Magic Fairies Cause Recessions

Saying that something akin to magic fairies causes recessions isn't a very satisfactory explanation.
Close your eyes and make a wish.                                                  

Here's how recessions work. Sometimes, for whatever reason, the Federal Reserve decides to raise interest rates. That's expected to cause deflation, so companies want to lower their prices to avoid being outcompeted when all the other companies lower their prices. But here's the problem -- some of them can't. Because every quarter, a magical fairy taps a certain percentage of them on the shoulder and says "Sorry, you're not allowed to change your prices this quarter." Since they can't drop their price, companies that get cursed by the fairy end up just producing less. Voila -- a recession!

Actually, I'm just kidding. I don't really think this is how recessions work. But, like the Real Business Cycle theory I described in a previous article, this is a real, honest-to-God macroeconomics model. In fact, more complicated versions of it are the dominant theory used by central banks all over the world. It's called the New Keynesian model, and it was the major challenger to RBC theory back in the 1990s. Its inventors, who include Greg Mankiw, Mike Woodford, Jordi Gali, Olivier Blanchard and others, haven't won Nobel prizes yet, but you can bet they're in the pipeline.

To most people, the idea of a magical fairy that tells you when you're allowed to change your price might sound crazy. But when economists use the fairy -- called the "Calvo mechanism" after the economist who conceived of it -- they're just using it as a stand-in for other, more sensible reasons why companies might not be able to change their prices quickly.

The timing of the New Keynesian emergence was no coincidence. Just as the RBC (or "New Classical") models had gained some credence amid the stagflation of the 1970s, the New Keynesian models gained support from the Volcker recessions of the early 1980s, where former Fed Chairman Paul Volcker's attempts to whip inflation with high interest rates seemed to plunge the economy into two short, sharp contractions. RBC theory gave no mechanism by which that might happen; New Keynesian theory did. But that wasn't the only reason New Keyensian models caught on. The New Keynesians saw themselves as preserving a tradition of intellectual thought that stretched back to John Maynard Keynes and Milton Friedman, but which had been forgotten and minimized by the New Classicals in the 1980s.

When the New Keyensian models started coming out in the 1990s, they came under immediate and vigorous attack from the slightly older generation of macroeconomists who had developed the rival New Classical models. Robert Barro, a Harvard professor, went so far as to write a paper labeling the New Keynesians the "bad guys" and his own New Classical group the "good guys." New Classical pioneer Robert Lucas was even harsher, responding thus to a New Keynesian manifesto by Mankiw:

Why do I have to read this? The paper contributes nothing - not even an opinion or belief - on any of the substantive questions of macroeconomics...One can speculate about the purposes for which this paper was written - a box in the Economist? - but obviously it is not an attempt to engage other macroeconomic researchers in debate over research strategies.

As you can see, contentiousness among macroeconomists didn't begin with the advent of blogs!

An interesting sociological pattern was established, with nice-guy New Keynesians bending over backward to accommodate and placate the fiery New Classicals. But make no mistake -- there were plenty of substantive critiques of the New Keynesian models as well. The great empirical macroeconomist Chris Sims showed that while monetary policy can affect the economy, in practice it's usually not the cause of recessions. Randall Wright and others found that a more realistic description of "sticky prices," without the need for a magic fairy, might not produce New Keynesian-style effects. Some economists at the Federal Reserve Bank of Minneapolis argued that New Keynesian models might not accurately describe human behavior. And, as with RBC, New Keynesian models had various other empirical problems.

Still, New Keynesian models became the dominant model used by central banks. One reason for this was simple: unlike their RBC cousins, New Keynesian models actually had something to say about monetary policy. If you're a central banker trying to make policy, you probably want a model that actually includes that type of policy instead of just ignoring it. Eventually, more and more complex New Keynesian models were developed, incorporating many different possible causes of recessions. The most popular model, the Smets-Wouters model, is an absolute beast.

As New Keynesian models slowly and politely nudged their rivals aside, some of the paradigm's founders declared victory. The Great Moderation seemed to justify the New Keynesian idea that the Fed could stabilize the economy.

Then came the financial crisis and the Great Recession.

Suddenly, New Keynesian models didn't look so attractive. It seemed hard to believe that a magical price-fixing fairy could be responsible for the economic carnage. Furthermore, like their RBC cousins, New Keynesian models didn't include the financial sector at all.

So although they live on inside central banks, the star of New Keynesian models is now on the wane. The second great efflorescence of macroeconomic model-making of the late 20th century proved only a bit more durable than the first.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.