In a previous post I discussed the recent turn of some notable mainstream economists towards reconsideration of Alvin Hansen’s thesis of secular stagnation.
It would seem that there is a more general trend at work here, which embodies at least two themes:
- A modest revival of some parts of the “Old Keynesian” class of models, in particular the Hicks-Hansen ISLM and Liquidity Traps ;
- A recognition that business cycle theory should not be entirely separated from growth theory.
I’m not sure where point 1 gets us and on point 2, the issue is “on what basis”.
Since one of my goals in this blog is to aim at an audience much wider than economists, some background discussion will probably be helpful. The story I’ll give you is a bit of a potted plant, but I think, essentially true in general terms. Unfortunately, it will take me a bit of space to get through some of this so I hope you will bear with me. Coincidentally, as I was writing this piece I came across some similar ideas some similar ideas published a few hours earlier than this post which helped to crystallize some of my own thoughts.
Following the publication and acceptance by economists and policy makers of some aspects of Keynes’ General Theory of Employment, Money and Interest there was some debate over who had the correct interpretation of Keynes. Who I think was right, and whether or not this matters for purposes other than intellectual history is a point I’ll leave aside for now. The Hicks-Hansen interpretation, which was the one that triumphed among American academic economists allowed that a modern, market economy could sink into a slump for an extended period of time and that even very low interest rates might not be sufficient to return the economy to full employment. Where Keynes had advanced some of these ideas as a “General Theory”, the Hicks-Hansen model posited this as a special case. Paul Samuelson married some of these same ideas to a mathematically formal model based on an underlying conception of rational economic agents. Hansen’s secular stagnation thesis was a little different in that it was focused more on an extended period of slow growth and accompanying higher unemployment, rather than on the problem of the business cycle. This was for all intents and purposes, the macro (and micro) I learned as an undergraduate, save for a smattering of Marxist and Post Keynesian ideas.
A notable problem for mainstream Keynesians was how to marry ideas about rational agents, competitive markets and optimal equilibria to a theory in which an economy could perform sub-optimally for an extended period of time. One possibility would be to abandon ideas about rational agents which would lead to ideas about market power, institutional influences on behavior, class structure and other heresies-which of course the profession as a whole rejected. A second path would be to jettison Keynes in entirety. And this latter path was the “modern macro” that was beginning to achieve hegemony in the profession about the time I hit graduate school. This counter revolution is nicely summarized in a 1989 article by Charles Plosser
“The essential flaw in the Keynesian interpretation of macroeconomic phenomenon was the absence of a consistent foundation based on the choice theoretic framework of microeconomics. Two important papers, one by Milton Friedman (1968) and the other by Robert Lucas (1976), forcefully demonstrated examples of this flaw in critical aspects of the Keynesian reasoning and set the stage for modern macroeconomics.”
This trend culminated in the research agenda of what came to be known as “real business cycle theory” (again, the quote below is by Plosser):
“Real business cycle models view aggregate economic variables as the outcomes of the decisions made by many individual agents acting to maximize their utility subject to production possibilities and resource constraints.”
And later in the same article Plosser states:
“Thus,a productivity disturbance results in a dynamic response by Robinson Crusoe that involves variations in output, work effort, consumption and investment over many periods. It is important to stress that there are no market failures in this economy, so Robinson Crusoe’s response to the productivity shifts are optimal and the economy is Pareto efficient at all points in time. Put another way, any attempt by a social planner to force Crusoe to choose any allocation other than the ones indicated, such as working more than he currently chooses, or saving more than he currently chooses, are likely to be welfare reducing. Therefore, business cycle characteristics exhibited by this economy are chosen in preference to outcomes that exhibit no business cycles.
The decision rules summarize the solution to Robinson Crusoe’s dynamic optimization problem. As stated above they depend explicitly on the current and future productivity disturbances. “
If there is one saving grace, one iota of a point buried in absurd fictional stories about Robinson Crusoe and economic agents with infinite lifespans responding to technological shocks embraced by the real business cycle theorists, it was the recognition that “growth theory” needed to be tied to “business cycle theory”. But an earlier generation of Keynes’ associates at Cambridge had attempted just that in various ways in an effort to wed Keynes’ General Theory to the foundations of the Classical Political Economy Smith, Ricardo and Marx, absent Say’s Law and later on to the Old Institutional Economics pioneered by Thorstein Veblen.
In some respects, the “New” Classical economists had a point: the “Old Keynesianism” of Hicks, Hansen, Samuelson and others did embody a split personality of a commitment to a microfoundations of rational agents, optimal outcomes in competitive markets, stable long run growth paths and convergence based on ideas of capital as a homogeneous substance that could be assembled and reassembled like building blocks made of playdough. But a turn towards the Classical Political Economy and Old Institutional Economics which pointed towards a broader anthropological-sociological foundation for economics was not to be.
Instead of questioning the conclusions of the Arrow-Debreu orthodoxy, the orthodoxy was instead converted into axiomatic dogma. In other words, the idea that a market economy, as the outcome of the optimizing decisions of rational agents, had an innate tendency to an optimal outcome became the default position of the mainstream of the profession.
“Modern Macro” thus required a formal mathematical model replete with an axiomatic foundation of rational economic agents. Economists, sometimes called “New Keynesians” like Summers of course could emphasize the role of “frictions” in creating departures from the idealized outcomes of real business cycle theory, thus allowing limited roles for “social planners” and stabilization policy. In other words, a “New Keynesian” model was a model that embraced the above counter revolution in some form, and yet managed to add assumptions that would allow short run deviations from an otherwise stable growth path of full employment. And it was based on this view that the first Clinton administration embraced neoliberalism and financial deregulation. Even today, influential principles textbooks by such Keynesians as Paul Krugman embody vertical Long Run Aggregate Supply Curves and the “natural rate of unemployment”.
And this is how “modern macro” came to be as described by Larry Summers (see previous post on the same topic for the reference):
“Macroeconomics, just six or seven years ago, was a very different subject than it is today. Leaving aside the set of concerns associated with long-run growth, I thinkit is fair to say that six years ago, macroeconomics was primarily about the use of monetary policy to reduce the already small amplitude of fluctuations about a given trend, while maintaining price stability. That was the preoccupation. It was supported by historical analysis emphasizing that we were in a great moderation, by policy and theoretical analysis suggesting the importance of feedback rules, and by a vast empirical program directed at optimizing those feedback rules.”
But now it seems in reality that mainstream economics, even in its’ current “New-Old Keynesian” form really isn’t all that different from several years ago. Instead, we seem to be back to the Hicks-Hansen IS-LM model coupled with some hand waving about and the Solow growth model and a slowdown in technological progress.
In a subsequent post I’ll explore what I think the contributions of ecological evolutionary political economy might be to this whole mess.