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Was the neoclassical synthesis unstable?

From Mainly Macro by Simon Wren-Lewis:

This post
presents a very simple story of the development of macroeconomic thought from
Keynes until today. It is related to a recent post from Brad DeLong on ‘economic theology’
and the neoclassical synthesis. (See also a response from Robert Waldmann.) 

Economics as a
science that studies markets is ideologically neutral. Economic theory can be
used to support ‘unfettered’ markets, or it can be used to justify interventions
to avoid various kinds of market failure. The former means that it will
inevitably be used by some to support a laissez-faire ideological position.
There are two checks against this one-sided presentation of economic theory:
economists presenting alternative theories that embody imperfections, and the
use of evidence to show that a particular theory works, either in terms of its
assumptions or results.

Before
considering macroeconomics, take an example from labour economics: the minimum wage. Standard competitive theory
suggests a minimum wage will reduce employment and raise unemployment. Card and
Krueger undertook a famous study suggesting
that in one particular example where the minimum wage was increased there was no
reduction in employment. That led to a substantial amount of additional
research, much (but by no means all) backing up the result that the impact of
moderate increases in the minimum wage on employment was either non-existent or
very small. For similar developments in the UK, see this account by Alan Manning. This empirical
evidence was sufficient to encourage the development of alternative theoretical
models: principally but not only monopsony.

So here we see
theory and evidence interacting in a Popperian type way, hopefully leading to
better theory. [1] Yet with economics there will always be ideological
resistance, so there will always be those who want to stick to the basic model
and who select those empirical studies that support it. For the discipline to
survive, those ideologues have to be a minority. But even if this condition is
met, a healthy discipline has to recognise the influence of that minority,
rather than try and pretend it does not exist or does not matter.
There is a
slight twist for macroeconomics. As governments are the monopoly providers of
cash, and provide a backstop to the financial system, they are involved in the
‘market’ whether they like it or not. Complete non-intervention is not an
option: instead the next best thing (from a laissez-faire point of view) is some
kind of ‘neutral’ default policy rule, like keeping the stock of money constant.
The Great
Depression was the empirical wake-up call (the equivalent of the Card and
Krueger study) for macroeconomics. So profound was the impact of this empirical
event that it led to a whole new way of doing the subject. Keynesian economics
was methodologically different from much of microeconomics: it put much more
weight on aggregate evidence (through time series econometrics), and much less
on microeconomic theory. One way of putting this is that in the 1960s, general equilibrium theory of the
Arrow-Debreu-McKenzie type seemed a complete contrast to what macroeconomists
were doing. That an event as powerful as the Great Depression should have had
such a profound methodological impact is not really surprising.

The Great
Depression also meant that those advocating non-intervention had to make an
exception of macroeconomics. It was for the generation after the Great
Depression abundantly clear that here was a colossal market failure. This is one
sense in which the term neo-classical synthesis can be used: to allow the state
to combat the market failure represented by Keynesian unemployment (albeit, in
the case of Friedman, in as rule like way as possible), but to maintain advocacy
of non-intervention elsewhere. Note however that this is a synthesis servicing a
particular ideological point of view, rather than being anything inherent within
economics as a discipline.

Was this
‘ideological synthesis’ tenable among those supporting the ideology? There were
two natural tensions. First, the position that macro intervention should be rule
based and minimal was contestable. Second and more importantly, as the memory of
the Great Depression faded (and neoliberalism spread), the temptation grew to
ask ‘do we really have to accept the need for state intervention at the macro
level’. However I’m not sure the latter would have become critical had it not
been for another tension within macroeconomics itself. 
What was not
tenable from a methodological point of view was the distance between the very
empirical orientation of macroeconomics, and the more axiomatic foundation of
much of microeconomics. What was required here was a different kind of
synthesis, one which allowed for a healthy dialogue between theory and evidence.
My impression is that in many areas of microeconomics this happened: that is
partly why I gave the minimum wage example, but it is also worth noting that
general equilibrium theory lost the primacy that it might once had among
microeconomists. But these are impressions, and I’ll happily be
corrected.
I think the
same thing couldhave happened in macroeconomics. Heterodox economists
(and Robert Waldmann) would almost certainly disagree, but I think
macroeconomics has gained a great deal from the project to add microfoundations.
Where I hope heterodox economists would agree is that a dialogue where theorists
engaged with macroeconomics and tried to persuade macroeconomists of the
importance of following particular theories would have been healthy. But that
was not the way it turned out. What could have been a dialogue of the Popperian
kind became instead a theoretical and methodological counter revolution. Instead
of asking ‘what can we do to get better microfoundations for sticky prices’, the
assertion became ‘without good microfoundations we should ignore sticky
prices’.

Why was there
a counter revolution in macro rather than a Popperian dialogue? I think it is
here that the second tension in the ‘ideological synthesis’ I identified above
is important. Those who wanted to dispute the need for macro intervention
realised that the microfoundations for macro market failures that existed at the
time were poor (adaptive expectations in a traditional Phillips curve), and so
any macroeconomics based on ‘rigorous’ (textbook, imperfection free)
microfoundations would not be Keynesian. They also realised that they could
produce models which generated real business cycles which were entirely
efficient. These models assumed all unemployment was voluntary, which in any
normal science would lead to their rejection, but in an axiomatic based approach
where some evidence can be ignored it was acceptable.  

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