Snowdon & Vane Modern Macroeconomics

pounds or kilos of material. What it means is that we took the finite resources that are available here on earth and just rearranged them in ways that made them more valuable. For example, we now take abundant silicon and we rearrange it into microchips that are much more valuable. So the question is: how much scope is there for us to take the finite amount of mass here on earth and rearrange it in ways that people will find more valuable? Here, you can make a strong case that the potential is virtually unlimited. There is absolutely no reason why we cannot have persistent growth as far into the future as you can imagine. If you implement the right institutions, the type of growth might take a slightly different form from what we anticipated. If carbon dioxide turns out to be a really big problem and we implement institutions which raise the price of carbon emissions, then cars will get smaller. Or we might drive cars somewhat less frequently, or we might rely on video conferencing, instead of driving automobiles, to meet with family and so on. We could shift to much greater reliance on renewable biomass or photovoltaics as a primary source of energy. We have the technology to do this right now. It’s a more expensive way to generate electricity than burning oil and coal, but if income per capita is five to ten times higher 100 years from now, paying a bit more for energy will be a minor issue.

The bottom line is that there are pollution and other environmental problems that we will need to address. But these problems will not stop microchips from getting faster, hard disc storage densities from continuing to get higher, new pharmaceuticals from being introduced, new communications technologies from emerging, new methods for distributing goods like overnight delivery and discount retailing from emerging. All those processes will continue in the rich countries and will spread to the poor countries. In the process, the standards of living will go up for everyone.

In looking at the post-war economic growth performances of Germany and Japan compared to the UK, do you think there is anything in Mancur Olson’s [1982] argument, developed in his book The Rise and Decline of Nations, that societies which have been stable for a long time such as the UK develop organizations for collective action which are harmful to economic efficiency and dynamism?

His conjecture is interesting, but to evaluate it we have to come back to the discussion we had earlier about production possibilities versus preferences. What Mancur tried to do was bring back into the discussion some theory about what is going on inside someone’s head. He wanted to do this so he could understand the political dynamics that influence policy decisions about universities, regulations, rent seeking and so on. Those are important questions both from a development perspective and from a long-run growth perspective for advanced countries like the UK. These are important issues,

other advanced industrial countries. What is your personal interpretation of the findings from this research?

When I talk to students and with people from outside the university, I try to be honest about our ignorance. It is always very tempting for economists to claim more than they know. We do not know what happened with the productivity slowdown in two senses. First, I don’t think we know for sure what the basic facts are. The quality of the data is such that we cannot speak with authority and answer the question about what has happened over time to the rate of growth of productivity. Second, even if there was a slowdown we do not know the reasons with any confidence. In a recent paper with Kevin Murphy and Craig Riddell [Murphy et al., 1998] I have started looking at the labour market evidence which suggests to me that technological change has proceeded at a pretty rapid but steady pace for the last three or four decades, neither slowing down nor speeding up. This calls into question some of the interpretation of the output data that we have, which does suggest that there has been a big slowdown. But all of the inferences here have to be quite tentative. You have to be realistic about what you can expect. It could be that when we get the hard numbers we will conclude that there was a productivity slowdown and we may never completely understand why it happened. I have never claimed that endogenous growth theory is necessarily going to be able to predict or explain precisely all the things that we observe. The economy is a very complicated beast and the goal for us should not be to predict within a few tenths of a percentage point the rate of growth, prospectively or retrospectively. The real test is, does the theory give us some guidance in constructing institutions that will encourage growth? Does it help us understand what kinds of things led to difference between the growth performance of the UK and the USA in the last 100 years? If the theory gives us that kind of guidance, then it has been successful and can help us design policies to improve the quality of people’s lives and that is an extremely important contribution.

Where do you think the direction of research into economic growth is likely to go next or where should it go next?

I have referred a couple of times to the process of crossing the divide from thinking only about the physical opportunities to thinking about what goes on in someone’s head. Once we do that more systematically, we can begin to understand the choices that individuals and societies make about growth. I believe that we already know the policies that would speed up growth in a country like India. What we need to know is why individual and collective decision procedures in India keep them from implementing these policies. This should be the next item on the research agenda.

ing the work of James Meade and Richard Stone (1944) in developing a system of national accounts;

2.the development of, and improvements in, econometric methods (see Hoover, 1995a, 2001a, 2001b);

3.more detailed modelling of the behavioural relationships of consumption (for example Modigliani and Brumberg, 1954; Friedman, 1957), investment (for example Jorgenson, 1963) and the demand for money (for example Baumol, 1952; Tobin, 1958);

4.the construction of macroeconometric models of the economy, for example Klein and Goldberger (1955);

5.the incorporation of the expectations-augmented Phillips curve analysis into macroeconomic models and an examination of the implications for stabilization policy, for example Friedman (1968a);

6.more careful modelling of how expectations are formed, for example Cagan (1956); Muth (1961); and

7.an examination of the implications of rational expectations for the analysis of policy changes, for example Lucas (1976).

This list is far from being exhaustive and merely illustrates a number of important developments and breakthroughs achieved during this period, some of which were recognized by the award of the Nobel Memorial Prize in Economics (see Blaug and Vane, 2003; Vane and Mulhearn, 2004). However, by the end of the 1970s Blanchard argues that ‘too casual a treatment of imperfections’ led to a ‘crisis’ in macroeconomics, which initially resulted in two different routes of enquiry. In the ensuing post-1980 epoch of new exploration one group of economists labelled new Keynesians (see for example Gordon, 1990; Mankiw and Romer, 1991) concentrated their attention on market imperfections in goods, labour and credit markets, and their implications for macroeconomics. Another group referred to as real business cycle theorists (see for example Kydland and Prescott, 1982; Long and Plosser, 1983; Prescott, 1986) adopted new classical methodology and assumptions and initially explored how far equilibrium theorizing could go in explaining aggregate fluctuations without resorting to monetary shocks and without introducing imperfections in their analysis.

In contrast, in his survey Woodford (2000) agues that the ‘degree to which there has been progress over the course of the century is sufficiently far from transparent’ and that macroeconomics ‘has been famously controversial’. Acknowledging that ‘discussions of twentieth-century developments in macroeconomics make frequent references to revolutions and counter revolutions’ (see for example the titles adopted by Klein, 1947; Clower, 1965; Brunner, 1970; Friedman, 1970c; Johnson, 1971; Tobin, 1981; Begg, 1982; Barro, 1984; Tomlinson, 1984; Booth, 1985; Dimand, 1988; Blaug, 1991b), he

traces the development of macroeconomics in historical perspective. Starting from Keynes’s (1936) General Theory he tracks progress in macroeconomics from the Keynesian revolution, the neoclassical synthesis, the Great Inflation and the crisis in Keynesian economics, monetarism, rational expectations and the new classical economics, real business cycle theory to a new neoclassical synthesis. From Woodford’s historical perspective the evolution of economists’ thinking on macroeconomics has been far from smooth.

It should be immediately apparent that the approach we have taken in this book more closely parallels that taken by Woodford. There is no dissent that the birth of modern macroeconomics can be traced back to the publication of Keynes’s (1936) General Theory or that macroeconomics is a ‘quintessentially twentieth-century development’ (Woodford, 2000). Indeed, Blanchard (2000) notes that the term ‘macroeconomic’ does not appear in the economics literature until it formed part of the title of an article by De Wolff which was published in 1941, while the term ‘macroeconomics’ first appeared in the title of an article by Klein published in 1946. The central belief which underpinned the ensuing Keynesian revolution in macroeconomic thought is the need for stabilization, the view that the authorities can, and therefore should use discretionary fiscal and monetary policy to stabilize output and employment at their full employment levels (see Modigliani, 1977). According to Gerrard (1996), a unifying theme in the evolution of modern macroeconomics thereafter has been an ‘ever-evolving classical-Keynesian debate’ involving contributions from various schools of thought that can be differentiated and classified as being orthodox (the orthodox Keynesian and orthodox monetarist schools), new (the new classical, real business cycle and new Keynesian schools) or radical (the Austrian and Post Keynesian schools).

The rise and fall of orthodox Keynesian economics owed a great deal to its problem-solving effectiveness. It appeared to provide a robust explanation of a severe empirical problem, namely mass unemployment, which had persisted long enough not to be easily explained away as a minor anomaly. In addition it offered an attractive political action programme for the resolution of the diagnosed problem. Whilst it contained a number of serious conceptual problems, for example inconsistencies and ambiguities of presentation alongside more radical elements, these were effectively submerged by the neoclassical synthesis process. This synthesis of classical and Keynesian ideas, captured by the IS–LM AD–AS framework, represented the consensus view before the 1970s and was the standard approach to macroeconomic analysis both in textbooks and in professional discussion.

The demise of orthodox Keynesianism was in large part the result of its failure to deal adequately with the major new empirical problem posed by stagflation in the 1970s. Conceptually much of its ‘heuristic power’ had ‘petered out’ and ‘run dry’ (Leijonhufvud, 1968). As Klamer (1984) con-

cedes, ‘the 70s were a decade of retreat, defence, and frustration’ for Keynesian economics. During periods of consensus in macroeconomics divisions among economists naturally become less intense and less visible in the literature. The inherent weaknesses and practical failings of both Keynesianism and economic positivism highlighted in the late 1960s and early 1970s led to the demise of much of the old orthodoxy without its replacement by any single dominant new approach. Any continuing ‘submerged’ competition between rival macroeconomic explanations became more open and pronounced. The revival of much of the ‘old economics’, in a traditional (Austrian) or new form (monetarist, new classical and real business cycle approaches), undermined much of the ‘new economics’ of orthodox Keynesianism, which in turn encouraged the development of new Keynesian accounts. The more radical Post Keynesian interpretation of Keynes’s (1936) General Theory also continues to offer an alternative vision of how the macroeconomic system operates.

Keynesianism was initially faced by a potent rival, monetarism, which was better able to explain the empirical anomaly of stagflation in a more consistent fashion. As we have discussed, in the orthodox monetarist view (and the new classical approach) there is no need for stabilization policy, the authorities can’t, and therefore shouldn’t, attempt to stabilize fluctuations in output and employment through the use of activist aggregate demand management policies. Monetarism, in turn, experienced a period of progress before being faced with problems of its own, not least as noted earlier in Chapter 4 the sharp decline in trend velocity in the 1980s in the USA and elsewhere. The collapse of a stable demand for money function in the early 1980s was to seriously undermine monetarism. During the early 1970s a second counterrevolution took place associated with new classical school which cast further doubt on whether traditional Keynesian aggregate demand management policies can be used to stabilize the economy. While new classical macroeconomics evolved out of the monetarist approach, it in fact provided a sustained challenge to the monetarist as well as the Keynesian orthodoxies. As we have seen, the new classical case against discretionary policy activism and in favour of rules is based on a different set of arguments (most notably the policy ineffectiveness proposition, the Lucas critique and time inconsistency) to those advanced by orthodox monetarists.

New classical macroeconomics displayed important conceptual progress both by nurturing a rational expectations revolution, which was subsequently widely incorporated into the macroeconomic mainstream, and by highlighting the role of aggregate supply. However, important criticisms were increasingly directed at new classical macroeconomics concerning certain conceptual, empirical and policy deficiencies. Its empirical results have been, at best, somewhat mixed and inconclusive. Contrary to its early claims, both

unanticipated and anticipated policy changes appear to affect output and employment, while several economies have experienced real costs of announced disinflation. New classical macroeconomics has certainly left its mark, and both real business cycle theory and new Keynesian economics can be viewed as a response to issues raised by Robert E. Lucas Jr and other prominent new classicists.

During the 1980s a considerable divide emerged between the flexi-price competitive equilibrium real business cycle models and the sticky-price new Keynesian models, where monetary influences are viewed as central to any explanation of the path of real variables in the short run. In the real business cycle approach there is no need for stabilization policy. Furthermore, as monetary factors are irrelevant in explaining such fluctuations, monetary policy can’t be used to influence output and employment even in the short run. In these circumstances governments shouldn’t attempt to reduce fluctuations in output and employment, which are Pareto-efficient responses to shocks to the production function. In contrast, new Keynesians argue that there is a need for stabilization policy as capitalist economies are subjected to shocks from both the demand and supply side of the economy, which cause inefficient fluctuations in output and employment. Furthermore, since governments can improve macroeconomic performance, they should pursue stabilization policy. Although there is no unified view among new Keynesians with respect to the rules versus discretion debate, new Keynesians do not advocate ‘fine-tuning’ the economy, but have instead championed the case for ‘rough-tuning’ in response to large divergences in output and employment from their natural levels. Today the new Keynesian stance can best be characterized as one which supports the case for some kind of constrained discretion in the form of an activist rule, along the lines, for example, of a flexible Taylor-type rule.

As an aside, it is interesting to note that new Keynesian economics could have been named new monetarist economics (Mankiw and Romer, 1991) in that it represents a synthesis of certain key foundations of monetarism and new classical macroeconomics. For example, the new Keynesian school has absorbed what it regards as valid components of the monetarist and new classical counter-revolutions, most notably the natural rate hypothesis and the rational expectations hypothesis. However, responding to the challenge of new classical macroeconomists, the new Keynesian school has provided rigorous microfoundations to explain why markets may fail to clear due to wage and price stickiness. In so doing it has been able to account for involuntary unemployment as an equilibrium phenomenon and provide a rationale to justify interventionist policies to stabilize the economy.

Of course the demise of orthodox Keynesianism also permitted the revival of interest in such non-mainstream accounts as that of the Austrians and the salvaging of Keynes’s fundamental ideas by the Post Keynesians.

In Chapters 4–9 we examined the nature and extent of disagreement within macroeconomics resulting from the dismantling of the Keynesian orthodoxy. Over the decades macroeconomists have largely been engaged in emphasizing their differences rather than their similarities. They have often been more concerned with differentiating their intellectual products in the academic arena alongside a willingness to display conflicts over policy advice in the public arena. In short, there has been a tendency to emphasize uniqueness of identity, which, in turn, has led to both diversity and labelling.

Table 12.1 highlights some of the important features of the schools of macroeconomic thought explored in Chapters 3–9 of this book. The mainstream development of macroeconomics can be read from top to bottom, that is, from orthodox Keynesian to new Keynesian. The Austrian and Post Keynesian approaches represent the most important non-mainstream approaches. Two points should be borne in mind when consulting this table. First, within each school identified, there are differences of opinion and emphasis: the table merely characterizes the view most commonly held on particular issues. Second, as is evident from a close scrutiny of the table, there is a considerable degree of overlap between the various schools on a number of issues. This suggests that, in practice, the dividing line between schools is becoming increasingly blurred on many issues. With the benefit of hindsight, differences between schools have often been exaggerated. Take, for example, the debate between Tobin and Friedman concerning the transmission mechanism of monetary policy. In commenting on the debate Stanley Fischer (1994) suggests that:

you can read Friedman’s and Tobin’s statement of the transmission mechanism and you can’t tell who wrote which. The analogy I use is that when I was a kid I could tell cars apart coming down the road. Then the differences between say a Chev and a Ford were enormous. Now if you look at an old car I know it’s a 1950s model but I don’t have any idea whether it’s a Ford or a Chev because they look practically identical. In that sense the methods and models they used and the issues they looked at were very similar.

Ten years ago in the concluding chapter to our book A Modern Guide to Macroeconomics (Snowdon, Vane and Wynarczyk, 1994), we noted that ‘at the present moment macroeconomics lacks the degree of consensus it once had under orthodox Keynesianism’ and that ‘while there does not appear to be any clearly emerging consensus on the horizon we should not be surprised if a synthesis develops in the future, possibly even from disparate schools’. According to Marvin Goodfriend and Robert King (1997), the intellectual currents of recent years are moving modern macroeconomics towards a ‘New Neoclassical Synthesis’. The new synthesis ‘inherits the spirit of the old in that it combines Keynesian and classical elements’. This can be seen by