The New Beyond

by: David Warsh

The Worldly Philosophers, Robert Heilbroner's sentimental favorite from 1953, is all very well, but if you want a thorough account of the history of economics and AN explanation of why it changed so dramatically in the years after Heilbroner wrote, there is really only one book to read: A History of Economic Theory, Classic Contributions 1720-1980, by monetary theorist Jürg Niehans, (Johns Hopkins University, 1990). Niehans died, at 87, in 2007.

Niehans' book is slightly more intimidating than Heilbroner's. In keeping with the story that it tells, it has its share of diagrams and equations. Then, too, the author is more than a little pugnacious towards his predecessor. His book, Niehans says, is "not about frustrating struggles between obsolete half-truths and the irrelevant opinions of long-defunct men and women but about the progressive evolution of modern economic theory."

But Niehans, too, describes the lives and times and ideas of what he calls a pantheon - some sixty seminal thinkers, including those who, starting in the late 1930s ushered in the model-building era: Arthur Cecil Pigou, Frank Ramsey, Abba Lerner, Harold Hoteling, and James Meade.

There is just one problem. Niehans' account ends in 1980, just as economics was about to change again. He knew as much. That means his story gives short shrift to the developments in game theory that have produced behavioral economics; and it gives almost no account of the eclipse of Keynesian macroeconomics after 1975 by the movement known as dynamic stochastic general equilibrium (DSGE) macroeconomics, "dynamic," meaning unfolding over time; "stochastic," meaning probabilistically reacting to random events; "general equilibrium," meaning a system, like universal gravitation, in which each consideration depends on all others, not just a few.

The latter gap has now been filled by Michel De Vroey, of the University of Louvain, with A History of Macroeconomics: From Keynes to Lucas and Beyond (Cambridge, 2016). Though intended as a guide for graduate students and young economists, de Vroey's account is exceptionally lucid, if somewhat dry (there is none of the scandal and intrigue that enlivens Niehans' book). It can be read with profit by anyone seriously interested in the technical controversies of the present day. (Warning: it's expensive: $45 for the paperback.)

In a preface, de Vroey gives this summary of the action:

… Keynes' aim in The General Theory was to demonstrate the existence of involuntary unemployment under the assumption that wage rigidity was not responsible for it. The first generation of Keynesian economists, led by John Hicks, Franco Modigliani, and Lawrence Klein admitted, to all intents and purposes that Keynes had failed in his enterprise and argued that involuntary employment was due to wage rigidity. This proposition is the cornerstone of Keynesian macroeconomics, centered on the IS-LM model. In the late 1960s and 1970s {Axel] Leijonhufvud and non-Walrasian equilibrium economists (following Don Patinkin's footsteps), on the one hand, and Edmund Phelps and Milton Friedman on the other, started to question Keynesian macroeconomics, in different ways and for different reasons. Treading in Friedman's and Phelps' footsteps Robert Lucas launched a more radical attack against Keynesian macroeconomics. It led to a new approach, DSGE. macroeconomics. An occurrence that had all the trappings of a Kuhnian revolution, it sealed the fate of Keynesian macroeconomics. However the ascent of the DSGE program did not occur without resistance. Defenders of Keynesian macroeconomics dismissed it on grounds that it amounted [as Richard Lipsey put it] to "replacing messy truth with precise error." Other economists who rallied under the new Keynesian banner tried to rescue some Keynesian insights while espousing the new equilibrium standard Lucas had imposed. The new research program inaugurated came to fruition with the emergence of real business cycle (NYSE:RBC) modeling initiated [in 1982] by Finn Kydland and Edward Prescott. Bringing macroeconomics to the computer, it became the be-all and end-all for the young researchers entering the profession in the mid-1980s. Successive modifications of the inaugural RBC model brought about the realization that a breach had imperceptible occurred and that a distinct new way of pursuing the Lucasian program had emerged. For reasons that will become clear in the course of the book, I call it "second-generation New Keynesian" modeling. Although they are built on the methodological principles of the DSGE program, these models depart from RBC modeling by bringing back a few central Keynesian assumptions and resorting to other empirical techniques than those of RBC modelers. Second-generation New Keynesian modeling was the state of the art in macroeconomics at the onset of the 2008 recession.

There follow 388 pages divided into two parts in which De Vroey carefully enlarges on his summary with decision trees and tables and plenty of explication. Anyone who has gone to college can follow the train of the argument, if they really want to. There are boxes to explain various key innovations: the inter-temporal elasticity of leisure substitution (a big topic in the involuntary vs. voluntary unemployment controversy); the vector auto regression approach; the Solow residual; the Dixit-Stiglitz model of monopolistic competition.

I've just begun the book (although I read the parts that appeared as working papers over the last decade). These are events I've witnessed over the years as a journalist, usually out of the corner of my eye, as I chased the part of the story of macro that De Vroey wasn't able to cover, namely growth theory. Since the financial crisis began a decade ago, I've paid much closer attention to the fluctuations literature, and I see that that background for a few good stories and a great many dissertations contained in A History of Macroeconomics.

Meanwhile, I suspect that Vroey has suffered the same bittersweet fate as did Heilbroner and Niehans: that is, his book ends just as major new excitement begins. Not that there's anything wrong with writing a history that dominates the market for thirty-five or forty years! And DSGE methods are here to stay, thanks partly to the arrival of bulldozer computing. But the approach to business fluctuations that began with RBC and continued with the New Keynesian response, is probably living on borrowed time. Whatever else they may be, expansions and contractions of three economy are something more than statistically described deviations from a theoretically-established trend in gross national product.

All this came to mind as I listened to the discussions at the Thirty-first Annual Conference on Macroeconomics of the National Bureau of Economics last week. Seventy leading macroeconomists from North America and Europe appraising six papers over two days: an evaluation of an experiment in central bankers' "forward guidance"; a discussion of the difference between large and small shocks; a panel of experts on commodity prices; the possibility that what economists take to be business cycles are really just "one thing after another"; a new integrated database of the experience of seventeen advanced nations since 1870, showing a pronounced increase in financialization ("a hockey stick" shape in the graph of the data ) beginning in the last third of the twentieth century; DSGE interrogations of the Greek experience during the crisis; and of the possible benefits of a German stimulus to the peripheral European economies.

The conversations were acute, skeptical, shrewd, playful, but there was no urgency to them - and no hint that, as former Treasury Secretary Lawrence Summers said in his dinner remarks (as a young professor he had been a contributor to the first Macro Annual), the financial crisis and its aftermath today pose the same sort of fundamental challenge to professional economics as had stagflation forty years ago. Stagflation was, of course, the experience in the world itself that precipitated the DSGE revolution.