Sunday, March 01, 2009

Chicago vs. the World

Over on Angry Bear: Robert Waldman analyzes the validity of the IS-LM/Phillips Curve model, which Chicago finance guru John Cochrane called a "fairy tale". I am more than a little unclear on what models/assumptions my Chicago guys (Cochrane, Fama, Becker & Murphy; first-rate intellects all) are using that result in such different results from "everyone" else (Krugman, DeLong, et al). It is just a rehash of Friedman vs. Keynes or is there something more to it? Reading Cochrane's paper, it really does look like he's taking the Treasury View with regard to fiscal stimulus, by saying that an injection of $1 of government spending now is immediately offset by increased savings as we prepare to pay $1+interest in the future. An odd side effect of this is that actually paying down the debt in the future should not have any anti-inflationary effect at that time.

Update: Paul Krugman suggests an answer:

In the late 1960s macroeconomists began a search for microeconomic foundations — above all, an attempt to explain why nominal shocks seem to have real effects rather than merely affecting the price level. The 1970 Phelps volume, which suggested that imperfect information could explain a lot of what we see, had a huge impact on the profession. And when Lucas married this insight to rational expectations, it seemed to shake the foundations of Keynesian ideas about monetary and fiscal policy. Business cycles, Lucas suggested, last only as long as price- and wage-setters can’t disentangle nominal from real shocks — and monetary or fiscal policy can’t stabilize the economy, at most they add noise.

But it became clear after a few years that this approach wasn’t going to work: actual business cycles last too long to rely on imperfect information. And at that point the profession divided. One group went down the “new Keynesian” route, arguing that something such as small costs of changing prices must explain the rigidity we actually seem to see. This group isn’t averse to putting a lot of rationality into its models, but it’s willing to accept aspects of the world that seem clear in the data, even if it can’t (yet?) be fully explained in terms of deep foundations.

The other group decided that since they couldn’t come up with a rigorous microfoundation for price stickiness, there must not be any price stickiness: recessions are the result of adverse technological shocks, not demand shocks.

And the latter group, the equilibrium macro side, was so convinced of the logical correctness of its position that schools dominated by that view stopped teaching demand-side economics. (Schools dominated by new Keynesians, on the other hand, did teach real business cycle theory.) I haven’t been able to dig up the quote, but somewhere along the line Ed Prescott declared that his students wondered who Keynes was, because he was never mentioned in their courses.

And those trained according to this dogma were and are utterly ignorant of what Keynes, or modern Keynesians, have to say. They know that Keynesianism is stupid nonsense, because that’s what they remember having been told. But they don’t actually know why they’re supposed to believe that; the serious debates the profession had in the 70s about the microfoundations of inflation and unemployment theory are lost in the mist.

Update II 2/4/08: Brad DeLong reminds us that it's Say's Law , not Milton Friedman, that says that fiscal stimuli will result in immediate, perfectly counteractive measures, rendering fiscal policy useless.

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