Lucas and Sargent Revisited

The economics blogosphere has a big discussion going on over Bob Lucas and Tom Sargent's classic "After Keynesian Macroeconomics." You can start at Simon Wren-Lewis, Mark Thoma here and here and work back through the links.

A few thoughts here, as it bears on my WSJ oped from last week and my last post on EFG and how we do macro.

1. Views of Keynesian economics

Re-reading this paper, you will be struck about how much Lucas and Sargent praise Keynesian models, which you'd think it is their purpose to destroy.

They called the Keynesian revolution a "remarkable intellectual event." they continued

... some of its [Keynesian Revolution] most important features: the evolution of macroeconomics into a quantitative, scientific discipline, the development of explicit statistical descriptions of economic behavior, the increasing reliance of government officials on technical economic expertise, and the introduction of the use of mathematical control theory to manage an economy. 

Keynesian theory evolved from a disconnected, qualitative talk about economic activity into a system of equations that can be compared to data in a systematic way and which provides an operational guide in the necessarily quantitative task of formulating monetary and fiscal policy. 

neither the success of the Keynesisan Revolution nor its eventual failure can be understood at the purely verbal level at which Keynes himself wrote...

The Keynesian economics they are praising here is not Keynes' book -- one of those big muddy things that people are still writing "what did Keynes really mean" articles and books about nearly a century later -- but the subsequent quantification effort: Hick's creation of the ISLM model, its elaboration into computer models, estimation of those models, and the use of those models to make quantitative forecasts of the effects of policy interventions.

"Quantitative, scientific discipline," and "technical economic expertise" means we analyze policies by real models, not the opinions and judgments of famous economists turned public officials.

Yes, "mathematical control theory." Most readers will be too young to remember, but in the early 1970s academic journals were dynamic optimal control applied to simulations of large-scale Keynesian models.

Their goal was quite conservative: they wanted to preserve this great achievement:

The objectives of equilibrium business cycle theory are taken, without modification, from the goal which motivated the construction of the Keynesian macroeconometric models: to provide a scientifically based means of assessing, quantitatively, the likely effects of alternative economic policies. 

2. What was their basic criticism of Keynesian economics?

Lucas and Sargent make a two-pronged argument, one about theoretical coherence and the other about the grand econometric failure of Keynesian models.

As I see it, the main characteristic of "equilibrium" models Lucas and Sargent inaugurated is that they put people, time, and economics into macro.

Keynesian models model aggregates. Consumption depends on income. Investment depends on interest rates. Labor supply and demand depend on wages. Money demand depends on income and interest rates. "Consumption" and "investment" and so forth are the fundamental objects to be modeled.

"Equilibrium" models (using Lucas and Sargent's word) model people and technology. People make simultaneous decisions across multiple goods, constrained by budget constraints -- if you consume more and save more, you must work more, or hold less money.  Firms  make decisions across multiple goods constrained by technology.

Putting people and their simultaneous decisions back to the center of the model generates Lucas and Sargent's main econometric conclusion -- Sims' "incredible" identifying restrictions. When people simultaneously decide consumption, saving, labor supply, then the variables describing each must spill over in to the other. There is no reason for leaving (say) wages out of the consumption equation. But the only thing distinguishing one equation from another is which variables get left out.

People make decisions thinking about the future. I think "static" vs. "intertemporal" are good words to use.  That observation goes back to Friedman: consumption depends on permanent income, including expected future income, not today's income. Decisions today are inevitably tied to expectations --rational or not -- about the future.

The lack of budget constraint (or the "missing equation" and "Walras' law" issues much studied in earlier Keynesian literature) strikes me as another big conceptual and methodological difference between Keynesian models and equilibrium models, which flows from putting people rather than aggregates at the center of analysis.

Notice when you read any textbook that the microeconomic "demand" suddenly becomes the macroeconomic "plan." Why is that? Because demand curves respect budget constraints even at off-equilibrium prices. "Plans" like consumption equals c bar plus alpha times income do not respect any stated budget constraint.  You're allowed to say you want to consume and save more than income allows.

Optimization, rational expectations, and flexible prices are the ballyhooed centerpieces of the first round of equilibrium models to follow Lucas and Sargent, such as Kydland and Prescott's famous "time to build" model and the subsequent "real business cycle" models (examples: Bob King and Sergio Rebelo, John Long and Charles Plosser). But I don't think these ingredients are central to the program. The "new-Keynesian" (or, better, DSGE) school put in sticky prices with all the other Lucas-Sargent ingredients, and thus under the "equilibrium" banner.  Mike Woodford's "Interest and prices" is aimed proudly at that program. Sticky wages, distortions, and so on are just as  often included.

Simon Wren-Lewis questions  whether Lucas and Sargent were really focusing on empirical failure or methodological critique. He suggested that accelerationist Phillips curves, though adapted after the failure and thus appearing a bit as epicycles, can account for the data. (Lucas and Sargent: "In economics as in other sciences,...there is always the hope that if a particular specific models fails one can find a more successful model based on roughly the same ideas.")

I think Simon is a bit too blasé about how easy this modification is. Not only did inflation accelerate far faster than Keyensian models of the 1960s predicted, inflation dropped like a stone in 1982, far faster than  Keynesians thought possible based on adaptive expectations views. (If someone can find the quote from Samuelson in the early 1980s predicting decades of depression to wring out inflation, please add to the comments.) Proud as some self-identified Keynesians are about how well they think their unwritten, unquantified "model" fits the current recession, deep unemployment with no movement in inflation fits no Phillips curve that was actually written before the crisis. Infinite wage stickiness is an ex-post invention too, and still just a verbal debating point.

But the paper is really clear that empirical failure matters deeply to Lucas and Sargent. They said that

A key element in all Keynesian models is a trade-off between inflation and real output: the higher is the inflation rate, the higher is output (or equivalently, the lower is the rate of unemployment). For example, the models of the late 1960s predicted a sustained U.S. unemployment rate as consistent with a 4 percent annual rate of inflation. Based on this prediction, many economists at that time urged a deliberate policy of inflation. [plus ça change...]... policy in this period should, according to all of these models, have produced the lowest average unemployment rates for any decade since the 1940s. In fact, as we know, they produced the highest unemployment rates since the 1930s. This was econometric failure on a grand scale. [My emphasis]

Here as elsewhere, they said "econometric," not economic. They meant it.

Everyone was perfectly aware of the lack of "microfoundations" of Keynesian models, and the 50 year fruitless search for such foundations. But so long as the models worked, that had no real impact on their use for the "scientific" and technical policy advice Lucas and Sargent so admired.

And rightly so. Chemistry, until the last few decades, lacked "microfoundations" in quantum mechanics, first because nobody knew quantum mechanics, and later because working out how chemicals react from first principles was too hard. That did not stop chemistry from being a perfectly viable science. Biology, until the last few decades, lacked "microfoundations" in chemistry.

But chemistry and biology worked pretty well. Lucas and Sargent pointed to, and needed to point to, a grand empirical failure.

And that failure had to be accompanied not just by "well, these are reasonable rules, but they're not microfounded." The failure had to be accompanied by showing how the Keyensian model was logically flawed. That failure had to be accompanied by a better theory, which showed why the Keynesian equations were inconsistent with basic economics. That better theory had already predicted Keynesian model's  failure -- Friedman 1968, Phelps, and Lucas' prediction that the Phillips curve would shift if exploited. That is a lot more than "methodological purity."

3. So what happened?

As I survey the landscape now, it is interesting how much of the macroeconomics Lucas and Sargent praised has vanished. Quantitative, scientific discipline? Explicit statistical descriptions of economic behavior? Reliance of government officials on technical economic expertise?  The use of mathematical control theory to manage an economy? All that has vanished.

The sub-basements of central banks have big DSGE models, or combined models where you can turn Lucas and Sargent on and off. But I think it's fair to say nobody takes the results very seriously. Policy -- our stimulus, for example -- is based on back of the envelope multipliers and the authority and expertise, if you're charitable, or the unvarnished, verbal, opinions if you're not, of administration officials.

There are some large-scale empirical DSGE models left in academia too. But the vast bulk of policy analysis does not use them, as they did, say, the models of 1972. At conferences and in papers, academic work uses small scale toy models and a lot of words. Models do not seem to be cumulative. Each paper adds a little twist ignoring all the previous little twists.

A complete split occurred. "Equilibrium" models, in which I include new-Keynesian DSGE models, took over academia. The policy world stuck with simple ISLM logic -- not "models" in the quantitative scientific tradition Lucas and Sargent praised -- despite Lucas and Sargent's devastating criticism.   And, as I remarked in the earlier blog posts, the "purely verbal" or literary style of analysis is becoming more and more common now in academia as well as policy.

I'm not complaining about good vs. bad here. I write simpler and simpler models as I grow older, and spend more time thinking and writing about what those equations mean. It just is a fact about how we do things today and the "scientific," quantitative status of macroeconomics.

Lucas and Sargent's last sentence:

Unless the now evident limits of these models are also frankly acknowledged and radically different new directions taken, the real accomplishments of the Keynesian Revolution will be lost as surely as those we know to be illusory. 

Academic economics took the first half to hart. Policy economics froze in place. But Lucas and Sargent's "real accomplishments" were lost, or at least consciously abandoned, anyway.

PS: Lucas and Sargent have a delicious quote about Keynesian's loss of faith in their own model, as applicable now as then:

The current wave of protectionist sentiment directed at "saving jobs" would have been answered ten years ago with the Keynesian counterargument that fiscal policy can achieve the same end but more efficiently. Today, of course, no one would take this response seriously, so it is not offered. Indeed, economists who ten years ago championed Keynesian fiscal policy as an alternative to inefficient direct controls increasingly favor such controls as supplements to Keynesian policy.