From Keynes to Lucas, and Beyond

A History of Macroeconomics, by Michel De Vroey.  Cambridge University Press, 2016.

De Vroey’s book reads like a travelogue recounting his life journey as a macroeconomist, and his considered response to key texts he encountered along the way.  Always thoughtful and penetrating, he stimulates this reader to reflect anew on how we got to where we are today, and what might lie ahead.  In 1981, I commenced my own life journey as a macroeconomist, beginning in my final undergraduate spring semester by reading Keynes’ General Theory, and then continuing on in the fall as a Masters student by reading Malinvaud’s Theory of Unemployment Reconsidered as well as Lucas and Sargent’s newly published reader Rational Expectations and Econometric Practice.  Thirty five years later, De Vroey offers me the chance to revisit the texts on which I spent my youthful energies, and to reconsider the decisions I made about where to position myself in the intellectual turmoil then raging.

The book is an unapologetically internal history of macroeconomics, focused mainly on understanding the internal logic of the books and papers that made a difference.  But it is not Whig history—no triumphal account of the inexorable progress of knowledge.  Quite the contrary, a central theme of the book concerns the demise of a specifically Marshallian approach to economic thinking that DeVroey clearly favors, and that he detects not only in Keynes but also in Friedman, Clower, Leijonhufvud, and Phelps, the last of whom he characterizes as “the only one who really delivered” (p. 148) on the goal of explaining unemployment.

“Delivering”, for De Vroey, means providing an internally coherent theoretical account.  From this point of view, the fundamental problem of macroeconomics is that the urtext that started it all off, Keynes’ General Theory, didn’t actually deliver, and it didn’t deliver because the Marshallian framework that Keynes used to develop his ideas has no real place in it for involuntary unemployment.  Similarly, those who followed after Keynes made progress only to the extent that they deviated from the trade technology assumed by Marshall.  De Vroey’s quotation of Clower and Leijonhufvud’s list of the “main constitutive features” of their own effort to reconstruct macroeconomics reads like De Vroey’s own wish list:

“[The new trade technology] (1) lacks a central information-processing and bill-collecting agency; (2) has, instead, middlemen trying to coordinate production and consumption activities in each output market separately; (3) makes the management of stocks of inventories essential to the coordination of these activities; and (4) has the system potentially subject to the commercial crises associated with expansions and contractions of the volume of bank and non-bank credit” (p. 116).

But that’s not the road we have travelled, at least not yet.

Instead we got the dynamic stochastic general equilibrium (DSGE) program, which had its theoretical origins in Lucas’ “Expectations and the Neutrality of Money” (1972) and its empirical origins in the Real Business Cycle (RBC) work of Kydland and Prescott.  For a while the Keynesians tried to fight it off, defending the traditional IS-LM formulation of Keynes’ message, but it didn’t work.  Today, what De Vroey calls Second-Generation New Keynesian modelling is more or less a direct continuation of the Lucas program.  “New Keynesian modeling is no more directly explanatory of reality than RBC modelling.  This is the price to pay for having given the priority to internal consistency” (p. 334).

De Vroey clearly regrets the direction that macroeconomics has taken, but he also clearly admires the edifice that has been constructed.  By construction, it is definitely an internally coherent theoretical account of something.  The problem is that the internal coherence has been purchased at the price of external incoherence—the models have little connection to external reality.   Indeed, they operate, so De Vroey insists repeatedly, mostly as a kind of political philosophy.  “In an age when expertise is so valued, macroeconomists should refuse to play the part of experts and admit that their social usefulness is of the same subdued variety as that of political philosophers” (p. 380).   From a methodological standpoint, it is simply illegitimate to use these models to pronounce on policy.  Lucas comes in for praise for appreciating this inherent limitation, while those who followed after Lucas come in for criticism for ignoring it.

In a past age, the so-called “neoclassical synthesis” operated to create intellectual space for macroeconomics, which consisted of pragmatic theories of deviation from equilibrium, separate from the theory of long run equilibrium (e.g. Solow growth theory).  There never really was a synthesis, in the sense of an internally coherent theory linking the short run with the long run, just a division of labor.  But with Lucas, that separate space for macroeconomics came under attack and by now it has essentially vanished.  Formerly macroeconomics was about explaining unemployment; today it is entirely about the properties of equilibrium models.  Pragmatic policy-oriented macroeconomics, of the style exemplified by Okun’s posthumous Prices and Quantities (1981), survives only in policy schools and the voices of public intellectuals.  “Against Lucas’s newly defined standards, it was definitely sub-standard” (p. 217).  “With macroeconomics as it stands after the Lucasian revolution, making a theoretical case favoring Keynesian conclusions amounts to fighting with one hand tied behind one’s back:  the task is not impossible but it is difficult” (p. 376).

How did it all come to this?

De Vroey suggests that the rot began all the way back at the very beginning, when some early enthusiasts for Keynes shunted the Keynesian train onto the Walrasian track.  Some of the most fascinating pages of De Vroey’s travelogue trace the steps by which this was done—by Hicks, Modigliani, Klein, and Patinkin (Ch. 2-3).  Every one of them thought, of course, that he was “delivering”.  But the Walrasian framework has no more place in it for involuntary unemployment than does the Marshallian framework, not the original version put forth by Walras himself, not the modern general equilibrium version of Arrow and Debreu, and not even the so-called non-Walrasian equilibrium versions of Dreze, Benassy, and Malinvaud.   In the end, the internal logic of the Walrasian general equilibrium framework inevitably prevails, and that’s why we got new classical macroeconomics, real business cycles, and DSGE.  “Models have a life of their own that may evolve independently from the motivation and vision of those who created them” (p. 203).  De Vroey’s focus on internal history thus leads him to emphasize a kind of inexorable internal dynamic driving that history.

One question begged by De Vroey’s account is why those who wanted to build on Keynes chose to do so in a Walrasian frame.  For the early Keynesians, as DeVroey points out (pp. 299-300), Walras was mainly connected with social engineering and the socialist calculation debate.  As such, the Walrasian model represented a kind of normative goal, and the burning question was whether socialist planning, or free markets, or some hybrid with aggregative management (such as Keynes) could best achieve that normative goal.  De Vroey suggests that Lange was an important source of Walrasianism for Modigliani, Patinkin, and Klein.  In my own work, I have drawn attention instead to the role of Marschak (Mehrling 2002, 2010, 2014).  Whatever the origin, the important point is that Walras was brought in for a reason.  Even more, that reason is arguably the origin of the idea of the neoclassical synthesis, even though Samuelson’s coinage of the actual phrase did not come until 1955 (p. 46).

As a sometime historian of macroeconomics myself, I have some sympathy with this general line of argument, though I would put the emphasis somewhat differently.  For me, the central problem with the Walrasian framework is the lack of any place in it for money, sometimes called the Hahn Problem after Hahn’s 1965 essay which was directed toward Patinkin but applies more generally.   As De Vroey observes (p. 3), Keynes was a money guy, and before the General Theory he wrote the Treatise on Money (1930), which notably was organized around the quantity equation, not the Marshallian frame that De Vroey emphasizes.  The tepid reception of that earlier book is what led Keynes to try again with the General Theory.   As I read Keynes, his policy ideas always come from his practical experience, as investor and statesman, and his books are attempts to translate those ideas into scientific language that will convince his economist colleagues.  The problem is that the decision of his early followers to translate his ideas into a Walrasian frame wound up importing the Hahn Problem into the very center of macroeconomics, though at the time none of them realized it.  What I have called “monetary Walrasianism” (Mehrling 1997) became the postwar orthodoxy not only of the Keynesians but also of monetarists such as Friedman, and it was only with the turn toward microfoundations that the Hahn Problem really began to bite.  As DeVroey points out, even Lucas (1972) had a Friedman-like quantity theoretic frame that included money, and it was not until Kydland and Prescott that money was finally eliminated.   It took a while for the internal logic of the model to play out.

I thus have a certain sympathy with internal history driven by the internal logic of mental frameworks.  But more generally I think that a full understanding of the history of macroeconomics requires more than that.  I conclude by drawing attention to two bits of outside influence that seem to me quite important for the story.

The first is the influence of the American institutionalist tradition, a tradition that was generally antagonistic to Marshall, on the early American Keynesians (Mehrling 1997, especially 130-136 on Alvin Hansen).  De Vroey refers frequently to the “pragmatism” of the early Keynesians, but to my mind he does not adequately appreciate the way that, in the American scene, pragmatism operated as a scientific methodology.  What American institutionalist Richard T. Ely called the “look and see method” is in fact characteristic of most of pre-Keynesian American economics, stemming from the writings of Charles Sanders Peirce and John Dewey, among others.  What looks like eclecticism to a European sensibility is in fact, at least at its best, a disciplined attempt to find the appropriate theoretical framework for a particular problem.  From this point of view, the significant methodological breach represented by Lucas was not so much a shift away from Marshall, as De Vroey argues (Ch. 10), but rather a shift away from pragmatism.

The second is the influence of the new field of finance on macroeconomics.   The idea that prices move to keep markets in equilibrium at every point in time, short run as well as long run, was foundational for modern finance before it became foundational for modern macroeconomics.  In fact, as I have suggested elsewhere, it showed the way (Mehrling 2010).   Way back at the beginning, the idea to understand “Liquidity Preference as Behavior toward Risk” (Tobin 1958) linked the IS-LM model conceptually with developments in asset pricing.   Today the Euler equation characterizing intertemporal optimization lies at the heart of both modern finance and modern macroeconomics:

U′(Cit) = Et[δU′(Cit+1)Rjt+1].

For finance, this equation is about how asset prices Rjt+1 depend on time and risk preferences, the equation is called the “consumption CAPM,” and the asset in question is typically equity or long-term bonds. But the same equation can be used to talk about the intertemporal fluctuation of income, and as such is at the core of both real business cycle theory and its New Keynesian variants. In this application, the asset is typically capital, or a rate of interest.   From this point of view, the significant methodological breach represented by Lucas was not so much a shift toward Walras as it was a shift toward finance.

At the end of the book, De Vroey reaches beyond his internalist historical frame and reflects a bit on the likely effects of the “2008 Recession” on the future of macroeconomics.   Certainly the DSGE models had little to say about the cause of the recession or possible policy response to it.  “As a matter of construction, DSGE models … exclude the possibility of integrating important pathologies into the workings of the market system, and certainly any collapse in the trading system of the extent that we have experienced” (p. 387).  One consequence has been an increased interest in returning to Keynes, but De Vroey thinks there is no going back.  Developments in macroeconomics will continue to respect the methodological strictures that Lucas and his followers have established.  Indeed, currently economists are hard at work trying to integrate a financial sector into the DSGE framework.  “At this juncture, it is however still difficult to gauge whether a mere integration of the financial sector within the existing framework will suffice, or whether a more radical reorientation of macroeconomics will see the light of day” (p. 388).

If I read him right, the radical reorientation that De Vroey has in mind would involve something like what Phelps did.  Specifically, Chapter 14 “Reacting to Lucas:  Alternative Research Lines” has a kind of wistful road-not-travelled feel, drawing our attention to search-theoretic work that De Vroey himself thinks showed promise for a possible alternative direction.  But no one picked it up, and in particular that no one developed an empirical program that would allow researchers to apply the theory to practical problems.  Maybe, but I’m not convinced.

For me the problem with all these search-theoretic models is that they emphasize market failure in the labor market, which they view as a kind of special case.  But the global financial crisis that led to the 2008 Recession was not a breakdown in labor matching.  It was a breakdown in wholesale money markets worldwide, the fundamental infrastructure that supports trading in all markets.   The more general Clower-Leijonhufvud wish list seems to me very much in line with what I have been calling the “Money View”, which I consider to be the natural implicit theory for people whose lives bring them into contact with money markets.   Making that implicit theory explicit would provide foundations for a possible macroeconomics.



Hahn, Frank.  1965.  “On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy,” in Hahn and Brechling, editors, Theory of Interest Rates.

Mehrling, Perry.  1997.  The Money Interest and the Public Interest:  American Monetary Thought, 1920-1970.  Harvard Economic Studies #162.  Cambridge:  Harvard University Press.

Mehrling, Perry.  2002.  “Don Patinkin and the Origins of Postwar Monetary Orthodoxy.” European Journal of the  History of Economic Thought 9 No. 2 (Summer):  161-85.

Mehrling, Perry.  2010.  “A Tale of Two Cities.”  History of Political Economy 42 No. 2:  201-219.

Mehrling, Perry.  2014.  “MIT and Money.”  In MIT and the Transformation of American Economics, edited by E. Roy Weintraub.  History of Political Economy (supplement).  Duke University Press.

Tobin, James.  1958.  “Liquidity Preference as Behavior Towards Risk.”  Review of Economic Studies 25 (February):  65-86.