Monday’s Macro Memo: My Interview with Cloud Yip, Part 1

A couple of months ago, I had the pleasure of speaking with Cloud Yip. Cloud is running a series of interviews under the title of “Where is the General Theory of the 21st Century” and I was privileged to be included in that series. The interview was published in its entirety a couple of weeks ago but, because it is quite long, I will be serialising it on my blog over the next few weeks.In his series, Cloud asks prominent macroeconomists: “Why haven’t economists come up with a new General Theory after the Great Recession?” Those of you who have been following my blog will not be surprised by my answer. The theory of macroeconomics, described in my book Prosperity for All, makes fundamental changes to the dominant paradigm. And it leads to fundamentally different policy conclusions from either classical or New Keynesian alternatives. 

Q: Do you think that there have been “revolutionary” changes in macroeconomics since the Great Recession?

F: Yes and no. In my own work, I have made some major changes to macroeconomics. I will leave it to others to decide if they are revolutionary. But in my view, most macroeconomists are carrying on with business as usual. And that is discouraging because macroeconomics needs to change.

The dominant paradigm before the Great Recession was New-Keynesian economics. That paradigm is widely perceived to have failed in two key dimensions. It didn’t include a financial sector and it had no role for unemployment. New Keynesian economists have tried to fix the NK model by adding in these features and there have been some notable contributions. But for the most part, attempts to fix the NK model are akin to rearranging the deckchairs on the Titanic.

Economics is not an experimental science. As a consequence, frequently, people pursue avenues of research that are simply wrong or mistaken.

In my view, economics took a wrong path in the 1950s. Back in 1928, there was a book published by Pigou called “Industrial Fluctuations.” It is a very rich verbal theory about the causes of business cycles. According to Pigou, there are six different causes of business cycles. Those include what we would now call productivity shocks, monetary disturbances, sunspot shocks, that is, shocks to business confidence; agricultural disturbances, changes in tastes and news shocks.

Then in 1929, there was the stock market crash, and in 1936, Keynes wrote the General Theory. The General Theory was a revolutionary change in the way we think about the world. It was revolutionary because, instead of thinking of the economic system in a capitalist economy as self-stabilizing, Keynes’s vision was of a dysfunctional world in which high unemployment can persist for a very long time.

A few years ago, I wrote a book called “How the Economy Works“. In it I described two metaphors. The first was that of Pigou’s book in which the economy is like a rocking horse hit repeatedly and randomly by a kid with a club. The movement of the rocking horse is partly caused by the shocks of the club and partly caused by the internal dynamics of the rocker. We’ve modelled this system for decades using linear stochastic difference equations.

In my book, I provide a different metaphor to capture Keynes’ insight that the economy can get stuck in an equilibrium with high unemployment. I call that metaphor the “windy-boat model”. The economy is not like a rocking horse; it is like a sailboat on the ocean with a broken rudder. When the wind blows the boat, instead of always returning to the same point, the boat can become stranded a long way from a safe harbour.

In the language of equilibrium theory, Frisch’s analogy leads to a model with a unique steady-state equilibrium: the rocking horse always comes to rest at the same point. In the windy-boat model, which is, I think, the essence of the General Theory, the economy can get stuck with high unemployment for an extended period.

In the immediate aftermath of the Great Depression in the 1940s and 1950s, the economic model we were using was based on ideas from the General Theory. Then in 1955, Samuelson wrote the third edition of his introductory textbook, in which he introduced the concept of the neo-classical synthesis.

In Samuelson’s view, a view that has dominated the discipline since 1955, the economy is classical in the long run but Keynesian in the short run. Samuelson defined the short-run as the period over which prices don’t adjust. He defined the long-run as the period over which the economy has had enough time to return to a classical full-employment equilibrium. According to the neo-classical synthesis, the economy is temporarily away from the “social planning optimum”, but only temporarily.

In 1982, with the birth of Real Business Cycle Theory (RBC), economists gave up on Keynesian economics and we returned to the ideas of Pigou. Real Business Cycle theory formalized Pigou’s model of the economy, but instead of the rich verbal theory of Industrial Fluctuations, RBC theorists constructed complicated mathematical models. And because the mathematics was complicated, the models were very simple and, initially, driven by a single productivity shock. In the period from 1982 up through 2008, most macroeconomists were engaged in a research program that was, essentially, adding the shocks back to Pigou’s vision of the rocking horse model.

What happened in 2008 and in the aftermath of the Great Recession has, or should, cause us to rethink the entire enterprise of macroeconomics. In my work, I have formalized the main ideas in Keynes’ General Theory. These ideas are vastly different to those that preceded Keynes and they are very different from the ideas that have guided macroeconomics since the 1980s. Keynes argued that there are multiple steady-state equilibria and that the economy can get stuck in an equilibrium with high persistent involuntary unemployment. In my work, I have formalized that idea.

Q: Why, in your view, did economists, in the 1980s, give up on Keynesian economics?

F: The General Theory was incomplete. It was incomplete because it eliminated the idea of the labour supply curve but didn’t replace it with any convincing alternative.

Keynes argued that the economy is on the labour demand curve, but he threw away the labour supply curve and replaced it with the idea of involuntary unemployment. That was always somewhat unsatisfactory theoretically.  Involuntary unemployment is open to a number of criticisms. For example, why don’t firms offer to employ unemployed workers for lower wages when those workers would willingly accept a lower wage if they are involuntarily unemployed? This is a theoretical problem that was left hanging in the General Theory.

Then the other issue in the General Theory is that there was never a theory of what determines the price level. Hicks and Hansen, who interpreted the General Theory, considered it to be a short-term theory in which prices are temporarily fixed. Around the time that Samuelson was writing the third edition of his textbook, a New Zealander, William Phillips, published the article “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”. This empirical article demonstrated that there had been a stable relationship between wage inflation and unemployment in nearly a century of UK data. This has been known ever since as the Phillips curve.

Samuelson used the Phillips curve to bring together the short run and the long run. He saw it as a wage adjustment equation which explained how excess demand pressure would cause wages to rise. As wages and prices changed, the economy would return to its long-run steady state. The problem with that explanation is that as soon as Phillips had written the article, the Phillips Curve disappeared. There hasn’t been a stable Phillips Curve in data anywhere in any advanced economy that I know of since the mid 1960s.

Giovanni Nicolò and I wrote a paper recently (Farmer and Nicolò 2017) that replaces the Phillips Curve with an alternative equation, the Belief Function,  that I introduced in my 1993 book, The Macroeconomics of Self-fulfilling Prophecies. Giovanni and I showed in our paper that a three-equation model closed with the Belief Function instead of the Philips Curve provides a much better fit to US data. We find that a Bayesian economist who placed equal weight on both theories before confronting them with data would find overwhelming evidence that the Belief Function was the better approach.

Next week I will continue this serialisation of my interview with Cloud, and among other things, I will discuss my views on rational expectations.