Snowdon & Vane Modern Macroeconomics

In your recent edited volumes of collected papers on new Keynesian economics you say that ‘new Keynesian macroeconomics could just as easily be labelled new monetarist economics’. What exactly did you mean? [See Mankiw and Romer, 1991.]

The challenge raised by the real business cycle school is the question of whether money is neutral and, if not, why not? Twenty years ago when Friedman and Tobin were debating, there were some things they agreed on. They agreed on the proposition that the Federal Reserve was an important player in the economy, that what it did really mattered. The real business cycle school has challenged that by writing down models without any real effects of monetary policy. What the new Keynesian models have tried to do is establish why money is not neutral, what microeconomic imperfections are necessary to explain monetary non-neutrality at the macro level. In this sense, these models are trying to support both traditional Keynesian and monetarist views.

Would you agree with Stanley Fischer that the views of Friedman, Brunner and Meltzer are closer to those of Keynesians than they are to equilibrium business cycle theorists? [See Fischer, 1988.]

Oh yes absolutely. The essence of real business cycle models is the absence of any role for the Federal Reserve, whereas I think Brunner, Meltzer and Friedman would agree with Tobin that the Fed is very important. None of them would ever argue that money is neutral in the way that real business cycle theorists have.

James Tobin has suggested that good papers in economics contain surprises. What surprises have new Keynesian papers uncovered? [See Tobin, 1988.]

One of the big surprises is that one can go much further with menu cost models than people had once thought. A lot of people used to see these models as a silly way of thinking about price rigidity. What the new literature is trying to do is to say no, maybe we should take menu cost models seriously. I think the complementarity between real and nominal rigidities is a surprise. As I mentioned earlier, one of the disappointing features so far of the new Keynesian literature is that it hasn’t been as empirical as I would have liked. That is a problem being remedied right now in some research. Ultimately that is where the literature should go. More empirical work is needed.

Peter Howitt has talked about a Keynesian recovery, Alan Blinder about a Keynesian restoration; you seem to prefer the term reincarnation. Is there something important in the different terms used? [See Howitt, 1990; Blinder, 1992b and Mankiw, 1992.]

I chose the term reincarnation because it means rebirth into another body. While there are many similarities between new and old Keynesian economics, there are also a lot of differences as well, and I wanted to emphasize that. In some senses the spirit of Keynes has been brought back, but it doesn’t look like the old Keynes. In fact Keynes might not recognize the new Keynesians as Keynesians at all. In general, people might not recognize themselves after they have been reincarnated. So that is why I used the term reincarnation [laughter].

Would you say that your work is, with respect to Keynes, faithful in spirit, but critical in detail?

I think that is fair. It tries to go beyond Keynes in a sense of taking microfoundations more seriously. Alan Blinder wrote a paper ‘Keynes after Lucas’ and I think that title pretty much describes new Keynesians. It takes some of Keynes’s ideas seriously, and it also takes some of the critiques of Lucas seriously as well. [See Blinder, 1986.]

Do you think Keynes would have been a new Keynesian?

I don’t know; I think Keynes was a very unpredictable fellow. I guess he would see some things in it he would like, and some things in it he wouldn’t.

Real Business Cycle Theory

You’ve recently argued that real business cycle theory has served an important function in stimulating and provoking scientific debate, but you predict that the approach will eventually be discarded. What are your main objections to real business cycle theory? What are the weaknesses, theoretical, empirical, or both?

My objections are mainly empirical. Theoretically they are very elegant models, and that is a large part of their appeal. They are very parsimonious models. But when I look at the real world I see the same things that Milton Friedman and James Tobin do, which is a very powerful Federal Reserve board in the USA or the Bank of England in the UK. There is a lot of evidence across countries that periods of disinflation are periods of low output and high unemployment. Those effects are completely absent in real business cycle models. I think the central driving forces for the business cycle that those models highlight – technology shocks – aren’t very important.

Isn’t the procyclical behaviour of the real wage a strong feature of these theories? How do new Keynesians explain the movement of real wages over the business cycle?

The theories do predict procyclical wages. Although I’ve not looked at the models carefully on this question, my understanding is that they predict very

procyclical, real wages. While it is true that real wages are procyclical, my reading of the evidence is that they are only mildly procyclical. Therefore, the fact that these theories predict very procyclical real wages, and the data show that they are only mildly procyclical, makes it hard to reconcile this model with the evidence. I think the real wage evidence is not hard to explain. If you believe in a world where wages and prices are sluggish over time, the cyclical behaviour of the real wage is really a question of whether wages or prices are more sluggish. The fact that real wages are roughly acyclical, maybe slightly procyclical, is some indication to me that wages and prices are simply equally sticky. This is consistent with Alan Blinder’s evidence, which says that prices change on average once a year, and we know a lot of wages change on average once a year. So I think that explanation is consistent with much of the evidence.

How do we explain procyclical productivity? Some Keynesians seem to suggest that it is due to labour hoarding.

The procyclical behaviour of productivity is a puzzle for people who don’t believe in technology shocks. The traditional explanation for why productivity is procyclical is labour hoarding. In recessions firms keep on workers they don’t really need so that they can have the workers still available when the next boom comes, and that tends to give the appearance of procyclical productivity. These theories make a lot of sense to me. I know I work my secretary harder when I have more work to be done; therefore her productivity is procyclical. I know I work harder when there is more work to be done [laughter]. I think there is a great deal of casual evidence that labour hoarding and procyclical effort are important.

Macroeconomic Policy

One of the central ideas of Keynesian economics is that an increase in aggregate demand will stimulate the economy. Under what circumstances do you think a government should actually stimulate demand?

There are a couple of questions. First, when should it act? Second, how should it act? That is, should it use monetary or fiscal policy? On the first question, one should stimulate aggregate demand when it is too low to maintain full employment – that is, when you observe very high unemployment or when there is reason to believe that unemployment is going to rise. The policy implications of many new Keynesian theories really go back to the policy implications of the neoclassical synthesis of the 1960s. Some of the limitations on policy that were then debated are still relevant today. Even if you accept everything that new Keynesians say about prices being sluggish and so on, there is still the question of how good the government is at

responding in a timely fashion to the shocks. In that debate, I side to a large extent with Milton Friedman. The government is very bad at recognizing shocks in a timely fashion, and when they do respond to shocks they often do so quite late and counterproductively. So while I see the business cycle as a sign of market failure, I also think that it is a kind of market failure that a government is very limited in its ability to fix. If we have a very deep persistent recession, certainly something along the lines of the Great Depression, there is room for the government to do something. For the relatively minor wiggles that we have experienced in the post-war economy, it is not clear that the government can do much better than it has.

Do you think Keynes was politically naive in thinking that politicians would be advised by technocrats and take the correct action? We are thinking here of the public choice literature and the political business cycle literature. Can we actually trust politicians once they have their hands on the fiscal and monetary levers to use them in the right way?

I think that this is a serious concern, but there are many ways of fixing that problem. For example, there is a large literature showing that countries with more independent central banks have lower inflation on average. With less independence in the central bank, there is more political pressure and therefore a greater possibility of following a policy of inflating too much. There are ways around the political problem, like making independent central banks, which to some extent are staffed by technocrats. For that reason an independent central bank would be better at fine-tuning the economy, to the extent we fine-tune it at all, compared to fiscal policy which is always run by politicians.

You’ve said that the literature on time inconsistency has provided a persuasive case for a commitment to some sort of rule for monetary policy; do you also support fiscal rules?

Fiscal rules have to be well crafted. A balanced budget amendment that is too strict could be a disaster. At certain times, like recessions and wars, it is appropriate to run budget deficits. So any fiscal rule has to take into account those special situations where budget deficits are the appropriate policy response. A fiscal rule by itself wouldn’t be a bad idea, but it has to be well crafted and so far I haven’t seen one that is.

Isn’t one of the problems with devising rules that if the economy is hit by an unforeseen shock, then the government has to renege on that rule and take some discretionary action? It is difficult to think of a rule which really would be binding?

There are two parts to the question. First, how might you make the rule binding? Second, do you want to make the rule binding? One way to make

the rule binding is reputational. Many rules are rules just because long tradition has established them as rules and people don’t want to break the tradition. Another more legalistic way of imposing rules is by writing them into the constitution. I think the harder question you raise is do you want to make rules binding? The question is whether you can write a rule that works well even in response to unforeseen events. If it becomes too costly to be tied by the rule, people will stop abiding by it. What we want to do is write down a rule that will be good in response to normal kinds of shocks. That is, you don’t know what the shocks are going to be, but you know what kind of shocks are possible. You’ve got oil shocks, monetary demand shocks and so on. You write down a rule that is good in response to the kind of shocks you expect the economy to experience, based on the shocks experienced in the past. Therefore, unless something completely unforeseeable happens, you stick by the rule.

Leijonhufvud once argued that the economy can be thought of as travelling along a corridor. As long as it stays in the corridor, leave it alone, but if it gets out of the corridor into a severe recession, that is the time for intervention. Is that what you are saying? [See Leijonhufvud, 1981.]

Well no, because recessions are reasonably foreseeable. Although you don’t know when a recession is going to occur, you know that one will occur eventually. A recession is one of the contingencies that you want your rule to deal with. So I don’t think a recession per se is one of those extraordinary events that make you want to break the rule. A recession is something you can plan for in advance. I’m talking about an event that not only can you not predict when it is going to happen, but you have never even thought that it might happen. For example, before 1973 people never imagined an OPEC supply shock. The whole idea of OPEC never even crossed anybody’s mind. This is the type of situation where you might want to rethink the rule. Now that we know what OPEC is capable of, we can write down a rule that takes this into account.

What is the role of fiscal policy in new Keynesian macroeconomics?

To a large extent new Keynesian economics has been about the theory of aggregate supply and why it is that prices adjust slowly. It has been relatively neutral on the question of what determines aggregate demand, in particular whether monetary or fiscal levers are most useful. As I mentioned a moment ago, I am sceptical personally about the usefulness of fiscal policy in finetuning the economy because, at least in the USA, the Congress acts very slowly. Even as we are doing this interview [18 February 1993] the Congress is debating a fiscal stimulus, even though the recovery has been going on for about a year now. By the time this fiscal stimulus actually has an effect on the

economy, my guess is that we will be pretty close to the natural rate again. This is a perfect example of how the lags can be very long in fiscal policy. Monetary policy is a more useful tool for stabilizing aggregate demand.

Do budget deficits matter?

I think they matter a lot. The way they matter is not for short-run macroeconomic reasons but for long-run reasons – reasons that are best described not by Keynesian models but by growth models. The evidence as I see it is that large budget deficits reduce national saving. And the lesson from growth theory and growth experience across countries is that low saving leads to low growth. That is a big problem for the USA today.

If you were advising President Clinton about macroeconomic policy for the next three or four years, what would be the kinds of policies you feel are necessary?

My reaction to President Clinton’s speech [17 February 1993] is that I don’t think we need the fiscal stimulus that he is proposing. Recovery is already on its way. It wasn’t a very deep recession to start off with, so I’m not terribly shocked that there is a mild recovery. It will take the fiscal stimulus a while to get people employed. I am happy that he is worried about the budget deficit, as low national saving is an important macro problem in the long term in the USA. Yet I am disappointed that he is putting so much emphasis on tax increases rather than spending cuts. That is really a view not so much about macroeconomics as about the size of government. I am also disappointed that he is giving no attention to the low rate of private saving in the USA. I would recommend tax reforms to remove the present disincentives toward saving. So I give him a mixed review.

Current and Future Progress in Macroeconomics

Much research in the 1980s, your own included, was directed at providing more rigorous microeconomic foundations for the central elements of Keynesian economics. Taking an overview of the last decade, how successful do you think that research has been in providing a more substantial microfoundation for Keynesian economics?

It has been successful at the theoretical level in the sense that one can now say that Keynesian economics, the economics of wage and price rigidities, is well founded on microeconomic models. There are now several microeconomic models that people can pull off the shelf. The theoretical challenge of Lucas and his followers has been met. It is less clear whether this line of research is going to be successful as an empirical matter. That is, to what extent does it yield new insights to help understand actual economic fluctuations? Does it

give us new ways to look at data and policies? The jury is still out on that one. There is a small empirical literature, but I can probably count the number of empirical papers on the fingers of two hands. I hope it is a growth area, but so far the literature has not been as empirically orientated as I would like.

Do you think there is some truth to the view that at the moment we have too many theories?

Yes, I have a lot of sympathy with that view. There is too big a premium for coming up with clever theories in the profession. Yet I don’t know of any way to solve this problem. Obviously I believe the things I believe, and I can’t tell people that they should believe what I believe, just because there are too many theories [laughter]. It would be nice if macroeconomists reached a consensus and they could do more work on details and less work on creating brand new theories of the business cycle. Until we reach a consensus, there is no way to enforce that by fiat.

Do you see any signs of an emerging consensus in macroeconomics?

That is a good question. I change my mind on that a lot, depending on what conference I go to [laughter]. There are certainly groups within the profession that are agreeing with each other. There is much agreement among new Keynesian people like Olivier Blanchard, Larry Ball, David Romer, George Akerlof, Alan Blinder and so on. Whether we as a group are coming to agreement with some of the real business cycle group is hard to say. I’m delighted that some of the people who previously worked closely with the real business cycle models are now trying to incorporate monetary effects into those models. That provides a hope that somewhere down the line the new Keynesian models and the real business cycle models are going to merge to some grand synthesis that incorporates the strengths of both approaches. That hasn’t happened yet; that is just a hope.

Additional Questions Answered by Correspondence: February/March 1988

When we last talked with you in February 1993 you were somewhat hopeful that ‘somewhere down the line the new Keynesian models and the real business cycle models are going to merge to some grand synthesis that incorporates the strengths of both approaches’. Have developments in macroeconomic research during the last five years moved in the direction of more consensus, as you had hoped?

To some extent, yes. Increasingly, there are economists (such as Bob King, Julio Rotemberg and Mike Woodford) trying to integrate the insights of the

new Keynesian and real business cycle literatures. Not surprisingly, this raises a host of difficult technical issues. We have long known that dynamic sticky price models are hard to solve except in some special cases. But some progress has been made.

Your new Principles of Economics textbook [Mankiw, 1997] has generated a great deal of interest and comment. For example, in his Wall Street Journal review of your book [October 1997] Mark Skousen interprets your overall message to be that ‘classical economics is now the “general theory” and Keynesian economics to be the “special” case’. Skousen also writes that ‘virtually the entire book is devoted to classical economics leaving the Keynesian model as an afterthought in the end chapters’. Is this an accurate view of the balance of the book and your own current position?

I have been delighted about the response to my new textbook. Some of the commentary, such as the Skousen op-ed piece in the Wall Street Journal exaggerated what my book does, and the Journal published a letter I wrote responding to that article. In the book, I try to present a balance between Keynesian and classical ideas. The Keynesian analysis is developed over three full chapters, which explain and apply the model of aggregate demand and aggregate supply. That is perhaps less coverage than in many traditional texts, but in no sense is Keynesian economics treated as a mere ‘afterthought’. I begin with classical ideas – including long-run growth, the quantity theory of money and so on – but by the end of the book the student is fully acquainted with the importance and role of Keynesian theory.

In our previous interview you commented that the ‘natural rate hypothesis is pretty well entrenched’ and that ‘most new Keynesians believe in the natural rate hypothesis’. How do you account for the remarkably low combination of inflation and unemployment currently being experienced in the US economy?

It seems increasingly clear that the natural rate of unemployment has fallen in the USA. At one level, that is not terribly shocking, since in principle there is no reason to think the natural rate must be constant. Various changes in the labour market can alter the natural rate. But I have not yet seen a good explanation of the decline, which is somewhat troubling. Some people might react by rejecting the whole natural rate framework, but I am not ready to do so. In part, I remain committed to the natural rate model because I have not seen a good alternative to it.

Your research interests in recent years have been more focused on economic growth than the short-run issues of aggregate fluctuations. Unlike Paul Romer and other endogenous growth theorists, you provide a spirited defence of a modified Solow model in your [1995] ‘Growth of Nations’ paper. What is

450 Modern macroeconomics

your assessment of the progress that has been made in this burgeoning research area?

The growth literature has been a very positive development for the economics profession. After all, long-run growth is at least as important for human welfare as the business cycle, so it’s great that the issue is being studied seriously again. In my new principles textbook, as well as in my intermediate macro text, I introduce the topic of long-run growth quite early. This is in large part a reflection of the research trend started by Paul Romer and others.

On the question of what progress has been made, I remain somewhat ambivalent. There are now many theoretical models of growth and more empirical studies than we have data points. Yet it is hard to find important questions that we can now answer with confidence that we couldn’t answer before. Adam Smith once said that ‘little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and tolerable administration of justice’. That still seems like the best policy advice. In that sense, we haven’t made much progress in 200 years. On the other hand, perhaps we better understand why Smith’s instincts were right ones, and that is progress.

What are the main differences between your view of technological progress and Paul Romer’s?

I don’t disagree with Paul Romer about technological progress. It comes mainly from the creation of ideas that are largely but not completely public goods. Both of us would agree that this explains why most nations are richer than they were a century ago.

Where Romer and I seem to disagree is whether this old insight is important for understanding cross-country differences. I have argued that much of the international variation in living standards can be explained by the differences in the quantities of human and physical capital. As I understand Paul Romer’s view, he is sceptical of this possibility. He argues that differences in knowledge across countries are important; in essence, he claims that different countries have access to different sets of blueprints. One problem in testing these two theories is that physical capital and human capital (schooling) can be measured and evaluated, which is what I tried to do in my [1992] Quarterly Journal of Economics paper with David Romer and David Weil, while the ‘ideas’ that Paul Romer emphasizes are harder to measure. I am sure that there is some truth in both the ‘capital view’ and the ‘ideas view’ and that other things – trade policy, property rights and so on – matter as well. The relative importance of these different factors is ultimately an empirical question that is very hard to answer conclusively.