The obvious criterion of success or failure for a macroeconomic theoretical framework is that it should provide the basis for predicting, understanding and responding to macroeconomic crises. If that criterion is applied to the current crisis, the micro-foundations approach to macroeconomics has been a near-total failure.

The failure of the dominant stream in macroeconomics was comprehensive.

First, during the bubble years the dominant approach gave little or no warning of the impending crisis. Neither sophisticated DSGE models nor the more pragmatic but less elegant micro-based models employed by the central banks gave much, if any, warning of the impending crisis.

Second, the dominant approach encouraged a benign view of the developments that gave rise to the crisis such as the growth and globalisation of the financial sector and the associated global imbalances. The boosterism of Alan Greenspan was an egregious example, but it was typical of the majority viewpoint.

Third, even as the crisis developed over the course of 2007 and 2008, its seriousness was persistently underestimated. This was exacerbated by the political context in which supporters of the Republican Administration in the US, a group little concerned with reality at the best of times, sought to deny the existence of a recession in an election year.

Fourth, the near-consensus apparent during the Great Moderation collapsed with the onset of crisis, revealing that the split between Keynesian and New Classical views had never been resolved, but merely papered over.

Fourth, it offered little or no useful guidance on the policy and theoretical issues raised by the crisis. The result that the public policy debate has been driven mostly by economists from outside the micro-foundations school. Advocacy of policies of fiscal stimulus has come, to a large extent,from economists such as Paul Krugman and Brad DeLong whose primary field is not macroeconomics, but who retain a historical understanding informed by Keynesianism. The most effective criticism has come from finance theorists like John Cochrane and Eugene Fama, mostly notable as advocates of the efficient markets hypothesis. Arguments on both sides have been couched in terms familiar to economists of 1970 and earlier, with each side accusing the other of holding views that had been refuted by the 1930s

The roots of this failure may be traced in part to problems with the micro-foundations approach itself. Micro-foundations models take general equilibrium as the starting point – modest variations of the standard classical assumptions suggest that deviations from classical properties are also likely to be modest. Macro models calibrated to the Great Moderation encouraged this assumption, as well as exclusive focus on monetary policy based on Taylor rules, which proved unavailing. The collapse of this position forced economists to shift either to the left (back to older versions of Keynesianism) or to the right (to extreme versions of classicism).

However, the broader intellectual climate of market liberalism, in which thinking about macroeconomic issues was conditioned by the assumptions of the efficient markets hypothesis and the apparent lessons of the Great Moderation. Concerns about market imbalances could not easily be reconciled with the implications of the efficient financial markets hypothesis or with the triumphalism of the Great Moderation.

At least since the 1970s, the description “politically correct” or, in Australia, “ideologically sound”, had been used within the left to mock those who were excessively concerned with doctrinal and linguistic orthodoxy. The story of how “political correctness” turned from an inside joke to a Marxist-inspired assault on All We Hold Dear is reasonably well known. Bernstein traces its emergence as a pejorative to a conference by the Western Humanities Conference held, appropriately enough, in Berkeley.

For me, at least, the real surprise in this article came right at the end, with a quote from Roger Kimball, now of Pajamas Media, who said “It’s a manifestation of what some are calling liberal fascism”. Apparently, Jonah Goldberg owes him royalties.

Update I haven’t made proper use of the excellent NYTimes search facility until now. This search shows a string of sardonic references to political correctness in the Arts section (and one reference to its use by the Chinese CP) appearing in the years before Bernstein’s piece. After that, there’s an explosion). And “liberal fascism” made its first outing (post-1980 at any rate) in a 1988 story about the Dartmouth Review, spoken by then editor Harmeet Dhillon.

But, I intend to say in the “Where next” section, it seems likely that heterogeneous and boundedly rational individuals, interacting in imperfect and incomplete markets will generate ‘emergent’ macro outcomes that are not obvious from the micro foundations. Of course, this is going to be a prospectus for a theory, not the theory itself.

In the meantime, comments on my snippet would be much appreciated.

Update Looking at the responses, I think just about everyone has missed the point, which suggests that maybe I didn’t make it very well.

I’m not saying that heterogeneity doesn’t matter, but that introducing (tractable) heterogeneity into a DSGE model isn’t likely to yield radically different predictions about macroeconomic outcomes. If that’s correct, then if you think DSGE models work well (for some evaluative procedure), you can be relaxed about using representative agents. And if you don’t think DSGE models work well, the representative agent assumption isn’t the problem, or at least it isn’t the only problem.

Since my statement of the situation didn’t help much, I’ll present it as a question instead. Can anyone point me to a DSGE-style model that derives strongly non-classical results from the introduction of heterogeneity? Or, failing that, does anyone have a convincing argument that such results should emerge?

I’m aware of course that, in general, anything can happen with aggregation across heterogeneous agents, so I’m not much interested in arguments for agnosticism starting from that point. End update

Commonly, though not invariably [in DSGE models], it was assumed that everyone in the economy had the same preferences, and the same relative endowments of capital, labour skills and so on, with the implication that it was sufficient to model the decisons of a single ‘representative agent’. This assumption has attracted a lot of criticism, and quite a few critics have suggested that models that take account of individual differences in tastes and endowments would yield more realistic results.

Such criticisms are somewhat off the point in relation to micro-based macro models. As long as the agents in such a model are rational optimizers in the standard sense of neoclassical microeconomics, any initial differences in tastes or endowments will be evened out by trade in competitive markets. In a standard market equilibrium, everyone will have the same preferences ‘at the margin’, namely the preferences given by market prices. If, for example, the market price of oranges is twice the market price of apples, then market equilibrium requires that everyone who trades in that market should be willing, at the margin, to trade two apples for an orange, regardless of whether they prefer to consume a lot of apples and a few oranges, or vice versa. In standard micro-based macro models, this means that not much is lost by aggregating all the participants in a market, and then working with an average or ‘representative’ agent.

Implications

The implications of the micro-foundations approach to macroeconomics can be assessed in the light of the introduction to Paul Krugman’s essay ‘How Did Economists Get it So Wrong’.

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes—or so they believed—were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association.

These conclusions did not emerge as specific implications of any particular model. Rather, the micro-foundations approach, at least in its current form, can only work well under specific assumptions and conditions. The crucial assumptions are that the standard microeconomic model in which market outcomes are driven by the optimizing decisions of rational individuals (in typical macroeconomic models, those of a single rational individual).

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Rationality everywhere

The incorporation of rational expectations into micro-based macroeconomic models went hand in hand with the acceptance of increasingly strong forms of the efficient markets hypothesis, and both fitted naturally with the rise of market liberalism. In competitive markets where participants are perfectly rational and display high levels of foresight, it is very hard to see any beneficial role for governments. Even if governments happen to better informed than market participants, they should not, in a world of perfect rationality, act on that information. Rather, they should release the information to the public, allowing market participants to combine this public information with their own private information, and secure better outcomes than would be possible from government action.

Of course, many macroeconomists, and particularly those of the New Keynesian school, explicitly rejected the ultra-rational assumptions that produced such implausible conclusions as Barro’s Ricardian equivalence. One of the standard moves in the construction of Blanchard’s haikus was to allow the ‘representative individual’ to deviate in some small way from perfect rationality.

A common example is the assumption of ‘hyperbolic’ discounting. The idea is that in assessing a choice between getting some benefit immediately, or at some point in the relatively near future, say, in a month’s time, people display a lot of impatience. They are willing to offer a big discount to get the benefit now rather than wait to get something better. But, if they are asked about two points in the future that are a month apart, they will offer only a small benefit. Such preferences, if maintained over time, are not consistent with standard rationality. The choices people make now regarding choices in the medium future are not the same as they would make if they waited until the opportunity for immediate consumption was actually available. A paper by Liam Graham and Dennis Snower showed that the combination of staggered nominal contracts with hyperbolic discounting leads to inflation having significant long-run effects on real variables, that is, to the existence of a Phillips curve relationship that might persist into the long term.

Papers in this tradition showed that small deviations from rationality can sometimes have big effects on economic outcomes. But they rarely have big implications for public policy. Rather, they point in the direction of the idea set out by Cass Sunstein and Richard Thaler in their recent book Nudge. Sunstein and Thaler argue that governments can sometimes exploit deviations from rationality by framing choices that will ‘nudge’ people’s decisions in a socially desirable direction. George Lakoff in Don’t Think of An Elephant makes the same argument in a political context, suggesting that the Republican Party has had more success than would be expected based on underlying support for its policies, because it has done a better job of ‘framing’ political issues. Rather than seeking a more rational debate, Lakoff, argues, Democrats should respond in kind.

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Fiscal and monetary policy

The theoretical complacency with which the DGSE school viewed the state of macroeconomic theory was matched by a similar complacency regarding macroeconomic policy. From the early 1990s to the panic of 2008, macroeconomic policy was, for all practical purposes, monetary policy, or, more precisely interest rate policy. The standard approach involved what is called a Taylor rule, after … economist John Taylor, later the Under Secretary of the US Treasury for International Affairs under the George W. Bush|Bush Administration, who proposed in 1993. Taylor presented his rule as a way of describing the actual behavior of central banks, but it soon came to be used as a normative guide to policy.

The idea of the Taylor rule was to set interest rates in such a way as to keep two variables, the inflation rate and the rate of growth of Gross Domestic Product, as close as possible to their target values. Typical targets might be an inflation rate of 2 to 3 per cent, and a real GDP growth rate in line with long-term growth in the labour force and labour productivity, say 3 per cent for a developed country like the US. Given

Within this framework, the essential functions of macroeconomic theory are relatively simple. Complex macroeconomic models can be reduced to simple relationships between one policy instrument (interest rates) and two targets (inflation and growth). Since there are two target variables, it’s impossible to hit each target exactly, so the models give rise to a trade-off. Using the single representative agent who typically inhabits a DGSE model, it’s possible to calculate the optimal trade-off, which can be expressed as the range of acceptable variation in inflation rates.

During the Great Moderation, all this seemed to work very well, to the extent that commentators spoke of a ‘Goldilocks economy’, neither too hot, nor too cold but just right. Even with a tight target range for inflation, between 2 and 3 per cent per year, it seemed possible to stabilise growth and avoid all but the mildest recessions. In these circumstances, the comment of Robert Lucas that the “central problem of depression-prevention has been solved,” seemed only reasonable.

To the extent that there was any coherence to the higher education policies of the Howard government, it was derived from the idea that universities should become more like ordinary commercial businesses. Managerialism and market liberalism are at one in their rejection of notions of professionalism and the idea of autonomous academic disciplines. Both managerialists and market liberals reject as special pleading the idea that there is any fundamental difference between higher education and say, the manufacturing and marketing of soft drinks. In both cases, it is claimed the optimal policy is to design organisations that respond directly to consumer demand, and to operate such institutions using the generic management techniques applicable to corporations of all kind. They should compete on the basis of price (fees) as well as quality, and tailor their offerings to market (student) demand. The laws of economics would then ensure an efficient outcome.

This theory seemed beautiful to the ideologists of market reform, but it failed to account for an ugly fact. For-profit education has been a consistent failure in all times and places. The limited exceptions relate to areas of vocational training with little or no general educational components.

The market euphoria of the 1990s produced a large number of for-profit educational ventures, most of which quickly failed. Rather than conduct a post-mortem on the departed, it is instructive to look at some of the survivors.

Edison Schools was founded in 1992 and was widely viewed as representing the future of school education. Its plans were drawn up by a committee headed by John Chubb, the co-author of the most influential single critique of public sector education in the United States (Chubb and Moe 1990).

The period since then has been one of decline. Edison has lost numerous contracts, along with its stockmarket listing and has largely abandoned new bids to operate schools, focusing instead on a variety of peripheral educational services, such as testing and the provision of course materials. Even operating in a highly favorable political and financial climate, Edison was unable to deliver on its promise of transforming the school sector, and seems unlikely to survive as a school operator in the long run.

The University of Phoenix, founded in 1976, has been widely represented in Australia as a successful challenger to traditional universities. Such claims are exaggerated to say the least. Although the University does compete with traditional providers of undergraduate university education, its record in this area is exceptionally poor, with a graduation rate of 16 per cent (“the percentage of first-time undergraduates who obtain a degree within six years”). The performance of online programs (6 per cent) is even worse.

Alarmingly in the context of discussions of FEE-Help, the University of Phoenix has been subject to persistent accusations of rorting the government-subsidised student loan system. It was fined $10 million for illegal recruitment practices in 2004. A shareholder lawsuit based on the same issue recently led to a jury award of $280 million against the University’s parent company, Apollo Group, and further litigation under the False Claims Act is continuing.

The most prominent Australian venture into for-profit higher education is U21Global, a joint venture of the Universitas21 alliance of universities, of which the most prominent driver has been the University of Melbourne. Launched in 2001, it projected enrolments of 60 000 students, and annual revenue of $500 million by 2010. As of 2008, U21Global claims 1600 students, many undertaking short courses aimed at professionals. No financial reports appear to be publicly available, but it seems unlikely that the $US50 million invested in the venture will be recovered.

The failure of for-profit education reflects fundamental characteristics of education that make models based on competition and consumer sovereignty inappropriate as a basis for policy. Because the benefits of education are hard to assess in advance, and only realised over a number of years, short-term market incentives are ineffective or perverse. Only a long-term commitment to academic standards and professionalism can maintain the quality of education, and such a commitment cannot be driven by managerial skill or direct incentives.

The main point, though, is that the fuss over the global cooling chapter in Levitt and Dubner’s new book is the first occasion, I think, where the refutation of specific errors has taken a back seat (partly because, in this case, it’s so easy) to an attack on contrarianism, as such. The general point is that contrarianism is a cheap way of allowing ideological hacks to think of themselves as fearless, independent thinkers, while never challenging (in fact reinforcing) the status quo. Here’s Krugman and Joe Romm, for example

I can certainly remember that I was once positively disposed to contrarianism. Trawling through the blog records, I can find

• A mixed review of Christopher Hitchens (on our side then), Letters to a Young Contrarian. If memory serves, I had a more favorable view of contrarianism, and Hitchens, before reading the book than after.

• A reference to “The worst kind of contrarian: That is, one who makes great play with contradictions in the conventional wisdom, does not put forward a coherent alternative, but nonetheless makes authoritative-sounding pronouncements on public policy.”

• A diagnosis of Richard Lindzen as someone who is “just an irresponsible contrarian as a matter of temperament. ”

To sum up my current view: “contrarianism” is mostly contrary to reality, the “conventional wisdom” is probably wiser than the typical unconventional alternative, and “politically incorrect” views are almost always incorrect in every way: literally, scientifically and morally.

A big reason for Goldman Sachs’s blowout profits this year has been the willingness of its traders to take big risks — they have put more money on the line while other banks that suffered last year have reined in such moves. Executives say there are big strategic gaps opening up between banks on Wall Street that are taking on more risks, and those that are treading a safer path.

Looking at this more seriously, the effect of the crisis has been to drastically weaken US financial regulation. In place of the Greenspan put, a generalized commitment to protect the financial sector from the consequences of its own bad behavior, we have the Goldman put, where a single firm runs the show, in the general manner of the United Fruit Company. This kind of situation is ideally suited to the rhetorical and forensic talents of Glenn Greenwald, and he doesn’t disappoint.

Most of what I’ve written in the book so far has been pretty easy. I’ve never believed the Efficient Markets Hypothesis or New Classical Macro and it’s easy enough to point out how the occurrence of a massive financial crisis leading to a prolonged macroeconomic crisis discredits them both.

I’m coming now to one of the most challenging section of my book, where I look at why the New Keynesian program (with which I have a lot of sympathy) and ask why New Keynesians (most obviously Ben Bernanke) didn’t, for the most part, see the crisis coming or offer much in response that would have been new to Keynes himself. Within the broad Keynesian camp, the people who foresaw some sort of crisis were the old-fashioned types, most notably Nouriel Roubini (and much less notably, me) who were concerned about trade imbalances, inadequate savings, and hypertrophic growth of the financial sector. Even this group didn’t foresee the way the crisis would actually develop, but that, I think is asking too much – every crisis is different.

My answer, broadly speaking is that the New Keynesians had plenty of useful insights but that the conventions of micro-based macroeconomics prevented them from forming the basis of a progressive research program.

Comments will be appreciated even more than usual. I really want to get this right, or as close as possible

New Keynesian macroeconomics 

In the wake of their intellectual and political defeats in the 1970s, mainstream Keynesian economists conceded both the long-run validity of Friedman’s critique of the Phillips curve, and the need, as argued by Lucas, for rigorous microeconomic foundations. “New Keynesian economics” was their response to the demand, from monetarist and new classical critics, for the provision of a microeconomic foundation for Keynesian macroeconomics.

The research task was seen as one of identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions, such as the possibility of significant welfare benefits from macroeconomic stabilization. A classic example was the  ‘menu costs’ argument produced by George Akerlof, another Nobel Prize winner. Akerlof sought to motivate the wage and price “stickiness” that characterised new Keynesian models by arguing that, under conditions of imperfect competition, firms might gain relatively little from adjusting their prices even though the economy as a whole would benefit substantially.

The approach was applied, with some success, to a range of problems that had previously not been modelled formally, including many of the phenomena observed in the leadup to the global financial crisis, such as asset price bubbles and financial instability generated by speculative ‘noise trading’. 

A particularly important contribution was the idea of the financial accelerator, a rigorous version of ideas first put forward by Fisher and by Keynesians such as Harrod and Hicks. Fisher had shown how declining prices could increase the real value of debt, making previously profitable enterprises insolvent, and thereby exacerbating initial shocks. The Keynesians showed how a shock to demand would result in declining utilisation, meaning that firms could meet their production requirements without any additional investment. Thus the initial shock to demand would have an amplified effect on the demand for investment goods.

In a 1989 paper, Ben Bernanke and Mark Gertler integrated these ideas with developments in the theory of asymmetric information to produce a rigorous model of the financial accelerator. 

It would seem, then,  that New Keynesian economists should have been well equipped to challenge the triumphalism that prevailed during the Great Moderation. With the explosion in financial sector activity, the development of massive international and domestic imbalances and the near-miss of the dotcom boom and slump as evidence, New Keynesian analysis should surely have suggested that the global and US economies were in a perilous state.

 Yet with few exceptions, New Keynesians went along with the prevailing mood of optimism. Most strikingly, the leading New Keynesian, Ben Bernanke became,  the anointed heir of the libertarian Alan Greenspan as Chairman of the US Federal Reserve. And as we have already seen, it was Bernanke who did more than anyone else to popularise the idea of the Great Moderation.

Olivier Blanchard summarises the standard New Keynesian approach (which converged, over time with the RBC approach) using the following, literally poetic, metaphor

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, ¯rms 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.

Blanchard’s description brings out the central role of microeconomic foundations in the New Keynesian framework, and illustrates both the strengths and the weaknesses of the approach. One the one hand, as we have seen, New Keynesians were able to model a wide range of economic phenomena, such as bubbles and …, while remaining within the classical general equilibrium framework. On the other hand, precisely because the analysis remained within the general equilibrium framework, it did not allow for the possibility of a breakdown of classical equilibrium, which was precisely the possibility Keynes had sought to capture in his general theory.

The requirement to stay within a step or two of the standard general equilibrium solution yielded obvious benefits in terms of tractability. Since the properties of general equilibrium solutions have been analysed in detail for decades, modeling “general equilibrium with a twist” is a problem of exactly the right degree of difficulty for academic economists – hard enough to require, and exhibit, the skills valued by the profession, but not so hard as to make the problem insoluble, or soluble only with the abandonment of the underlying framework of individual maximization.

A critical implication of Blanchard’s haiku metaphor is that the New Keynesian program was not truly progressive. A study of some new problem such as the incentive effects of executive pay would typically, as Blanchard indicates, begin with the standard general equilibrium model, disregarding the modifications made to that model in previous work examining other ways in which the real economy deviated from the modelled ideal. The cumulative approach would imply a model that moved steadily further and further away from the standard GE framework, and therefore became less and less amenable to the standard techniques of analysis associated with that model. 

This, I think, is what Paul Krugman had in mind when he suggested in his essay ‘How Did Economists Get It So Wrong?’ that economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. The work described by Blanchard was beautiful (at least to economists) and illuminated some aspects of the truth, but beauty came first. An approach based on putting truth first would have incorporated multiple deviations from the standard general equilibrium model then attempted to work out how they fitted together. In many cases, the only way of doing this would probably be to incorporate ad hoc descriptions of aggregate relationships that fitted observed outcomes, even if it could not be related directly to individual optimization.

New Keynesian macroeconomics, of the kind described by Blanchard, was ideally suited to the theoretical, ideological and policy needs of the Great Moderation. On the one hand, and unlike New Classical theory it justified a significant role for monetary policy, a conclusion in line with the actual policy practice of the period. On the other hand, by remaining within the general equilibrium framework the New Keynesian school implicitly supported the central empirical inference drawn from the observed decline in volatility, namely that major macroeconomic fluctuations were a thing of the past.

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DSGE

Eventually, the New Keynesian and RBC streams of micro-based macroeconomics began to merge. The repeated empirical failures of standard RBC models  led many users of the empirical techniques pioneered by Prescott and Lucas to incorporate non-classical features like monopoly and information asymmetries. These “RBC-lite” economists sought, like the purists, to produce calibrated dynamic models that matched the “stylised facts” of observed business cycles, but quietly abandoned the goal of explaining recessions and depressions as optimal adjustments to (largely hypothetical) technological shocks.

This stream of RBC literature converged with New Keynesianism, which also uses non-classical tweaks to standard general equilibrium assumptions with the aim of fitting the macro data.

The resulting merger produced a common approach with the unwieldy title of Dynamic Stochastic General Equilibrium (DSGE) Modelling. Although there are a variety of DSGE models, they share some family features. As the “General Equilbrium” part of the name indicates, they take as their starting point the general equilibrium models developed in the 1950s, by Kenneth Arrow and Gerard Debreu, which showed how an equilibrium set of prices could be derived from the interaction of households, rationally optimising their work, leisure and consumption choices, and firms, maximizing their profits in competitive markets. Commonly, though not invariably, it was assumed that everyone in the economy had the same preferences, and the same relative endowments of capital, labour skills and so on, with the implication that it was sufficient to model the decisons of a single ‘representative agent’.

The classic general equilibrium analysis of Arrow and Debreu dealt with the (admittedly unrealistic) case where there existed complete, perfectly competitive markets for every possible asset and commodity, including ‘state-contingent’ financial assets which allow agents to insure against, or bet on, every possible state of the aggregate economy. In such a model, as in the early RBC models, recessions are effectively impossible – any variation in aggregate output and employment is simply an optimal response to changes in technology, preferences or external world markets. DGSE models modified these assumptions by allowing for the possibility that wages and  prices might be slow to adjust, by allowing for the possibility of imbalances between supply and demand and so on, thereby enabling them to reproduce obvious features of the real world, such as recessions.

But, given the requirements for rigorous microeconomic foundations, this process could only be taken a limited distance. It was intellectually challenging, but appropriate within the rules of the game, to model individuals who were not perfectly rational, and markets that were incomplete or imperfectly competitive. The equilibrium conditions derived from these modifications could be compared to those derived from the benchmark case of perfectly competitive general equilibrium.

But such approaches don’t allow us to consider a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory and where markets depend not only on prices, preferences and profits but on complicated and poorly understood phenomena like trust and perceived fairness. As Akerlof and Shiller observe 

…

It was still possible to discern the intellectual origins of alternative DSGE models in the New Keynesian or RBC schools. Modellers with their roots in the RBC school typically incorporated just enough deviations from competitive optimality to match the characteristics of the macroeconomic data series they are modelling, and prefer to focus on deviations that are due to government intervention rather than to monopoly power or other forms of market intervention. New Keynesian modellers focused more attention on imperfect competition and were keen to stress the potential for the macro-economy to deviate from the optimal level of employment in the short term, and the possibility that an active monetary policy could produce improved outcomes  

Because New Keynesians were (and still are) concentrated in economics departments on the East and West Coast of the United States (Harvard, …) while their intellectual opponents are most prominent in the lakeside environments of Chicago and Minnesota, the terms ‘saltwater’ and ‘freshwater’ schools have been coined (by Krugman?) to describe the two positions. But such a terminology suggests a deeper divide between competing schools of thoughts than actually prevailed during the false calm of the Great Moderation. The differences between the two groups were less prominent, in public at least, than their points of agreement. The freshwater school had backed away from extreme New Classical views after the failures of the early 1980s, while the distance from traditional Keynesian views to the New Keynesian position was summed up by Lawrence Summer’s observation that ‘We are now all Friedmanites, Lawrence Summers’. And even these limited differences were tending to blur over time, with many macroeconomists, and particularly those involved in formulating and implementing policy shifting to an in-between position that might best be described as ‘brackish’.  

However, the similarities outweigh the differences. Whether New Keynesian or RBC in their origins, DSGE models incorporate the assumption, derived from Friedman, that there is no long-run trade-off between unemployment and inflation, that is, that the long-run Phillips curve is vertical. And nearly all allowed for some trade-off in the short run, and therefore for some potential role for macroeconomic policy.

The differences between saltwater and freshwater DGSE models may be discussed in terms of the venerable Keynesian idea of the multiplier, that is, the ratio of the final change in output arising from a fiscal stimulus to the size of the initial stimulus. Old Keynesians had argued that the multiplier (as the name suggests) was greater than one since the beneficiaries of government expenditure would increase their consumption of goods and services, leading to more workers being hired who in turn would increase their own consumption and so on.  The ‘policy ineffectiveness’ proposition of the New Classical school implied that the multiplier should be zero or even negative, because of the incentive-sapping effects of government spending and the taxes required to finance it. The DGSE modellers tended to split the difference.

Although the issue was rarely discussed explicitly, the DGSE models favored by the New Keynesian school typically implied values for the multiplier that were close to 1, while those derived from RBC approaches suggested values that were positive, but closer to zero. Given the mild volatility of the Great Moderation, such models yielded no justification for active use of fiscal policy, and good reasons for governments to maintain budget balance as far as possible. New Keynesians also typically rejected active use of fiscal policy, and relied exclusively on monetary policy to manage the economy, But, compared to their freshwater colleagues they had a more positive view of the ‘automatic stabilisers’. Since tax revenues tend to fall and welfare expneditures to rise during recessions a government that maintains a balanced budget on average will tend to run deficits during recessions and surpluses during booms. On a Keynesian analysis, the fact that government spending net of taxes is countercyclical (moves in the opposite direction to fluctuations in the rate of economic growth) tends to stabilise the economy. Vast numbers of journal pages were devoted to refining these different viewpoints, and to defending one or the other. But in practical policy terms, the differences were marginal

Reflecting their origins in the 1990s, most analysis using DSGE models assumed that macroeconomic management was the province of central banks using interest rate policy (typically the setting of the rate at which the central bank would lend to commercial banks) as their sole management instrument. The central bank was modelled as following either an inflation target (the announced policy of most central banks) or a “Taylor rule”, in which the aim is to stabilise both GDP growth and inflation.

On the whole, while central banks showed a some interest in DSGE models, and invoked their findings to provide a theoretical basis for their operations, they made little use of them in the actual operations of economic management. For practical purposes, most central banks continued to rely on older-style macroeconomic models, with less appealing theoretical characteristics, but better predictive performance. However, neither DSGE models nor their older counterparts proved to be of much use in predicting the crisis that overwhelmed the global economy in 2008, or in guiding the debate about how to respond.

I’ve now posted drafts of the first three chapters (+Intro) at my wikidot site, so you can get some context. In particular, before commenting on omissions, take a quick look to see that the point hasn’t been covered elsewhere.

Micro-based macro is here

I’ve got a lot out of comments and discussion so far, and I hope some of this is reflected in what you are reading.

The Phillips curve

Throughout the history of capitalism it has been observed that boom periods tended to be accompanied by inflation (an increase in the general price level), and depressions by deflation. This observation formed a central part of the Keynesian economic system. While Keynes is commonly remembered for his advocacy of budget deficits to stimulate the economy in periods of recession, he also grappled with the problem of how to avoid inflation in the postwar period. In his famous and influential pamphlet, How to Pay for the War, Keynes argued that inflation was the product of an excess of demand over supply, and that the appropriate policy response was for governments to increase taxes and run budget surpluses, to bring demand into line with supply.

 In 1958, New Zealand economist A.W (Bill) Phillips undertook a statistical study which formalised the relationship between unemployment and inflation.  in the now-famous Phillips Curve. The curve related unemployment to the rate of change in money wages, showing that, at very low rates of unemployment, wages tended to grow rapidly. Since wages account for the majority of production costs, rapid wage inflation also implies rapid price inflation. The higher the rate of unemployment, the lower the rate of wage growth. However, because workers generally resist outright cuts in wages, the curve flattens out, with increases in unemployment beyond a certain rate (typically between 5 and 10 per cent) having little further deflationary effect.

Phillips was famous (or perhaps notorious) for having designed a hydraulic analog computer that could be used to represent the Keynesian economic model (the Faculty of Economics and Politics at Cambridge University still has a working version) and had, as a Japanese prisoner of war built a miniature radio at great risk. Despite his engineering skills, and his general reputation as an exponent of ‘hydraulic’ Keynesianism, he did not endorse a mechanical interpretation of the curve. He is said to have remarked that “if I had known what they would do with the graph I would never have drawn it.

The leading American Keynesian economists of the day, Paul Samuelson and Robert Solow, were less cautious. They estimated similar relationships for the US, and drew the conclusion that society faced a trade-off between unemployment and inflation. That is, society could choose between lower inflation and higher unemployment or lower unemployment and higher inflation. This point was spelt out in successive editions of Samuelson’s textbook, simply entitled Economics, which dominated the market from its initial publication in 1948 until the mid-1970s. Given a menu of choices involving different rates of unemployment and inflation, it seemed obvious enough that, since unemployment was the greater evil, a moderate increase in inflation could be socially beneficial/

The interpretation of the Phillips curve as a stable trade-off between unemployment and inflation led to an acceptance of higher rates of inflation as the necessary price of reducing unemployment still further below the historically low levels of the postwar boom. So, whereas previous episodes of inflation had been met with the orthodox Keynesian response of fiscal contraction aimed at reducing aggregate demand, there was no such response to the acceleration of inflation in the late 1960s. The Phillips curve idea appeared to justify expansionary fiscal policy except when unemployment was very low, and embedded the notion of Keynesian economics as a justification for budget deficits under any and all circumstances. 

Friedman, Natural Rate and NAIRU…

The Keynesian adoption of the Phillips curve paved the way for  Milton Friedman’s greatest intellectual victory, based on a penetrating analysis offered in the late 1960s at a time when inflation, while already problematic, was far below the double-digit rates that would be experienced in the 1970s.

In his famous 1968 Presidential address to the American Economic Association, Friedman argued that the supposed trade-off between unemployment and inflation was the product of illusion. As long as workers failed to recognise that the general rate of inflation was increasing, they would regard wage increases as real improvements in their standard of living and therefore would increase both their supply of labor and their demand for goods. But, Friedman argued, sooner or later expectations of inflation would catch up with reality. If the rate of inflation were held at, say, 5 per cent for several years, workers would build a 5 per cent allowance for inflation into their wage claims, and businesses would raise their own prices by 5 per cent to allow for the increase in anticipated costs.

Once expectations adjusted, Friedman argued, the beneficial effects of inflation would disappear. The rate of unemployment would return to the level consistent with price stability, but inflation would remain high. Interpreted graphically, this meant that the long-term Phillips curve was a vertical line.

Friedman’s analysis gave no specific answer to the question of where unemployment would stabilise. Friedman argued that this could be determined as “the level ground out by the Walrasian system of general equilibrium equations … .including market imperfections …the cost of gathering information about job vacancies and labor availabilities, the costs of mobility and so on’ ” Friedman introduced the unfortunate description of this outcome as the ‘natural rate of unemployment’, although even on his own telling there was nothing natural about it. The same terminology was adopted by Edmund Phelps, who developed a more rigorous version of Friedman’s intuitive argument, for which he was awarded the Economics Nobel in 2006. These days, most economists prefer to use the euphemism “NAIRU,” which stands for Non-Accelerating Inflation Rate of Unemployment.

In summary, Friedman and Phelps suggested, the beneficial effects of inflation were the product of illusion on the part of workers and employers. And by implication, they suggested that their Keynesian colleagues were subject to a more sophisticated form of the same illusions.

Within a few years, Friedman’s judgement was vindicated.  The Samuelson-Solow interpretation of the Phillips curve as a stable trade-off was soon proved wrong in practice, as inflation rates increased without any corresponding reduction in unemployment, a phenomenon that came to be referred to by the ugly portmanteau word, stagflation (stagnation + Inflation).  Inflation rates rose steadily, reaching double digits by the early 1970s.

The simplistic Keynesian interpretation of the Phillips curve was discredited forever. No one in the future would suggest that policymakers could exploit a stable trade-off between unemployment and inflation, except under special conditions. But this idea, dating only from the 1960s, was a late development in Keynesian thought, and its failure did not imply that Keynesian macroeconomics itself was unsound. To banish the idea that governments could and should act to stabilise the economy and preserve full employment (or even Friedman’s ‘natural rate’) the critique of Keynesianism had to be pushed further.

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The New Classical school 

Friedman argued that exploitation of the Phillips curve could not work for long, because expectations of inflation would eventually catch up with reality. Experience seems to support this argument, at least once inflation rates are high enough for people to take notice (anything above 5 per cent seems to do the trick). 

But Friedman’s reasonable argument was neither logically watertight nor theoretically elegant enough for the younger generation of free-market economists, who wanted to restore the pre-Keynesian purity of classical macroeconomics, and became known as the New Classical school. Their key idea was to replace Friedman’s adaptive model of expectations with what they called ‘rational expectations’ (a term coined much earlier, and in a microeconomic context, by John F. Muth). Although Muth had been cautious about possible misinterpretation of the term, his successors showed no such caution. Having adopted Muth’s characterization of rational expectations as “those that agree with the predictions of the relevant economic model”, and defined the relevant economic model as their own, New Classical economists happily traded on the implicit assumption that any consumer whose expectations did not match those of the model must be irrational.

One of the first and most extreme and applications of the rational expectations idea was put forward in 1974 by Robert Barro, then an up-and-coming young professor at the University of Chicago, and who now makes regular appearances, not only in academic journals and lists of likely candidates for the Nobel Prize in Economics, but also in the Opinion pages of the Wall Street Journal.

Barro drew on the work of the first great formal theorist in economics, David Ricardo. Ricardo, a successful speculator, financier and member of the House of Commons developed the ideas presented in Adam Smith’s Wealth of Nations into a rigorous body of analyis. He observed that, if governments borrow money, say to finance wartime expenditures, their citizens should anticipate that taxes will eventually have to be increased to repay the debt. If they were perfectly rational, Ricardo noted, they would increase their savings, by an amount equal to the additional government debt, in anticipation of the higher tax burden. So it should make no difference whether the war is financed by current taxation or by debt. Having observed this theoretical equivalence, Ricardo immediately returned to reality with the observation that “the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly”.

Barro’s big contribution, in an article published in 1974, was to  focus on theory rather than reality and suggest that what he called ‘Ricardian equivalence’ actually holds in practice.  Barro’s claim was never widely accepted, even among opponents of Keynesianism.

Barro’s claim was made without regard to empirical evidence. Econometric testing strongly rejected the “Ricardian equivalence’ hypothesis, that current borrowing by governments would be fully offset by household saving. Some tests suggested that borrowing might moderately increase household saving, but others showed the exact opposite.  Critics pointed out numerous theoretical deficiencies in addition to Barro’s reliance on ultra-rational expectations. For example, the argument assumes that households face the same interest rate as governments, which is obviously untrue. 

Nevertheless, despite failing to gain significant acceptance, the Ricardian Equivalence hypothesis had a significant effect on the debate within the economics profession. Extreme assumptions about the rationality of consumer decisions, that would once have been dismissed out of hand, were now treated as the starting point for analysis and debate. In this way, Barro paved the way for what became known as the Rational Expectations revolution in macroeconomics. And, while Barro’s Ricardian arguments for the claim that Keynesian policies could not possibly work were seen as implausible other versions of the same claim were soon produced, and widely accepted.

The result has been called New Classical Economics, a body of economic theory which reproduces the classical conclusion that government intervention cannot improve macroeconomic performance and that, in the absence of such intervention, the economy will rapidly adjust to economic shocks, returning in a short term to its natural equilibrium position.

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Lucas critique and RE 

The central idea of rational expectations goes back to the early 1960s. Agricultural economists at the time often modelled price cycles in commodity markets as the outcome of lags in the production process. The idea was that  a high price for, say, corn, would occur in some season because of, say, a drought or a temporary increase demand.  Farmers in one season would observe the high price and plant a lot of it for the next season. The result would be large crop and a low price. Farmers would therefore plant less corn for the following season and the price would go up again. Eventually, this series of reactions and counter-reactions would bring the price back to the equilibrium level where supply (the amount of corn farmers would like to produce and sell at that price) equalled demand. As represented on the supply-and-demand diagrams economists like to draw, the path of adjustment resembled a cobweb, and so, the model is 

Economist John(?) Muth saw a problem. In the cobweb model, farmers expect a high price this season to be maintained next season, and so produce high output. But this is a self-defeating prophecy, since the high output means that the price next season will be low. Why, Muth, asked would farmers keep on making such a simple, and costly, mistake. If farmers based their expectations on their own experience, they would not expect high prices to be maintained. But, what, then, would they expect? An expectation that high prices are followed by low prices, as occurs in the cobweb model, would be similarly self-defeating. 

Muth’s answer was both simple and ingenious. The requirement that the price expected by farmers should equal the expected price generated by the model can be incorporated within the model itself, and this requirement closes the circle in which expectations generate prices and vice versa. Muth showed that, with this requirement, the cobweb model could not work. As long as the ‘shocks’ that raise or lower prices in one season are not correlated with the shocks in the next season, the only ‘rational’ expectation for farmers is that the price next season will be equal to the ‘average’ equilibrium price that the model generates in the absence of such shocks. If farmers expect this, they will produce, on average, the supply associated with that price, and, on average, that price will in fact arise.

In the late 1970s, Robert E. Lucas took Muth’s idea and applied it to the macroeconomic debate about inflationary expectations. Friedman had convinced most economists that, if high rates of inflation are maintained long enough, companies and workers will come to expect it and build this expectation into price-setting decisions and wage demands. He suggested a simple adjustment process in which expectations gradually catch up with a change in the inflation rate. That process was sufficient to kill off the idea of a stable trade-off between unemployment and inflation, and to explain how continued high inflation, initially associated with low unemployment, could turn into the ‘stagflation’ of the 1970s. 

In Friedman’s ‘adaptive expectations’ model, there was a lag between an increase in the rate of inflation and the adjustment of inflationary expectations. That lag left open the possibility that governments could manipulate the Phillips curve trade-off, at least in the short run. Lucas used the idea of rational expectations to close off that possibility. In a rational expectations model, workers and businesses (commonly referred to in this literature as ‘economic agents’) make the best possible estimate of future inflation rates, and therefore cannot be fooled by government policy. Lucas’ ideas were developed by Tom Sargent and Neil Wallace into the ‘Policy Ineffectiveness Proposition’

Lucas developed a more general critique of economic policymaking, using the case of the Phillips curve as an example.  His general point was that there was no general reason to suppose that an empirical relationship observed under one set of policies, like the Phillips curve relationship between unemployment and inflation, would be sustained in the event of a change in policies, which would, in general, imply a change in expectations. The Lucas critique works with a range of assumptions about expectations, including Friedman’s adaptive expectations, but it is most naturally associated with Lucas’ favored rational expectations model. Lucas argued that the only reliable empirical relationships were those derived from the ‘deep’ microeconomic structure of models, in which economic outcomes are the aggregate of decisions by rational agents, making decisions aimed at pursuing their own goals (maximising their utility, in the jargon of economists).

The solution it seemed was obvious, though not simple. The Keynesian separation between macroeconomic analysis, based on observed aggregate relationships and microeconomic analysis, must be abandoned. Instead, macroeconomics must be built up from scratch, on the microeconomic foundations of rational choice and market equilibrium.

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RBC 

The micro-based approach to macroeconomics appealed to large segments of the economics profession, who valued the elegance and apparent precision of microeconomics more than the messy empiricism of macro. But there was an obvious problem. General equilibrium models like those of Walras, Arrow and Debreu naturally generated a stable, static equilibrium. But the reality that business conditions fluctuate over time could scarcely be denied. So, the problem was posed as one of producing a general equilibrium model in which such fluctuations could arise. 

The first attempt, Real Business Cycle theory emerged in the early 1980s as a variant of New Classical Economics. The big papers were by Plosser & Long and Kydland & Prescott. The RBC literature introduced two big innovations, one theoretical and one technical.

In theoretical terms, relative to the standard New Classical story that the economy naturally more rapidly back towards full employment equilibrium in response to any shock, RBC advocates recognised the existence of  fluctuations in aggregate and employment but argued that such fluctuations represent a socially optimal equilibrium response to exogenous shocks such as changes in productivity, the terms of trade, or workers’ preference for leisure.

In technical terms, RBC models were typically estimated using a calibration procedure in which the parameters of the model were adjusted to give the best possible approximation to the observed mean and variance of relevant economic variables and the correlations between them (sometimes referred to, in the jargon, as ‘stylised facts’). This procedure, closely associated with a set of statistical techniques referred to as the Generalized Method of Moments, differs from the standard approach pioneered by the Cowles Commission in which the parameters of a model are estimated on the basis of a criterion such as minimisation of the sum of squared errors (differences between predicted  and observed values in a given data set.

There’s no necessary link between these two innovations and there gradually emerged two streams within the RBC literature. In one stream were those concerned to preserve the theoretical claim that the observed business cycle is an optimal outcome, even in the face of data that consistently suggested the opposite. In the other stream were those who adopted the modelling approach, but were willing to introduce non-classical tweaks to the model (imperfect information/competition and so on) to get a better fit to the stylised facts.

The big exception that was conceded by most RBC theorists at the outset was the Great Depression. The implied RBC analysis that the state of scientific knowledge had suddenly gone backwards by 30 per cent, or that workers throughout the world had suddenly succumbed to an epidemic of laziness was the subject of some well-deserved derision from Keynesians.  A couple of quotes I’ve pinched from a survey by Luca Pensieroso

“the Great Depression [. . . ] remains a formidable barrier to a completely unbending application of the view that business cycles are all alike.” (Lucas (1980), pg. 273.) “If the Depression continues, in some respects, to defy explanation by existing economic analysis (as I believe it does),

perhaps it is gradually succumbing under the Law of Large Numbers.” (Lucas (1980), pg.284)

But towards the end of the 1990s, at a time when RBC theory had in any case lost the battle for general acceptance, some of the more hardline RBC advocates tried to tackle the Depression, albeit at the cost of ignoring its most salient features . First, they ignored the fact that the Depression was a global event, adopting a single-country focus on the US. Then, they downplayed the huge downturn in output between 1929 and 1933, focusing instead on the slowness of the subsequent recovery which they blamed, unsurprisingly, on FDR and the New Deal. The key paper here is by Cole and Ohanian who put particular emphasis on the National Industrial Recovery Act.

There are plenty of difficulties with the critique of the New Deal, and these have been argued at length by Eric Rauchway among others. But the real problem, is that RBC can’t possibly explain the Depression as most economists understand it, that is, the crisis and collapse of the global economic system in the years after 1929.  Instead, Cole and Ohanian want to change the subject. The whole exercise is rather like an account of the causes of WWII that starts at Yalta.

The failure of RBC is brought into sharp relief by the current global crisis. Not even the most ardent RBC supporter has been game to suggest that the crisis is caused by technological shocks or changes in tastes, and the suggestion that it was all the fault of a minor piece of anti-redlining law (the Community Reinvestment Act) has been abandoned as the speculative excesses and outright corruption of the central institutions of Wall Street has come to light.

Unlike New Keynesian macro, where some useful insights will be relevant to policy in future periods of relative stability, it’s hard to see much being salvaged from the theoretical program of RBC. On the other hand, it has given us some potentially useful statistical techniques.  The idea that parameters of macroeconomic models may be selected by calibration rather than by statistical estimation has an appeal that does not depend on accepting the theoretical commitments of the RBC school.

Micro-based macro is here

Macroeconomics began with Keynes. [1]Before Keynes wrote The General Theory of Employment, Interest and Money, economic theory consisted almost entirely of what is now called microeconomics. The difference between the two is commonly put by saying that microeconomics is concerned with individual markets and macroeconomics with the economy as a whole, but that formulation implicitly assumes a view of the world that is at least partly Keynesian. Long before Keynes, neoclassical economists had both a theory of how prices are determined in individual markets so as to match supply and demand (‘partial equilibrium theory’) and a theory of how all the price in the economy are jointly determined to produce a ‘general equilibrium’ in which there are no unsold goods or unemployed workers.

The strongest possible version of this claim was presented as Say’s Law, named, somewhat misleadingly, for the classical economist Jean-Baptiste Say. Say’s Law, as developed by later economists such as James Mill, states, in essence, that recessions are impossible since ‘supply creates its own demand’. To spell this idea out, think of a new entrant to the labour force looking for a job, and therefore adding to the supply of labor. According to the classical view of Say’s Law, this new worker plans to spend the wages he or she earns on goods and service produced by others, so that demand is increased by an exactly equal amount. Similarly, any decision to forgo consumption and save money implies a plan to invest, so planned savings must equal planned investment and the sum of consumption and savings must always equal total income and therefore can’t be changed by policy. Say’s argument allows the possibility if prices are slow to adjust, there might be excess supply in some markets, but implies that, if so, there must be excess demand in some other market. It is this idea that is at the core of general equilibrium theory.

The first formal ‘general equilibrium’ theory was produced by the great French economist Leon Walras in the 1870s. Walras, like many of the pioneers of neoclassical economics, was inclined towards socialist views, but his general equilibrium theory was used by advocates of laissez-faire to promote the view that, even if subject to severe shocks, the economy would always return to full employment unless it was prevented from doing so by government mismanagement or by the actions of unions that might hold wages above the market price of labour.

The point of Keynes’ title was that “general equilibrium” was not general enough. A fully general theory of employment must give an account of equilibrium states where unemployment remains high, with no tendency to return to full employment.
In the simplest version of the Keynesian model, equilibrium can be consistent with sustained unemployment because, unlike in the classical account of Say, the demand associated with workers’ willingness to supply labour is not effective and does not actually influence the decisions of firms. So unsold goods and unemployed labour can co-exist. Such failures of co-ordination can develop in various ways, but in a modern economy, they arise through the operation of the monetary system.
Keynes showed how the standard classical interpretation of Say’s law depended on the assumption that economic transactions could be analysed as if they were part of a barter system, in which goods were exchanged directly for other goods. In a economy where money serves both as the medium of exchange and as a store of value, the analysis works differently. In the standard classical analysis, expenditure, consisting of consumption and investment, must be equal to income for every household and for the economy as a whole, and so, by the arithmetic of accounting, savings (the difference between income and consumption) must equal investment. This equality always holds true, as you can check by looking at any good set of accounts, including the national accounts drawn up for the economy as a whole, originally by Keynes’ students such as the Australian economist Colin Clark (I work in a building named for him). [2]
But, as Keynes observed, savings initially take the form of money. If lots of people want to save, and few want to invest, total demand in the economy will fall below the level required for full employment. Actual savings will equal investment, as they must by the arithmetic of accounting, but people’s plans for consumption and investment may not be realised. A simple and homely illustration is provided by Paul Krugman’s description of a babysitting co-operative in Washington DC, where babysitting credits worked as a kind of money. When members of the group tried to build up their savings by babysitting more and going out less, the result was a collapse of demand. The problem was eventually addressed by the equivalent of monetary expansion, when the co-operative simply issued more credits to everyone, resulting in more demand for babysitting, and a restoration of the original equilibrium.
Keynes’ analysis showed how monetary policy could work, thereby extending the earlier work of theorist such as Irving Fisher. However, the second part of Keynes’ analysis shows that the monetary mechanism by which equilibrium should be restored, may not work in the extreme recession conditions referred to as a ‘liquidity trap’. This concept is illustrated by the experience of Japan in the 1990s and by most of the developed world in the recent crisis. Even with interest rates reduced to zero, banks were unwilling to lend, and businesses unwilling to invest.

Keynes General Theory provided a justification for policies such as public works programs that had long been advocated, and to a limited extent implemented, as a response to the unemployment created by recessions and depressions ( Jean-Baptiste Say himself supported such measures in the early 19th century). More generally, Keynes analysis gave rise to a system of macroeconomic management based primarily on the use of fiscal policy to stabilise aggregate demand. During periods of recession, Keynes analysis suggested that governments should increase spending and reduce taxes, so as to stimulate demand (the first approach being seen as more reliable since the recipients of tax cuts might just save the money). On the other hand, during booms, governments should run budget surpluses, both to restrain excess demand and to balance the deficits incurred during recessions.

At first, it seemed, both to Keynes’ opponents and to some of his supporters, that Keynesian economics was fundamentally inconsistent with traditional neoclassical economics. But the work of John Hicks and others produced what came to be called the Keynesian-neoclassical synthesis, in which individual markets were analyzed using the traditional approach (now christened ‘microeconomics’) while the determination of aggregate output and employment was the domain of Keynesian macroeconomics.

The synthesis was not particuarly satisfactory at a theoretical level, but it had the huge practical merit that it worked, or at least appeared to. In the postwar era, the mixed economy derived from the Keynesian-neoclassical synthesis provided an attractive alternative both to the failed system of laissez-faire reliance on free markets and to the alternative of comprehensive economic planning, represented by the (still rapidly growing) Soviet Union. Modified to include a theory of market failure, neoclassical microeconomics allowed for some (but only some!) government intervention in particular markets to combat monopolies, finance the provision of public goods and so on. Meanwhile, the tools of Keynesian macroeconomic management could be used to maintain stable full employment without requiring centralised economic planning or controls over individual markets.

[1] That is not to say that no-one paid attention to the economic issues with which macroeconomics is concerned: the business cycle, inflation and unemployment. On the contrary, the early 20th century saw the beginnings of serious empirical research into the business cycle, most notably by the National Bureau of Economic Research, established in the US. And there were some important theoretical contributions, from economists such as Irving Fisher. Most notably, the great economists of the Austrian School, FA von Hayek and Ludwig von Mises, produced an analysis of the business cycle based on fluctuations in credit markets that remains highly relevant today. But neither Fisher nor the Austrians took the final steps needed to create a theory of macroeconomics, and the Austrians in particular recoiled from the implications of their own ideas.

[2] In a global economy, savings in one country, such as China, can finance investment in another, such as the United States. But the arguments between Keynes and the classical economists mostly focused on the “closed economy” case where international trade was relatively unimportant.

So, they have a problem. They’ve used their near-majority in the Senate to block the ETS legislation, but now its coming up again. On a second rejection the government can dissolve both houses of Parliament and call an election which would almost certainly produce a crushing defeat. But, for a number of technical reasons, the government doesn’t want to go this way and might just be willing to do a deal. The party leader, Malcolm Turnbull (the most able they have by far, but not known for sound judgement) is desperate to do such a deal and has put his leadership on the line. But the hardline delusionists are, so far, unwilling to go along. All in all, there’s plenty of pain to go around, and the government has been happy to watch the Opposition wallow, arguably at the price of a less effective response to climate change.

There’s a bit of a puzzle to me here. In the US and UK, as in Australia, the conservative commentariat is solidly delusionist. In the US, Republican politicians, activists and voters are similarly deluded, so there is no coherence problem. But in the UK, it seems as if Conservative politicians ought to be facing a difficult choice between going with the majority of their supporters (sane, on this issue at least) and the commentariat (delusional). But as far as I can see, the Conservatives are at least as good as Labor on this issue, yet they don’t seem to cop any flak from the Telegraph, Spectator, Times etc, all of which push a solidly delusionist line. I’d be interested in observations from those closer to the action.

• On top, from an equally valid perspective, but I’ll let the northern hemisphere majority have their comforting conventions on this one.

But a close reading of Tett’s account yields a different story. These innovations were defective from day one.

The crucial thing that made all these deals work was the so-called ‘super-senior’ tranche of debt that was supposed to be almost completely immune to failure (until, of course, it failed). This stuff was rated better than AAA, with the result that lots of banks were willing to carry it on their own books, using Enron-like special investment vehicles to skirt the Basel 2 requirements for capital adequacy. The alternative was to find a supposedly risk-free backer, such as an insurance company (AIG) or that contradiction in terms, a “monoline” municipal bond insurer willing to diversify into insuring exotic derivatives (Ambac and MBIA). The JP Morgan crew were never comfortable carrying huge volumes of debt, even allegedly riskless debt on their own books, and that’s why they ultimately left the field to others. But according to Tett, the very first deal that was done involved transferring the super-senior debt to none other than AIG, whose threatened collapse forced the Fed into the trillion dollar bailout of 2008. So, the worm was in the bud – there never was a sound basis for the whole idea.

Another important implication is that, thanks to the massive size and complexity of modern financial markets, fundamentally defective innovations need not be weeded out quickly, and can grow to astronomical size before they are. Bernie Madoff’s Ponzi scheme is a straightforward illustration of this. When it was exposed, quite a few commentators suggested that no one could run a Ponzi on this scale for nearly 20 years, as Madoff did. The alternative explanation, which was shown to be baseless, was that Madoff must have initially run a speculative strategy, turning to a Ponzi only when that ran into difficulties.

This is one instance of a more general point emerging from discussion of the financial crisis. As Felix Salmon observes, the extraordinary profitability of investment bank can most plausibly be explained by the hypothesis that risk is being shifted, without compensation, to someone else. Salmon focuses on the case of ignorant buyers, sold products they don’t understand. But, as Arnold Kling observes, an equally important source of investment banking profits is regulatory arbitrage at the expense of governments, and, ultimately, the public at large.

There are two main ways these problems can be resolved. To protect both ignorant buyers and the public, it would be necessary to regulate investment banks in the same way as other banks, and much more tightly than either was regulated pre-crisis. In particular, the idea of letting Goldman Sachs get the protection of a commercial banking license while operating as an investment bank is an obvious example of the kind of regulatory arbitrage that needs to be stopped. Properly done, regulation of this kind would kill off investment banking of the kind with which we are familiar.

The alternative is to assume that the buyers of investment bank products can look after themselves, and focus on protecting citizens from being made to repeat the bailout disasters of last year. The only way to do this is to reinstitute a much tougher version of Glass-Steagall, raising high barriers to all kinds of transactions (ownership, financing, joint venture) between investment banks and the core financial system guaranteed by government. Something of this kind will have to be done with respect to hedge funds and similar outfits if we are not to have a repeat of LTCM somewhere before long.

The original source is something called the Levitt Institute and the Courier-Mail story is a pretty fair summary of the Levitt Institute report, which is here (PDF). I’ll leave the deconstruction as an exercise for readers, with a bonus mark for the question “Which basic concept of classical hypothesis testing is ignored in this study of ‘ability to detect erroneous information’”

Here’s a post with a couple of links arguing the opposite.

UpdateSucked in! It turns out the whole thing is in fact a hoax by Andrew Denton’s new show.. Sad to say, with the irony detector already blown, it’s hard to tell the difference between genuine and fake stupid.