Memories of the Carter Administration

One of John Updike’s novels was titled Memories of the Ford Administration; needless to say, it wasn’t about Gerald Ford — basically it was about sex, because Updike remembered the Carter years as the golden age of extramarital affairs. Similarly, this post isn’t about Jimmy Carter – it’s about macroeconomic theory. (Sorry.)

For the late 1970s was when macroeconomics experienced its great divide. It’s a period engrained in the memory of those of us who were young economists at the time, trying to find our own paths. Yet I haven’t seen a clear explanation of what went down at the time. So here’s a sketch, which I hope a serious intellectual historian will fill in someday.

As I remember it, it all began with the Phelps volume: Microeconomic Foundations of Employment and Inflation Theory. The issue these papers tried to resolve is nicely summarized here. Keynes (and, for that matter, Milton Friedman) argued that a decline in aggregate demand due to, say, a fall in the money supply would lead to a fall in employment and output – and experience showed that they were right. Yet standard microeconomic theory implies that production should respond only to changes in relative prices, not changes in the overall level of prices – and this in turn implies that money should be “neutral”: a 20 percent fall in the money supply should lead to a 20 percent fall in the overall price level, but no change in output or employment.

Phelps and others tried to explain why the economy looks so Keynesian in terms of imperfect information: workers and firms respond to a change in the price level as if it were a change in relative prices, because they can’t at first tell the difference. Over time, however, they will realize their mistake – so that, for example, a rise in the inflation rate will reduce unemployment at first, but won’t do so on a sustained basis, because eventually inflation will get built into expectations. So the new theory predicted the emergence of stagflation, a prediction that was duly confirmed.

But where do expectations come from? Robert Lucas married Phelps-type models of employment with rational expectations, the view that people in the economy use all available information to make predictions. And this led to a startling conclusion: anticipated policies have no effect on employment. Only surprise changes in, say, the money supply matter – which means that you can’t use monetary or fiscal policy to stabilize the economy.

The Lucas view took the economics profession by storm – not because there was any solid evidence for it, but because it was so clever, because it led to nice math, because it let macroeconomists give in to their inner neoclassicists.

But by the late 70s it was already clear that rational expectations macro didn’t work. Why? Because people have too much information.

Think about the story of unemployment I’ve just described. It’s a story in which a contraction in the money supply can produce a recession – but only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand, not specifically low demand for their products.

In Lucas-type models, people were supposed to look at the prices they received, and optimally extract the “signal” from the “noise”. The models broke down, however, as soon as you let people have access to any other information – say, by looking at interest rates, or reading a newspaper. And the reality, of course, is that recessions persist long after everyone knows that there’s a recession, so that the confusion required by Lucas-type models is long since gone.

I recall a seminar, I think in 1980, in which Robert Barro was presenting a rational-expectations business cycle model. Someone asked him how he could reconcile his model with the severe recession taking place as he spoke. “I’m not interested in the latest residual,” Barro snapped.

But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?

The answer was that they split. One faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever.” That faction became New Keynesian, saltwater economics.

The other faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can’t.” That faction became real business cycle, freshwater economics.

But here’s the thing: at this point, the freshwater school no longer remembers any of that – largely because they purged Keynesian and even monetarist thought from their classes. All they know is that Keynesianism was “disproved”, and that none of it – not even New Keynesian models with rational expectations (an approach which, as Greg Mankiw says, “provides a rationale for government intervention in the economy, such as countercyclical monetary or FISCAL POLICY.”) – is worth listening to.

So that’s how we got to where we are today.

Comments are no longer being accepted.

I swear this was a Star Trek episode. Or perhaps yet another Generation Ship science fiction story.

What’s going to happen is three young freshwater economists are going to have an adventure and find the ancient library at the same time as the ship encounters a galactic recessionary force. Sadly, their new models will not be believed by the chief shaman and they will not make what they refer to as tena yar, or the ability to become shaman in their own right.

The ship will end up recessing into a mix of micro and macro goolike objects all in the name of individual liberty.

The end.

Most succinct and erudite professor. One wonders whether the future historians you mention will note the freshwater school’s ascendency coincided with the rise of anti-intellectualism and aw-shucksness of certain U.S. politicians in league with a certain religious zealotry inclined to accept revisionist political sound-bites as articles of faith ?

In retrospect, this blind acceptance was the beginning of a cultism most clearly manifested with David Stockman’s faux budget numbers prepared for Reagan, quckly replaced with Lafferism.

Please enjoy your trip; fortunately, ‘wodka’ is good for sniffles. Could we look forward to a report on conditions you may find at The Hermitage, one of the world’s great treasures ?

Paul,

You make a caricature out of freshwater economists: you think they are all completely and utterly identical clones of Ed Prescott. Well, you’re completely wrong about that.

For one, there are many freshwater economists that have tried to engage NKE models (use Google Scholar and yep, there they are).

Secondly, it’s ironic that you highlight the failure of the Lucas signal-extraction model because
a) we know it doesn’t work, because we took the math and quantitative implications seriously. (Some verbal story about the same mechanism is a lot harder to disprove, and we would still be entertaining the theory today if we hadn’t done the quantitative work.)
b) you say that having access to information about unemployment/interest rates makes people realize they are in a recession, thus changing their behavior, and diminishing the effect. I am still not entirely sure what the ‘kind’ of Keynesian economics is you are promoting (after all, you are not really explicit about it), but, whatever argument you make against the signal-extraction models can also be made against the Keynesian models you seem to be promoting. Thus, at this stage in your story we can conclude that we cannot really promote one story over the other. Both stories need additional frictions to work. Now, because of the mathematics and being explicit, we have now figured out that there is more needed to understand what is going on than just the simple stories above. Why not focus on this ‘more going on’, in current economic research, instead of going back to an old modeling approach where we basically do not allow people to change their savings behavior.

You are also dead wrong about the fact that government policy is ignored on the freshwater side (at least that is what I take from the highlighting in the last lines, and from previous posts). There is an enormous literature on frictions out there you never seem to mention. Search frictions more often than not lead to benefits of government intervention of some kind (but which ones out of the set of all possible interventions?); there is a large literature on issues of dynamic commitment in fiscal policy that comes from the freshwater side completely ignored by you; there is work being done (and these days a lot more work being done, in fact) on frictions in the credit market, also ignored by you. Perhaps you could use your platform to inform the general public about these things that we are doing in macroeconomics, after all you are both a gifted writer and a gifted translator from the abstract into the everyday. This would be way more constructive than the ‘old bitter man on a bench’ approach that you radiate today.

So, I think you are setting up a straw man when you go on the attack against freshwater economists. There is a valid point to make, and that is that business cycle research in general (fresh and saltwater) did not focus much in the last two decades on ‘extreme events’, because everything seemed to be smoothing out a bit in the data. This seems to be a point of focus of topic, not a point of modeling approach! If your argument is that we cannot get extreme events going in rational expectations models, this is not correct: it might take a little extra work specifying the frictions (information,limited commitment, limited liability, hidden actions), but it is certainly possible and in fact done in the field.

Part of the reason for not focusing on extreme events is that when problems occur elsewhere, it is human nature to look at these problems first. Another part of it is a measure of some, but by no means all-encompassing, complacency in central banks (which btw are much more saltwater in the NKE models they use). Their n-shock (where n is large) models fit the past data well, and also did a good job forecasting (until this crisis), so why think about events outside these models? I haven’t heard you talk about this central bank NKE complacency as much as ‘what’s wrong with macroeconomic theory in general’. (I would have expected more about this, after all, NKE complacency is a problem on the demand side for macroeconomic theory!)

However, at the same time macroeconomic theory did not focus as much on extreme events than we now deem optimal, theoretical and computational advances occurred that make it much easier to start to think about the current crises. Economists (on both sides of your divide) were modeling credit frictions before the crisis, but not as many as will be working on it today. I for one have hope that we will be able to learn a lot from them, working within a framework where agents that are able to decide what is best for them, but where their incentives not necessarily align with the greater good.

Mr. Krugman,

Which theory claims that the government should intervene to support insolvent banks at the possible expense of systemic collapse of the interventionist government? Or that corporations that would and probably should go under should be propped up by the government backing their debt issuance, that they will more than likely default on?

Perhaps we should consult Chrysler and GM how well their September sales are?

Where we are today is becoming a hopeless situation as income levels and assets values travel back in time while debt, public and private, moves forward and grows exponentially.

At what point does the economic and political system of the United States break under the weight of bearing an insolvent Wall Street?

And the people that protested in Washington DC, how much longer before they feel ignored and then turn to not paying their credit off?

And as Crony Capitalism now seeks to bankrupt the Nation with the blessing of Mr. Bernanke and apparently now President Obama, Congress continues to prove that it is nothing more than a debating society waiting for Wall Street to tell them what legislation to pass, and when to pass it.

I certainly find many things suspect with President Obama’s health plan, especially as he slipped in the 4 yrs before it would take effect, and in the mean time we implement former all-star point guard of the “Keating Five”, Senator McCain’s plan as an interim; but instead of having a real debate on health care the Republican, the majority anyways, have opted to outright use lies and propaganda. And now that President Obama actually issues a decision of reason in scrapping that silly missile defense shield, the Republicans are up in arms.

As both political parties play their games like it’s going to be business as usually, the international economy continues to cave in (seen the recent lack of movement from international shipping recently?).

Come January when it becomes obvious that Christmas sales are going to go the same way as the back-to-school sales did, and we realize that the United States has no fundamental economy to stimulate, perhaps then it will dawn on our government that our best case scenario is a severe depression–maybe upwards to a 25-30% contraction in GDP.

Perhaps they don’t and then we’re faced with an utter collapse–one much worse than the Soviet Union. We also face unique problems in US history beyond economics: what about companies like Dyncorp and Blackwater? Perhaps luck will have them find a foreign market for their employees instead of dumping them into the unemployment line–or worse, they’re used domestically in greater numbers, and force.

I hope we come to realize very soon that Mr. Bernanke’s plan is hopeless and that he should have, and should still do so, enforce a controlled bankruptcy of the financial system. Certainly it will be tough, but the alternative may be outright collapse–and his currency swaps will only stabilize the dollar as a funding currency only for so long.

We should have asked, not are these financial institutions too big to fail, but perhaps they’re too big to prop up. Are nations too big to fail? History doesn’t seem to think so.

Clear as a bell. Here in the UK there Archbishop Williams has kindled a debate by observing that nothing seems to being learned from the crash and that people seem to be re-forgetting Keyne’s emphasis on uncertainty.

//news.bbc.co.uk/1/hi/uk/8258136.stm

This seems a little similar to your own call for humility and repentance, as I say here.

//senseorsensibility.com/blog/economists-repent/

Would not the situation be helped if everyone were to emphasise their own contribution more as Williams suggests (for which he was mocked, of course–see above). Bubbles and recessions happen in people’s; maybe it isn’t so irrational to look there for a cure.

Not a welcome thought for a progressive, but then we are expecting conservatives to make some drastic changes in outlook.

Thanks. This is very helpful to us non-economists who have been dozing at the back of the class. But I’m still confused as to why adding , say, teaching staff to private schools constitutes economic growth, while adding the same to public schools does not.

“And this led to a startling conclusion: anticipated policies have no effect on employment. ”

— Was this also an argument for secret government?

I’ve been reading the linked description of Neo-Keynesian Economics, and I have a simple question.

If menu costs were big part of the problem, wouldn’t VAT cuts (as UK did) magically solve recessions? VAT cuts mean all prices are cut at the same time.

If economies with and without VAT cuts do equally well in recessions, perhaps menu cost explanation is completely missed.

There’s also wages menu cost, which might be even higher, but surely there’s a tax relief solution to those too.

Do you expect these to have much effect at all; is menu cost explanation of recessions completely wrong; or is there some third alternative?

This is an interesting theme, and based upon your earlier column, it’s one you’re continuing to develop.

You have much to do otherwise, I suppose, but I for one would like to read more along these lines. Maybe someone will take it up too and the concept will become more widely studied.

This divide, and its implication that macroeconomists couldn’t agree on anything, was the reason that I chose international trade as my field instead of macroeconomics.

It is true that this course of events is a fascinating piece of history of science.

Why don’t economists study natural growth and regression processes? It’s the same reason physicists don’t study things like why are galaxies flat and spiral shaped, or what subatomic particles are made of. It’s is more mathematically convenient to come up with some thought that if we observe it then that may have changed its behavior (wave or particle?) or how it really looks? This way the “herd” can stay together and their total ignorance will not be exposed to the masses. Einstein knew better.

The thing that caused macroeconomics to go very wrong is the belief that the theory of perfect competition provides the appropriate microfoundations on which macroeconomics should be built. This got the approach following Phelps into trouble. And Friedman also tried to explain the fluctiations in unemployment caused by monetary shocks as the result of imperfect information. For example, workers during a recession believe that their real wage has decreased even though it has actually increased and choose to work less, so that the people who are unemployed during a recession are voluntarily unemployed.

The fundamental problem is tha while the theory of perfect competition is an intellectually interesting LIMITING CASE, the assumptions on which it is based are not even approximately met by real world economies. Therefore the theory of perfect competition lacks sufficient generality to provide an appropriate microfoundation for macroeconomics. And trying to base macroeconomics on the perfectly competitive model will inevitably lead to false macro models of the economy.

One of the fundamental features of actual economies is that prices and wages in many real world markets change not only slowly, but also sequentially, rather than simultaneously. As a result, when an economy is in a recession transactions take place and are finalized in many markets when those markets fail to clear. The frustrated supplies and demands of people who are unable to carry out their desired transactions in one market spill over into other markets and alter the effective demands in those markets. For example, workers who are unable to sell all the labor they desire at the going wage in their market (and are therefore involuntarily unemployed) reduce the amount they buy, and therefore reduce aggregate demand. Firms that are not able to sell all they desire and the going prices for their products reduce their production and lay workers off.

Any successful attempt to build models of the funtioning of the macroeconomy in the short run must make non-clearing-markets and the consequences thereof as one of their absolutely essential features.

As to clever math econ models I wish to relate this true story. I thought I was pretty smart whe I graduated from college as a math major with an A average and took a teaching job in a small ranching community. At lunch one day an old rancher came up to me and asked if he could pose a math problem. I said sure and he asked; “if you had 20 sheep in a yard and one of them crawled out through a hole in the fence, how many would be left?” Before thinking I said 19.” He laughed really loud and said, “you may know your math sonny but you do not know anything about sheep.”

This is one of the best blog posts ever! For me it cuts the gordian Knot and explains much. Thanks. I have about thirty pages of download on this topic and now much is clear.

One other point that noone ever makes. There is a gazillion dollar marketing industry that is designed to minimize rational expectations and behavior.

I like this post, and it’s far more defensible than the assertions in the NYT magazine article. However, the characterization of RBC theory is a bit misleading in that you don’t present what RBC theorists thought must be driving business cycles instead of demand — you just present it as a vacuous theory. Of course Kydland and Prescott won a Nobel for developing the theory of how business cycles could be driven by supply-side technology shocks.

Ex-ante, the research agenda of RBC theorists was worth looking into, even if ex-post, it hasn’t turned out to be too valuable in explaining our most recent recessions. But certainly it makes no sense to exclude all competing theories. I didn’t agree with the magazine article’s conclusion that overall the profession turned a blind eye to competing theories, but it is fair to say (as you suggest here) that some leading theorists did.

The understanding I take from this article is that all the economic discussion going on is nothing more than intellectuals having intellectual discussions with orther intellectuals, all with very little basis in real life facts.

I’ve been trying to plot my financial future (I;m retired living on my IRA and SS. To this end I am looking for guidance on the future of our financia, political, and industrial systems. What I see is chaos, incompetence, and intellectual dishonesty. I voted for change and got more of the same.

I think we should stop discussing interesting details and cut to the chase of working on getting people to demand a more populist government and a responsible financial system.

As has been said before we fiddle (dither) while Rome (America) burns.

Jim Sward

What’s interesting to me is that, while Paul’s analysis focuses purely on economists and their theories, the movement he describes is contemporaneous with the larger movement towards conservativsm in US society and government. Off the top of my head, that dark era brought us the Moral Majority, Ronald Reagan, the “War on Drugs” and draconian punishment of marijuana users, slasher movies and violent comic books. Most significantly, it saw wealth beginning its journey back into the hands of the wealthiest rather being spread across society as a whole and thus improving the lives of the poor and the middle class. How does it come about that a bunch of economists, working more or less within the Ivory Tower of their discipline, fall so perfectly into into the incipient zeitgeist of 1980s conservatism?

Sounds to me like religion, not science.

i’m all for the usefulness of developing theoretical paradigms in order to model something and learn from the process.

i cannot for the life of me understand so falling in love with your models that you confuse them with reality the way the freshwater school does.

as the old wall street saw has it, don’t fall in love with a theory; the theory doesn’t know you love it.

The thing is, it’s fairly obvious that it was the monetarists who were closest to the truth. So what went wrong with monetary policy?

Well, central bankers were targeting a very low inflation rate, but ignoring regulation of credit markets. So as you got a massive expansion of excessive lending, the Fed cut back sharply on currency growth to allow it to continue without overheating the economy. In turn, this strengthened the dollar, which increased demand for treasuries, and which lowered interest rates, further fueling the twin deficits and further lending excess.

What if instead they had targeted steady currency growth, allowing inflation to occur? In the face of rising inflation, lenders would have realized that they would be getting paid back in less valuable dollars than they lent out, which would have led them to cut back on lending and demand higher interest rates. The irony is that the Fed set out to do its best to eliminate inflation expectations from the economy, but in doing so, eliminated the economy’s main mechanism for self-correction against overheating credit markets. Perhaps allowing inflation to float somewhere in the 3-4% range would be a wiser monetary approach.

When monetary policy fails, this creates the conditions under which Keynesian theory really does work, and where Keynesian stimulus is likely even required to avoid a prolonged slump. Thankfully global policy makers haven’t been as forgetful of once standard economic theory as some prominent economists have been. It seems that a global Keynesian response, with every member of the G20 agreeing to fiscal stimulus of at least 2% of GDP, has managed to prevent a more severe adjustment. Thankfully, no geographic divisions got in the way of good sense there.

So how do RBC economists explain current unemployment? I would genuinely like to know. Anyone have a link? The government triggered collapse of financial institutions has caused firm productivity to collapse and labour supply is very elastic in response to temporary wage rate shocks ?

This discussion of the warring salinity schools seems to me to be largely irrelevant to what was actually going on in public policy. What happened there was that crackpot supply-side economics (e.g. the Laffer curve) was reinforced by the idea that the Fed was largely responsible for and could control any problems by manipulation of the money supply. These things led directly to deregulation and tax cuts, and “liberal” economists, including Paul Krugman, were important supporters of the power and supposed benovolent influence of the Fed.

Strictly speaking Milton Friedman suggested that the money supply should be controlled and expanded at a constant rate, but the attempt to do this during the 70’s and 80’s was an utter failure. Now the Fed’s role according to the “liberals” is supposed to be to preserve “liquidity” through changing interest rates, but trying to do this from rate levels in the range of 5-6 % for Federal funds has led either to a housing bubble (after the 2001 recession) or to a “liquidity trap” (current recession). In fact the freshwater school has not prevented monetary intervention at any time, and monetary intervention has not prevented recessions.

We should also remember the political aspects of the late 1970’s.

While studying at a proto-freshwater department in 1977 I remember hearing the chairman say: “We used to have Marxists here but we got rid of them.”

After that they started to work on the Keynesians.

Dr. Krugman–
Are You familiar with Barry Schwarz’s work on the effects of ‘too many choices’ on decision making?
It supports the inherent irrationality of rational decision theory.
A necessary assumption of rational decision theory is therefore that there must be some rational emergent aggregate behavior resulting from irrational individual behavior.
Unfortunately, as you indicate, there is no evidence for this in the real world of consumer behavior.

As a former student of Herb Simon’s, I’m surprised that economists don’t give him his due. As soon as I read your comments about Lucas, I thought “well, didn’t Simon show he was wrong, pretty much right away?” Your magazine article argument about the role of math in economics was exactly what Simon taught psychologists to do.

As far as salt vs. freshwater economics, I guess Carnegie Mellon has always been a brackish kind of place – maybe it’s the mix of the Allegheny and Mon becoming the Ohio.