Schools of Thought, Rules, Discretion, and Rational Expectations

Arnold Kling has written a piece in which he implies that Keynesians and Monetarists are all victims of confirmation bias. They see things around them that reinforces their priors and they view this as evidence that their worldview is correct. He also concludes by suggesting that he thinks that both schools of thought are wrong. There are a couple of points that I want to assess.

First, I have pointed out confirmation bias before when Paul Krugman described why he is a Keynesian. However, as I discuss in that post, the problem is not that Krugman is wrong, but rather that there are other theories that predict observationally equivalent observations. The key is to develop a null hypothesis to differentiate between the two. Confirmation bias is only a bias if you are incorrect, otherwise it is evidence. (I am reminded of the idea that the first stage of being an alcoholic is the same as that of someone who is not alcoholic: denial.)

The problem, I think, is with falsifying schools of thought. You cannot falsify Keynesianism, Monetarism, or any other school of thought. Each of these schools — to the extent to which they even exist today in the profession — is made up of diverse members. There are a broad range of issues in which there is agreement. Some of these positions might be well-founded, others not. However, the idea is to develop testable hypotheses. If my model is correct, I would expect to observe X. Do I observe X? Are there other possible explanations? If so, can I differentiate between these explanations?

One of the most dubious aspects of modern macro, in my view, is the role of sticky prices. One can track prices and determine that they are slow to adjust, but does that mean that they are important from a macroeconomic perspective? Not necessarily. In order to test this, one needs a better way to test this hypothesis than simply observing that prices adjust slowly or asking business people how, when, and why they adjust prices. If sticky prices don’t have macroeconomic effects, this is an IO story. The conventional way to test the hypothesis is to write down a model without sticky prices and the identical model with sticky prices, simulate the models and see which one better predicts what we observe in reality. However, does this necessarily tell us that sticky prices are important? No. It could be that something is missing from the model and that sticky prices are picking up that effect. For example, we know that monetary policy shocks have persistent effects on real output. A basic RBC model cannot replicate this observation. Modifying the RBC model to have sticky prices (i.e. a New Keynesian model) is better able to explain the persistence. But so what? The RBC model cannot pick up this characteristic because all markets are centralized. In reality, the true data generating process might have segmented markets, decentralized trading, or a variety of other features. The fact that models with sticky prices perform better than models without does not necessarily tell us anything.

The point that I want to make is not that we should forsake sticky price models or a belief in the macroeconomic implications thereof. Rather, my point is that we need to generate better testable hypotheses to examine these questions. In other words, the reason that I am skeptical of the role of sticky prices is not because I believe that there is no evidence, but rather that it is not clear how this evidence stacks up against possible alternatives, which have not been examined. The evidence in favor of these views lies in the confirmation of a basic hypothesis. It does not, however, mean that those who accept the important macroeconomic role of sticky prices have committed confirmation bias, but rather that they have tested the hypothesis against insufficient alternatives.

What’s more, this is only one issue. Keynesians believe in a lot more than sticky prices. As such, it should take a lot more evidence to overturn an entire school of thought. And examining each issue is hard. Economics don’t get to use natural experiments. As such, one needs to develop clear, testable null hypotheses against reasonable alternatives.

This brings me to my second point. Who are the stubborn Monetarists and the stubborn Keynesians? The view of stubborn Monetarists and Keynesians suggests that those who see the world through a similar lens to these historical schools of thought are somehow standard bearers for this line of thinking and that nothing much has changed. New Keynesianism is different from Old. New Keynesians use microfoundations, they accept rational expectations, etc. Modern monetarists are largely divided into two categories: Market Monetarists and New Monetarists. If we take out nominal income targeting, there is very much agreement among the two groups. The blend of modern Monetarists is different from Old Monetarism, although both advocate the importance of money, both from a micro and a macro perspective. Nonetheless, there is a difference between modern Monetarism and Old Monetarism. Gone are the days of advocating constant rates of money growth, for example.

Arnold Kling seems to suggest that the primary difference between Monetarists and Keynesians is one of policy, with Keynesians favoring fiscal policy and discretion and Monetarists favor monetary policy and rules. This is a mischaracterization and is, in fact, undermined by Kling’s own article as he implies that John Taylor is a stubborn Monetarist advocating the Taylor rule. But there is nothing Monetarist about John Taylor or his monetary policy rule. Taylor is a New Keynesian and his monetary rule is of central use in New Keynesian models. While it is true that the most vocal advocates of fiscal stabilization are what one would consider Keynesians, the consensus of the profession prior to the recession was not one in favor of fiscal stabilization. See, for example, James Bullard’s “Death of a Theory” paper.

Finally, tucked into this article is a mild critique of rules and rational expectations. Kling states:

The rational expectations hypothesis virtually ensures that macroeconomic performance will be better under rules than under discretion. If policy follows predictable rules, then individuals in the private sector will not make mistakes that come from guessing incorrectly about the path of policy. If such mistaken guesses are the main cause of recessions, then the use of rules could eliminate recessions.

First, the literature on rules versus discretion with rational expectations was really about the inflationary bias of the central bank, not about recessions. This mixes the view of Friedman and other Old Monetarists that the Fed tended to either stimulate too much, causing inflation, or contract too much, causing a recession with the rational expectations literature that focused on inflation bias.

Second, Kling seems to offer a veiled criticism of rational expectations. What rational expectations suggests is that people do not make systematic errors. As such the literature on rules versus discretion suggests that if the central bank is able of systematically misleading the public, then rules are better than discretion. In that sense the rational expectations hypothesis is important to the debate, but what is the alternative? Even under adaptive learning, the solution will converge to the rational expectations solution.

Overall, I don’t see schools of thought dominating the literature. I see a lot of loud voices in the blogosphere and I think that Arnold Kling views these voices as a representative sample of the profession. I think this is very misleading.