Morning Must-Read: Paul Krugman’s Take on the History of Macroeconomic Thought

Paul Krugman: Microfoundations and the Parting of the Waters:

Phelps… [made] two observations… nominal shocks had large real effects… [and] with everyone acting rationally, money should have been neutral even in the short run. Traditional Keynesian analyses… [only provided] ex-post rationalizations…. So the Phelps crowd came up with a lovely story…. Individuals and firms couldn’t tell… whether a rise in the price… represented a shock specific to them… or a general change in demand… confusion could explain why short-run aggregate supply seemed upward-sloping…. This meant that the apparent tradeoff between unemployment and inflation would be unstable…. The stagflation of the 70s seemed to confirm this prediction, and brought the microfoundations project immense prestige…. Freshwater economists gleefully proclaimed Keynes dead, the subject of nothing but ‘giggles and whispers’.

But… Phelps-Lucas/type microfoundations quickly collapsed both intellectually and empirically. Intellectually… rational individuals simply should not have been confused in [that] way…. Empirically… slumps last too long…. Microfoundations in macroeconomics… failed utterly at the one thing it was sold, above all, as being able to do…. Time, you might think, to reconsider…. But many… had so committed themselves to the idea that Keynes was dead and rationality roolz that they simply dug in deeper….

Now we have people debating whether models with microfoundations lead to better predictions… [even though] the microfoundations are wrong…. But what you want to realize is that this isn’t going to convince the microfoundations crowd. After all, more than thirty years ago they decided that the joy of microfoundations trumped the utter failure of microfounded models to work… and… have now trained successive cohorts of students in this view. There are, it’s true, some hints of a guilty conscience… the odd tendency of freshwater types to immediately accuse anyone with saltwater ideas of being dishonest. (I’m not a nice guy, but if look at what I said about, say, Cochrane, it was that he was ignorant, not corrupt.)…

The notion that there had been a convergence of views by 2007, which was then ruptured by the crisis, was a saltwater delusion. People like Olivier Blanchard convinced themselves that the other side was listening; it wasn’t. The hysterical reaction to the notion that fiscal policy is effective at the zero lower bound demonstrated that the freshwater types had never bothered to learn…

Paul Krugman: Uber and the Macro Wars:

Wages generally don’t fall in recessions… changes in nominal spending are reflected in real output. (Just as a reminder–this does NOT mean that wage flexibility would improve our current situation–on the contrary, thanks to the overhang of household debt, it would make things worse). The Keynesian attitude… has been that we should try to understand this…. The freshwater view began with an intellectually appealing solution… turned out to be all wrong… [and so] freshwater economists decided to deny the facts instead. Which brings me to Uber’s… surge pricing…. When there’s a snowstorm or something that makes everyone want a car at the same time, prices go way up–sometimes sevenfold. This makes a lot of sense from a rational economic point of view–and it makes people totally furious. It turns out that people are OK with fluctuating prices when it’s really an impersonal market–but they get really angry at any hint that someone with whom they have some sort of ongoing relationship is exploiting their distress….

In the 1990s the economist Truman Bewley… did something novel on the subject of wages, and why they don’t fall in recessions: he went out and asked people. And what he found was that issues of fairness and morale were key. Employers… believed that morale and workplace cooperation would collapse if their employees felt that the company was exploiting a bad economy for its own gain…. Is there a rigorous way to model this kind of behavior? Not yet. Someday, one suppose, we’ll be able to put it all in equations–after all, everything is quantum mechanics in the end. But… this kind of thing really happens… and cannot be derived from the narrow notion of maximization that underlies what passes for “microfounded” macroeconomic models…. Can you live with that reality, and accept the notion that not everything you put in your model has microfoundations? If you can, you’re a saltwater economist, in some sense a Keynesian. If you can’t, you’re part of what has gone wrong…