What is the macroeconomic divide, and how did it develop?

What’s at stake: Following up on his mathiness critique that economic theory is becoming a sloppy mixture of words and symbols, Paul Romer wrote a series of blog posts over the past few weeks discussing how things went so far off in the macroeconomic field, where a group (often referred as fresh-water economists) completely retreated from scientific engagement with macroeconomists who disagreed with them and gave up on using evidence to evaluate models.

What went wrong with macro redux

Simon Wren-Lewis writes that you can describe what happened in two ways. You could say that the New Classicals always had the goal of overthrowing (rather than improving) Keynesian economics, thought that they had succeeded, and simply ignored New Keynesian economics as a result. Or you could say that the initially unyielding reaction of traditional Keynesians created an adversarial way of doing things whose persistence Paul Romer both deplores and is trying to explain.

Paul Romer writes that, within a few years after presenting their famous critique, Lucas and his supporters seem to have stopped engaging with any macroeconomists outside of their well-defined circle of supporters, even though some of these outsiders were taking them seriously. The ensuing self-imposed isolation let real business cycle models take root and persist for far too long. Their group-think allowed a coordinated move away from the use of data to evaluate or test a theory, and toward the use of calibration instead. Loyalty seems to have precluded any internal criticism as theory became opaque and misleading.

Paul Romer writes that that the problems cannot be attributed solely to obstinacy on the part of Lucas and his supporters. What Lucas and Sargent wrote in 1978 suggests that they would have been willing to engage in a scientific exchange even if it ultimately undermined their assertion about policy ineffectiveness. They cared more about following the Samuelson program than the policy ineffectiveness result. Lucas and Sargent, for example, express a willingness to engage seriously in a scientific discussion about how to build macro models that try to explain why money matters. In particular, they expressed interest in contract models, search models, expectations and learning, and types of imperfect information beyond that in the Lucas 1972 paper. Later, Lucas (with Golosov, JPE 2007) investigated a model with menu costs. Sargent wrote an entire book about the role of learning on the dynamics of inflation.

Simon Wren-Lewis writes that many among the then Keynesian status quo did react in a defensive and dismissive way. They were, after all, on incredibly weak ground. That ground was not large econometric macro models, but one single equation: the traditional Phillips curve. This had inflation at time t depending on expectations of inflation at time t, and the deviation of unemployment/output from its natural rate. Add rational expectations to that and you show that deviations from the natural rate are random, and Keynesian economics becomes irrelevant. As a result, too many Keynesian macroeconomists saw rational expectations (and therefore all things New Classical) as an existential threat, and reacted to that threat by attempting to rubbish rational expectations, rather than questioning the traditional Phillips curve.

The sarcasm of Robert Solow

Paul Romer writes that Robert Solow had a choice about how to respond. He chose sarcastic denial over serious engagement. Solow probably responded harshly and defensively because he was worried about the possibility that people who could influence policy, such as the economists at the conference who worked in the Federal Reserve System, would accept the policy advice that Lucas and Sargent offered. After Lucas and Sargent’s sweeping policy claim and Solow’s dismissive response, there was no way forward.

Arnold Kling writes that Solow’s problem with Lucas was that Solow thought that reality should take precedence over microfoundations. Solow equated Lucas’ approach to macro with deciding that because one’s theory could not explain how a giraffe could pump adequate blood to its head that one had proven that giraffes do not have long necks.

Charles Steindel finds a bit baffling the supposed major influence of Bob Solow’s comments on creating a more permanent rift since Solow was no longer the dominating MIT figure on these topics. Paul Krugmanwrites that Rudi Dornbusch and Stan Fischer, not Robert Solow, were the preeminent teachers of macroeconomics at the time. Both wrote seminal papers during those years that combined rational expectations with realistic limitations on wage and price flexibility. This was an attempt to build bridges with Chicago, not a war on Chicago ideas. But Chicago responded with trash talk. Lucas and Sargent 1978 talked a lot about the “wreckage” of Keynesian economics.

Paul Romer writes that, in 1978, Fischer and Dornbusch had just attained the rank of full professor. They did not attend the Boston Fed conference where Lucas and Sargent tangled with Solow. At that time, the external perception was that Solow was the more influential voice on macroeconomic theory and policy even though inside the department at MIT, Dornbusch and Fischer were the ones training the next generation of macroeconomists. So Solow’s response mattered.

Brad DeLong writes that the cutting-off of contact went only one way. Saltwater economists kept on reading, assigning their students, borrowing from, and reacting to New Classical models. Freshwater economists, however, by and large did not assign what became known as New Keynesian work to their students, in large part did not borrow from and react to it, and so we get situations like Robert Lucas in 2009 having absolutely no understanding of what Obstfeld and Rogoff (1996) had taught everyone who had kept up with the literature about fiscal policy.

Evidence, theory, and trash-talking

Paul Krugman writes that what happened to freshwater is that a movement that started by doing interesting work was corrupted by its early hubris; the braggadocio and trash-talking of the 1970s left its leaders unable to confront their intellectual problems, and sent them off on the path Paul Romer now finds so troubling.

Paul Krugman writes that what matters in fine is how one responds to evidence that goes against one’s preferred framework. Events in the early 1980s showed that Lucas-type models were wrong, and also that anticipated monetary shocks have real effects as when the Federal Reserve tightened monetary policy, it did so openly, with much public discussion, such that anyone who opened a newspaper should have been aware of what was happening. The clear implication of Lucas-type models was that such an announced, well-understood monetary change should have had no real effect, being reflected only in the price level. But there was no reconsideration on the part of the freshwater economists. My guess is that they were in part trapped by their earlier trash-talking. Instead, they plunged into real business cycle theory (which had no explanation for the obvious real effects of Fed policy) and shut themselves off from outside ideas.

This article is published in collaboration with Bruegel. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Jérémie Cohen-Setton is a PhD candidate in Economics at U.C. Berkeley and a summer associate intern at Goldman Sachs Global Economic Research.