That Toddlin Town II

Whatever else one may say about the Chicago School of economics, it is a wonderful source of quotes - the kind where a Nobel Memorial guy makes himself look like an idiot. Paul Krugman's analysis of the great macroeconomic divide finds one by Robert Barro:

Robert Lucas married Phelps-type [inperfect information] models of employment with rational expectations, the view that people in the economy use all available information to make predictions. And this led to a startling conclusion: anticipated policies have no effect on employment. Only surprise changes in, say, the money supply matter – which means that you can’t use monetary or fiscal policy to stabilize the economy.

The Lucas view took the economics profession by storm – not because there was any solid evidence for it, but because it was so clever, because it led to nice math, because it let macroeconomists give in to their inner neoclassicists.

But by the late 70s it was already clear that rational expectations macro didn’t work. Why? Because people have too much information.

Think about the story of unemployment I’ve just described. It’s a story in which a contraction in the money supply can produce a recession – but only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand, not specifically low demand for their products.

In Lucas-type models, people were supposed to look at the prices they received, and optimally extract the “signal” from the “noise”. The models broke down, however, as soon as you let people have access to any other information – say, by looking at interest rates, or reading a newspaper. And the reality, of course, is that recessions persist long after everyone knows that there’s a recession, so that the confusion required by Lucas-type models is long since gone.

I recall a seminar, I think in 1980, in which Robert Barro was presenting a rational-expectations business cycle model. Someone asked him how he could reconcile his model with the severe recession taking place as he spoke. “I’m not interested in the latest residual,” Barro snapped.

Not allowing the facts to get in the way of your theory is one way to make it clear that what you are doing isn't science. The same time of response, by the way, almost perfectly describes the freshwater response to our own current crisis. If worst comes to worst, and you really must admit that reality exists, blame it on the government - the fault really couldn't belong to you theory.

Krugman continues:

But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?

The answer was that they split. One faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever.” That faction became New Keynesian, saltwater economics.

The other faction said, in effect, “OK: we can’t explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can’t.” That faction became real business cycle, freshwater economics.

But here’s the thing: at this point, the freshwater school no longer remembers any of that – largely because they purged Keynesian and even monetarist thought from their classes. All they know is that Keynesianism was “disproved”, and that none of it – not even New Keynesian models with rational expectations (an approach which, as Greg Mankiw says, “provides a rationale for government intervention in the economy, such as countercyclical monetary or FISCAL POLICY.”) – is worth listening to.

So that’s how we got to where we are today.

Aside for the sort of hysterical nonsense in Cochrane's response to Krugman, it is interesting that we haven't heard much from the freshies lately. Are they unprepared to dispute Krugman's version of events? Are they demoralized? Intimidated by Krugman's superior rhetorical skills? Or do they just not have anything to say.

I would love to think it was the last - folly abashed is on the first step of the path to wisdom.