Monday, March 5, 2012

Crisis divides macroeconomic schools of thought

Here is Simon Wren-Lewis over at VoxEu:

So why have schools of thought within mainstream macroeconomics returned? One simple story is that schools of thought are associated with macroeconomic crises, and macro synthesis follows periods of calm. Keynesian theory itself was born out of the Great Depression. The first Neoclassical Synthesis arose from the period of strong growth and low inflation in the postwar period. Monetarism gained strength from the rapid inflation of the 1970s. The more recent synthesis may be a child of the Great Moderation, and now we have the Great Recession, schools of thought have returned. Because these crises are macroeconomic, and there are no equivalent crises involving microeconomic behaviour or policy, then fragmentation of the mainstream into schools will be a macro, not micro, phenomenon.

However I think this is too simplistic a view of what is happening today. One interesting feature of the current divide is that the label ‘Keynesian’ appears to be used more by those opposed to certain policies – and in particular fiscal stimulus – than those on the other side. Typically Keynesians see themselves as putting forward synthesis analysis, without the need for branding. What has become clear is that the New Neoclassical Synthesis was in many ways a celebration of New Keynesian theory which was not shared by many freshwater departments in the US.

There may be good reasons why New Keynesian economists might have imagined that their analysis was now an uncontested part of the mainstream. In particular, it is used in nearly all central banks as their main tool in carrying out monetary policy. With monetary policy somewhat depoliticised through central bank independence, the successful implementation of New Keynesian theory during the Great Moderation allowed divisions among academic departments to remain dormant.

On the other side, there was a belief that New Classical economics had been revolutionary, ie a successful counter-revolution against Keynesian ideas.  Once again there were good reasons supporting this belief. On consumption, rational expectations, the Lucas critique and more, traditional Keynesians had unsuccessfully opposed New Classical ideas. Furthermore, many of the leaders of New Classical thought did not want to update Keynesian thinking; they wanted to destroy it. The label ‘Keynesian’ was associated with much more than a belief that prices were sticky and that therefore aggregate demand mattered. Instead it became associated with state intervention. Wikipedia, in its third paragraph on ‘Keynesian economics’, says: “Keynesian economics advocates a mixed economy – predominantly private sector, but with a significant role of government and public sector...”.

The New Classical counter-revolution failed in one respect. While Keynesian analysis may have suffered a near-death experience, it survived and subsequently prospered. New Classical critiques led to fundamental and largely progressive changes. Yet, for many reasons including ideological ones, the would-be counter-revolutionaries did not want to give up their counter-revolution. Partly as a result, the degree to which New Keynesian theory was taught to graduate students differed widely among academic departments, at least in the US.

So, perhaps unlike the first (postwar) neoclassical synthesis, the New Neoclassical Synthesis was partial in terms of its coverage among academics. This incompleteness was not apparent during the Great Moderation, because in central banks the synthesis was uncontested. The fault lines only became evident when monetary policy became relatively impotent at the zero bound after the Great Recession, and fiscal stimulus was used both in the US and UK. Once that happened, what might be called the Anti-Keynesian school re-emerged.

Using this account, it is perhaps possible to view the current emergence of schools of thought as a historical aberration. The microfoundation of macroeconomics would seem to imply that mainstream macro should be as free from fragmentation into schools as microeconomics. As it becomes clear that the New Classical counter-revolution was not successful, the New Neoclassical Synthesis may yet become complete. (For an argument along these lines, see Economist 2012) After all, New Keynesian models are essentially real business cycle models plus sticky prices, and the addition of price rigidity seems both empirically plausible and inoffensive in itself. Both sides could agree that for economies with a floating exchange-rate monetary policy is the stabilisation tool of choice, with fiscal policy only being used if monetary policy is constrained (Kirsanova et al 2009). When interest rates are stuck at the zero lower bound, synthesis models clearly show fiscal policy can be highly effective at stimulating output (Woodford 2011). What has been called ‘demand denial’ appears not to make academic sense, particularly at a zero lower bound (Wren-Lewis 2011).

This outcome may, however, represent wishful thinking by New Keynesians. An alternative reading is that the Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention. That divide occurs all the time in microeconomics, but because it involves arguing about many different externalities or imperfections it does not lend itself to fragmentation into schools. In macro, however, there is one critical externality to do with price rigidity, and so disagreements about policy can easily be mapped into differences about theory. Demand denial is attractive because it gives a non-ideological justification for what is essentially an ideological position about economic policy. Unfortunately, there is a danger that dividing mainstream analysis this way makes macroeconomics look more like a belief system than a science.