Snowdon & Vane Modern Macroeconomics

I’m not at all sympathetic to it. I don’t know what you mean by the ‘available evidence’. The degree of intertemporal substitution of labour assumed in real business cycle models is selected to generate employment fluctuations of the magnitude we observe, which is to say, to be consistent with some of the ‘available evidence’. Economists who have used survey data on individuals have been unsuccessful in explaining employment fluctuations at the individual level – we just haven’t learned anything about preferences from their work. This is a disappointment, but no good purpose is served by reinterpreting this failure as though it were a successful attempt to estimate something.

Do you consider your 1972 Journal of Economic Theory paper on ‘Expectations and the Neutrality of Money’ to be your most influential paper?

It seems to be, or maybe the paper on policy evaluation [1976].

How important do you think the ‘Lucas critique’ has been?

I think it has been tremendously important, but it is fading. It used to be that you could hold that up, like a cross to a vampire, and defeat people simply by saying ‘Lucas critique’. People have gotten tired of that and I think that is fair enough. If you want to criticize work effectively you have to get into it and criticize its details. But I think it is basic that you can’t get economic conclusions without putting in some economic theories, some economic structure.

Your 1978 paper with Thomas Sargent ‘After Keynesian Macroeconomics’ seemed to be pronouncing the death of Keynesian macroeconomics. Do you now think that this was perhaps premature given its revival in the form of new Keynesian economics?

Well, the label ‘Keynesian’ is a flag a lot of people salute, so it’s not going to lie around unused. Of course Sargent and I were talking about a particular set of models which we were completely clear about.

You were talking about 1960s-style Keynesian models?

The Wharton model, the Michigan model, the MPS model, models which existed and were in some sense Keynesian. If a completely different class of models comes up which people like to call Keynesian, of course our criticisms can’t apply. You can’t write a paper in 1978 criticizing work done in 1988 [laughter].

That [1978] paper contains a lot of powerful rhetorical statements. Were you conscious of this at the time of writing?

Yes. We were invited to a conference sponsored by the Boston Fed. In a way it was like being in the enemy camp and we were trying to make a statement that we weren’t going to be assimilated.

Real Business Cycle Theory

In your 1980 paper ‘Methods and Problems in Business Cycle Theory’ you seem to be anticipating in some respects the next decade’s work. You appear to be asking for the kind of methodological approach which Kydland and Prescott were about to take up. Were you aware of what they were doing at the time?

Yes. But I wasn’t anticipating their work.

But your statements in that paper seem to be calling for the kind of methodology that they have used.

Well, Prescott and I have been very close for years and we talk about everything. But if you’re asking whether at the time I wrote that paper I had an idea that you could get some sort of satisfactory performance out of a macroeconomic model in which the only disturbances were productivity shocks, then the answer is no. I was as surprised as everybody else when Kydland and Prescott showed that was possible [laughter].

Is it fair to say that you, Friedman, Tobin and other leading macroeconomists up until 1980 tended to think of a long-run smooth trend around which there are fluctuations?

Yes.

Basically differences of opinion concerned what caused these fluctuations and what you could do about them. Then Kydland and Prescott [1982] came along and changed that way of thinking.

Well, they talk about business cycles in terms of deviations from trend as well. The difference is that Friedman, Tobin and I would think of the sources of the trend as being entirely from the supply side and the fluctuations about trend as being induced by monetary shocks. Of course we would think of very different kinds of theoretical models to deal with the long-run and the short-run issues. Kydland and Prescott took the sources that we think of as long term to see how well they would do for these short-term movements. The surprising thing was how well it worked. I am still mostly on the side of Friedman and Tobin, but there is no question that our thinking has changed a lot on the basis of this work.

In an article in Oxford Economic Papers Kevin Hoover [1995b] has suggested that ‘the calibration methodology, to date, lacks any discipline as stern as that imposed by econometric methods … and above all, it is not clear on what standards competing, but contradictory models are to be compared and adjudicated’. Does this pose a problem?

Yes, but it is not a problem that’s resolved by Neyman–Pearson statistics. There the whole formalism is for testing models that are nested. It has always been a philosophical issue to compare non-nested models. It’s not something that Kydland and Prescott introduced. I think Kydland and Prescott are in part responding to the sterility of Neyman–Pearson statistical methods. These methods just don’t answer the questions that we want to answer. Maybe they do for studying the results of agricultural experiments, or something like that, but not for dealing with economics.

Would you agree with the view that a major contribution of the real business cycle approach has been to raise fundamental questions about the meaning, significance and characteristics of economic fluctuations?

I think that is true of any influential macroeconomics. I don’t think that statement isolates a unique contribution of real business cycle theory.

In commenting on recent developments in new classical economics Gregory Mankiw [1989] has argued that although real business cycle theory has ‘served the important function of stimulating and provoking scientific debate, it will [he predicts] ultimately be discarded as an explanation of observed fluctuations’. What are your predictions for the future development of macroeconomics?

I agree with Mankiw, but I don’t think he understands the implication of his observation. We are now seeing models in the style of Kydland and Prescott with nominal rigidities, imperfect credit markets, and many other features that people thinking of themselves as Keynesians have emphasized. The difference is that within an explicit equilibrium framework we can begin to work out the quantitative implications of these features, not just illustrate them with textbook diagrams.

New Keynesian Economics

When we interviewed Gregory Mankiw in 1993 [see Snowdon and Vane, 1995] he suggested that ‘the theoretical challenge of Lucas and his followers has been met’ and that Keynesian economics is now ‘well founded on microeconomic models’. Do you think that new Keynesians such as Mankiw have created firm microeconomic foundations for Keynesian models?

There are some interesting theoretical models by people who call themselves ‘new Keynesians’. I don’t know who first threw out this challenge but I would think it was Patinkin. When I was a student this idea of microfoundations for Keynesian models was already on everyone’s agenda and I thought of Patinkin as the leading exponent of that idea.

Keynesian models in the 1960s, and this is what excited people like Sargent and me, were operational in the sense that you could quantify the effects of

I am certainly a Friedmanite. The problem with that statement is that not all empirical corroborations are equal. There are some crucial things that a theory has to account for and if it doesn’t we don’t care how well it does on other dimensions.

Do you think that it is crucial for macroeconomic models to have neoclassical choice-theoretic microfoundations?

No. It depends on the purposes you want the model to serve. For short-term forecasting, for example, the Wharton model does very well with little in the way of theoretical foundations, and Sims, Litterman and others have had pretty good success with purely statistical extrapolation methods that involve no economics at all. But if one wants to know how behaviour is likely to change under some change in policy, it is necessary to model the way people make choices. If you see me driving north on Clark Street, you will have good (though not perfect) predictive success by guessing that I will still be going north on the same street a few minutes later. But if you want to predict how I will respond if Clark Street is closed off, you have to have some idea of where I am going and what my alternative routes are – of the nature of my decision problem.

Why do you think there is more consensus among economists over microeconomic issues compared to macroeconomic issues?

What is the microeconomic consensus you are referring to? Does it just mean that microeconomists agree on the Slutsky equation, or other purely mathematical propositions? Macroeconomists all take derivatives in the same way, too. On matters of application and policy, microeconomists disagree as vehemently as macroeconomists – neither side in an antitrust action has any difficulty finding expert witnesses.

I think there is a tremendous amount of consensus on macroeconomic issues today. But there is much that we don’t know, and so – necessarily – a lot to argue about.

Do you see any signs of an emerging consensus in macroeconomics, and if so, what form will it take?

When a macroeconomic consensus is reached on an issue (as it has been, say, on the monetary sources of inflation) the issue passes off the stage of professional debate, and we argue about something else. Professional economists are primarily scholars, not policy managers. Our responsibility is to create new knowledge by pushing research into new, and hence necessarily controversial, territory. Consensus can be reached on specific issues, but consensus for a research area as a whole is equivalent to stagnation, irrelevance and death.

In what areas, other than the monetary sources of inflation, do you think there is now a consensus in macro? Do you think, for example, that there is a majority of economists who are now anti fine-tuning?

Yes. Fine-tuning certainly has come down a few pegs. Paul Krugman has been doing a lot of very effective writing attacking non-economists writing about economic matters. Paul is speaking for the whole profession in a very effective way and addressing the most important questions in social science. Economists have a lot of areas of agreement, partly due to the fact that we look at numbers. If somebody says the world is breeding itself into starvation, we look at numbers and see that per capita incomes are rising in the world. It seems to be that on a lot of questions there is a huge amount of consensus among economists. More and more we are focusing on technology, supply-side, long-run issues. Those are the big issues for us now, not on depression prevention.

Economic Growth

In their recent book on economic growth Robert Barro and Xavier Sala-i- Martin [1995] express the view that ‘economic growth is the part of macroeconomics that really matters’. In your Yrjo Jahnsson lectures [1987] you seem to be saying something similar, that macroeconomists have spent too much time on stabilization and neglected growth, which is a far more important issue for macroeconomics to look at.

Yes. That is becoming the consensus view. David Romer’s new textbook, which we use in our first-year graduate macro course at Chicago, begins with growth. Romer would call himself a new Keynesian and he is perfectly entitled to call himself that. But his book shows a shift in emphasis towards long-run growth questions. Quite rightly, I think.

So it’s back to the classics and the grand issues of the long run?

Yes. OK [laughter].

What in your view was the stimulus to the new endogenous growth economics? Was it the lack of convergence which people were observing empirically between rich and poor countries, apart from maybe a ‘convergence club’?

No. What is new about the new growth theory is the idea that what we ought to be trying to do is get a single neoclassical model that can account for rich and poor countries alike in the same terms. This contrasts with the view that we had in the 1960s that there was one theory for the advanced countries and some other model was needed for the Third World. The whole presumption in the 1960s was that some explicit policy, perhaps based on the Russian model, was needed to promote development in poor countries.

We didn’t think of economic growth as something that just happened through market forces.

What do you see as being the important policy implications of the work that has been done so far on endogenous growth? Some economists have interpreted the work as suggesting that there is a more positive role for government than, say, was the case with the Solow model.

Yes. An implication of the Solow model was that the long-term growth rate of an economy was dictated by technological change and there wasn’t anything we could do about it. Some of the endogenous growth models have the property that the long-term growth rate is endogenously determined and that changes in the tax structure, for example, can influence what that growth rate is. We can now use these new models to analyse the growth effects of changes in tax policy. That is something we couldn’t do before. But these effects I think are pretty small. Even where you have a model where growth rates can be changed by policy the effects seem to be pretty modest.

What in your view is the reason why the ‘Tiger’ economies of South East Asia have been so successful? While the Tiger economies have been catching up with the West with 8 or 9 per cent growth rates, in Africa the 1980s was almost a completely lost decade as far as economic growth was concerned.

Well, you know Africa has had awful politics.

Do you think African countries generally lack the necessary institutional framework required for successful development?

No. There has been much too much socialist influence. The common feature of countries like Taiwan, Korea and Japan is that they have had some kind of conservative, pro-market, pro-business, economic policies. I mean I wouldn’t exactly call them free trade because Japan and Korea at least are very mercantilist in their trade policies, which I don’t approve of. But it is better than socialism and import substitution by a long, long way.

While they have been outward-looking, some development economists would argue that within many of the South East Asian Tiger economies there has been quite a lot of government intervention. As such they see it as being an example of successful government intervention.

Right. That is how everybody in Japan and Korea sees it [laughter].

You don’t see it that way?

Even Chicago Korean students think that the Korean growth rates have been engineered by government manipulation. I don’t agree with that view. I don’t see any evidence for that at all. But it is hard to refute. There is no question

that governments have been extremely active in doing things that they think promote economic growth.

Economic Policy

In your 1978 AER paper on ‘Unemployment Policy’ you suggested that macroeconomic analysis would make better progress if the concept of involuntary unemployment were abandoned. Many economists, for example Kevin Hoover [1988, 1995c], have criticized you for this and question whether you can regard unemployment as simply voluntary.

There is both an involuntary and a voluntary element in any kind of unemployment. Take anybody who is looking for a job. At the end of the day if they haven’t found one, they are unhappy about it. They did not choose to find one in some sense. Everyone wishes he has better options than he does. But there is also obviously a voluntary element in unemployment when there are all these jobs around. When we are unemployed it is because we think we can do better.

I suppose this is something that bothers Europeans more because aggregate unemployment is much more of an issue in Europe. It doesn’t seem to be as much of an issue in the USA.

It should be.

Many European economies including Germany, France and Italy are currently experiencing unemployment rates in excess of 10 per cent.

Well, if you go into the neighbourhoods within a mile of my university you will find 50 per cent unemployment rates. So it is an issue here too.

The Bank of England is less independent than the German Bundesbank. Do you see that as a possible reason why Britain’s inflation performance has been less successful than that of Germany?

I don’t know, it could be. I don’t feel I have much understanding of the political sources of differences in monetary policy across countries.

Economic policy doesn’t seem to have been guided by new classical theoretical developments in the same way as it has by Keynesianism and monetarism. Why has its impact been less influential in economic policy making?

Why do you say that? We have talked about the increasing focus of central bankers on inflation and the de-emphasis of everybody on fine-tuning. That is an important trend in the last 20 years in the USA and Europe, and to my mind a very healthy one.

Would this not have come about in any case as a result of Friedman’s influence, without rational expectations and equilibrium theorizing?

Maybe.

Have you ever been invited to be an economic adviser in Washington? Is that a role you see for yourself?

No.

You once made a comment [Lucas, 1981c] that ‘as an advice-giving profession we are in way over our heads’. Is that the reason you haven’t considered such a role more seriously?

No. Not at all. I believe economists ought to run everything [laughter].

So did Keynes.

I know. I don’t think I personally have any particular talent or liking for that kind of role. But I am glad that other people like John Taylor or Larry Summers do. For example, I think that the whole reason the Clinton health insurance reform fell on its face was that not enough economists were involved. I like economics and I think economics is hugely relevant on almost any issue of national policy. The more good economists are involved the happier I am. But I don’t personally feel drawn to doing it.

What are your views on European Monetary Union?

Again I don’t know enough about the politics, which has to be central.

Does it make economic sense to you?

Well, it’s an issue in inventory theory. The cost of dealing with multiple currencies is that if you are doing business in Europe you, or people you hire to help you, have to have stocks of inventories of a lot of different currencies because payments are coming due in a lot of different currencies. The inventory cost of holding money is the interest foregone you could have earned by holding interest-bearing assets. If you have a common currency you can consolidate your cash inventories so that there is a saving involved. That is a very modest saving, but it is positive. But obviously multiple currencies are not inconsistent with a huge amount of prosperity. If you can consolidate, all the better, but those purely economic gains are pretty modest. If you don’t trust somebody else to run your monetary policy, maybe you want to oppose monetary union. For myself, I would be happy to turn my monetary policy over to the Germans any day [laughter].