Brief History of Macroeconomics and The Origins of Freshwater vs. Saltwater Economics

I and others, particularly Paul Krugman, occasionally make reference to “freshwater” vs. “saltwater” economics.  Here’s a little background to explain the terms and, I hope, shed a little light on current disputes in macroeconomic theory.

First, let’s go back in time.  The stuff that economists study, namely the economy, economic behavior, and markets, really emerged as it’s own discipline in the 1700’s with Adam Smith.  It had always been a topic for philosophers to discuss. Even Aristotle writes about the topics.  But it didn’t really emerge from “moral philosophy” into it’s own field of study until Smith.  Originally Smith and the subsequent economists such as Ricardo focused on markets and what we now  call microeconomics with a nod towards questions of political economy (public policy and the whole economic system).  The industrial revolution was in full swing.  The economic system wasn’t really “capitalist” because nobody knew what that was yet.  It wasn’t until the mid-1800’s that the word capitalism becomes commonly used.   Note:  Adam Smith was not a capitalist.  According to the Oxford English Dictionary, the earliest recorded usage of “capitalist” comes in 1792 in France, well after Smith wrote the Wealth of Nations.  

Then in the years just after the Napoleonic wars, England suffered some very severe financial crises and depressions involving the collapse of canal-building businesses.  At the time, Smith’s famous treatise was now 40-55 years old.  The authors now called economists argued about it’s causes and the policies needed to right the economy and restore full-employment.  The center of the debate revolved around questions of “whether there could ever be such a thing as a general glut of commodities”.  In other words, was it possible that the now industrialized economy with it’s newly enlarged banking sector and wide circulation of paper money could be too efficient?  Would such an economy always produce willing buyers for all the goods that sellers wanted to supply?

Two views emerged. One of them, later called “Classical” becomes the dominant thinking in economic circles.  The Classical view denies that long-term high unemployment is even possible as long as the government balances it’s budget and follows a laissez-faire policy of not interfering in markets.  A very mechanistic view of the economy as being constructed of self-adjusting markets that always return to equilibrium evolves.  The Classical view supports a very liberal (old sense) and anti-regulation view of government policy.

Critics existed but they failed to dominate the debate.  Karl Marx in the mid-1800’s writes some scathing critiques of Classical economics focusing on how the mechanism of market equilibrium cannot and does not work as described in labor markets.  Yet despite the critique, the Classical economists continue to dominate policy making and academic circles.  The debate, however, becomes more polarized with the Classicals of the late 1800’s and early 1900’s pushing even more extreme anti-government, pro-market policy positions and models than their Classical predecessors advocated. Many of the critics of capitalism and Classical economics move to the opposite end of the spectrum and embrace socialist, communist, or fascist/syndical economics, in effect taking a position that market capitalism is so fatally flawed that it must be completely replaced by a system of planning by the government.

Despite the dominance of the Classicals, there were always some economists laboring, researching, and writing about the cycles of business and the workings of money and banks.  They just didn’t get much attention or have a comprehensive framework to distinquish themselves from either the Classicals or the planned economy types.

Then came Keynes and the Great Depression.  Classical economics denied The Great Depression could happen – much like University of Chicago economists in 2010 who claimed that today’s high unemployment is the result of workers suddenly choosing to voluntarily have leisure instead of a job.  Keynes writes a powerful book called The General Theory of Employment, Interest, and Money.  Macroeconomics is born.

Keynesian macro focuses on a total systems approach to the economy instead of just assuming that whatever works in a micro perspective in each market will make the total system work.  Keynes attempts to avoid the fallacy of composition. Keynes’s analysis shows that an industrialized, capitalist market economy with a financial/banking sector is inherently unstable.  It tends to have cycles – business cycles.  It’s beyond the intent of this post to explain the reasons, but the bottom-line was that Keynes identified a role for active government and central bank policy to maintain full employment  and stable prices.  Keynes rapidly gained converts in economics and soon the field was split into microeconomics and macroeconomics.

The success of Keynesian economists and Keynesian policies in the 1940’s, 1950’s and 1960’s led to dominance of Keynesian viewpoints.  But there were two subversive trends underway that would eventually reverse the Keynesian dominance and return the Classical viewpoint to dominance.  One was an attempt to build a comprehensive mathematics framework for all economics built on the math of Newton’s physics.  This effort, called the neo-classical synthesis, originally focused on microeconomics.  But eventually it turned it’s attention to putting Keynes’s ideas into the same optimizing-behavior mathematics.  Unfortunately, Keynes himself was long dead by now and unable to clarify what he “meant”.  Some ideas are forced onto him that weren’t necessarily there in the original (such as insisting on static equilibrium).  The second trend was a small group of economists who never agreed.  They were in effect Classicals in exile.  Led by Milton Friedman at University of Chicago and Friedrich Hayek, they launched a two-prong attack.  Hayek’s attack led to what we call Austrian economics today and is often embraced by extreme libertarians.  I won’t get into that here, there’s not enough time.

Friedman’s initial attack focused on re-writing our understand of The Great Depression.  Friedman works to show that monetary policy by the central bank was at fault for the Depression, implying that a laissez-faire government fiscal policy would be best.  Friedman’s disciples at Chicago and elsewhere expanded the attack by insisting on “micro-foundations” in all macro-economic theories and models.  By micro-foundations, they mean that the only acceptable basis for a macroeconomic model is one that is based only on the micro ideas of perfectly rational individuals acting on perfect information with perfectly rational expectations about the future and the nature of the economy.  By the mid-1970’s the Friedman posse was clearly winning the academic wars, in part because their position lent itself easily to using neo-classical synthesis  mathematics and because it was consistent with “micro-foundations”.

Friedman originally took a modified Classical position.  Classicals denied that either fiscal or monetary policy could affect or correct the performance of the whole economy.  Friedman pushed the idea that fiscal policy wouldn’t work but that monetary policy would.  Eventually the next generation of Friedman students and disciples went further and returned to the Classical position that neither fiscal nor monetary policy would work.

As it turns out, these newly re-ascendant Classicals, now being called New Classicals, inspired by Friedman, often taught at universities located inland near some kind of “freshwater”.  The remaining supporters of Keynesian viewpoints, now under severe attack, taught at schools nearer the ocean.  Then in 1976 R.E. Hall pens a paper called Notes on the Current State of Empirical Macroeconomics and identifies this split and associates freshwater and saltwater with the split.

As I see it, the major distinguishing feature of macroeconomics is its concern with fluctuations in real output and unemployment. The two burning questions of macroeconomics are: Why does the economy undergo recessions and booms? What effect does conscious government policy have in offsetting these fluctuations? These questions define the issues considered here. I will further restrict my attention to structural approaches, and will avoid discussion of the reduced-form approach, including its recent sophisticated manifestation (7).

As a gross oversimplification, current thought can be divided into two schools. The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity). The old division between monetarists and Keynesians is no longer relevant, as an important element of fresh-water doctrine is the proposition that monetary policy has no real effect. What used to be the standard monetarist view is now middle-of-the-road, and is widely represented, for example, in Cambridge, Massachusetts.

1To take a few examples, Sargent corresponds to distilled water, Lucas to Lake Michigan, Feldstein to the Charles River above the dam, Modigliani to the Charles below the dam, and Okun to the Salton Sea.


 

Quotes from the Freshwater/Saltwater Wars

Brad Delong summarizes and links some quotes from dueling Freshwater (Classical Macro) vs. Saltwater (Keynesian and others) at Macro Wars

The conflict in many ways boils down to this: is economics to be philosophy where internal, logical consistency of the theory is most important and absolute faith in the theory is commanded of all true-believers (the Classical / Freshwater view), or is economics to be a science where empirical data about how the world actually works is to rule (Keynesian and others in Saltwater schools)?   In my opinion, the Freshwater/New Classical school with it’s message of  “completely free markets, absolutely no regulation ever, government is always evil, private corporate ownership is hollowed”  is no better than old-style Marxism: it’s philosophy and religion masquerading as a socil science.  If we’re ever going to get somewhere in improving the people’s lot in life, we have to deal in reality, not fantasies of worlds than can never be because we made impossible assumptions.

BTW: my favorite quote is from Robert Solow (saltwater) about why he doesn’t engage the freshwater folks in debates much anymore:

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon Bonaparte.

Krugman on How Did Economists Get It So Wrong? – Excellent

Long, but excellent reading on the recent (last few decades) of the history of macro thinking.  I think Krugman understates some issues, but much of it is good.  I recommend.

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

For the complete article, see:  http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=all

Krugman’s article caused quite a stir in academic and professional economics.  Many have agreed with him, such as Jeff Frankel who posted this:

The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession.   Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse.  The real questions are, rather how macroeconomists (most of us) could have gotten it so wrong as to believe that: (i) a severe recession like this was not even looming ahead as a danger, and (ii) a breakdown of many of the world’s most liquid financial markets, in New York and London, was not possible.To anyone wondering about these questions, I recommend Krugman’s essay in the New York Times Sunday magazine, September 6:  “How Did Economists Get it So Wrong?” . I think he has it exactly right.

I would only add that he is modest in skipping over one point:  during Japan’s lost decade of growth in the 1990s Paul forcefully drew from the Japanese experience the implication that a severe economic breakdown was, after all, possible in a modern industrialized economy – a breakdown that both was reminiscent of the Great Depression and was outside the ken of modern macroeconomic theory.   But macroeconomics went on as before.   (Likewise with the stock market correction of 1987, the LTCM crisis of 1998, and the dotcom bust of 2000-01.   I do think, however, that our field did a better job with the emerging market crises of 1994-2001, in part because it was considered permissible to argue that financial markets in this case were highly imperfect.)

Even the cartoons in the NYT article are good…  except that I have never seen Olivier Blanchard in a double-breasted suit.    But Robert Lucas definitely merits a place there:   when given one page to defend orthodox economists regarding the crisis in a recent  Economist essay, he actually thought it was a useful rebuttal to point out that critics are repeating arguments they have made before.  And he also thought it was useful to explain: “The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.”  — as if it is not the latter question that the public is wondering about.

I am pleased that at least some in the profession are waking to the serious methodological and intellectual problems that have crept into economics (not just macro) in recent decades.  There’s a long way to go though before we return to math only being a tool to check/explore the logic instead of the centerpiece.  We need to put real-world economies back in focus as the topic of our theorizing and research.