I, Too, Remember the 1970s

Robert Waldmann writes,

There is a blog discussion among Keynesian to New Keynesian economists on the cause of the new Classical & Rational expectations revolutions. I have been typing my usual comments. I will now try a post. The question is: how important was stagflation in causing the abandonement of old Keynesian models ? I basically agree with Simon Wren-Lewis this time.

On the other hand, Noah Smith writes,

Sure, the old paradigm could explain the 70s, but it didn’t predict it. You can always add some wrinkles after the fact to fit the last Big Thing that happened. When people saw the “Keynsian” economists (a label I’m using for the pre-Lucas aggregate-only modelers) adding what looked like epicycles, they probably did the sensible thing, and narrowed their eyes, and said “Wait sec, you guys are just tacking stuff on to cover up your mistake!” The 70s probably made aggregate-only macro seem like a degenerate research program.

Pointers from Mark Thoma.

Let me try to clear some things up. In some sense, Milton Friedman predicted stagflation in his 1967 Presidential address, but he did not use a New Classical Model. By introducing rational expectations, Lucas produced the New Classical Model.

I want to talk about two stages of “conversion” of mainstream macro. Stage one was the conversion to Milton Friedman’s Presidential Address, delivered in 1967 and published in 1968. Stage two was the conversion from Friedman’s non-rational-expectations version to the New Classical model, which had rational expectations.

Stage one:

–By the mid-1970s, mainstream macro featured a natural rate of unemployment. Before the Great Stagflation, it didn’t.

–By the mid-1970s, mainstream macro featured an equation in which the price level was determined by the money supply. Before the Great Stagflation, it didn’t.

Stage two took over graduate macro without really penetrating freshman macro. It changed from Friedman’s story, which implicitly used backward-looking expectations, to Lucas’ model, which used forward-looking expectations.

In my view, there was no empirical event that drove the stage two conversion. That is, there was nothing that took place in the 1970s that required a rational-expectations explanation. You could predict stagflation just using Friedman’s model with backward-looking expectations. So maybe I am agreeing here with Wren-Lewis rather than with Smith, or maybe I am disagreeing a tad with both.

In my view, what drove stage two was (a) the inconsistency between believing in the paradigm of rational agents and believing in backward-looking expectations and (b) the aura of mathematical superiority that was associated with rational expectations modeling. Honestly, I think that (b) had a lot to do with it.

My macro memoir blames Stan Fischer at MIT for a lot of (b).

2 thoughts on “I, Too, Remember the 1970s

  1. Your post is very interesting, but I confess that I don’t understand what you said. I think you may be abbreviating some of your statements to keep your post relatively short, which is understandable….you’re a busy man. However, I would guess that I am not the only reader who doesn’t comprehend your post. I should add that I am able to comprehend about 99% of your posts.

  2. Thanks for the link. I think that you and Wren-Lewis agree 100%.

    As I noted in the linked post I agree with you two guys 99.9%. Actually I have a tiny bit more of a tiny objection to Wren-Lewis’s post.

    The 0.1% is that I think Friedman’s story (in which backward looking expectations were pretty explicit) is sufficient to explain stagflation in the USA in the 1970 but not necessary. I think the pre-Friedman and contra Friedman Keynesians could fit the facts too.

    [this “comment” has become much too long for a comments thread. The rest is over here http://rjwaldmann.blogspot.com/2014/07/a-comment-on-kling-on-remembering-1970s.html I would tend to recommend against clicking that link as I typed the usual at great length]

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