Monthly Archives: September 2011

Paul Krugman on the Lucas project

Link to the original.

Lucas In Context (Wonkish)

I thought it might be helpful to think of Lucas now in terms of the history of economic thought. By the way, I basically lived through the story I’m about to tell, so this is more or less first-hand.

So, here’s the history of macro in brief.

1. In the beginning was Keynesian economics, which was ad hoc in the sense that on some important issues it relied on observed stylized facts rather than trying to deduce everything from first principles. Notably, it just assumed that nominal wages are sticky, because they evidently are.

2. In the 1960s a number of economists started trying to provide “microfoundations”, deriving wage and price stickiness from some kind of maximizing behavior. This early work had a big payoff: the Friedman/Phelps prediction that sustained inflation would get “built in”, and that the historical tradeoff between inflation and unemployment would vanish.

3. In the 1970s, Lucas and disciples take it up a notch, arguing that we should assume rational expectations: people make the best predictions possible given the available information. But in that case, how can we explain the observed stickiness of wages and prices? Lucas argued for a “signal processing” approach, in which individuals can’t immediately distinguish between changes in their wage or price relative to others — changes to which they should respond by altering supply — and overall changes in the price level.

4. In the 1980s, the Lucas project failed — pure and simple. It became obvious that recessions last too long, and there are too many sources of information, for rational confusion to explain business cycles. Nice try, with a lot of clever modeling, but it just didn’t work.

5. One response to the failure of the Lucas project was the rise of New Keynesian economics. This basically went back to ad hoc assumptions about wages and prices, with a bit of hand-waving about menu costs and bounded rationality. The difference from old Keynesian economics was the effort to use as much maximizing logic as possible to interpret spending decisions. I find NK economics useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.

6. The other response, by those who had already invested vast effort and their careers in the Lucas project, was to drop the whole original purpose of the project, which was to explain why demand shocks matter. They turned instead to real business cycle models, which asserted that the ups and downs of the economy are caused by technological shocks magnified by rational labor supply responses. Full disclosure: this has always seemed absurd to me; as many have pointed out, the idea that the unemployed during a recession are voluntarily choosing to take time off is something only a professor could believe. But the math was impressive, and RBC became a self-contained, self-replicating intellectual world.

7. The Lesser Depression arrives. It’s clearly not a technological shock; clearly, also, nobody is confused about whether we’re in a slump, as the old Lucas model required.

In fact, it looks a lot like what Keynes described, and old-Keynesian models work very well, thank you, both at explaining it and in making predictions about such things as interest rates and the effects of fiscal austerity. But the descendants of the Lucas project know that Keynes was wrong — it’s what their teachers and their teachers’ teachers have been saying all these years. They cannot accept anything resembling a Keynesian explanation without devaluing everything they’ve done with their intellectual lives.

So it must be Obama’s fault!

So the jobs really didn’t go to China…

On several occasions, I wrote about manufacturing jobs going to machines rather than to China.  Just another piece of evidence on that.

Paul Krugman recently did something interesting; he used industrial production data and capacity utilization data to obtain an estimate of U.S. industrial capacity.  Here’s the result:

Note the rapid capacity build-up during 1990s, as America was supposedly losing its manufacturing base…

Paul Krugman on old and new Keynesianism

Link to the original.

How Much Hoc to Add? (Wonkish and Methodological)

Mark Thoma objects to Tyler Cowen’s attempt to pigeonhole some of us as “Old New Keynesians”, and makes the case for flexibility in use of models. Indeed. But there’s something more systematic to the macro story – something that very much informs my work. Namely, “old Keynesian” and “new Keynesian” models represent two intelligent but imperfect responses to the problem of thinking about an economy in which people must make future-oriented decisions. Neither is fully convincing, but there are no better alternatives at this point. So what I do, and I hope others do as well, is to think about policy issues both ways, and try to “bracket” things in a way that leads to reasonably secure conclusions.

Like a lot of macro, this goes back to John Hicks. In his classic Value and Capital (1939, but he had much of the work done when he invented IS-LM), he laid out the basics of general equilibrium analysis – that is, thinking about how all market interrelate, instead of thinking about each one in isolation – but realized that he had a problem when key decisions in markets depended on expectations about the future. One way out is to assume Arrow-Debreu markets in which contracts can be signed now governing all possible future states of the world; never mind.

What Hicks proposed was an ad hoc solution (“temporary equilibrium”): let’s just assume that people expect future prices to be the same as current prices (“static expectations”). This lets you collapse the dynamic problem into a sort of quasi-static analysis of the short run.

And in particular, Hicks suggested thinking in terms of a three-good economy, in which the three goods were money, bonds, and physical output. When you do that and add temporary price stickiness, you get IS-LM.

Now, you can add a bit more flexibility by making assumptions about expectations more complicated in ways that seem more realistic – adaptive expectations, regressive expectations, etc.. In international macro, for examples, the Mundell-Fleming model – which is just IS-LM with borders – gets more convincing if you assume that investors expect exchange rates to revert to some kind of normal level. But it’s basically about squeezing dynamic issues into something that looks like a static framework.

And that’s not a criticism! IS-LM is in fact a deeply sophisticated framework, as evidenced by the number of economists who dismiss this crude stuff, then stumble ludicrously over even very simple issues.

But can’t we do better? The only workable alternative to temporary equilibrium at this point is rational expectations – assuming that what people expect about the future is what your model says they should expect. When you do that, and again add some realistic temporary price stickiness, you get New Keynesian macro, which is in a way more intellectually satisfying that old Keynesianism.

The trouble with New Keynesian macro is that it goes too far the other way – people aren’t that rational, or if you prefer, in the real world nobody knows what the right model is, so rational expectations breaks down as a concept. Also, NK models are much harder to work with; compare Obstfeld-Rogoff with Mundell-Fleming, and you’re going from simple diagrams to 60-plus-equation derivations.

So what’s an economist to do? Well, what I do is use both. Typically, I work things out first in terms of IS-LM, but then try to write down a stripped-down NK model with similar results; if I can’t make that work, it’s time for some hard thinking about where the difference lies. And sometimes this leads to insights that I don’t think would have come from either approach alone, like the crucial role of monetary credibility in making a liquidity trap possible.

The point is always to realize that the map is not the territory, but also to realize that IS-LM is a pretty good map, and that you can often fill in the gaps with a fancier—but not better, just different – NK model.