The start of any new year is a time to review what is past and ponder what is yet to come. In this contemplative spirit, I recently found myself reflecting on the doctrinal disputes within the economics profession.
In the wake of the twelfth-hour New Year’s Day agreement on the fiscal cliff impasse, the prospects for the global economy look less threatening than they have been for some time. Indeed, while the looming crisis over the U.S. debt ceiling poses potential risks as great as, or greater than, the fiscal cliff, there are, nevertheless, reasons for guarded optimism: the U.S. economic outlook has improved (notwithstanding the fiscal drag embodied in the New Year’s day agreement) given the apparent—albeit long-delayed—recovery in the housing market; the crisis in Europe has (thankfully) stabilized for the time being as a consequence of Mario Draghi’s “put”, although unemployment remains abysmally high with no recovery in sight; and the slowdown in China appears to have bottomed out.
Five years after the onset of the biggest global economic crisis since the Great Depression, however, the cleavages between economists remain as wide—if not wider—as they were before the crisis. Bitter debates are being waged about some pretty fundamental policy issues. These disputes include the appropriate use of fiscal policy as a stabilization tool, the effects of the extraordinary policy measures taken by some key central banks, and most significantly clear differences of opinion of what lessons should be drawn from the crisis in terms of how economists should model the economy. This is hugely important. After all, the policy prescriptions that are offered to policy makers (and which may be adopted) are derived from the underlying model that the economist has used to analyze the economy.
At the risk of creating a caricature, the debate is between two camps. The first includes those economists who use admittedly simple — their opponents would say ‘ad hoc’ (the greatest of all possible academic insults) — models, drawing on the essential insights of Keynesian analysis, namely that rigidities and coordination failures in the economy can lead to sustained economic stagnation; in other words, the kind of situation prevailing today in a good part of the global economy. To generalize, the approach used is “partial” in the sense that the source of these market failures — sticky nominal wages, for example — are assumed and the impacts of disequilibrium on other sectors of the economy are not factored in.
The second camp is the real business cycle school. And, at an even greater risk of distorting the picture, think of this approach in terms of a series of differential equations that describes the evolution of an economy. In these Dynamic Stochastic General Equilibrium (DSGE) models, the economy is always at or moving towards equilibrium, as all wages and prices adjust in response to excess demand pressures reflecting shocks that can be described as stochastic processes. At any given point, equilibrium is uniquely determined by the underlying characteristics of an economy — tastes, technology and endowments of human and physical resources.
This approach is intuitively appealing. After all, economic growth is an inherently dynamic process: deferred consumption today means investment and higher capital tomorrow, which generates higher output and expanded consumption opportunities. One period is linked to the next; all are linked to the past.
And, yet, despite its appeal, this approach is no panacea. The problem is that the theorist’s ability to model the economy using this strategy is limited by computational constraints. The reason for this is simple: Conceptually, the goal is to model the subtle interactions between the markets for all goods and services in an economy, based on the tastes and endowments of all individuals in that economy.
Needless to say, this is a daunting assignment. Modelling an economy — even an artificial economy — made up of a large number of different individuals, each with different abilities and wealth, is an incredibly difficult task. To make the problem tractable, some serious assumptions are required. An assumption or two (such as identical agents) allows a complex problem to be reduced to a far simpler exercise of solving the 'representative agent' problem. Unfortunately, that assumption — made for mathematical tractability — eliminates much of the interesting economics of the real world, which focuses on the consequences of heterogeneous individuals that have access to different information. This is one of the tradeoffs associated with this approach.
Another tradeoff associated with real business cycle models is between the internal consistency of the modeling strategy and its application to policy. In most DSGE models, protracted periods of high unemployment (aka: recessions or depressions) are ruled out. Fluctuations in output reflect positive and negative shocks to productivity; regardless, with flexible wages, the labour market adjusts to “clear” the market and prevent sustained periods of high unemployment. It is, however, difficult to explain the Great Depression or the current “Great Stagnation” in these terms. As the late James Tobin quipped, the Great Depression was not a case of “contagious laziness” that afflicted workers across the globe.
So what does all this say about the state of macroeconomics? Frankly, I’m not sure.
I was fortunate to have endured the trials of graduate training just as real businesses cycle was breaking into course curricula. As a result, while being exposed to the criticisms made by real business cycle, I also had a good grounding in the old fashioned workhorse of Keynesian analysis — the IS, LM model popularized by Sir John Hicks shortly after the publication of Keynes’ General Theory. That training served me well both in assessing the risks preceding the crisis, and in understanding the crisis as it has evolved over the past five years.
In this respect, while the emphasis that real business cycle theory places on long-term growth and the fundamental role, say, of institutions in fostering an environment conducive to the development, adoption and exploitation of innovation cannot be overemphasized, as Keynes noted in his debate with the intellectual forefathers of today’s real business cycle theorists:
"Long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."
To say the least, it is not wholly satisfying that, 80 years after the fact, the wheel of macroeconomics has returned, full circle, to its origins. But there you have it. Surveying the state of the field in his final years, the great, controversial — or perhaps polarizing — economist, Joseph Schumpeter, who, as a young man, announced his ambition to become “the greatest economist in the world, the greatest horseman in Austria, and the best lover in Vienna,” strove to develop a theory that wove together the general equilibrium of Walras with underlying ethical values that are constant, in contrast to tastes, which can change over time. Like Einstein, he failed to develop his unified (unifying) theory. In a sense, DSGE models pick up the challenge. Only time will tell if they succeed; in the interim, the doctrinal disputes in macroeconomics will continue.
And, in closing: of his three youthful ambitions, an older, but equally mischievous Schumpeter admitted to failing in but one.
 This is not, strictly speaking, entirely accurate. There is a class of DSGE models that replicate the dynamics of the post-war cycle by adding “frictions” that slow the market’s response to multiple shocks. See Roger E.A. Farmer, “The Evolution of Endogenous Business Cycles,” National Bureau of Economic Research Working Paper 18284, August 2012.