Keynesian Economics Is Hot Again
To the growing list of famous mainstream macroeconomists who have publicly criticized their discipline, add another: In a recent essay, Lawrence Christiano of Northwestern University argues that the Great Recession was an “earthquake” that dramatically changed how researchers think about the U.S. economy.
Christiano is known as a scholar who straddles macroeconomics’ great divide. His models adopt the basic form and some of the bedrock assumptions of the New Classicals, the economists who insisted in the 1980s that monetary and fiscal policy can’t fight recessions. But he also incorporates some elements of Keynesianism, the idea that aggregate demand shortages exist and can be corrected by the government stimulus. Perhaps as a result of their centrist take on that long-running debate, theories inspired by Christiano’s have won pride of place in central banks around the world.
But after the Great Recession, Christiano says, the pendulum should swing decisively in the Keynesian direction:
The Great Recession was the response of the economy to a negative shock to the demand for goods all across the board. This is very much in the spirit of the traditional macroeconomic paradigm captured by the [simple Keynesian] model… The Great Recession seems impossible to understand without invoking…shocks in aggregate demand. As a consequence, the modern equivalent of the IS-LM model—the New Keynesian model—has returned to center stage.
Another way of putting this is that Paul Krugman was right. Krugman has long advocated that macroeconomists learn to once again think in terms of simple simple Keynesian theory. And when more fully developed, complex models are needed, Krugman uses the kind of models that Christiano endorses.
As Christiano mentioned, the New Keynesian revolution isn’t so new. Even in the 1990s, economists like Greg Mankiw and Olivier Blanchard were arguing that monetary policy had real effects on demand. And at the same time, international macroeconomists were realizing that Japan’s post-bubble experience of slow growth, low interest rates and low inflation implied that demand shortages could last for a very long time unless the government rode to the rescue. Krugman, Adam Posen, Lars Svensson, and others were already referring to a Japan-type stagnation as a liquidity trap in the late 1990s, and warning that standard monetary policy of cutting interest rates wouldn’t work in that sort of situation.
But the profession didn’t listen, and only the smallest deviations from the New Classical orthodoxy were accepted into the mainstream. The idea of fiscal stimulus was still largely taboo. Nobel prizes were awarded to the economists who made theories in which demand shortages can’t exist, while no Nobels were given to New Keynesians for suggesting otherwise. When the Great Recession hit, some prominent macroeconomists pooh-poohed the idea that stimulus could help.
Christiano’s essay should serve as a needed rebuke to the profession for resisting Keynesian ideas just when they were needed most. But it also raises an uncomfortable question: Why didn’t macroeconomists catch on until years after disaster struck?
One explanation is sociological. Perhaps the influence of legendary figures like Robert Lucas, Thomas Sargent and Edward Prescott -- all anti-Keynesians who now have big gold medals from Sweden -- was enough to scare younger economists away Keynesian ideas. Some of macroeconomics’ internal critics, such as World Bank chief economist Paul Romer, have suggested as much. Political considerations might have played a role as well -- to many economists on the free-market end of the ideological spectrum, Keynesianism represents unacceptable government meddling.
But these explanations, by themselves, are unsatisfying. In most scientific fields -- biology or astronomy, for example -- the weight of evidence is enough to overcome social fads and political bias. Even in most areas of economics, empirical results gradually push the profession in one direction or another. For example, relatively few economists now believe a $15 minimum wage is likely to reduce employment very much; a plurality is uncertain. The steady drumbeat of papers showing small or zero job losses from minimum-wage hikes probably played a role in altering the expert consensus.
If economists gravitated toward anti-Keynesian theories, it was at least in part because evidence wasn’t strong enough to push them in the right direction. It’s just very hard to assess the impacts of fiscal stimulus. For example, Japan’s tremendous government spending binge in the 1990s looks to a casual observer like it had no effect, since the economy didn’t recover until years later -- but government spending might have been the only thing saving the country from a deeper recession.
For a great explanation of why macroeconomic evidence is so weak and subject to multiple interpretations, read this excellent post by the University of Oregon’s Mark Thoma.
When evidence is sparse or inconclusive, things like sociology and politics often fill the gap. That just means macroeconomists should be a lot more careful, cautious and humble than researchers in other areas. Instead, perhaps intoxicated by the importance of their subject, they are often given to making grand, overconfident pronouncements.
The right way forward for macro isn’t to go all-in on a hot new theory, or to passionately embrace old paradigms either. The best approach is to adopt more public humility and caution about their theories, while working to understand microeconomics better. Someday, when economists have a better handle on the basics of why people consume and businesses invest, macroeconomic models won’t have to be rethought every time a big recession happens.
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