The New Classical Revolt Against Activist Economic Policy

In the 1970s macroeconomics witnessed a counterrevolution, or perhaps more aptly an insurgency, against Keynesian orthodoxy. The insurgency targeted the entire Keynesian economics: theory, empirical validity, and policy. The New Classicals argued that the Keynesian model lacked microfoundations , that is, the posited macro relations had no grounding in microeconomics of optimizing individuals and firms. They also argued that econometric analysis does not validate Keynesian macro relationships; at best it shows that the reduced form of the Keynesian model corresponds to the data. Worse, the New Classicals argued, Keynesian models do not perform well against simple time series forecasting models such as Box-Jenkins method (see below). A consequence of ad hoc modeling is that the estimated relationships are not stable over time. Lucas criticized activist economic policy on the ground that it is based on a misperception. The policy is based on an estimated econometric model, which according to Lucas, would not be stable and whose estimated coefficients would change once the policy goes into effect. As a result what would have been an optimal policy would not be so anymore. We already saw in Chap. 5 how the Phillips curve on which macroeconomic policy during the 1960s was based shifted over time. The upshot was that well-intentioned policies resulted in simultaneous rise of unemployment and inflation. But the Lucas critique went beyond this and extended the instability to all reduced forms.

An expectation acquires explanatory value only if we are made to understand why people expect what they expect. Otherwise expectation is a mere deus ex machina that conceals problems instead of solving them.

Joseph Schumpeter , “Review of Keynes ’s General Theory.”

If, for example, you come at four o’clock in the afternoon, then at three o’clock I shall begin to be happy. I shall be happier and happier as the hour advances. … But if you come at just any time, I shall never know at what hour my heart is to be ready to greet you.

Antoine de Saint Exupèry, The Little Prince.