The consequences for macroeconomics during the past 60 years: Defending temple of macroeconomics

The new edition of Journal of Economic Perspectives is out (HT: Niranjan Rajadhyaksha). The editor Tim Taylor blogs about it

Apart from papers on populism, it has this fascinating paper by Prof George Akerlof on macro during the last 60 years.

This passage on how certain ideas become paradigms and then defended at all costs is something:

In summary, here’s what they were thinking about macroeconomic stabilization and business cycles at MIT in the early 1960s. A hard and important problem, where a lack of understanding had led to the long continuation of the Great Depression, was now solved. In the form of the Keynesian-neoclassical synthesis, it offered a solution that could also inform policy even after the economy had recovered. Questioning the model then would be dangerous: it might divert the public, already misguided by their misunderstandings of economics, away from the expansionary fiscal policy needed to hold unemployment at bay.
I once saw this implicit, but rarely expressed, message stated openly. It took place in a seminar on money and banking, taught by Samuelson in spring 1964. His idiosyncratic teaching style was to ramble through class with his reflections of the moment; at the end, usually running into overtime, he would give his take on the syllabus topic for the day. In one of his class-time ramblings, Samuelson told us of a special problem regarding the Phillips curve. An article by him and Solow had plotted the rate of change of hourly earnings and unemployment by year for the US economy. They said that this plot gave the
policy trade-off between inflation and unemployment. Zero inflation would entail about 5.5 percent unemployment; 4.5 percent inflation would result in unemployment of 3 percent (Samuelson and Solow 1960, 192–93). The heart of US aggregate macro policy was to choose the optimal trade-off between unemployment and inflation over this range. 
But Samuelson alerted the class to a potential problem with this conventional wisdom. Maybe, he said—just maybe—with high levels of employment, inflationary wage and price changes that would occur would feed back into higher inflationary expectations. And, if those higher expectations themselves were added onto the  wage (and price) changes, inflation would accelerate. Thus, the trade-off would not be between unemployment and a constant level of inflation; it would be between unemployment and the acceleration of inflation.
Samuelson revealed his own take on this proposition. Belief in it would result in contractionary policies: aimed at keeping inflation low, thereby resulting in high unemployment. Belief in this accelerationist theory, if it was erroneous, would then have a high cost.
….Then it happened. Just three and a half years later, Samuelson’s chickens came home to roost. Milton Friedman (1968) would make this accelerationist argument the theme of his American Economic Association presidential address. Together with the stagflation that occurred shortly thereafter, this address exploded the field of macroeconomics. Later, Samuelson would publicly confess that he had lost sleep over this possibility.
The idea was to keep the secrets of the temple:
As I look back on it now, I see that in that class-time musing, Samuelson had entrusted us students with the major unspoken secret of the Temple of Keynesian Macroeconomics. He had also revealed the ill consequences that would occur if that secret became known. No graduate student at MIT took on the accelerationist view of the Phillips curve as a research topic. For us students in the Temple, that would have been unthinkable: it was our moral duty to keep the secret entrusted to us. So on to growth theory, where little damage could be done, for example, by proofs that there was no steady state for an economy without Cobb–Douglas production functions and without labor-augmenting technical change, which was the subject of my first (joint) paper (G. Akerlof and Nordhaus 1967). But that turn to growth theory was an unfortunate choice, because the Keynesian-neoclassical synthesis was not the end of macroeconomics. Much fundamental work remained to be done.
The defense of the temple ignored linkages of finance crisis and macro:
In the push to assure acceptance of the dominant-paradigm Keynesianneoclassical synthesis, a major macroeconomic question was left unresolved: what
is the basic reason for very hard times that especially require fiscal or monetary stimulus? Keynesians such as Hicks (1950), Kaldor (1940), and Samuelson (1939) offered answers to that question—based on small deviations from the standard framework—with dynamic multiplier-accelerator models of investment and savings.
But in chapter 12 of The General Theory, on “the state of long-term expectation,” Keynes (1936) had suggested a very different analysis of boom and bust: those bad times result largely from financial fragility. Famously, in that chapter, Keynes (1936, 140) analogized stock prices to the outcomes of a newspaper beauty competition. Entrants to that contest would choose the most attractive faces from a batch of photographs—with prizes awarded not to those who picked the most attractive by some external standard, but instead to those who chose the faces picked by the greatest number of other contestants. The outcomes of such a contest did not necessarily depend on the “fundamentals”—that is, individual views regarding the faces. Instead, contestants would be trying to deduce what other contestants would be taking into account about what others were also thinking.
He points to three models of financial crashes:
Three examples illustrate the centrality of the preceding skeleton for leading models of financial crash: bank runs, fire sales with collateralized loans, and currency speculations. In a bank run model (like that of Diamond and Dybvig 1983), if only the usual transactors are making withdrawals, there is not much reason to line up  at the bank. But if others are lining up out of fears of its insolvency, there is reason to rush to be among those first in line to retrieve one’s deposit. In models of fire sale crashes with collateralized loans (Shleifer and Vishny 1997, 2011), short-term lenders hold collateral from leveraged borrowers. Absent a decline in the value of the collateral, the borrowers do not have special need to sell it. But once such declines have begun, forced sales can trigger a vicious cycle of further declines in asset values and further forced sales. In models of currency speculation (as in Morris and Shin 1998), he payoff to withdrawal into a foreign currency is negative if other speculators do not make that move. However, the payoff to such withdrawal to a foreign currency is likely quite high if a large number of speculators also withdraw.
Each of these three examples of financial crash shares a crucial feature: those who continue to hold a position, or to withdraw from that position, are positively related to the numbers of those who take the same action. But such representation of financial markets had no substantial place in mainstream macroeconomics in the period leading up to the Great Recession. In the aftermath of the 2008 crash, Ricardo Caballero (2010, in this journal) explained why macroeconomists had not predicted it. He said that macroeconomists had a modeling aesthetic based variously on either dynamic stochastic general equilibrium or neo-Keynesian models, and while researchers permitted themselves to depart from such baseline models, they allowed themselves only one deviation at a time. I agree. 
In the end. Akerlof takes part of the blame for this omission on himself:
The Keynesian-neoclassical synthesis that had emerged by the early 1960s put constraints on macroeconomics. Foremost, it divorced macroeconomists from
working on financial stability. Luckily, after the crash of 2008, the prior work of finance economists has been belatedly acknowledged, and the subfield of macro stability has also emerged as quite possibly the most vibrant research frontier in economics.  Nevertheless, macroprudential concerns remain as back matter in the textbooks. Correspondingly, macroprudential policy is undervalued in the councils of government. Yet its importance remains, given the likelihood of another crash. In these consequential ways, macroeconomists’ dismissal of “satiric entertainment” in the decades after The General Theory still lives with us. If there is blame to be faced, Iconfess that it should be placed on me as much as on anyone else. I tried, but I too was one of those macroeconomists.
Akerlof is as prominent a macroeconomist as any and has opened a cupboard which has quite a few skeletons…

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