Tag: dismal science

Part 2: Mainstream Macroeconomics – A Nothing-New Consensus?

When I started to study economics in the mid-1970s, it was a period of rapid theoretical development in mainstream macroeconomics. The established post-war consensus in mainstream macroeconomics built around the Neoclassical Synthesis was breaking down because of the obvious disconnect between the rational-agent/constrained-optimisation models of microeconomics and the simple IS-LM and AD-AS macro models based on seemingly ad hoc behavioural assumptions. The search was on for the appropriate microfoundations of macroeconomics. Those of a more Keynesian disposition focused initially on disequilibrium models, providing a sophisticated treatment of quantity adjustments when prices are slow to adjust. But this still left open the question as to why prices, particularly, wages were sticky. Ultimately this led to the emergence of the New Keynesian Economics (NKE) in the 1980s/1990s with a veritable proliferation of choice-theoretic models of price and wage stickiness. The invisible-hand theorem of self-equilibrating markets requires a whole set of structural and informational conditions to be met. Relaxing any of these assumptions and allowing for imperfections could explain why prices and wages might be slow to adjust, or indeed never adjust fully, to the perfectly competitive (full-employment) equilibrium. The NKE is effectively just the macroeconomics of market failures.

              The alternative search for microfoundations focused on the dynamic behaviour of rational agents under conditions of stochastic uncertainty. The New Classical Economics (NCE) rejected the ad hoc assumption of adaptive expectations that had been used in the expectations-augmented Phillips curve (EAPC) to justify the possibility of effective short-run stabilisation policy. The NCE adopted instead the rational expectations hypothesis (REH), assuming that rational economic agents are fully informed of the systematic behaviour of the economy with expectational errors due to unpredictable shocks to the economic system. The NCE integrated the REH into a market-clearing equilibrium model of the macro economy to provide a powerful theoretical argument against policy activism. The NCE argued for a Panglossian world characterised by REH, information-efficient markets, and policy irrelevance. Two influential NCE propositions were Ricardian equivalence and the Lucas critique, both of which reinforced policy irrelevance. Ricardian equivalence implies that forward-looking rational agents treat debt-financing and tax-financing as equivalent so that fiscal policy has no first-order impact on aggregate demand. The Lucas critique recognises the endogeneity of behaviour responses to policy changes with forward-looking rational agents, making the construction optimal policy responses to economic shocks as something of a will-o’-the wisp.

The New Consensus Macroeconomics combines elements of both NKE and NCE. The simple macro model is in many ways just a modern version of the ISLM and AD-AS models of the Neoclassical Synthesis. The IS and AD curves are retained with the supply side represented by the EAPC (incorporating the REH) and the LM curve replaced by a Taylor-type monetary rule relating the nominal interest rate to deviations in inflation and output from their target levels. The case for activist stabilisation policy remains an empirical question of the speeds of adjustment and the degree of price and wage stickiness. In a very real sense the New Consensus Macroeconomics is a Nothing-Fundamentally-New Consensus Macroeconomics.

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• The Dismal Science – A Personal Reflection Part 1, 6^th Sept 2023

Part 1: The Rip van Winkle Effect

As an undergraduate student in the mid-1970s, I remember reading Robert Gordon’s 1976 Journal of Monetary Economics paper on recent developments in macroeconomics using the Rip van Winkle device. Gordon asked the question as to what would Rip van Winkle have found so different about the theory of inflation and unemployment in 1976 if he had been asleep for 10 years. I feel in a similar Rip van Winkle position today. After 20 years in economics, I left the academic subject in the mid-1990s. There were many reasons for my exit, partly disillusionment and loss of passion, partly because I thought that I really had nothing more to say that was new, and partly because I wanted to make a practical difference. After leaving economics, I moved into accounting and finance, then data analytics, still working as a business-school academic but also involved in supporting coaches and executives in elite sport. Now 25 years further on, my passion for economics has been reignited and I have started to again present at economics conferences and publish in economics journals. But I now have a very different perspective on economics, what I’ll call the “Rip van Winkle effect” of moving from being an insider to being a complete outsider with little knowledge of what other insiders have been up to in the interim. And these days I am not just an outsider to mainstream economics; I am an outsider to all economics including radical economics. But crucially my outsider’s perspective is a much more pragmatic, practice-oriented perspective that is not so heavily constrained by the demands of the academic discipline. 

Thomas Carlyle, the 19^th Century Scottish philosopher, described economics as the dismal science because, as he saw it, economics rather dismally claims that supply and demand is the secret of the Universe which leads to the laissez-faire directive of “letting man alone”, a very dismal conclusion that we can do nothing to improve the economic condition. As a radical Keynesian I fully understand Carlyle’s attitude to (mainstream) economics. But I have always considered economics to be the dismal science in a more positive sense of being the science of how to help human beings in dismal times. I started my studies of economics in the mid-1970s in a post-Watergate/post-Vietnam world suffering the consequences of the first oil price shock, the onset of a world recession and rampant stagflation. I was drawn to the later economics of John Maynard Keynes developed in the dismal times of the 1930s in which the world had to deal with the Great Depression, the rise of totalitarianism and the prospect of global military conflict. Economics to me has always been about making a positive difference to people’s lives, particularly in dismal times. When we look at today’s world and the immense problems faced, the need for an activist economics is as great as ever. But sadly economics is still failing to respond in any meaningful way to the challenges of our times, as wedded as ever to its core Panglossian instinct that all is for the best in the best of all possible worlds. Over the next three weeks I will provide my outsider’s thoughts on the current state of economics, both mainstream and radical.