An excerpt from Chapter 5 of Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.
“I wrote a paper with Andreas Beyer of the ECB where we showed that New Keynesian models are unidentified. The implication of our work is that the parameters of the mainstream NK model are identified by theoretical restrictions and not by data. That may work well as a description of past data. But if the model is wrong, it will not help to predict future data nor is it a good laboratory for conducting policy experiments.”
“… as I have consistently argued since 1993 we should be embracing multiple equilibria as a way of integrating key ideas from the General Theory with General Equilibrium theory. Once you realise that economic fundamentals – technologies, preferences and endowments – are not enough to pin down the equilibrium, you open the door for psychology and sociology to come in and to close an economic model with a theory of beliefs.”
PA: Now I’ll move on to heterodox economics, and I’m looking for your personal opinion and your perception of the environment in which you work. So, what do you personally understand by the term ‘heterodox economics’, and could you give me any examples of groups of economists that you would identify as heterodox?
RF: Well, for anyone in a major university in the UK or the US, ‘heterodox’ is an insult used to put down people who don’t agree with you. For anyone in non-mainstream universities, it’s a badge of honour, a term used to identify the fact that they really are guardians of the truth.
PA: So it’s a very loaded term, then!
RF: I don’t think it’s a very useful term. Let’s take post-Keynesians. I wrote a piece recently – it was called ‘Post Keynesian Dynamic Stochastic General Equilibrium Theory’ (Farmer, 2017) – which was an attempt to unite post-Keynesians and orthodox economists. In that article I pointed out that post-Keynesians kept alive a flame of truth from Keynes’ General Theory that had been lost by the mainstream.
The world moves on, thought moves on, and Keynes would not be a Keynesian today. There were ideas in the General Theory that were kept alive in heterodox circles. The split came in the 1950s with Samuelson, who was a dominant figure on the East Coast of the US, who rejected certain ideas of the General Theory – in particular, a central idea from the General Theory that there are multiple equilibrium unemployment rates. That idea got thrown out, and that’s the point where what we now call New Keynesians and Post Keynesians diverged.
PA: Thank you. I think you’ve accurately covered questions 11, 12 and 13, so I might ask you question 14. Do you consider yourself to be heterodox, firstly, and secondly, do you work in a university department, do you teach undergraduates? What’s your current role?
RF: That’s an interesting question for me, because I always considered myself mainstream but slightly on the edge.
PA: The fact you’re talking to me shows you must be somewhere near the edge, I think!
RF: So, what am I doing? I no longer teach undergraduates, I teach graduate students. I teach two graduate courses at Warwick. I’m also the Research Director at the National Institute of Economic Social Research in London, and as part of that, a bunch of my time is spent running a programme called ‘Rebuilding Macroeconomics’, which is an ESRC funded initiative.
After the financial crisis, the ESRC decided that macroeconomics was broken, but they weren’t sure how to fix it. So, they asked for bids from teams to allocate funds. A group of people – myself and four other people on the management team – won that bid. Whereas initially I thought that I was kind of on the edge, I soon realised otherwise.
The management team consists of me; Angus Armstrong, who’s an economist at NIESR; then we have an anthropologist, Laura Bear, from LSE, a psychologist, David Tuckett, from UCL and a complexity theorist, Doyne Farmer, from Oxford. And once I started interacting with them, I realised that my role was not to map out new territory – it was to ground the project and interactions with mainstream economists. There was a danger the project would move so far from orthodox theory that none of the mainstream economists would listen to what was being said. Having said that, I guess I must be a heterodox economist, because I’m entertaining notions of introducing psychology, sociology, anthropology, and complexity theory into mainstream economics. It’s a fascinating conversation with people from outside the discipline.
PA: That’s great. This one relates to the new consensus macro; however you want to interpret that, and the global financial crisis - do you consider that the GFC gave any evidence to contradict the NCM, the rational expectations, new Keynesian, new classical school of thought?
RF: Yes, I think so.
PA: OK, and how can they get away with it then? How can they remain in this position of ascendency if evidence of the GFC wasn’t what they expected, they were caught by surprise? I think the Queen said, “How come none of you guys saw it coming?” – how do you think they’ve managed to remain on top, all the Nobel Prize winners who’ve still got their status?
RF: Oh goodness, we need to get into the philosophy of science. Max Planck said that ‘science progresses one funeral at a time’. He meant by this that established scientists do not change their minds in the face of contradictory facts. They simply amend their theories. And eventually, established research programmes die out because they fail to attract the best new students.
The New Keynesian paradigm has simply adapted. And to use an idea from the philosopher Imre Lakatos, it’s a degenerative research agenda.[1] It’s amazing – people are taking the models they were using before the Great Recession, and they’ll say, “Well, we’re just missing a piece. We really should have had the financial market in – well, let’s just tack it on!” And now it’s there, they go back, and they say that their model works.
It’s much like Ptolemaic astronomy. When Copernicus came along, Ptolemaic astronomy continued to predict the movement of the planets better than Copernicus, initially, because followers of Copernicus were using circles instead of ellipses in the description of planetary movement. The new Keynesians are doing much the same thing. I wrote a paper with Andreas Beyer of the ECB where we showed that New Keynesian models are unidentified.[2] The implication of our work is that the parameters of the mainstream NK model are identified by theoretical restrictions and not by data. That may work well as a description of past data. But if the model is wrong, it will not help to predict future data nor is it a good laboratory for conducting policy experiments.
PA: How would you describe your relationship with new Keynesianism? You obviously have some aspects in common, like methodological individualism, rational expectations – but from hearing you speak I sense that you’re quite willing to criticise new Keynesianism. If there is such a thing as New Keynesian orthodoxy, you seem to have quite an uneasy relationship with it.
RF: Yes. I use the same methods, but I’m willing to give up on some of the assumptions. The big difference I have with New Keynesians goes back to the split that occurred in 1955 between New Keynesians and Post-Keynesians. In a sense, I am a Post-Keynesian who uses neoclassical methods. But even that description is not quite right because my research has also led me to be critical of Post-Keynesian policy prescriptions. For example, I believe an asset market intervention to support equity prices is a better cure for a big financial contraction than traditional fiscal policies.[3]
Samuelson’s new-classical agenda of combining Keynesian economics with equilibrium theory was a great idea. But he made a huge mistake by assuming that Keynesian economics was about sticky prices. Keynesian economics was never about sticky prices. My own work reconciles Keynes’ General Theory with Walrasian or temporary equilibrium theory in a different way.
There are two principle aspects of the New Keynesian model that I disagree with. Most New Keynesian economists writing before the 2008 financial crisis modelled the labour market as an auction. In an auction model, the labour market is always in equilibrium. The quantity of labour demanded is always equal to the quantity of labour supplied. The real wage and the volume of employment are determined by the intersection of the labour demand and supply curves. That’s not a good assumption for a variety of reasons, not least of which is that it jettisons the concept of involuntary unemployment. Prior to 2008, most New Keynesian economists gave up on unemployment entirely. That was a big mistake.
After the 2008 financial crisis some New Keynesian economists reintroduced unemployment into NK models using search theory. But they are doing it the wrong way. The right way is as ‘Keynesian Search Theory’, a version of search theory originally developed in my own work. This is a way of closing search models that leads to the potential for a continuum of steady state equilibrium unemployment rates. That’s one area where I have a difference with mainstream New Keynesian economists.
My second point of disagreement is with mainstream models of financial markets. Writing in 1972, Lucas threw away all of Keynesian economics and replaced it with Walrasian general equilibrium theory. But he did it in a way that made microeconomic theorists who worked in general equilibrium theory – I have in mind Frank Hahn and Ken Arrow – absolutely horrified. Instead of thinking about an equilibrium as something that the economy was tending towards, for Lucas the market was in equilibrium at all points in time. That was a massive transformation.
Ironically, I think that Lucas’ shift in viewpoint was a useful one. Moving to the ‘Lucasian’ view was the right way to go. But what Lucas knew, but glossed over, is that once you take that route you can no longer pin down equilibrium in terms of economic fundamentals. As I explain in my forthcoming encyclopaedia entry, `The Indeterminacy School in Macroeconomics’ (Farmer, 2020), there are always multiple equilibria in monetary general equilibrium models.
Not only are there multiple dynamic paths, there are also multiple steady states. Lucas was unhappy with me promoting that view argued in my book, The Macroeconomics of Self-Fulfilling Prophecies, and he wrote me a letter at the time saying, ‘why are you doing this?’.[4] For more than forty years, mainstream economists have been trying to purge multiple equilibria from their models. In contrast, as I have consistently argued since 1993 we should be embracing multiple equilibria as a way of integrating key ideas from the General Theory with General Equilibrium theory. Once you realise that economic fundamentals – technologies, preferences and endowments – are not enough to pin down the equilibrium, you open the door for psychology and sociology to come in and to close an economic model with a theory of beliefs. For me, beliefs should be modelled as fundamentals which have the same methodological status as preferences, endowments and technologies. So that, in a nutshell, is where I differ from most mainstream New Keynesian economists.
PA: And if you were to identify yourself with a school of economics, are new Keynesians, with reservations, as close as you would come?
RF: I refuse to be labelled. I’m a ‘Farmerian’!
Stay Tuned for Part 4 on Modern Monetary Theory