recovery (growth averaged 8% in the first FDR term) as a result of the New Deal, and leave the question of what was the supply side shock that caused the Depression.

Lucas, who converted to RBC at some point in the 1980s, asked (cited here) poignantly: "Where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn't we be able to see it in the data?" For that reason Lucas still believes, like Friedman, that the Fed did it. And if one is going to blame regulation for the duration of the Depression, one must deal with the fact that in the 1950s, if anything, labor and financial regulations were as stringent, if not more, than in the 1930s and unemployment was fairly low.

A more subtle critique of the conventional view, and its emphasis on the Gold Standard comes from Christina Romer. She suggests that the path of American output and unemployment before 1931 can be explained quite well with only domestic factors, and that even after 1931, international factors affected American economic conditions mainly through their impact on American policy decisions. Note that that this is not incompatible with Kindleberger's view that the US, in the process of becoming the hegemon, was central for the global economic collapse.

This should cast some doubts on FE's conclusion that:

"putting all the blame on Wall Street for the Great Depression -- or on bankers in the current crisis -- does not stand up to historical scrutiny. The responsibility may more properly lie in a complex combination of factors, like how global financial systems are structured."

Romer notes that in the US the collapse in consumption was more important than in other economies (harking back to Peter Temin's reply to Friedman that it was the collapse in consumption, not monetary policy, that caused the Depression). And the collapse in the demand for consumer durables, which depended on credit for their purchase, was affected by financial conditions. Romer argues:

“Both the initial recession in the United States in the summer of 1929 and the acceleration of the decline in late 1929 and 1930 are ultimately attributable to the stock market boom and bust of the late 1920s. The stock market boom is the prime explanation for why the Federal Reserve was pursuing tight monetary policy starting in 1928. The stock market crash is the prime source for the collapse in durable goods purchases starting in November 1929.”

So the financial bubble and the crash did matter, and John Kenneth Galbraith (among others) was correct about it. I would add that income distribution, which we know from Piketty and Saez, was as bad in the 1920s as now, did also play a role in the bubble and the expansion of private indebtedness. So Wall Street was to blame indeed, as much as it should be too in the recent Great Recession.

* Kindleberger, in his classic The World in Depression, goes further and suggests that it was the absence of an hegemon that acted as a source of demand in situations of crises (distressed markets), as a stabilizer of exchange rates, and as a source of international finance (an international lender of last resort) that caused  the Depression, since the UK was incapable and the US unwilling to assume that position. The Depression was essentially an hegemonic crisis.

PS: For further reading my forthcoming paper in the Cambridge Journal of Economics here.

Hysteresis and the natural rate

I've been teaching on the price and quantity interactions, and the natural rate or NAIRU (Non Accelerating Inflation Rate of Unemployment), that is the level of activity at which you have price stability. One of the papers assigned is the one by Franklin Serrano (here or here for a Spanish version; another assigned paper is this one by yours truly). By the way, I've dealt with the issue of hysteresis briefly before here, mostly to distinguish it from path dependency, following Setterfield (Serrano also suggests differences between heterodox and more conventional views on hysteresis).

As noted by Serrano, the research by Nelson and Plosser (1982) (here; subscription required) and Real Business Cycle (RBC) authors suggests that GDP follows a random walk, and as a result after a productivity shock (which they measure as changes in TFP, in spite of significant problems with that measure; see here) output does not return to its previous trend. The point is that once the output trend is affected there are persistent effects that change the trend itself, that is hysteresis. Fluctuations are variations of the optimal level itself.

Serrano correctly points out that "this means that the long run trend of output is not only partially determined by whatever drives short run output (presumably aggregate demand) but rather that potential output is actually fully determined by the trend of whatever drives actual output. As it is well known, this result of strong hysteresis in the output (GDP) series has been taken to provide evidence in favor of the 'real business cycles' strand of new classical macroeconomics in which the common element driving trend and cycle are factor supplies and their productivity." The natural rate or NAIRU is supply determined, but is variable (something that, in a different context, Robert Gordon would call the Time Varying NAIRU or TV-NAIRU).

Supply shocks imply that in a boom the potential output moves first, and actual output adjusts as individuals readjust to higher productivity. Hence, the output gap, if defined as the difference between actual and potential output, becomes negative. And if you believe in a Phillips curve and some sort of central bank monetary rule, a negative output gap suggests a deflationary pressure (and yes RBC authors do believe in endogenous money). Yes, that's what the RBC theory implies! In fact, according to Kydland and Prescott (1990): "the price level has displayed a clear countercyclical pattern."*

Serrano points out a simpler (Occam's Razor applies) explanation for the favorable evidence on hysteresis, namely that demand (in fact, the autonomous components of demand) determine potential output (the supermultiplier). Note that this approach does not require, as the RBC or the acceleracionist versions of the Phillips Curve, any definite relationship between prices and quantities. As noted here (and here) before, there is no reason to expect an unambiguous or systematic relation between prices and quantities, unless you think that prices are always driven by excess (or lack of) demand.

As Serrano argues the: "trend and the cycle indeed have a common nature as the empirical literature shows but this common nature reflects that both are explained by demand (not supply) factors" and "with full hysteresis in output levels and partial inertia on inflation, 'demand-pull' inflation is just a temporary phenomenon and therefore does not determine 'core' or persistent inflation." And it is hard not to agree on this with New Keynesians, and their dismissal of supply shocks as the main cause of business cycles. It is harder to agree with their insistence on a natural rate, even if it's variable.

* The obvious historical event they would have in mind is the stagflation of the 1970s. Note, however, that more often than not deflationary periods are contractionary, like the 1930s. Of course the oil shocks and the increase in costs can explain, together with wage resistance and price inertia, the inflationary pressures of the 1970s in a model that is perfectly compatible with demand driven recessions.

Krugman and the natural rate again

Krugman again (re-channeling Hicks) restates his argument that the problem with the US economy is that the natural rate of interest is negative. Note that he also admits, as did recently Goldman Sachs or anybody that looks at data, that the accelerator is what determines investment. Not only his stance has serious logical problems, but also it weakens his own arguments about confidence fairies and so on. And there is no empirical evidence favoring the view that in any period, not just now, non residential investment is significantly affected by variations of the rate of interest. But yes we do need more fiscal expansion, even if lack of full employment is not simply a market failure.

PS: Note that Krugman's second graph, showing the equilibrium of I and S with a negative natural rate, implies that either we had a negative shock to I or a positive shock to S. That is, either a negative productivity shock or a change in preferences about present and future consumption. Real shocks. So what, now he is a Real Business Cycle (RBC) guy? Just drop the natural rate already. Evidence and logic require it.