The first, and arguably the last, government to adopt New Classical economics as the basis of macroeconomic policy was that of Margaret Thatcher in the United Kingdom. Thatcher took office after a decade of high inflation, and at a time when the framework of monetary policy was based on Friedman’s ‘monetarist’ model, in which inflation was determined, in the long run, by the rate of growth of the money supply. The standard policy prescription was to reduce the rate of growth of money supply, and therefore the rate of inflation gradually over time. This prescription required governments to accept a rate of unemployment above the NAIRU (the rate at which inflation would neither accelerate nor decelerate) for a long period: as it turned out, a decade or more in many cases.
The New Classical school offered a short cut. Provided that governments announced in advance that they would reduce the growth of the money supply to a rate consistent with low inflation, and made credible commitments not to back down, businesses and workers would rationally adjust their expectations and inflation would fall quickly, without the need for a long period of high unemployment. The paradox that, according to the model, a willingness to endure economic pain would render such endurance unnecessary was pointed out by critics at the time. But a taste for paradoxical reasoning is common among economists; to the point where it is a job requirement in such circles.
The only requirement for the New Classical prescription to work was the credibility of the government’s commitment. Thatcher had credible commitment in bucketloads: indeed, even more than an ideological commitment to free-market ideas, credible commitment was the defining feature of her approach to politics. Aphorisms like “The lady’s not for turning” and “There is no alternative” (which produced the acronymic nickname) TINA were characteristic of Thatcher’s “conviction” politics. The slogan “No U-turns” could be regarded as independent of the particular direction in which she was driving. In a real sense, Thatcher’s ultimate political commitment was to commitment itself.
So, if New Classical economics was ever going to work it should have done so in Thathcer’s Britain. In fact, however, unemployment rose sharply, reaching three million and remained high for years, just as both Keynesians and monetarists expected. New Classical Economics, having failed its first big policy test, dropped out of sight, reviving only in opposition to the stimulus proposals of the Obama Administration.
However, Thatcher did not pay a political price for this policy failure, either at the time (the Falklands war diverted attention from the economy) or, so far, in subsequent assessments. The only alternative to the ‘short sharp shock’ was a long, grinding process of reducing inflation rates slowly through years of restrictive fiscal and monetary policy. While it can be argued that the resulting social and economic costs were significantly lower, political perceptions were very different. The mass unemployment of Thatcher’s early years was either blamed directly on her predecessors or seen as the necessary price of reversing chronic decline. And the depth of the Thatcher recession meant that the recovery, for which Thatcher’s government got the credit, was correspondingly stronger. Finally, the destruction of British manufacturing industry paved the way for the rapid expansion of the financial sector, in which the City of London had always been an international leader, second only to New York. At least until the global financial crisis, this seemed like a good trade.
The retreat, and resurgence of New Classical
As for the New Classical economists, they moderated their claims, at least in public. Extreme claims that macroeconomic policy could never be effective were dropped, and the standard position of ‘freshwater’ economists was close to that of Milton Friedman: sceptical of attempts to “fine-tune” variations in the level of economic activity and supportive of low inflation as the primary goal of macroeconomic management, but accepting the idea of that monetary policy could be a stabilising factor in the economy. In particular, there was not much criticism of the monetary policy framework of the US Federal Reserve, even though the Lucas critique was just as applicable to a system of monetary policy based on regular adjustments of interest rates as to attempts to stabilise the economy using fiscal policy.
In the wake of the GFC however, there has been a rush back to hard-line New Classical views, and even further back, to 19th Century ideas like Say’s Law.
The obvious criterion of success or failure for a macroeconomic theoretical framework is that it should provide the basis for predicting, understanding and responding to macroeconomic crises. If that criterion is applied to the current crisis, the micro-foundations approach to macroeconomics has been a near-total failure.
The failure of the dominant stream in macroeconomics was comprehensive.
First, during the bubble years the dominant approach gave little or no warning of the impending crisis. Neither sophisticated DSGE models nor the more pragmatic but less elegant micro-based models employed by the central banks gave much, if any, warning of the impending crisis.
Second, the dominant approach encouraged a benign view of the developments that gave rise to the crisis such as the growth and globalisation of the financial sector and the associated global imbalances. The boosterism of Alan Greenspan was an egregious example, but it was typical of the majority viewpoint.
Third, even as the crisis developed over the course of 2007 and 2008, its seriousness was persistently underestimated. This was exacerbated by the political context in which supporters of the Republican Administration in the US sought to deny the existence of a recession in an election year.
Fourth, the near-consensus apparent during the Great Moderation collapsed with the onset of crisis, revealing that the split between Keynesian and New Classical views had never been resolved, but merely papered over.
Fourth, it offered little or no useful guidance on the policy and theoretical issues raised by the crisis. The result that the public policy debate has been driven mostly by economists from outside the micro-foundations school. Advocacy of policies of fiscal stimulus has come, to a large extent,from economists such as Paul Krugman and Brad DeLong whose primary field is not macroeconomics, but who retain a historical understanding informed by Keynesianism. The most effective criticism has come from finance theorists like John Cochrane and Eugene Fama, mostly notable as advocates of the efficient markets hypothesis. Arguments on both sides have been couched in terms familiar to economists of 1970 and earlier, with each side accusing the other of holding views that had been refuted by the 1930s
The roots of this failure may be traced in part to problems with the micro-foundations approach itself. Micro-foundations models take general equilibrium as the starting point - modest variations of the standard classical assumptions suggest that deviations from classical properties are also likely to be modest. Macro models calibrated to the Great Moderation encouraged this assumption, as well as exclusive focus on monetary policy based on Taylor rules, which proved unavailing. The collapse of this position forced economists to shift either to the left (back to older versions of Keynesianism) or to the right (to extreme versions of classicism).
However, the broader intellectual climate of market liberalism, in which thinking about macroeconomic issues was conditioned by the assumptions of the efficient markets hypothesis and the apparent lessons of the Great Moderation. Concerns about market imbalances could not easily be reconciled with the implications of the efficient financial markets hypothesis or with the triumphalism of the Great Moderation.