I have refrained from commenting on Paul Krugman's lengthy critique of macroeconomics which was published earlier this month in the NYTimes Magazine. I am not sure if I have anything useful to add. It is an important essay that is part of the conversation economists will be having for years to come (which I am calling the "Macro War"). It is quintessential Krugman being Krugman: brilliant, funny, nasty, and a puzzling blend of revelation and overstretch. And forgive me for protesting, but if I see the baby co-op story in print again, I'm submitting Krugman to the authorities for unfairly regurgitating the same pop material to pad his pubs.
If you are genuinely interested in the macro war, do not miss an alternative critique recently published by Northwestern 's distinguished professor Robert Gordon. I highlight five sections here: the entire abstract, three clips on growth vis-a-vis macro, and his assessment of Krugman. It is amazing. (Thanks to Greg Mankiw for the pointer).
Is Modern Macro or 1978‐era Macro More Relevant to the Understanding of the Current Economic Crisis?
This paper differs from other recent critiques of “modern macro” based on DSGE models. It goes beyond criticizing these models for their assumptions of complete and efficient markets by proposing an alternative macroeconomic paradigm that is more suitable for tracing the links between financial bubbles and the commodity and labor markets of the real economy.
The paper provides a fundamental critique of DSGE and the related core assumptions of modern business cycle macroeconomics. By attempting to combine sticky Calvo‐like prices in a theoretical setting that otherwise assumes that markets clear, DSGE macro becomes tangled in a web of contradictions. Once prices are sticky, markets fail to clear. Once markets fail to clear, workers are not moving back and forth on their voluntary labor supply curves, so the elasticity of such curves is irrelevant. Once markets fail to clear, firms are not sliding back and forth on their labor demand curves, and so it is irrelevant whether the price‐cost markup (i.e., slope of the labor demand curve) is negative or positive.
The paper resurrects “1978‐era” macroeconomics that combines non‐market‐clearing aggregate demand based on incomplete price adjustment, together with a supply‐side invented in the mid‐1970s that recognizes the co‐existence of flexible auction‐market prices for commodities like oil and sticky prices for the remaining non‐oil economy. As combined in 1978‐era theories, empirical work, and pioneering intermediate macro textbooks, this merger of demand and supply resulted in a well‐articulated dynamic aggregate demand‐supply model that has stood the test of time in explaining both the multiplicity of links between the financial and real economies, as well as why inflation and unemployment can be both negatively and positively correlated.
Along the way, the paper goes beyond most recent accounts of the worldwide economic crisis by pointing out numerous similarities between the leverage cycles of 1927‐29 and 2003‐06, particularly parallel regulatory failings in both episodes, and it links tightly the empirical lack of realism in the demand and supply sides of modern DSGE models with the empirical reality that has long been built into the 1978‐era paradigm resurrected here.
(Krugman critique mentioned)
The malaise of modern macroeconomics has recently been the subject of strikingly vitriolic accusations. The Economist (p. 70) quotes Paul Krugman’s LSE Lionel Robbins Lecture of 10 June 2009 as stating “most macroeconomics of the past 30 years was spectacularly useless at best, and positively harmful at worst.” More recently Krugman (2009) has amplified this criticism in a long and overly argumentative denunciation of modern macroeconomics. In notably similar language that might have inspired Krugman, Buiter (2009) wrote three months earlier that “the typical graduate macroeconomics. . . training received at Anglo‐American universities during the past 30 years or so may have set back by decades serious investigations of aggregate economic behaviour and economic policy‐relevant understanding. It was a privately and socially costly waste of time and other resources.”
(Three sections that mention growth are below)
The adjective “business cycle” in front of the phrase “modern macro” represents an important qualification to the scope of this paper. Much of modern macro escapes its critical overview, including such broad areas of modern macro progress as growth theory, search and matching models of unemployment, theories of why prices and wages are only partial flexible, and attempts to use modern versions of production functions and factor input measurement to develop empirical counterparts to longstanding 1978‐era macro constructs such as potential GDP growth and the GDP gap.
Viewed more broadly, a more basic similarity between the 1920s and the period between 1995 and 2006 was the view that permanent prosperity had arrived, and that the good times should be allowed to roll. The underpinning of this benign environment was the parallel upsurge in productivity associated with the invention of new “general purpose technologies” (GPTs, Bresnahan and Trajtenberg, 1995). In the 1920s productivity was boosted by the delayed payoff of the invention in the late 19th century of two revolutionary GPTs, electricity and the internal combustion engine. Many of the reasons for the delay in the application of electricity to manufacturing in the analysis of David (1990) apply as well to the internal combustion engine which required technical development and highway construction fully to transform transportation and distribution. Likewise, in the late 1990s the invention of the internet together with other delayed applications of the computer, including bar‐code scanning, boosted productivity growth for several years after the collapse of the late 1990s investment boom itself. More rapid productivity growth held down inflation and in this decade allowed the Fed to justify its maintenance of low interest rates.
The required condition for continued full employment is the opening of a gap between the growth rate of nominal GDP and the growth rate of the nominal wage (Gordon, 1984, p. 40) to make room for the increased nominal spending on oil. If nominal wages are flexible, one option is for the growth rate of wages to become negative, allowing the growth rate of nominal GDP to remain fixed. At the alternative extreme with rigid wages, to avoid a decline in nonenergy output an accommodating monetary policy must boost nominal GDP growth by the amount needed to “pay for” the extra spending on oil, but this will lead to an inflationary spiral if expectations respond to the observed increase in the inflation rate. A third alternative, and the one that actually occurred in the 1970s, was a combination of wage rigidity with a partial response of nominal GDP growth, pushing down both real non‐energy spending and employment.