... I assume that most of those hearing or reading this speech at all closely are aware of the great divide that emerged in macroeconomics in the 1970s. For those who aren’t familiar with the story: in the 1930s Keynesian economics emerged as a response to depression, and by the 1950s it had come to dominate the field. There was, however, an undercurrent of dissatisfaction with that style of modeling, not so much because it fell short empirically as because it seemed intellectually incomplete. In “normal” economics we assume that prices rise or fall to match supply with demand. In Keynesian macroeconomics, however, one simply assumes that wages and perhaps prices too don’t fall in the face of high unemployment, or at least fall only slowly.
Why make this assumption? Well, because it’s what we see in reality – as confirmed once again by the experience of peripheral European countries, Portugal included, where wage declines have so far been modest even in the face of very high unemployment. But that’s an unsatisfying answer, and it was only natural that economists would try to find some deeper explanation.
The trouble is that finding that deeper explanation is hard. Keynes offered some plausible speculations that were as much sociological and psychological as purely economic – which is not to say that there’s anything wrong with invoking such factors. Modern “New Keynesians” have come up with stories in terms of the cost of changing prices, the desire of many firms to attract quality workers by paying a premium, and more. But one has to admit that it’s all pretty ad hoc; it’s more a matter of offering excuses, or if you prefer, possible rationales, for an empirical observation that we probably wouldn’t have predicted if we didn’t know it was there.
This, understandably, wasn’t satisfying to many economists. So there developed an alternative school of thought, which basically argued that the apparent “stickiness” of wages and prices in the face of unemployment was an optical illusion. Initially the story ran in terms of imperfect information; later it became a story about “real” shocks, in which unemployment was actually voluntary; that was the real business cycle approach.
And so we got the division of macroeconomics. On one side there was “saltwater” economics – people, who in America tended to be in coastal universities, who continued to view Keynes as broadly right, even though they couldn’t offer a rigorous justification for some of their assumptions. On the other side was “freshwater” – people who tended to be in inland US universities, and who went for logically complete models even if they seemed very much at odds with lived experience.
Obviously I don’t believe any of the freshwater stories, and indeed find them wildly implausible. But economists will have different ideas, and it’s OK if some of them are ones I or others dislike.
What’s not OK is what actually happened, which is that freshwater economics became a kind of cult, ignoring and ridiculing any ideas that didn’t fit its paradigm. This started very early; by 1980 Robert Lucas, one of the founders of the school, wrote approvingly of how people would giggle and whisper when facing a Keynesian. What’s remarkable about that is that this was all based on the presumption that freshwater logic would provide a plausible, workable alternative to Keynes – a presumption that was not borne out by anything that had happened in the 1970s. And in fact it never happened: over time, freshwater economics kept failing the test of empirical validity, and responded by downgrading the importance of evidence.
Read the whole thing.