Dynamic Stochastic General Equilibrium

We are now all Friedmanites, Lawrence Summers, (former US Treasury Secretary, now Director of the White House's National Economic Council, and prominent New Keynesian economist)

In the life cycle of ideas, the point where everyone has accepted an idea often seems to come just before its death. So it was at the high water mark of orthodox Keynesianism in the late 1960s. So it has also turned out for the elegant theoretical framework that ultimately succeeded Keynesianism. This framework went under the grandiose title of dynamic stochastic general equilibrium (DGSE to its friends). At the moment of triumph, this beautiful theory was struck down by the ugly fact of the global financial crisis. It now lives on, but only in zombie form.

At the end of the 19th century, British Liberal politician Sir William Harcourt observed “we are all socialists now”. Harcourt was referring to a radical land reform measure that had been denounced as socialist when it was introduced, but was generally accepted by the time he was speaking (a couple of years later). Harcourt’s point was applicable to the whole trend of economic and social policy, in Britain and elsewhere, from the 1867 Reform Bill that gave millions of working class men the vote (women had to wait until after World War I) to the crisis of the 1970s. From progressive income taxes to publicly-owned infrastructure services (both prominent items in the 10-point program of the Communist Manifesto)) ideas that were unthinkable in mainstream politics became issues of political contention and then established institutions.

As a pithy summary of the way ideas that were once radical become acceptable, and are ultimately embodied in conventional wisdom, Harcourt’s quip has never been bettered. As a result, it has been reused many times over.

One of the most notable adaptations of Harcourt was that of Time Magazine in 1965, which noted, following the successful use of fiscal policy to stabilize the economy that “we are all Keynesians” now. This statement was made by Keynes’ greatest modern critic, Milton Friedman (though he later said it had been taken out of context). Even more famously, it was repeated by Richard Nixon in 1971.

But whereas Harcourt was speaking at the beginning of a nearly a century of reform that did indeed take economic policy in a socialist, or at least social-democratic direction, Nixon’s statement marked the end of the era of Keynesian dominance.

In fact, Nixon was citing Keynes’ aversion to the gold standard (a “barbarous relic”) as a justification for abandoning the pegging of the US dollar to gold, which was a central feature of the Bretton Woods system of fixed exchange rates that had underpinned Keynesian economic management since World War II. The outcome was not a system of stable exchange rates backed by a basket of commodities rather than gold, as Keynes had proposed, but the complete breakdown of Bretton Woods and a shift to the floating exchange rate system advocated by the greatest critic of Keynesian economics, Milton Friedman.

In the course of the 1970s, Friedman and his supporters, centred on the University of Chicago, won a series of political and intellectual victories over the Keynesians. Following the failure of attempts to stabilise the economy using Keynesian fiscal policy, governments around the world switched to Friedman’s preferred remedies based on controlling the growth of the monetary supply. Even though this did not work particularly well, and was later replaced by policies based on managing interest rates, the resurgence of the Chicago School was not reversed. Their case against government intervention, both to stabilise the macroeconomy and to address market failures in particular industries, was widely accepted.

The Keynesians conceded Friedman’s central points: and that macroeconomic policy can affect real variables, like the levels of employment and unemployment, only in the short run. They sought to develop a ‘New Keynesian’ economics, by showing that, given small deviations from the competitive market assumptions of the basic neoclassical economics model, it would be possible to explain the recurrence of booms and recessions and to justify the modest stabilisation policies pursued by central banks during the Great Moderation.
Because New Keynesians were (and still are) concentrated in economics departments on the East and West Coast of the United States (Harvard, Berkeley and others) while their intellectual opponents are most prominent in the lakeside environments of Chicago and Minnesota, the terms ‘saltwater’ and ‘freshwater’ schools were coined by Robert Hall, then at Stanford, to describe the two positions.

Members of the freshwater school sought to push Friedman’s conclusions even further, arguing that macroeconomic policy could not be beneficial even in the short run. They tried to show that government intervention could only add uncertainty and instability to the economic system, and that, in the absence of such intervention, economic fluctuations like booms and slumps were actually good things, reflecting economic adjustments to changes in technology and consumer tastes. The resulting models went by various names, but the most popular was ‘Real Business Cycle Theory’.

Despite his central role in the critique of Keynesianism, Friedman was never truly a freshwater economist. Most importantly, while he opposed active use of fiscal policy, he supported the use of monetary policy to maintain medium-term economic stability.

Despite their often heated disagreements, saltwater and freshwater economists were in agreement on one fundamental point: that macroeconomic analysis must be based on the foundations of neoclassical microeconomics. And, although they disagreed about economic policy, these disagreements could be contained within a very narrow compass.

With a handful of exceptions, both schools took it for granted that macroeconomic management should be implemented through the monetary policies of central banks, that the only important instrument of monetary policy was the setting of short-term interest rates and that the central goal of monetary policy should be the maintenance of low and stable inflation. Granting these premises, saltwater economists argued that stability could only be achieved if central banks paid attention to output and employment as well as inflation, while the freshwater school favored an exclusive focus on price stability.

The global financial crisis did not so much confirm or refute the elaborate arguments of the competing schools as render them irrelevant. The saltwater school could claim vindication for their view that the economy is not inherently stable, but their models had little to say about the kind of crisis we have actually observed, driven by an interaction between macroeconomic imbalances and massive financial speculation. Meanwhile, the freshwater side of the dispute rapidly reverted to arguments from the 19th century, which had been debunked by Keynes and Irving Fisher.

The freshwater-saltwater disputes were similarly irrelevant to the policy debate which was conducted in terms that would be familiar to someone who had not looked at an economics book since 1970. As Gregory Clark of UC Davis observed ‘ The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.’

As David Gruen of the Australian Treasury observed of macroeconomics in the leadup to the crisis

It was as if, as the Titanic was sailing into iceberg-infested waters, those with the requisite skills and training to warn of the impending danger were instead hard at work, in a windowless cabin, perfecting the design of ship hulls … for a world without icebergs’

If we are to develop a macroeconomic theory that can help us to understand economics crises and improve policy responses, economics must take a different road from that it has followed since the 1970s. The appealing idea that macroeconomics should develop naturally from standard microeconomic foundations has turned out to be a distraction. In its place, we must accept, in the language of systems theory, that macroeconomic phenomena are emergent, arising from complex interactions of behaviors we do not fully understand, but must nevertheless respond to.

What Next?

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On to Trickle Down (next chapter)
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