Macroeconomics and Ideology

Jo Michell has a long postin which he enters in a debate between Ann Pettifor and myself about the role of mainstream macroeconomics in austerity. Ann wanted to pin a large part of the blame for austerity on mainstream macroeconomics, and Jo largely sides with her. Now I have great respect for Jo’s attempts to bridge the divide between mainstream and heterodox economics, but here he is both wrong about austerity and also paints a rather distorted picture of the history of macroeconomic thought.

Let’s start with austerity. I think he would agree that the consensus model of the business cycle among mainstream Keynesians for the last decade or two is the New Keynesian (NK) model. That model is absolutely clear about austerity. At the zero lower bound (ZLB) you do not cut government spending. It will reduce output. No ifs or buts.

So to argue that mainstream macro was pushing for austerity you would have to argue that mainstream economists thought the NK model was deficient in some important and rather fundamental respect. This was just not happening. One of, if not the, leading macroeconomist of the last decade or two is Michael Woodford. His book is something of a bible for those using the New Keynesian model. In June 2010 he wrote “Simple Analytics of the Government Expenditure Multiplier”, showing that increases in government spending could be particularly effective at the ZLB. The interest in that paper for those working in this area was not in that this form of fiscal policy would have some effect - that was obvious to those like myself working on monetary and fiscal policy using the NK model - but that it could generate very large multipliers.

This consensus that austerity would be damaging and fiscal stimulus useful was a major reason why we had fiscal stimulus in the UK and US in 2009, and why even the IMF backed fiscal stimulus in 2009. There were some from Chicago in particular who argued against that stimulus, but as bloggers like DeLong, Krugman and myselfpointed out, they simply showed up their ignorance of the NK model. Krugman in particular was very familiar with ZLB macro, having done some important work on Japan’s lost decade.

What changed this policy consensus in 2010 was not agitation from the majority of mainstream academic macroeconomists, but two other events: the Eurozone crisis and the election of right wing governments in the UK and US Congress.

Jo tries to argue that because discussion of the ZLB was not in the macroeconomic textbooks, it was not part of the consensus. But textbooks are notorious for being about 30 years out of date, and most still base their teaching around IS/LM rather than the NK model. Now it might just be possible that right wing policy makers were misled by the consensus assignment taught in these textbooks, and that it was just a coincidence that these policy makers chose spending cuts rather than tax increases (and later tax cuts!), but that seems rather unlikely. You do not have to be working in the field to realise that the pre-financial crisis consensus for using changes in interest rates as the stabilisation tool of choice kind of depended on being able to change interest rates!

Moving on from austerity, Jo’s post also tries to argue that mainstream macroeconomics has always been heavily influenced by neoliberal ideology. To do that he gives a short account of the post-war history of macroeconomic thought that has Friedman, well known member of the Mont Pelerin society, as its guiding light, at least before New Classical economics came along. There is so much that could be said here, but let me limit myself to two points.

First, the idea that Keynesian economics was about short term periods of excess or deficient demand rather than permanent stagnation pre-dated Friedman, and goes back to the earliest attempts to formalise Keynesian economics. It was called the neoclassical consensus. It was why the Keynesian Bob Solow could give an account of growth theory that assumed full employment.

Second, the debates around monetarism in the 1970s were not about the validity of that Keynesian model, but about its parameters and policy activism. Friedman’s own contributions to macroeconomic theory, such as the permanent income hypothesis and the expectations augmented Phillips curve, did not obviously steer theory in a neoliberal direction. His main policy proposal, targeting the money supply, lost out to policy activism using changes to interest rates. And Friedman certainly did not approve of New Classical views on macroeconomic policy.

Jo may be on firmer ground when he argues that the neoliberal spirit of the 1980s might have had something to do with the success of New Classical economics, but I do not think it was at all central. As I have argued many times, the New Classical revolution was successful because rational expectations made sense to economists used to applying rationality in their microeconomics, and once you accept rational expectations then there were serious problems with the then dominant Keynesian consensus. I suppose you could try to argue a link between the appeal of microfoundations as a methodology and neoliberalism, but I think it would be a bit of a stretch.

This brings me to my final point. Jo notes that I have suggested an ideological influence behind the development of Real Business Cycle (RBC) theory, but asks why I stop there. He then writes

“It’s therefore odd that when Simon discusses the relationship between ideology and economics he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. The beliefs of the latter group are, Simon suggests, ideological, while those of the former group are based on ideology-free science. This strikes me as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable.”

This misses a crucial distinction. The whole rationale of RBC theory was to show that business cycles were just an optimal response to technology shocks in a market clearing world. This would alwaysdeny an essential feature of business cycles, which is involuntary unemployment (IU). It is absurd to argue that NK theory denies all the things on Jo’s list. Abstraction is different from denial. The Solow model does not deny the existence of business cycles, but just assumes (rightly or wrongly) that they are not essential in looking at aspects of long term economic growth. Jo is right that the very basic NK model does not include IU, but there is nothing in the NK model that denies its possibility. Indeed it is fairly easy to elaborate the model to include it.

Why does the very basic NK model not include IU? The best thing to read on this is Woodford’s bible, but the basic idea is to focus on a model that allows variations in aggregate demand to be the driving force behind business cycles. I happen to think that is right: that is what drives these cycles, and IU is a consequence. Or to put it another way, you could still get business cycles even if the labour market always cleared.

To suggest, as Jo seems to, that the development of NK models had something to do with the Third Way politics of Blair and Bill Clinton is really far fetched. It was the inevitable response to RBC theory and its refusal to incorporate rigid prices, for which there is again strong evidence, and its inability to allow for IU.

That’s all. I do not want to talk about globalisation and trade theory partly because it is not my field, but also because I suspect there is some culpability there. I would also never want to suggest, as Jo implies I would, that ideological influence is confined to the New Classical part of macroeconomics. But just as it is absurd to deny any such influence, it is also wrong to imagine that the discipline and ideology are inextricably entwined. 2010 austerity is a proof of that.