Saturday, December 8, 2012

I think it was the Lucas Critique, not stagflation

A common thing you hear is that stagflation was what lead to the decline of Keynesianism in the 1970s. I think a lot of Keynesians are puzzled by this because although policymakers in the 50s and 60s might have counted on a stable Phillips Curve it doesn't seem like anything at the heart of Keynesian theory.

You can also think about one of the earliest efforts to think more critically about the Phillips Curve: the Phelps volume in 1970. If you read the introduction to this book it sounds like New Keynesians' stuff you might read two decades later. It's explicit goal was to make a connection between Keynesian macro and necolassical micro, both of which were considered to be the right approach forward. So there was nothing anti-Keynesian in spirit about Phelps's expectations augmentation of the Phillips Curve (perhaps Friedman thought of his work in those terms). This sort of "working in the Keynesian tradition" attitude is still apparent on Phelps's website today even though he's come out with some goofy critiques of Keynesians during the crisis. So what is the classic answer to stagflation? Expectations augmentation of the Phillips Curve, right? We talk like that was a non-Keynesian thing, but I don't think that's the right way to look at it (although I'm sure lot's of people at the time talked like that as well... I doubt Keynesians felt very shocked by it all, though).

I think the Lucas Critique was much more significant, not so much because it impressed upon Keynesians the need for microfoundations (as I said, that was already being pursued by guys like Phelps who framed their work as a Keynesian effort), but especially because it offered a structural model that was distinctly non-Keynesian that predicted the same phenomena. Suddenly non-Keynesian stories became viable. In addition, the big macroeconomic models people were running couldn't just cite the fledgling Phelpsian microfoundations literature with a Keynesian story and then go on modeling their reduced forms - people had to actually worry about whether a completely different microfoundations was the real story and that required testing and running more structural models.

I am with Noah Smith in thinking that the Lucas Critique was very good for economics and that it exposed a severe blindspot of Keynesian economics. I think the response has been well handled, and we've done a lot of work testing alternative microfoundations. Not only that, but the critique is still in the background - it's something we always have to worry about - which is pushing important work in things like agent-based modeling.

In the end, I think this had a lot more to do with the decline of Keynesianism than stagflation did.

13 comments:

  1. Daniel,

    You seem to have an assumed definition of Keynesianism.

    Reading Coase's recent HBR comment, would you be willing to state your definition of Keynesian and then to or restate a definition of Keynesianism that is useful for the business person or banker.

    Second, as regards the Phelps curve, why is such assumed to be curved. Could the devil be that it is "quantum," in nature, "moving only in chunks." I realize it is simplistic, but a factory closes and 3000 people lose a job a once---that is a chunk.

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  2. "especially because it offered a structural model that was distinctly non-Keynesian that predicted the same phenomena."

    Except it didn't. The "Lucas Critique", which was bogus from day one, didn't offer a model which predicted the Great Depression or anything else. So, in fact, the Lucas Critique was inferior the moment it appeared.

    Why were people open to bogosity like the Lucas Critique? Stagflation. Keynesians offered bad explanations of stagflation....

    ("So what is the classic answer to stagflation? Expectations augmentation of the Phillips Curve, right? We talk like that was a non-Keynesian thing, but I don't think that's the right way to look at it (although I'm sure lot's of people at the time talked like that as well... I doubt Keynesians felt very shocked by it all, though)."

    I think that classic answer is wrong, and I think it was fairly obvious that it was wrong, even at the time. An expectations-based cycle would have involved *everything* being inflation-indexed, as happened in some South American countries later. Although the US had some inflation-indexing, the inflation-indexing had been present since the 1950s and *does not correlate* with the stagflation.

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  3. OK, there is an important point you're making, though: microfoundations. It was found that the current micro models and the current macro models weren't really consistent with each other.

    The micro models which were popular then have since been shown to be completely wrong, and the macro models to be right. However, at the time, this was abused by right-wingers to discredit the *macro* models.

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  4. I will tell you your main mistake though: you are underestimating the degree to which the 0.1% was looking for ANY EXCUSE to attack Keynes.

    Keynesian policies are bad for the relative position (not the absolute position, but the relative position) of the elite. Many in the elite care mostly about their relative position; what matters to them is how many starving children they can laugh at as they eat their caviar. (Yes, this sounds callous, but it is only a slight exaggeration.) Keynesian policies are directed at universal prosperity and therefore have a levelling effect. The 0.1% will therefore pay off absolutely anyone who is peddling any theory which would have the effect of ending this levelling effect.

    No intellectual consistency is required; merely an *opening for attack*. Stagflation gave the 0.1% an *opening for attack* among the common people. The "Lucas critique" gave the 0.1% an *opening for attack* among the intellectuals. The 0.1% pushed an army of corrupt hacks spouting bullshit through this opening, using their funding mechanisms (Olin Foundation, etc.).

    You have to see this as a political activity, where one side (the 0.1%) was not interested in being right, but was only interested in winning. Then you'll begin to understand what happened.

    Keynes would have understood this; he faced self-interested, short-sighted, big-money political opposition. People who were brought up in the '50s, era of the 92% tax rates and "levelled" society, don't seem to understand it at all.

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  5. FYI, there is no need for "microfoundations". Apart from the fact that neoclassical micro is a completely rotten pile of garbage having nothing to do with the behavior of actual consumers or firms, go look at some actual sciences. Evolution by natural selection was understood, proven to be correct, and accepted *a long, long time* before its biochemical foundations were established.

    Eventually it would be good to have an economics founded on psychology, but psych isn't well-developed enough to really do this properly yet. And you don't need to.

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  6. Daniel Kuehn, you know from your readings of the Tinbergen-Keynes correspondence that the Lucas Critique is really a footnote to Keynes's criticisms of the nascent field of econometrics. In turn, Keynes's criticisms of econometrics go back to his Cambridge fellowship dissertation, which was finalized for publication as A Treatise on Probability in 1921. You may want to see the following links for further reference...

    http://www.amazon.com/review/R2HY4DQV7ZDJNP

    http://www.amazon.com/review/R1CWP15DVWEU5Y

    http://www.amazon.com/review/R3VENX8RPWEQXH/

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  7. Daniel,

    Do you know why the academic opinion on the stagflation of the 1970's did not attribute the said stagflation mainly to the supply shock (that is, in the AD-AS diagram, AS moving to the left)? I am honestly interested.

    When I was taught macro my teacher touched the issue of the simultaneously rising inflation and unemployment and pretty much my whole course just got confused: "Isn't it perfectly explained by the declining production due to the oil prices rising?". We didn't get how this disproved (Old) Keynesianism at all. Maybe it was because we were taught AD-AS the first thing, I dunno. I don't like AD-AS now because of the devastating heterodox criticism (mainly Sraffa 1925) but to me this model always was an intuitive start for the macroeconomics.

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    1. I've wondered that myself - I think some of the concern was the persistent growth of inflation which doesn't really seem consistent with a supply shock but which is explained by expectations augmentation. It may just be that this was an opportunity to use the expectations thinking that had been sketched out a few years prior.

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    2. Daniel, I don't understand this either.

      John Quiggin has claimed the idea that the oil shock caused the high inflation of the seventies is a zombie idea of the left, but as far as I can tell his only evidence is one month of higher inflation prior to official date of the oil crisis.

      It seems there was world wide higher inflation in the seventies, so I wonder if all those governments were blindly pursuing Phillips curve style policies or maybe a few big countries are supposed to have exported their inflation.

      That said I'm fine with the idea of an expectations augmented curve, but wonder if it's overstated.

      I think Dean Baker has argued that Volker overreacted, that inflation went down around the world around the same time as oil prices fell.

      It seems like we never talk about what an appropriate response to an oil shock actually is. Maybe higher inflation is appropriate. (Apparently, according to Econlib, Abba Lerner had a plan to deal with OPEC.)

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    3. Daniel, xgsmmy, thank you for the replies.

      I think I have yet to see a completely compelling theory on the stagflation of the seventies. Perhaps several explanations are right: oil price shocks rising the prices of the consumer goods; wage-price spirals; the self-sustaining inflationary expectations; etc.

      Still, for all of its shortcomings, I do wonder how Neo-Keynesian school crumbled so easily over, at most, a decade. Had Hicks publicly denounced IS-LM in the early 70's, that would have been less of a riddle, but he did it well after the whole stagflation debate, in the 1981 in the relatively obscure Post-Keynesian journal that I doubt even most --contemporaries-- did read (JPKE, Hicks 1981).

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    4. There is also the role of credit liberalisation and subsequent credit expansion:

      http://www.leftfootforward.org/2011/06/ann-pettifor-labour-suffers-from-economic-stockholm-syndrome/

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    5. The things which make me still think it was the oil are:
      (1) The economy was *actually production-constrained by oil*. Extra labor didn't have anything to do without oil. We were that dependent.
      (2) The tightening of the oil spigot wasn't really alleviated until *1981*. Not coincidentally, stagflation ended around the same time....

      Basically, if the US economy is oil-import-constrained, then putting money into the economy doesn't alleviate unemployment -- due to a missing cofactor of production. I have never seen this clearly stated by anyone but me.

      Most recessions are not driven by an actual supply shock, let alone a supply shock where substitution requires massive retooling of factories nationwide (a decade-long process minimum). Therefore in most recessions putting money in does alleviate unemployment.

      So, basically, I think the right response to an oil shock is to retool the economy to not be dependent on oil. Until you do that you're going to have increased unemployment; you're stuck with it. Go ahead and tighten monetarily if inflation is considered a problem. But do it *while redirecting fiscal expenditure to the free-from-oil retooling*, the way you'd redirect spending to the war during a war. Arguably Jimmy Carter had figured it out, but it never got fully implemented.

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