Simon Wren-Lewis
Keywords: New Classical Counter Revolution; microfoundations
Published in print:Jan 2016
Category:Research Article
Pages:20–35
Download PDF (124.6 KB)
To understand the position of Keynes's The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the New Classical Counter Revolution (NCCR), and why it was so successful. This revolution can be seen as having two strands. The first, which attempted to replace Keynesian policy, failed. The second, which was to change the way academic macroeconomics was done, was successful. Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive.
As a result, most academic macroeconomists today would see the foundation of their discipline as not coming from The General Theory, but as coming from basic microeconomic theory – arguably the ‘classical theory’ that Keynes was so keen to cast aside. Students are also taught that pre-NCCR methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong. The problem with the NCCR was not the emergence of microfoundations modelling, which is a progressive research programme, but that it discouraged the methods of analysis that had flourished after The General Theory. I argue that, had there been more academic interest in these alternative forms of analysis, the discipline would have been better prepared ahead of the financial crisis.
Full Text
1 INTRODUCTION
The General Theory of Employment, Interest and Money (Keynes 1936) is sometimes credited with creating modern macroeconomics. Today that observation appears highly questionable for two reasons. The first relates to policy. We have once again found ourselves in a global liquidity trap of just the kind that The General Theory was designed to explain and avoid. Yet policy-makers have prolonged that liquidity trap by doing precisely the opposite of what The General Theory recommended. Can anyone doubt that Keynes would be turning in his grave seeing the current obsession with fiscal austerity?
There is of course nothing that compels policy-makers to base their decisions on macroeconomic theory, and a large part of what is currently going on may just be politicians using populist analogies between state and household budgets to achieve goals to do with the size of the state. Yet we have to ask whether they would be able to get away with that if macroeconomists were united in their opposition to fiscal austerity. Instead, the economics profession appears much more divided. This in turn reflects the second reason why the importance of The General Theory to modern macroeconomics might be questioned. The reality is that most academic macroeconomists no longer regard The General Theory as the defining text of their discipline. If they had to name one, they might be more likely to choose one of the seminal texts of the New Classical revolution: Lucas and Sargent (1979), which is aptly titled ‘After Keynesian Macroeconomics’.
Much discussion of current divisions within macroeconomics focuses on the ‘saltwater/freshwater’ divide. This understates the importance of the New Classical Counter Revolution (hereafter NCCR). It may be more helpful to think about the NCCR as involving two strands. The one most commonly talked about involves Keynesian monetary and fiscal policy. That is of course very important, and plays a role in the policy reaction to the recent Great Recession. However I want to suggest that in some ways the second strand, which was methodological, is more important. The NCCR helped completely change the way academic macroeconomics is done.
Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. As Hoover (2001, p. 72) writes, ‘[t]he conviction that macroeconomics must possess microfoundations has changed the face of the discipline in the last quarter century’. In terms of this second strand, the NCCR was triumphant and remains largely unchallenged within mainstream academic macroeconomics.
To understand the position of The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the NCCR, and why it was so successful.
One explanation, which I consider in Section 2, could be summed up in Harold Macmillan‘s phrase ‘events, dear boy, events’. Just as the inability of economists to understand the Great Depression gave rise to The General Theory and the Keynesian consensus that followed, the Great Inflation of the 1960s and 1970s undermined that Keynesian consensus. The suggestion is that the NCCR was a response to the empirical failure of the Keynesian consensus. I will argue instead that the NCCR was primarily driven by ideas rather than events.
Section 3 considers the methodological revolution brought about by the NCCR and the microfoundations research strategy that it championed. Section 4 argues that this research methodology weakened the ability of macroeconomics to respond to the financial crisis and the Great Recession that followed. Although microfounded macroeconomic models are quite capable of examining financial and real economy interactions, and there is a huge amount of recent work, it is important to ask why so little was done before the crisis. I will suggest that a focus on explaining only partial properties of the data and an obsession with internal consistency are partly to blame, and this focus comes straight from the methodology.
Many economists involved with policy have commented that they found texts written prior to the NCCR, like The General Theory, or texts written by those outside the post-NCCR mainstream, more helpful during the crisis than mainstream macroeconomics based on microfounded models. Does that mean that macroeconomics needs to discard the innovations brought about by the NCCR, just as that revolution wanted to discard so much of Keynesian economics? In Section 5 I argue that that would make exactly the same mistake as the NCCR made. We do not need a discipline punctuated by periodic revolutions. The mistake that the discipline made in the 1980s and 1990s was to cast aside, rather than supplement, older ways of doing things. As experience in the UK shows, it is quite possible for microfounded modelling to coexist with other ways of modelling and estimation, and furthermore that different approaches can learn from each other.
2 IDEAS, NOT EVENTS
Download PDF (124.6 KB)
To understand the position of Keynes's The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the New Classical Counter Revolution (NCCR), and why it was so successful. This revolution can be seen as having two strands. The first, which attempted to replace Keynesian policy, failed. The second, which was to change the way academic macroeconomics was done, was successful. Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive.
As a result, most academic macroeconomists today would see the foundation of their discipline as not coming from The General Theory, but as coming from basic microeconomic theory – arguably the ‘classical theory’ that Keynes was so keen to cast aside. Students are also taught that pre-NCCR methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong. The problem with the NCCR was not the emergence of microfoundations modelling, which is a progressive research programme, but that it discouraged the methods of analysis that had flourished after The General Theory. I argue that, had there been more academic interest in these alternative forms of analysis, the discipline would have been better prepared ahead of the financial crisis.
Full Text
1 INTRODUCTION
The General Theory of Employment, Interest and Money (Keynes 1936) is sometimes credited with creating modern macroeconomics. Today that observation appears highly questionable for two reasons. The first relates to policy. We have once again found ourselves in a global liquidity trap of just the kind that The General Theory was designed to explain and avoid. Yet policy-makers have prolonged that liquidity trap by doing precisely the opposite of what The General Theory recommended. Can anyone doubt that Keynes would be turning in his grave seeing the current obsession with fiscal austerity?
There is of course nothing that compels policy-makers to base their decisions on macroeconomic theory, and a large part of what is currently going on may just be politicians using populist analogies between state and household budgets to achieve goals to do with the size of the state. Yet we have to ask whether they would be able to get away with that if macroeconomists were united in their opposition to fiscal austerity. Instead, the economics profession appears much more divided. This in turn reflects the second reason why the importance of The General Theory to modern macroeconomics might be questioned. The reality is that most academic macroeconomists no longer regard The General Theory as the defining text of their discipline. If they had to name one, they might be more likely to choose one of the seminal texts of the New Classical revolution: Lucas and Sargent (1979), which is aptly titled ‘After Keynesian Macroeconomics’.
Much discussion of current divisions within macroeconomics focuses on the ‘saltwater/freshwater’ divide. This understates the importance of the New Classical Counter Revolution (hereafter NCCR). It may be more helpful to think about the NCCR as involving two strands. The one most commonly talked about involves Keynesian monetary and fiscal policy. That is of course very important, and plays a role in the policy reaction to the recent Great Recession. However I want to suggest that in some ways the second strand, which was methodological, is more important. The NCCR helped completely change the way academic macroeconomics is done.
Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. As Hoover (2001, p. 72) writes, ‘[t]he conviction that macroeconomics must possess microfoundations has changed the face of the discipline in the last quarter century’. In terms of this second strand, the NCCR was triumphant and remains largely unchallenged within mainstream academic macroeconomics.
To understand the position of The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the NCCR, and why it was so successful.
One explanation, which I consider in Section 2, could be summed up in Harold Macmillan‘s phrase ‘events, dear boy, events’. Just as the inability of economists to understand the Great Depression gave rise to The General Theory and the Keynesian consensus that followed, the Great Inflation of the 1960s and 1970s undermined that Keynesian consensus. The suggestion is that the NCCR was a response to the empirical failure of the Keynesian consensus. I will argue instead that the NCCR was primarily driven by ideas rather than events.
Section 3 considers the methodological revolution brought about by the NCCR and the microfoundations research strategy that it championed. Section 4 argues that this research methodology weakened the ability of macroeconomics to respond to the financial crisis and the Great Recession that followed. Although microfounded macroeconomic models are quite capable of examining financial and real economy interactions, and there is a huge amount of recent work, it is important to ask why so little was done before the crisis. I will suggest that a focus on explaining only partial properties of the data and an obsession with internal consistency are partly to blame, and this focus comes straight from the methodology.
Many economists involved with policy have commented that they found texts written prior to the NCCR, like The General Theory, or texts written by those outside the post-NCCR mainstream, more helpful during the crisis than mainstream macroeconomics based on microfounded models. Does that mean that macroeconomics needs to discard the innovations brought about by the NCCR, just as that revolution wanted to discard so much of Keynesian economics? In Section 5 I argue that that would make exactly the same mistake as the NCCR made. We do not need a discipline punctuated by periodic revolutions. The mistake that the discipline made in the 1980s and 1990s was to cast aside, rather than supplement, older ways of doing things. As experience in the UK shows, it is quite possible for microfounded modelling to coexist with other ways of modelling and estimation, and furthermore that different approaches can learn from each other.
2 IDEAS, NOT EVENTS
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