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The state of macroeconomics: it all went wrong in 1958

From Crooked Timber by John Quiggin:

Much of the recent discussion in the “state of macroeconomics” has concerned the question

  • Is macroeconomics making progress?
  • If not, when did it stop?

I’m not going to survey the whole debate, but I will point to a good contribution from Robert Gordon (linked by JW Mason in comments to a previous post). Gordon argues that 1978-era New Keynesian macro is better than the DSGE approach dominant today. That implies 30 years of retrogression.

My own view is even more pessimistic. On balance, I think macroeconomics has gone backwards since the discovery of the Phillips curve in 1958 [1][2]. The subsequent 50+ years has been a history of mistakes, overcorrection and partial countercorrections. 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.

Phillips showed that there was a negative correlation between unemployment and inflation, a finding replicated for the US by Samuelson and Solow. The result was consistent with the then-dominant (Old) Keynesian models which taught that inflation (or deflation) arose in situations of excess (inadequate) aggregate demand and therefore low (or high) unemployment.

The first mistakes in interpreting the result were made by Keynesians, notably including Samuelson and Solow. Although their journal articles included lots of qualifications about expectations effects, these qualifications were downplayed in policy discussions, leading to the idea that policymakers had a menu of choices. In particular, appropriate use of fiscal and monetary policy could permanently reduce unemployment at the cost of somewhat higher inflation. This claim went along with the widespread belief that macroeconomics was now, for policy purposes, an exact science, which would allow “fine tuning” of the economy, in the unfortunate phrasing of Walter Heller, Kennedy’s head of the Council of Economic Advisers.

Taken together, the “menu” interpretation of the Phillips curve and the belief in fine tuning imparted an inflationary basis to policy, which was already evident by the time Milton Friedman gave his 1968 Presidential Address to the American Economic Association. Friedman argued that the trade-off in the Phillips curve was only temporary. Once firms and workers got used to higher inflation, they would build it into their expectations, and the initial reductions in unemployment would be lost. Friedman also argued against fine-tuning, pointing out the “long and variable lags” that made short-term fine-tuning impossible.

Friedman’s criticisms were broadly correct, and were validated by the inflationary explosion that began around the time of his address, but he pushed the point too far in several respects. First, at inflation rates near zero, there really is a trade-off, arising from the fact that interest rates can’t be negative. This point was implicit in Keynes’ discussion of the liquidity trap, but was reinforced by Krugman’s analysis of the Japanese experience in the 1990s, and is highly relevant today. Second, he took his critique of the Phillips curve to mean that there was a “natural rate” of unemployment, determined by labour market conditions (this is now usually called the NAIRU or non-accelerating inflation rate of unemployment). It’s turned out that long-periods of high unemployment have their own self-sustaining effects – Olivier Blanchard and Larry Summers christened this “hysteresis”. So, estimates of the natural rate tend to rise when unemployment is high, making the concept virtually useless as a guide to policy.

Third, Friedman used his critique of fine-tuning that macro policy should be confined to a rules-based monetary policy, with no role for fiscal policy. Although Friedman’s own prescription (a rule controlling the rate of growth of the money supply) was unsuccessful and quickly abandoned, these ideas were the basis of the policy regime, based on the use of interest rates as an instrument to meet inflation targets, that prevailed from the 1980s to the financial crisis, and to which central banks plan to return as soon as the crisis is over.

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.


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