SCHOOLS BRIEF Paradigm lost Our new series looks at ten modern classics of economics—the aca- demic articles of recent years that have done most to shape the way ‘now think. Starting next week, each brief will explore one article. This introduetion to the series sets the scene FOR rou 25 years ater 1950, despite all the clichés about economists never agree- ing, i¢ was fair to talk of a broad academic consensus on the big economic questions. Almost all economists were believers in what they called the “nevelassi- cal synthesis”. Inthe mid-1970s, thanks to a mixture of theoreti cal argument and unhelpful eco- nomic events, this consensus broke down. Economists have een trying to repair it ever sinee, bue with litele success. ‘The neoclassical synthesis was so named because it claimed to unite what was valuable in cassi- cal economics with the Keynes jan theories that had see out to refute classicism. In this blend- ing of schools, the classical tradi- tion supplied the underpinnings aud the methodoloey—novab, (a) the idea that economic agents (firms, workers, consumers) are rational; and (b) the eechnique ‘of describing an economy as ase- ries of markets (for goods, la- bour, money) in which prices ad- fax fo mais 2 balance of supply and demand. ‘The trouble was that classical economics was notoriously bad a actountng for 9 parlor sore of excess supply—that of la our, otherwise called unem- ployment. Rational agents and unfettered markets ought, it feared fo keep an economy ly employed. Jobless workers would force wages down, thus spurring the demand for labour. In the classical tradition ie fol: lows that the persistently unem- ployed are out of work by choice; the jobless simply prefer not to work at the offered wage, “That was unconvincing, espe- cially ater the Great Depression of the 1930s. The Keynesian revolution obliged the classical apparatus to confront a variety ‘of questions, bue “What causes unemployment?” was the most important. Then came a para- dox. While challenging, often ridiculing, the classical’ ortho- doxy, Maynard Keynes and his followers supplied the insights that the neoclassical synthesis would use to rescue the classical approach. Of these, the most crucial was the notion of sticky rices—the idea that prices (and especially wages, the price of le bout) move sluggishly. ‘Agents were still in rational pursuit of selfinterest; markers were still a good way to carve up an economy for inspection. In these respects, the Keynesian ‘macro-economy was sill “classi cal”. But slow-changing. prices make a big difference to the way ‘an economy behaves, especially ingheshor nm, Suppose that firms for some reason reduce their demand for labour. In the classical model, wages would quickly fall; that would restore “full employ: ment” partly because at the new, lower wage, firms would demand more labour and partly because some workers would decide to drop out of the labour force (ie, they would become unemployed by choice), If wages are sticky, however, ‘more workers will want jobs than firms are willing to hire. There will be an excess supply of lar bour—unemployment—at least for a time. Gradually, even in a Keynesian world, excess supply in the labour markee will drive wages down, which in turn will restore full employment. So in the long term (when ‘we are all dead”) the economy will look classical. In the short term it will be plagued—just asin real life— by spells of unemployment. Classic Keynes The neoclassical synthesis thus ‘combined a Keynesian shore run and a classical long run. Ie also combined, in effect, a demand side and a supply side. The de- mand side was developed in great detail thanks to Sir John Hicks at Oxford and, later, Har- vard’s Mr Alvin Hansen. designed the model tha is famil- iar t0 anybody who has studied economics in the past 40 years: IsuM analysis, Many others, led by luminaries such as Mr Paul Samuelson of mr and Mr James Tobin of Yale, buile towers of so- phisticated analysis on the Hicks Hansen foundation, The neoclassical synthesis ruled for s0 long because of the expositional brilliance of the is: Lat approach. This reduced six crucial economic relationships 0. simple diagram of wo cross- ing lines, plocted with. incerest rates on one axis and ourput (ag- sregate demand, to be accurate) on the other. The simplest is line embodies: fan equation explaining con- sumption "(che "consumption inction); another explaining in- ind the rule that, in savings equals’ in- vestment. The simplest txt line embodies: an equation explain- ing the “transactions” demand for money; another explaining the “speculative” demand for money; and a second equilib- rium rule, which says that the de- a fr money ms a the supply of money {itself fixed by government, and thus deter- mined outside the system). Theis line looks atthe market for goods and says that, as inter- xt rates fall, aggregate demand increases (thanks to more. fers ment and consumption); it therefore slopes downwards. ‘The io line looks at the marker for money and says that, as ag- sregate demand increases, ince ext rates rise (because higher ag- gregate demand also raises the demand for money); the LM line therefore slopes upwards. The economy isin equilibrium only where the lines cross. At every ‘other point, one or more of the six relationships underlying the am will be out of | Ee neoclassical synth ex plained supply by looking atthe labour market The idea was to account for the level of employ. ‘ment; via another equation (the “production . function”), the amount of labour employed would then determine the econ- a output. This He where sticky wages come in. If wages in ‘money terms are fixed (Keynes's assumption), then a rise in the ‘overall price level will temporar- lly reduce wages in real terms, cela the demand for or and raise output and employ- ment. A fall in prices will raise the real wage, depress the de- mand for labour and lead to loys cut und epporaee 38 aicky-wage description the labour market was married to the 1st framework to pro- dice an integrated model of ag- stepatedemand and supply. This ‘was the engine-room of the big computerised forecasting models that began to be built in the 1960s—the heyday of economics ‘as a quantitative science for mak- ing the world more prosperous. For years it was also the starting- point for — all mactoeco- THEECONOMST NOVEMEER 2180The downfall of the neoclassi- cal synthesis was its account of inflation. Early versions of the is Lat approach were cile wich the Phi First described by Me William Phillips in a paper in 1958, the Phillips curve was not a theory, bua aia observation. It said that low unemployment went hand in hand with high in- flation, and vice versa. Recal, the iStm approach had said that a one-off rise in prices could lower real wages, temporarily boosting output ‘and employ: ment. Perhaps persistently rising prices—inflation—could buoy output and employment for longer, as the Phillips curve said Meltdown Friedman Ie all seemed to fit. Economists were soon talking about the trade-off beeween inflation and unemployment. | Governments were cold that aiming for price sxability, desirable in its own right, would mean throwing peo- ple out of work. The question was howto exploie the outpuvin- flation trade-of In 1968. separate papers by Messrs Milton Friedman of the University of Chicago and Ed- mund Phelps of the University of Pennsylvania left this theory in shreds. Their work looked at the microeconomic underpinnings. ‘Suppose, asthe neoclassical syn- thesis said, inflation depresses the real wage and thus increases the demand for labour. What about the supply of labour? If workers are unwilling to supply as much labour as before, the ine creased demand for labour may not cause employment ro rise. True, if workers are mistaken about real wages—if they do not tunderstand that higher prices have cut them—a stronger de- mand for labour will hoost em- ployment. But for the Phillips curve to be true in this way, workers would have to” keep making the same mistake. The annual inflation rate might have been 10% for years, but workers would need to keep on expecting prices to be stable next year; oth enwise they would make good their real-wage cut by demanding higher money wages. This is a ridiculous assump- tion. Persistent inflation cannot ep coming as a surprise. Ever- Fising inflation might; in thae case there would be a tradeoff between output and the rate at which inflacion accelerates. But even this would be temporary. THEECONOMIST NOVEMBER 1980 e SCHOOLS BRIEF Moutld-breakers: Friedman, Phelps, Lucas, Sargent People would learn to anticipate alongside massive _unemploy- ‘sing inflation just as they learn ment could be dismissed as spe- to anticipate stable inflation. cial cases.) Messrs Friedman and. ‘The upshot of the Friedman- Phelps insisted that the Phillips Phelps attack was the expecta- curve would break down, It did. The 1970s brought curve, This says thac if inflation stagflation—high inflation and is fully expected, there is no high unemployment, which the trade-off between inflation and old Phillips curve had said did employment. A Phillips curve not happen. Messrs Friedman. only appears, and then briefly, and Phelps were vindicated, the when the economy's expecta” neoclassical synthesis was re- tions are upset by a surprise. futed, and the consensus of 25 With hindsight, the Fried years ell apart. cvanPhelps arack was all the : pote, npenive Beat wag Tnereatng ies Launched wien facts as opposed Forte past 15 years, economists to theory, sil seemed in tune have been searching for a new sah theo Philip cane, (Hie paradigm ore the neal torical episodes of nperinfation sical synthesis. One group is led How to get a PhD JK ROWING alot about the economy sa big help if you are 2 graduate student in economics, isn’t it? Messrs David Colander and Arjo Klamer surveyed more than 200 students in America’s top graduate-economics programmes. Just 3% thoughe chat a thorough knowledge of the economy was ‘very important”; what mattered far more was “being good at prob- lemsolving” and “excellence in mathematics". Today's stu- dents are learning their trade at a time of great doubt about the application of economics to real problems—the legacy of the 1970s. Perhaps this is why their focus has shifted to clever- ness for its own sake. In due course, tenure at a ood university will be a licence to be interested in the real world again. But that 3% is a poor verdict on the ceaching of economics by Messrs Robert Lucas of the University of Chicago and ‘Thomas Sargent of Stanford. In the spirit ofthe i Phel stock chi New Gaal school works on the presump- tion that markets clear. Another loose coalition, the New Kemesians, challenss chat again learning Phelps and Friedman, its adherents are care ful to explore the microeco- nomic causes of market failure. ‘The neoclassical synthesis continues to exert a powerful ine fluence on economic thinking. 1 1m analysis is still the way most students fis learn their macto- economics, and much research in recent years can be under- stood as modifying or refining the old model. An isan sjstem i sill the core of most economet: se models, However, macroceo nomic forecasting, for reasons t0 be explained in the nexe brie, has lost its academic respectabil ity. Few of today's leading theo- Tiss find ic fruitful to cast their ideas in terms of the old frame- otk, This is the biggest reason why, in the modem debate among and within the different schools, economises talk past each other. The breakdown of the neo- classical synthesis has. affected not just macroeconomics, but ‘other branches of economics, too. The new m by peer i niques that are ox sere ten tec bes) b stee the character of the whole sub- ject. In some ways, as a result, economics has become mor ward-looking than ever before. But economics is also learning to tackle entirely new questions of practical importance. The com> ing briefs in this series will show that no new synthesis is yet in age ‘but bleed economics is livelier and more interesting than for many years. 119