In Which I Agree in Part and Dissent in Part with Paul Romer's Narrative of the Intellectual Collapse of Chicago-School Macro
Over at Equitable Growth: Paul Romer has a long post that seems to me to get some elements of the story right, some elements of the story wrong, and to miss some elements of the story completely:
What Went Wrong in Macro--Historical Details: "During my time at MIT, Robert Solow was harshly critical...:
...of the new classical macro models pioneered by Robert Lucas, dismissive in a way that seemed to me to skirt uncomfortably close contempt. I recall hearing the same type of criticism from Frank Hahn.... If it sounded like contempt to me, others may have heard it the same way.
At this point, Romer should say what Solow's and Hahn's criticisms were ca. my freshman college year 1978-1979. The argument, as I remember it, went like this: READ MOAR
Lucas dismisses models that said that ,for institutional, behavioral, psychological, and historical reasons outside the model, prices are slow to adjust as ad hoc: he says that the patterns of and reasons for price adjustment durations need to be built in the model.
Lucas proposes models that say that, for no reason at all, prices are slow to adjust because people cannot open the newspaper to read the inflation report.
Lucas's models do not fit the data. The most that can be said of them is that if you stringently restrict the set of allowable tests you might be able to fail to reject them at the 0.05 level if you give them the initial high ground of the null hypothesis.
And, at this point, Romer ought to say that Solow's and Hahn's criticisms were (a) no more biting in their rhetoric than the criticisms that Stigler, Friedman, and company had been inflicting on their victims at Chicago for a generation, and (b) correct and accurate. He ought to say that Lucas, too, eventually said that his proposed mechanism--that "surprises" in the prices they were offered on the market led them to misperceive their real terms-of-trade--simply did not work theoretically. And Romer ought to say that the evidence that Lucas's mechanism simply did not work had emerged even while Romer was still in graduate school:
Monetary Neutrality: "In the models in Lucas (1972) and (1973), trade takes place in competitive markets...:
...though these markets are incomplete, so any real effects of monetary policy need to work through movements in prices. The tests de-scribed in the last paragraph do not use data on prices and so do not test this prediction. Other econometric work that did require money shocks to be transmitted through price movements was much less favorable. Estimates in Sargent (1976) and in Leiderman (1979) indicated that only small fractions of output variability can be accounted for by unexpected price movements. Though the evidence seems to show that monetary surprises have real effects, they do not seem to be transmitted through price surprises, as in Lucas (1972).
And it would be nice if Paul Romer also acknowledged that, in his Nobel lecture, Lucas finally admitted that the bad ad hoc sticky-price assumption was no less microfounded than Lucas's good ad hoc people-cannot-open-the-newspaper-to-read-the-price-level assumption:
One such... described in Lucas (1972)... was based on suppliers’ imperfect information.... Some of... assum[ed] that some nominal prices are set in advance, as in Fischer (1977), Phelps and Taylor (1977), Taylor (1979), or Svensson (1986).... All... offer rationalizations of a short-run monetary non-neutrality.... None of these models deduces the function f from assumptions on technology and preferences alone... [but also from] the specific assumptions one makes about the strategies available to the players, the timing of moves, how information is revealed, and so on. Moreover, these specifics are all, for the sake of tractability, highly unrealistic and stylized: We cannot choose among them on the basis of descriptive realism...
In short, Romer ought, at this point, to say, simply: Solow and Hahn were right. He does not. Instead, he says:
Solow also seemed to be motivated to attack harshly because he was concerned that the type of model Lucas was developing might undermine political support for active countercyclical policy. To his credit, there was a legitimate basis for this concern.... But... in retrospect, if the goal was to maintain support for active macro policy, the better course would have been to take seriously what the rebel group that was forming around Lucas was saying. This might have kept the rebels from cutting off contact with all outsiders...
As Matthew Shapiro has frequently pointed-out, the cutting-off of contact went only one way. Saltwater economists kept on reading, assigning their students, borrowing from, and reacting to New Classical models. Freshwater economists, however, by and large did not assign what became known as New Keynesian work to their students, in large part did not borrow from and react to it, and so we get situations like Robert Lucas in 2009 having absolutely no understanding of what Obstfeld and Rogoff (1996) had taught everyone who had kept up with the literature about fiscal policy.
Once they cut off contact with the outside, these rebels developed a sub-culture that was more like what you’d expect to find among members of a platoon on the battlefield than among scientists parsing logic and weighing evidence. Loyalty and group cohesion took priority, so models that were illogical or inconsistent with the evidence went unchallenged. These values might have developed in any department, but they found support and encouragement at the University of Chicago, which was already committed to Stigler conviction instead of Feynman integrity. As a result, real business cycle models, which were introduced by Prescott and Kydland in 1979, attracted support among the rebels, even though these models did an even worse job of matching the empirical evidence than the model that Lucas first proposed.... assumed away the possibility that monetary policy and inflation could have any interaction with output and employment... decided that econometrics was getting in the way. Word came down from the top that they were abandoning the cutting-edge econometric work that Sargent had specialized in and using calibration in its place....
The alternative to derision would have been for skeptics to embrace and extend. This was what Stan Fischer and Rudi Dornbusch, who were supervising almost all of the Ph.D. students at MIT doing anything related to macro, were quietly doing at this time.... Fischer and Dornbusch trained a cohort of Ph.D. students at MIT who put the tools of modern macro to work and, as Krugman has observed, turned out to be unusually influential...
Perhaps Stan was doing so quietly. Rudi never did anything quietly. Rudi was constitutionally incapable of ever doing anything "quietly". He was the kind of person who would dismiss a paper of Allan Meltzer's in public as "Tobin, plus original errors". In Rudi's view, rational expectations was a superb modeling tool for many problems, a very useful tool that allowed for enormous amounts of simplification while not forcing your conclusions into an unwanted and unwarranted coneptual Prokrustean box for many other problems, and a bonkers stupid assumption in some others. And he made that very clear. In Rudi's view, Lucas's people-cannot-open-the-newspaper assumption was silly, but as long as it was innocuous you should use it because it would help you communicate with more people--yet whenever it turned out not to be innocuous, but to instead be making you say something stupid, you should, of course, drop it immediately.
If Dornbusch and Fischer had set the tone for the response to Lucas and his followers things might have turned out differently...
But they did set the tone! As Romer writes immediately, in the next paragraph:
The rebels... won the battle for mindshare among the next generation of macroeconomists... could have taken credit for killing off the large multi-equation models.... Lucas could have been embraced as a leading contributor to the larger intellectual program launched by Paul Samuelson, the founder of the department [at MIT]... could... have healed the divide that had separated MIT and Chicago... [with] its roots in Stigler’s political agenda...
I think not. I think that the reason for cutting off of communication on the part of Lucas and company was that the MIT contingent refused to accept the policy implications that Lucas and Sargent had derived from their models with the particular ad hocness that they liked. Romer again:
In 1978, when I was hearing the harsh critique from Solow, it is hard to find evidence of a closed-minded intransigence among the people he was criticizing. That mindset did develop soon thereafter and it seems to me that the frustration that would encourage it was already evident. Lucas and Sargent also wrote [in "After Keynesian Macroeconomics", published in 1979, written presumably in 1978]:
Criticism of equilibrium models is simply a reaction to these implications for policy. So wide is (or was) the consensus that the task of macroeconomics is the discovery of the particular monetary and fiscal policies which can eliminate fluctuations by reacting to private sector instability that the assertion that this task either should not, or cannot be performed is regarded as frivolous independently of whatever reasoning and evidence may support it.... To confuse... faith in the existence of efficacious, reactive monetary and fiscal policies with scientific evidence that such policies are known is clearly dangerous, and to use such faith as a criterion for judging the extent to which particular theories “fit the facts” is worse still...
Lucas and Sargent, writing back in 1978 and 1979, are already saying that criticism of "equilibrium models" is neither because they fail to fit the data nor because they are no more grounded in real microfoundations than what they are trying to replace, and are saying that the government "either should not or cannot" pursue policies that attempt to "eliminate fluctuations by reacting to private sector instability".
Ever since then, it seems to me that for Lucas, at least, the most important factor in his judgment of whether a model is worth discussing is whether it leads to that "either should not or cannot" policy conclusion.
I came through this process some seven years behind Paul Romer. I have learned huge amounts from Robert Barro and Thomas Sargent (but I have never interacted with Robert Lucas). But I don't think my different reading of this history is due to my relative youth here.
And what I do want to earn is why Milton Friedman and company weren't able to bring the Chicago Boys back into some contact with reality...