Economist's Notebook: We Are All Keynesians Again

When I was in graduate school in the late nineties, the field of macroeconomics was having a bit of an identity crisis. Early twentieth century Keynesianism was out because it did not rely on the careful building up of a theory of aggregate economics from the simple rational economic agent that was the basis of modern neo-classical microeconomics. How could you, the argument went, have a macro theory that is disconnected to micro theory and still call it well-founded?

Thus, Robert Lucas, at the University of Chicago, and others set out to re-invent macroeconomics based on 'microfoundations.' Starting with the individually rational decision maker and adding up, in essence, led to a new macroeconomics that has been called many things but is most commonly described by the rubric 'real business cycle' theory (RBC). It had its origins in the monetarism of Milton Friedman, but was (is) a much more fully realized theory (and in that I mean, among other things, highly mathematical - which I consider a good thing in that mathematics helps prevent logical inconsistencies). A number of graduate programs became associated closely with it, Chicago, Rochester, and, most prominently (or perhaps better said, the department whose identity is most deeply enmeshed in RBC theory), the University of Minnesota.

It was a fresh Minnesota PhD who taught me most of my graduate macro (after a breathtaking few weeks with Bruce D. Smith who was an amazing teacher and researcher). The lessons from this training was clear: markets are efficient and people are rational. This means that the government has little role in the economy and will generally muck it up if it tries. This is a strong departure from the Keynesian macro of the past which implicitly assumed that markets had lots of frictions and would often find themselves in less than efficient outcomes, so the federal government has a very necessary role to play.

By the mid 1990s RBC macro was ascendant and Keynesians were struggling trying to proffer arguments why frictions existed and incorporate them into models that looked nothing like Keynsian ones. The most compelling of these frictions was the idea of 'sticky prices' - that prices and wages were slow to adjust to changing economic circumstances like the RBC models assumed. Union contracts, cognitive dissonance and the simple cost of reprinting menus we all given as evidence of this phenomenon (as was a wealth of empirical evidence).

It wasn't until a new class of macroeconomists came along, most prominently Michael Woodford and Julio Rotemberg, who were able to construct a microfounded model of Keynesianism (essentially a melding of the RBC models and some Keynesian principals) that this gulf was bridged -partly. This is still process and will take a generation - Minnesota is still pretty orthodox RBC, for example - and, unfortunately it came too late for me (Woodford's now canonical book Interest and Prices: Foundations of a Theory of Monetary Policy was published in 2003). These new 'Dynamic Stochastic General Equilibrium' models (DSGE) incorporate less than fluid prices but are essentially still based on monetary policy, not fiscal policy. [If you want a more thorough treatment of DSGE models, there is no better place than this]

These DSGE models are still mostly based on rational agents but with economic frictions. One way to view the current crisis is that it is being driven by a panic. This implies a degree of irrationality. The only place to turn for theories where agents are behaving less than perfectly rationally is to the macroeconomists working in the area of 'bounded rationality' who reject the perfectly rational agent in favor of agents who have a hard time figuring it all out and so use rules or learning mechanisms. George Evans of the U of O and his student, and my colleague, Bruce McGough of OSU work in these areas, but many mainstream macroeconomists are uncomfortable with such departures from the basic rational agent framework we are used to in economics.

So where does the modern macroeconomist turn for guidance on the effects of fiscal policy? Well, it appears that most of them are turning all the way back to 1936 and Keynes's General Theory. International economists (like Krugman) will claim that New Open Economy Macro (NOEM) does talk about fiscal policy, but I would argue that it is still mostly monetary based, and doesn't tell us a whole lot about our current situation. Keynes, on the other hand, speaks to just these types of systemic economic crises and offers solutions.

So we are all scrabbling around and opening up our intermediate macroeconomics textbooks (that still rely heavily on Keynes's model as a pedagogical tool). What I wonder is if the 'great moderation' in business cycles showed us that modern RBC theory was essentially right or was it the other was around, the serendipitous moderation of business cycles gave us false confidence in the RBC framework. Either way, we are in new territory now and virtually all modern, cutting-edge macro models don't help much in guiding us through these troubled times.

We are all Keynesians again.