Where macroeconomics went wrong

In my view, the answer is in the 1970/80s with the New Classical revolution (NCR). However I also think the new ideas that came with that revolution were progressive. I have defended rational expectations, I think intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy, as well as many other areas of economics. I also think, along with nearly all macroeconomists, that the microfoundations approach to macro (DSGE models) is a progressive research strategy.

That is why discussion about these issues can become so confused. New Classical economics made academic macroeconomics take a number of big steps forward, but a couple of big steps backward at the same time. The clue to the backward steps comes from the name NCR. The research programme was anti-Keynesian (hence New Classical), and it did not want microfounded macro to be an alternative to the then dominant existing methodology, it wanted to replace it (hence revolution). Because the revolution succeeded (although the victory over Keynesian ideas was temporary), generations of students were taught that Keynesian economics was out of date. They were not taught about the pros and cons of the old and new methodologies, but were taught that the old methodology was simply wrong. And that teaching was/is a problem because it itself is wrong.

There had always been opposition to Keynesian ideas, and much (though not all) was ideological, such as attempts to remove Keynesian textbooks from US universities. However the NCR gave what should more precisely be called ‘aggregate demand denial’ an intellectual respectability that it never deserved. The reasons for believing that shifts in demand move output and employment in the short run and prices are sticky are overwhelming, so to deny both was a seemingly impossible task. It was achieved by adopting a methodological position which could ignore inconvenient evidence.

I do not think it had to be like this. Mainstream macroeconomics did not need a revolution in the 1970s and 1980s. Ideas like rational expectations could have been assimilated into the mainstream methodology, and microfounded models could have been developed alongside more eclectic econometric models (SEMs, not VARs), or aggregate theoretical models that Blanchard and Fischer rightly called ‘useful models’. Microfounded models could have shown the kind of errors that can arise in more empirically based models when theory is ignored or only applied piecemeal, and these empirical models could have highlighted the key areas where additional microfoundations were needed.

I think if this had happened, macroeconomics would have been better prepared when the financial crisis hit. Take just one issue: the role of credit conditions in influencing consumption. This is clearly crucial in understanding how consumption might respond to a credit crunch, yet any mechanism of this kind was absent from most DSGE models in 2008. However a more empirically based model of consumption would have had to address this issue well before 2008, as I argue here. If these types of models had continued to be developed within academia, rather than confined to the dustbin by the microfoundations revolution, then at least policymakers would have had something to work with. If there had been interaction between empirical and microfounded models some of the financial frictions literature that has flourished since 2008 might have appeared earlier.

So why didn’t this happen? Why did we have a revolution which overturned an existing methodology and temporarily banished Keynesian theory, rather than an adaptation and augmentation of what was then mainstream? Was the attraction of overturning orthodoxy too strong, as it is for a minority of heterodox economists today? Did an ideological imperative of dismissing Keynesian ideas play a role? To what extent was the hostile reaction of many in the macroeconomic establishment to eminently sensible ideas like rational expectations responsible? Was the attraction of a methodology where at least you could be sure you were consistent too enticing, perhaps encouraged by increasing segmentation between theoretical and empirical macro? I would love to know the answer to these questions.