Macroeconomics is a child of the Great Depression. Before the publication of Keynes’ book, The General Theory of Employment, Interest and Money, macroeconomics consisted primarily of monetary theory. Economists were preoccupied with price stability, as we are today, but the idea that government should control aggregate economic activity through active fiscal and monetary policy was absent. At the risk of oversimplifying a complex pattern of ideas, I refer to the view of macroeconomics that preceded the publication of the General Theory as classical economics.
Classicals, Keynesians, and Bastard Keynesians
Classical economics saw the economy as self- stabilizing. Writing in 1933, Ragnar Frisch revived a metaphor, first used by Swedish economist Knut Wicksell. The economy is like a rocking horse, hit repeatedly by a child with a club. The child represents random shocks to the economy caused by an array of random events. Frisch called this the “impulse.” The rocking horse represents the behavior of millions of people, interacting in markets. He called this the “propagation mechanism.”
If struck by a club, the rocking horse swings back and forth before it comes to rest. If struck repeatedly and randomly by a club, the horse swings back and forth in an erratic manner with a path that depends on the entire history of blows and on the internal dynamics of the rocker. Almost all economists who model the macroeconomy today accept Frisch’s vision of economic dynamics. Importantly, the propagation mechanism in Frisch’s metaphor is self-stabilizing.
In my book How the Economy Works, I introduced an alternative metaphor designed to capture the essence of Keynesian economics. The economy is like a boat on the ocean with a broken rudder. As the club hits the rocking horse, so the wind blows the boat. In the windy boat metaphor, there is no self- correcting market mechanism to return the boat to a safe harbor. We must rely, instead, on political interventions to maintain full employment. That is the essential insight of Keynes’ General Theory.
After WWII, academic economics sought to reconcile Keynes’ economics with the classical ideas embodied in the microeconomics of the day. During the mid nineteenth century, French economist Léon Walras had developed the microeconomic theory of general equilibrium. During the 1920s, Sir John Hicks was a key player in the development of that theory. In an important book, Value and Capital, Hicks introduced the idea of a temporary equilibrium. He invited us to simplify our view of markets by envisioning a sequence of periods. For Hicks, a period was a week, and each week the people in the economy would come together to trade goods.
In Value and Capital, an auctioneer mediates the market that occurs each week. His job is to ensure no trades take place until all demands and supplies have been equated by market prices. In between weekly market meetings, people carry assets that represent claims to future goods. These assets include money and bonds, and, in modern versions of temporary equilibrium theory, they also include stocks, insurance contracts, and options.
After reading the first draft of Keynes’ General Theory, Hicks became disillusioned with his own theory of temporary equilibrium, which was unable to provide an explanation for the mass unemployment he observed in the United Kingdom in the 1920s and in the United States during the Great Depression. Hicks embraced the Keynesian idea that mass unemployment is caused by insufficient aggregate demand, and he formalized that idea in the IS- LM model.
The program that Hicks initiated was to understand the connection between Keynesian economics and general equilibrium theory. But, it was not a complete theory of the macroeconomy because the IS- LM model does not explain how the price level is set. The IS- LM model determines the unemployment rate, the interest rate, and the real value of GDP, but it has nothing to say about the general level of prices or the rate of inflation of prices from one week to the next.
To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical synthesis in 1955. According to this theory, if unemployment is too high, the money wage will fall as workers compete with each other for existing jobs. Falling wages will be passed through to falling prices as firms compete with each other to sell the goods they produce. In this view of the world, high unemployment is a temporary phenomenon caused by the slow adjustment of money wages and money prices. In Samuelson’s vision, the economy is Keynesian in the short run, when some wages and prices are sticky. It is classical in the long run when all wages and prices have had time to adjust.
Although Samuelson’s neoclassical synthesis was tidy, it did not have much to do with the vision of the General Theory. Keynes envisaged a world of multiple equilibrium unemployment rates where the prevailing rate is selected by the propensity of entrepreneurs to take risks. He called this propensity animal spirits.
In Keynes’ vision, there is no tendency for the economy to self- correct. Left to itself, a market economy may never recover from a depression and the unemployment rate may remain too high forever. In contrast, in Samuelson’s neoclassical synthesis, unemployment causes money wages and prices to fall. As the money wage and the money price fall, aggregate demand rises and full employment is restored, even if government takes no corrective action. By slipping wage and price adjustment into his theory, Samuelson reintroduced classical ideas by the back door— a sleight of hand that did not go unnoticed by Keynes’ contemporaries in Cambridge, England. Famously, Joan Robinson referred to Samuelson’s approach as “bastard Keynesianism.”
The New Keynesian agenda is the child of the neoclassical synthesis and, like the IS- LM model before it, New Keynesian economics inherits the mistakes of the bastard Keynesians. It misses two key Keynesian concepts: (1) there are multiple equilibrium unemployment rates and (2) beliefs are fundamental. My work brings these concepts back to center stage and integrates the Keynes of the General Theory with the microeconomics of general equilibrium theory in a new way.
Macroeconomics at Penn during the 1980s
Not everything I say in my book book is new, and the insights I present are drawn from several different traditions. The school that most influenced my ideas was developing when I was an assistant professor at the University of Pennsylvania during the 1980s. At that time, Costas Azariadis wrote an important paper with the intriguing title of “Self- Fulfilling Prophecies” and David Cass and Karl Shell introduced the term sunspots into economics in a new way. All three authors were writing about the same idea: business cycles might be driven by arbitrary swings in the beliefs of market participants that have nothing to do with the so- called fundamentals of the economy.
Sunspots had been used previously by Stanley Jevons, who thought the sunspot cycle influenced business cycles through the effects of solar flares on agriculture. The modern use of sunspots is different. Cass and Shell used it as a spoof to mean the effect of nonfundamental shocks to business and consumer confidence that influence the economy only because people believe they will.
The idea that confidence matters was not new; it appears in Keynes’s General Theory where Keynes used the term animal spirits to mean the same thing. What was new in the work of Azariadis, and Cass and Shell, was that beliefs matter even in economic models that follow all the dictates of standard microeconomic theory. People are rational, prices are fully flexible, and people know with certainty the probabilities that future prices will be realized.
Shell presented the first work on “sunspots” in Paris in 1977 in a seminar run by legendary French economist Edmond Malinvaud. The idea that confidence can be an independent driver of business cycles in models of this kind was so revolutionary that it was met with disbelief from Malinvaud.
In 1977, Karl Shell and Costas Azariadis were living in West Philadelphia and they would often walk home together from the office. It was on these evening strolls that Karl discussed the sunspot idea with Costas. He, too, was initially skeptical. Azariadis believed the result that “sunspots matter” must be a special case that would not persist in more robust examples of economic models. After investigating dynamic models more carefully, he established that self- fulfilling prophecies are pervasive in models of overlapping generations in which people are born and people die, and he went on to publish a path- breaking paper on the topic.
Initially, the sunspot agenda was dismissed because the models used to convey the idea were technically demanding and did not have much empirical content. That soon changed. Writing with Michael Woodford, who was then an MIT graduate student visiting Penn, Woodford and I showed how to construct a monetary model in which beliefs drive business cycles independently in a version of the model that had been used by Robert Lucas to introduce modern theories of expectations to the profession.
Soon after the publication of the papers by Azariadis and by Cass and Shell, the idea that self- fulfilling prophecies can drive business cycles became mainstream. In coauthored papers with Jess Benhabib of New York University and Jang- Ting Guo of the University of California Riverside, we applied the idea to the model that was, by then, sweeping the profession: the real business cycle (RBC) model of Finn Kydland and Edward C. Prescott. I went on to write a textbook on the topic, The Macroeconomics of Self- Fulfilling Prophecies, which remains to this day a standard reference book and is used in graduate programs around the world.
It was clear to many of us, even back then, that self- fulfilling beliefs could explain business cycle fluctuations at least as well as the real- business- cycle paradigm that came to dominate graduate programs for the next thirty- five years. But, the sunspot agenda did not have a single strong leader and the figures who wrote the first two papers in the area, Azariadis, and Cass and Shell, were dismissive of the practical and empirical relevance of their ideas.
Two Generations of Models in Which Confidence Matters
In a survey paper published in 2014, I distinguished between first- and second- generation endogenous business cycle models. I used the term endogenous business cycle models to mean models in which confidence influences outcomes independently, as opposed to “RBC models,” in which all economic fluctuations are caused by shifts in technology.
In first- generation endogenous business cycle models, the economy retains the self- correcting mechanisms that Frisch described in his rocking- horse metaphor. Confidence shocks do rock the horse, but in this respect they are no different from productivity shocks, strikes, hurricanes, and monetary disturbances. Classical economists like Arthur Pigou, who wrote about business cycles in his 1927 book, Industrial Fluctuations, would not have been surprised by the notion that confidence matters for economic activity. All the work cited in the previous section, including that described in The Macroeconomics of Self- fulfilling Prophecies, falls into this category. These models lead to Pareto- inefficient fluctuations, but the social cost of business cycles is small.
In a more recent book, Expectations, Employment and Prices, published in 2010, I described a second generation of endogenous business cycle models. In these models, confidence does not just rock the horse; it knocks it over. The difference is between models in which the economy can be pushed away temporarily from its steady state and models in which it can be pushed into an entirely different steady state. In the first case, the economy is self- stabilizing and, most of the time, the allocation of resources is “almost” Pareto efficient. In the second case, the stabilization mechanism is broken and the allocation of resources is very far from being Pareto efficient most of the time. In my opinion, the idea that economic equilibrium can be Pareto inefficient, most of the time, is the most important idea to emerge from Keynes’ General Theory.
Reprinted from Prosperity for All by Roger E. A. Farmer with permission from Oxford University Press. Copyright © 2017 by Oxford University Press.