The Fall and Rise of Keynesian Economics* ALAN S. BLINDER Princeton Universiry Keynesian economics came under much criticism in the 1970s This paper argues that the decline in Keynesian economics and the rise in, notably, new classical economics in this period related to their respective theoretical appeal rather than their ability to explain recognized, and with the development of sound microeconomic /Introduction we now call new classical economics. By about According to T.S. Kuhn's The S 1980, it was hard to find an American academic Scientific Revolutions(1962 macroeconomist under the age of 40 who professed science' requires an agreed-upon etical to be a Keynesian. That was an astonishing framework or 'paradig ntellectual turnabout in less than a decade, an work to solve paradigm change w e might surmise that the data of the 1970s had and unequivocal rejection of . He would look for some anom ent that did to lid to Newton succ e in Section dancy as inst back to theory wa observation and, in tive ideology over a Kuhnian menon that non nomin but with existent ur. The first and evaluate t define especially in the Unite What it Means to be a Keynesian The word 'Keynesian' means many things to *lam grateful to Ben Bemanke, John Campbell, Stephe Goldfeld, John Seater, Steven Sheffrin an ISee Blinder (1979)and Blinder (1987a), Chapter for helpful comments on an earlier draft 278
1988 KEYNESIAN ECONOMICS 279 many people. Decades ago, it was a carelessly necessary to have some sort of nominal rigidi applied label for economic liberals and in the model; otherwise, an interventionists in general. For a while in the late like a currency reform which changes all prices 1970s and early 1980s it became a pejorative term equiproportionately 4 So Keynesian models more or less synonymous with old-fashioned. No generally either assume or try to rationalize two people have precisely the same definition of nominal rigidities. Because supply and demand Keynesian economics. But, as one of the few curves derived from standard neoclassical American economists of my generation who never maximizing principles are always homogeneous of shunned the label, I feel entitled to my own degree zero in nominal quantities, this is not an definition. To me, the heart of Keynesianism easy task. Real effecis aged on sicily ses. ernment purc consists of six principal tenets First and foremost, Keynesian economics is a classical grounds. s theory of aggregate demand and of the effects of Since prices do not absorb all shocks to deman aggregate demand on real output and inflation. The fluctuations in any component of spending will first three tenets follow from this cause sympathetic movements in output. In most I A Keynesian believes that aggregate demand Keynesian models, the latter are larger than the influenced by a host of economic decisions, both former because of the multiplier; but a multiplier private and public, and sometimes behaves greater than one is not central to Keynes erratically. Some decades ago, there were active analysis. a positive real multiplier is mpassioned debates over the propositions that(a) Although real effects from demand fluctuations monetary policy is powerless because money are often called Keynesian effects,most demand is infinitely elastic, or(b)fiscal policy is monetarists accept the idea as well-at least as powerless because money demand is totally it pertains to monetary policy. So this tenet does elastic. But both of these are dead issues now. not really divide those two schools of thought Essentially all Keynesians and most monetarists now However, at least some new classicals insist that believe that both fiscal and monetary policy afect changes in money affect real output only if they aggregate demand. 2 Many new classicals, however, are unanticipated believe in debt neutrality-the doctrine that 3 Keynesians believe that goods markets and substitutions of debt for taxes have no effects on especially, labour markets respond onty sluggishly to shocks, ie. that prices and wages do not move 2 According to Keynesian theory, changes in quickly to clear markets. This issue, once again, aggregate demand, whether anticipated or divides Keynesians more from new classicals than ipated, have their greatest shor - nun impact from monetarists-although monetarists tput and employment, not on prices, and place more faith in the economy's natural servo- bout.3 mechanism than Keynesians do. Milton Friedma In textbook expositions, this idea is conveyed by (1968, p. 13), for example, has written thatUnder a short-run aggregate supply curve that is upward any conceivable institutional arrangements, and sloping,and probably quite flat except at high levels certainly those that now prevail in the United States utilizatio changes in aggregate there is only a limited amount of flexibility in prices demand are normally not dissipated in higher and wages. In current parlance, that would prices In macroeconometric models, the same idea certainly be called a Keynesian position is captured by treating output and employment as The next three tenets have to do directly with run and letting policy, and here Friedman and other monetarists an inertial Phillips curve determine inflation part company with most Keynesians For a theoretical model to produce real effects ffects 4 To a Keynesian, the actual levels of rom anticipated monetary policy, it is usually 4 2 That does sum transfers. Open harket swaps of money for bonds are often( effects of fiscal policy by controlling nominal GNP. non-neutral because they change interest rates. Monetar on-neutrality can also be rationalized by distribution for example, the division of any given change in ffects but these are typically considered unimportant GNP into real effects and price effects might ely whether or not the change is anticipated uS, See, for example, Bao(1981b)
THE ECONOMIC RECORD DECEMBER employment and unemployment have no special unemployment than about co optimality-partly because However, there are plenty of anti-inflation unemployment is subject to the caprice of Keynesians; most of the worlds current and past aggregate demand, and partly because they believe central bankers, for example, merit this title that markets clear only gradually. In fact, whether they like it or not. Needless to say, relative Keynesians typically see unemployment as both too attitudes toward unemployment and inflation high on average and too variable, although they heavily influence the policy advice that economists know that rigorous theoretical justification for give and that policy makers accept. As a broad these positions is hard to come by. Keynesians also generalization, I think it safe to say that Keynesians feel certain that periods of recession or depression are typically more aggressive about expanding are economic maladies, not Pareto-optimal aggregate demand than are non -Keynesians. responses to unattractive technological My six tenets divide naturally into two equal opportunities. All this is summarized in the term groups: the first three are clearly assertions about involuntary unemployment, which Keynesians positive economics while the even he div difficult to define 6 On this tenet new classicals to positive and normative differ sharply from Keynesians, with monetarists to understanding both the 5 Many, but not all Keynesians advocate activist Positive Keynesianism is a matter of scientifi labilization policy to reduce the amplitude of judgement. a positive Keynesian believes that both business cycles, which they rank among the most monetary and fiscal policy can change aggregate important of all economic monetarists generally join new classicals, as well have real effects, and that prices and wages de as some conservative Keynesians, in doubting both not move rapidly to clear markets. No p the efficacy of stabilization policy and the wisdom prescriptions follow from these beliefs alone. And further and question whether business cycles are call themselves Keynesian would nevertheles a serious problem at all. 7 The argument that economic knowledge is not Normative Keynesians add both value secure enough to support what used to be called judgements and political judgements to the fine tuning is by now widely accepted, even by preceding list. a normative Keynesian believes that most Keynesians. Yet many Keynesians believe government should use its leverage over aggregate that more modest goals for stabilization policy demand to reduce the amplitude of business cycles. coarse tuning, if you will-are not only defensible He or she is probably also far more interested in but sensible. For example, an economist need not filling in cyclical troughs than in shaving off peaks. have detailed quantitative knowledge of lag These normative propositions are based on structures to prescribe a dose of expansionary judgements that(a) macroeconomic fluctuations monetary policy when the unemployment rate ignificantly reduce social welfare, (b)the 10 per cent or more-as it has been in many government is knowledgeable and capable enough countries in this decade. Furthermore, and this may to improve upon free-market outcomes, and(c) be the most important point, the nature of unemployment is a more important problem that government seems to abhor a vacuum of economic inflation. y dvice. If economists with admittedly limited The long, and to some extent continuing, battle knowledge refuse to offer their expert (if uncertain) between Keynesians and monetarists, you will note, counsel, assorted quacks with owledge at all will surely rush in to fill the void 8 I include myself here. See Blinder(1987a, Chapter 6 Finally, and even less unanimo Keynesians are more concerned abe the realm of positive economics. There is a huge literatu For this reason, I recently proposed that we rename ny Keynesians like m mployment as pornographic evidence that the costs of lot (1988) and readily avoidable. Nonetheless, value judgements are See Lucas( 1987)for an example. For a rebuttal, still involved in the trade-off between unemployment and see Blinder (1987b inflation
1988 KEYNESIAN ECONOMICS 281 as fought over the normative specific questions do, of c on ho issues-particularly(b) and(c). 10 Thus, by my expectations are modelled. And, for some issues most monetarists are positive the expectational mechanism is crucial. 14 But, for Keynesians but not normative Keynesians. So are the most part, these are not central to the debate other conservatives who shun the label K between new classical and Keynesian economists, 15 issues but make different value judgements and hypothesis. Pre-1970 Keynesianism included a seat-of-the-pants political judgements, and so Phillips curve that was negatively sloped even in reach different conclusions about policy. Their the long run. This idea was rejected theoretically disagreements in many ways mirror disagreements by Milton Friedman(1968), a monetarist, and among policy-makers Edmund Phelps(1968), a Keynesian, and shortly The briefer, but more intense, debate between thereafter was also rejected in econometric stud eynesians and new classicals had, by contrast, by Keynesians like Robert Gordon(1972). Since been fought primarily over the tenets of positive about 1972, a Phillips curve that is vertical in the Keynesianism. New classicals argue that long run has been an integral part of Keynesian economics. So the natural utput; that markets, including the labour market, essentially no role in the intellectual ferment lear quickly by pricel; and that business cycles the 1972-1985 period. Ironically, however. may be Pareto optimal. Here objective' scientific questions about its validity are now playing a role evidence can be brought to bear and, in my in the Keynesian renaissance. Specifically, models judgement, the evidence on all three issues points with hysteresis have reopened the theoretical and trongly in the Keynesian direction. 1 2 But rather empirical debate over the natural rate hypothesis, than try to summarize that evidence now, I only especially for Europe. (More on this below. want to make one point: that arguments over the d, I have ignored the choice between positive aspects of Keynesian economics are monetary and fiscal policy as the preferred potentially resolvable by the accumulation of instrument of stabilization policy. People differ scientific evidence in a way that disputes over along this dimension and occasionally change sides normative issues are not. my definition, however, it is perfectly possible Before leaving the realm of definition, let me to be a Keynesian and still believe either that nderscore several glaring and intentional responsibility for stabilization policy should in omissIons. principle be ceded to the monetary authority or First, I have said nothing about rational that it is in practice so ceded expectations. Many Keynesians are doubtful about the validity of rational expectations as a behavioral llI The fall of Keynesian Economics willing to accept it. But, when it comes to the large issues with which I have concerned myself so promoted with, let me first dispose of the view quarters, that the de nothing much rides on whether or not expectations eynesian economics was due to the doctrines are rational. In particular, rational expectations poor empirical predictions. Seven years ago,Robert models with sticky pnces-like those of Fischer Lucas (1981, page 559)wrote that'Keynesian (1977)and Taylor (1980), for example-are orthodoxy is in deep trouble, the deepest kind of thoroughly Keynesian by my definition. Details of trouble in which an applied body of theory can model construction and giving seriously wron swers to the most basic questions of macro- economic policy.. He was talking about the collapse of the Phillips curve in the US during the the old debate ove ther or not the lm curve is 1970s, which he and Thomas Sargent(1978,page vertical. This has long been a dead issu 57)had characterized as 'econometric failure on II The 'price'may be multi-faceted. Complicated a grand scale contractual agreements are allowed within the new nd to join the should be noted that some new classicals disagree evidence and see rational expectations ee, for example, Blinder( 1987b)and Lovell (1986). to the debat
282 HE ECONOMIC RI DECEMBER It is, of course, true that pre-1972 Phillips curves from the demand side. Analogously, pre-1973 were ill-equipped to handle the food and energy Keynesian theory produced a negatively sloped shocks that dominated the period from 1972 to statistical Phillips curve because of an unstated 1981 and, in consequence, badly underestimat sumption that m macroeconomic shocks com inflation. But it is also true that Keynesians quickly solely from the demand side-an assumption added supply-side variables (like oil or import proven wrong by the events of the 1970s and 1980s prices) to what had up to then been an entirely The very same model generates a positively sloped lemand-oriented theor on thereafter supply hillis curve if the shocks come from the supply shocks were also appended to empirical Phillips side, which is just what the econometric evidence curves. 17 By the early 1980s says happened in the 1973-1981 period documented the fact that a conventional Phillips If you don' t trust econometrics, the following curve equation with a supply-shock variable(any back-of-the envelope calculation should help drive one of several will do)fits the US data of the 1970s home the point Keynesian economists in the US and 1980s extremely well. 18 The charge that in the 1960s and early 1970s developed what I mpirical Keynesian models were, in Lucas and sed to call the Brookings Sargent's(1978)words, wildly incorrect' is, wel One objection frequently raised by supporters of a percentage point. Using a 5.6 per cent natural of new classical economics is that saving the rate, the US experienced about 15 point-years of Phillips curve after the fact by adding supply extra unemployment between 1980 and 1985 and variables is like saving Ptolemaic astronomy by during those years, the inflation rate declined about adding a new epicycle. I disagree. any economic .7 percentage points. Once you see how well model is fundamentally a set of statements about rule of thumb worked, you understand he behaviour underlying supply and demand and conventional Phillips curves fit data from the 1980s the nature of the shocks impinging on each. For so wel example, an empirical mode le market for Why, then, was the alleged demise of the Phillips wheat consists of a negatively sloped demand curve trumpeted so loudly and so widely? I think curve, a positively sloped supply curve, and some the reason was the conjunction of two events- assumptions about the shocks hitting each. one historical, the other intellectual specify not only aggregate demand and supply data in the 1970s, the familiar negative correlation behaviour but also the nature of the shocks that between inflation and unemployment-which is buffet the economy clearly visible on a scatter diagram of data for The empirical correlations implied by either sort the 1950s and 1960s-disappeared. The Phillips of model depend on both the model's structure and curve could no longer be depicted in two he shocks that predominate during a particular dimensions. To those too unsophisticated to historic period. For example, the same structural distinguish between a simple correlation and a modelof the wheat market will predict that price multivariate relationship, that seemed equivale and quantity are negatively correlated if most of to the death of the Phillips curve the shocks emanate from the supply side but Second, Lucas(1976)insightful critiqu of positively correlated if most of the shocks come econometric policy evaluation provided an elega a prion argument for why an empirical Phillips curve might collapse under the weight of a more For the rudimentary theory, see Phelps(1978)and inflationary policy. 19 Briefly, the argument went Gordon(1975). Phelps' ideas on the subject were first like this. a prototypical empirical Phillips curve by lagged inflation and 1 1974: Gordons were first offered at a Already in January 1974, Princeton graduate students Pr =a(L)P-1+f(Up+er were being asked(by me! to analyze supply shocks in 17 See Gordon (1977). 9 Though Lucass paper was published only in 1976 Some examples are Ando and Kennickell (1983), it had been given at a Carnegie-Rochester conference B Friedman(1983), Gordon(1985), and Perry(1983). in April 1973 and was well known in academic circles years