The New Keynesians and the Nobel Prize

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0:32Adam Tooze: Hi, and welcome to Ones and Twos, FPs Economics Podcast. Every week we take a couple of data points, use them to try to explain the world. I'm Cameron Abadi, FPs Deputy Editor with you in Berlin, Germany. Joining us as always is FPs Economics Columnist and Columbia University Professor Adam Tews in New York. Hi, Adam. Oh, I can. So one segment for you all this week, and it's something of a tradition. The data point specifically is 14.8. That is the rate of inflation in March 1980 in the United States. That's the rate at which consumer prices were going up per year at the time. Local business leaders heard the bad news with little surprise.

1:15If 1980 has been marked by wild fluctuations in interest rates, gold prices, and the stock market, 1981 promises more of the same.

1:23Adam Tooze: Today, in contrast, the United States Federal Reserve and the ECB, the Bank of England, they all publish an explicit target of about 2 % inflation. And that target tells us more or less in advance where interest rates will be heading.

1:42Cameron Abadi: We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.

1:53Adam Tooze: And so between those two numbers, between 1980 and today, between that 14.8 and the 2 % that I mentioned, lies a really big shift in modern economic governance. Because central banks stopped kind of just applying interest rates and started talking about interest rates, trying to shape what households and firms expect to happen. And behind that shift lies a development in economic science. And that development was recognized by the Royal Swedish Academy this past week. On Monday, the Nobel Prize for Economics was awarded to two Americans, Michael Woodford of Columbia and Robert Hall of Stanford, for, quote, microeconomic foundations of macroeconomic stabilization.

2:43Robert E. Hall and Michael Woodford's research has helped governments and central banks make better managed periods of economic boom and recession.

2:53Adam Tooze: So they said that the work of these economists gave us a new theoretical foundation for the models that are used by central banks and governments around the world. Their work focuses on how insights from individual households and businesses can be used to guide broader economic policy and stabilize the economy during times of uncertainty. tea.

3:18Adam Tooze: Woodford is often cited as the architect of the kind of modern central banking toolkit. Hall also is cited in this context in terms of generally leading this shift to expectations and what's sometimes dubbed neo-Keynesianism. So as I mentioned, it's something of tradition for us to discuss the winners of the Nobel Prize for Economics. This year is no different. It's a heady set of ideas. And so we're going to take the entire episode to unpack them and what exactly is at stake. And so to start off with Adam, if you had to explain Woodford's framework and how it changed what central bankers do exactly, what is that exactly?

4:01Adam Tooze: And then when it comes to Hall, he seems also like a potentially odd pairing. As I was reading about his work, it kind of ranges from consumption theory, unemployment, recession dating more recently wrote about flat tax so what what holds hall's work and woodford's work together why was this a pairing in the first place as well yeah this is um this

4:25Cameron Abadi: is fascinating stuff it's very uh reminiscent of my own days of training as an economist in the 80s and it's the most technical noble prize in economics we've had in a while so you know So may the Lord forgive us for what we're about to do in trying to make sense of this and convey its general import. And part of the problem, in fact, is that Woodford and Hall's theoretizations are themselves very complicated and situated in very sophisticated ways in bodies of literature. And yet they've entered the mainstream to such an extent that it's actually quite difficult to pinpoint, you know, against the backdrop of our just general kitchen sink economics, what the kind of brilliance of their contribution is.

5:08Cameron Abadi: Because in some sense, we live in a world that they, well, the question you're asking is, did they shape it? I think a fairer assessment might be to say that Hall, in his late 70s work, kind of opened the space, a discursive space for thinking about the way in which expectations shape long term future economic behavior, most fundamentally consumption, which is the largest driver of demand. And in the models that Woodford uses, the very simple models, the entire economy is consumption. And then in the 90s, central bankers, actually driven by their own policy logic, adopted the signature policy that these two converge on, or Woodford in particular converges on, which is inflation targeting.

5:55Cameron Abadi: And then in 2003, Woodford published his sort of foundational book, which founded a kind of modeling tradition, which rationalized, exposed what central bankers were doing. So I think it's that order. So we have the breakthroughs in the theory from Hall. We have the shifts in policy as a result of the disappointment with policy frameworks in the 80s. And then interest in prices, Woodford's key contribution of 2003, which anchors all of this and has become the workhorse for standard macroeconomic theorizing ever since and for policy theorizing ever since. Okay, so that's the setup and the way this works.

6:33Cameron Abadi: What are the key intuitions here? And one way of setting this up will be to say it comes out of the radicalization of the neoclassical paradigm in the 1970s towards rational expectations. So towards the idea that in thinking about the economy as operating over time, at any given moment, the conditions of the economy are not just determined by factors that are working at that moment, but crucially in really quite fundamental ways by the horizon of expectation, one would say, almost coming from the philosophy of history. Economists call it expectations. And so that is really what shapes decision making at the current moment.

7:13Cameron Abadi: It's the relationship between, I almost said dialectic, it's the relationship between the current conditions and the future outlook. And Hall's fundamental contribution, and a very, as you've said, diverse oeuvre, was to say, look, we've got two fundamental contributions from the 70s. One is this idea that to model rational action, we have to model rational expectations, because it's no good to just simply say people are making choices in the present. They're not. They're making rational choices over futures they are imagining. And then for Milton Friedman, we have this idea that the Keynesian vision of consumption as just a function of immediate income is inadequate because, in fact, what intelligent households do is that they map their long-term income expectation and they smooth their consumption.

7:58Cameron Abadi: Ideally, they would kind of smooth it, presumably pretty much flat over the course of their lifetimes. And if that's the case, then consumption should take a particular pattern, which Hall, in a complicated backwards kind of logic, theorized that it would be indeterminate, actually. It would be random, but it would just be determined by the preferences of households, which were then shaped by their expectations of future income flows. And if you take that as your central anchoring idea about the economy and you do what Woodford does, which is move from individual households who are doing this maximization to making households, which are 70 % of can demand anyway, into the driver of a whole economy in a simple model, then you arrive at the conclusion, which is the crucial payoff here, that the way in which central bank policy will affect the economy is by way of manipulating interest rate and price expectations, not just the current levels of prices and interest rates, but interest rate and price expectations going forward.

9:02Cameron Abadi: And if you model the economy as consisted of households, which smooth their consumption over time, and firms, which are in a Keynesian way, stuck in a world in which not everyone gets to adjust their price simultaneously, but randomly assorted, and you can set the parameter higher or lower, more or less firms at any given moment have the freedom to adjust prices, but not everyone can immediately adjust prices. And all the firms have to make guesses as to the future. And those guesses are about price inflation and interest rates in the future. And then to so-called close the model, you add a central bank, which has a policy rule, which determines interest rates it sets, with regards to the inflation rate and the unemployment rate or the Phillips curve, the relationship between unemployment, or they call it output gap because we're in a world of neoclassical formulations.

10:00Cameron Abadi: Then we have a closed system in which the key variables are price expectations and interest rate expectations. And the job of the central bank is to maximize utility. And in a world of fixed prices, any kind of substantial inflation causes considerable welfare loss because only a fraction of firms can actually do the adjusting. And so others are suddenly out of equilibrium and you get real effects because not all prices can adjust. And so the role of the central bank in a model like this is to stabilize prices. And to do that, you stabilize expectations. And to do that, you stabilize confidence around policy.

10:43Cameron Abadi: And when I say all that, lay all of that out, that is the kitchen sink economics, which you and I have used over and over again in the pod for the last however many years it is to make sense of the world. But it is Hall's theorization of long run consumption as the core of a modern economy with regard to expectations. And then Woodford's generalization of that, and the addition of a fixed price supply curve kind of model for the firm side, and a rationalized central bank that has created this, a central bank represented in the model by an equation, some sort of version of what's called the Taylor Rule, which also we've discussed on the pod, that creates this sort of this closed model, which has become, as everyone calls it, the workhorse model of modern macro.

11:26Cameron Abadi: So to that extent, it really is a convergence of a variety of different themes, themes from rational expectations economics, themes from neoclassical economics in that in these models, were it not for price stickiness, we would be in optimal equilibria. And then this idea, and Woodford's book is a homage to Vixell, the great late 19th century monetary theorist, who theorized this, the question of the natural rate of interest, R star, which has become the guiding policy tool of central banking, because it's deviations from R star. and R star is the interest rate at which the economy actually stabilizes, that are seen as being the drivers of either dynamism or deflation.

12:21Cameron Abadi: And so the job of the modern central banker, they retrospectively discovered after they'd started already doing it in the 1990s, what Woodford's model tells them is that what you're trying to do is to get R close to R star such that by means of the manipulation of interest rates and expectations, you stabilize the economy at something like 2 % or less inflation. That's the kind of derivation. But as I say, it's so in the mainstream that to realize that this is actually a theoretical construct is itself in some way slightly destabilizing, but it truly is. It's built on this modeling

12:59Adam Tooze: architecture yeah obviously the technicalities there are complicated but i wonder if it could be helpful to rewind a bit in time to when these developments were being introduced in theory and then in practice i i you know the 1970s were the context for these developments and i'm curious maybe what were the ideas that were upended by these theoretical developments? Because, you know, we're referring to these thinkers as Neo-Keynesianism. So what were the kind of Paleo-Keynesian ideas, so to speak, that were upended? And yeah, what was then the context for introducing these changed ideas of macroeconomics?

13:50Cameron Abadi: I mean, first of all, just, First of all, let's just get our terminology sorted out because it's bewildering. So these are neo-Keynesians. Neo-Keynesians are left 1970s Keynesians who are the sort of people that want to do more interventionist polity, corporatist, price controls, modern monetary theory, functional finance, are kind of neo-Keynesian positions in the 70s and the 80s. These are new Keynesians. And New Keynesians are the school of Keynesianism that came out of the synthesis between Keynesian and macro picture that Keynes painted and its domestication. The Neo-Keynesians will say it's domestication by the conformist tendencies essentially of MIT macroeconomics.

14:38Cameron Abadi: So it's the Samuelsons, the Solos, people like this. We've talked about them on the show. The people like Joan Robinson, who's a Neo-Keynesian, oppose. and what the new Keynesians are doing, are trying to make Keynesianism respectable in terms of neo-classical economics, right? So new Keynesians are married with neo-classical economics and neo-Keynesians oppose the two of them. That's a bad marriage, right? This is bastard Keynesianism, is what somebody like Robinson would have called this. It's Keynesian at all, because it says that neoclassical economics has to reckon with the fact that in the actual world, there are price rigidities, which we are going to model in the most minimal way imaginable, so as to make it tractable for new neoclassical models by introducing this limit on price adjustment on the corporate side.

15:28Cameron Abadi: And that's the way we're going to do this. Once you do that, a bunch of other things follow, it turns out, and you get to conclusions which are a little bit like Keynesianism. So that's how this works. It's a little bit cosplay, really, because you're pretending to do Keynesianism because you want to take things like unemployment seriously, but you're doing it within a framework defined by neoclassical economics, which as the ideologically sensitive people like Robinson would insist, basically gives the game away from the beginning, right? Which is where then criticisms by Hewitt and people like that come in more recently because they're saying, look, you've just evacuated everything that was actually Keynesian.

16:02Cameron Abadi: They'll set this apart and go back to the 70s and why this is happening. So what's happening in the 70s is that a more widely inflected Keynesianism, which had a bunch of different currents, comes under huge pressure because of the familiar story about the breakdown of the framework of policymaking from the late 60s, the fact that the tradeoff between unemployment and inflation embodied in the Phillips curve no longer appears very good. It doesn't appear very good because it seems that if you aim for a balance between unemployment and inflation, you think, great, OK, this is an acceptable compromise.

16:35Cameron Abadi: Unfortunately, what stops the heart start happening is the inflation rate starts drifting upwards. Why? Because of wage price spirals, because workers begin to realize you're targeting that inflation rate and this unemployment rate. And in that case, we would like to reconsider the bargain and keep driving this up. So there's a collapse in the confidence in the first generation Keynesian, neoclassical Keynesian synthesis. And so it's replaced by more or less radical answers. And the new Keynesians at MIT, of which these are key exponents, are trying somehow in a rearguard action to save Keynesianism from this massive onrush.

17:13Cameron Abadi: And the massive onrush initially says, right, you know what we're going to do is we're basically going to take the central bank and we're going to target inflation by targeting the money supply, first generation monetarism. So it's this logic that we're seeing with this Nobel Prize is actually the product not of one disappointment, that is the disappointment of classic Keynesianism in the 70s, but a disappointment, secondly, with monetary targeting in the 1980s. And what's interesting is that Hall actually in the 80s published pieces, and I remember this discussion very vividly, where they said, right, we can't really target money supply creation.

17:50Cameron Abadi: So let's target nominal GDP, which is inflation and real economic growth in a single blob. That is something maybe the central bank can set. It's a little bit like what the Chinese would call social credit creation. So we're going to focus on the entire aggregate of nominal demand, like the whole flow of demand through the economy. And that is not the strategy that won out because that potentially would widen the central bank's remit to all sorts of types of credit creation. No, what they did was they backed away in the 90s towards saying, you know, no, no, no. The thing we should focus on is prices, just the output.

18:26Cameron Abadi: And then we'll use the interest rate to do the adjusting. And we won't take a view on credit creation, the money supply. We'll just use the interest rate to target the price level. That'll be more parsimonious and more straightforward. And we'll close the door to any nasty, neo-Keynesian, lefty kind of ideas. And it's that which Woodford then in the early 2000s is pivotal to rationalizing. So that's the kind of story through two failures, the 70s failure of old Keynesianism, so-called, the so-called failure, the manifest failure of monetarism to actually deliver a reasonable policy framework, the search for a new policy framework, which actually goes down a narrowing path, leads to price stability mandates with interest rates as the key policy variable.

19:09Cameron Abadi: and Woodford delivers by far and away the most sophisticated sort of synthetic argument for that framework.

19:17Adam Tooze: Well, I guess I should apologize for getting the neo-Keynesian and new Keynesian distinction wrong. I mean, honestly, I was going to say that almost sounds intentionally obfuscating to sort of have the mean opposite or opposing ideas captured in that distinction between neo and new. so i guess i'll also pin the blame on the terminology itself there's also post keynesian by the way yeah takes the neo one step further i i do find it interesting that there is a kind of it seems to me almost a democratic idea in sort of introducing the sense that like people's cognitive understanding of the economy is itself a factor or it's like a the sort of the foundational then factor in determining then how the economy may develop.

20:07Adam Tooze: And that it's sort of that, and that there is something in that idea that is almost, you know, from a political perspective, seems actually interestingly, uh, democratizing sort of, you need to sort of that, that people understand the economy and that understanding need that needs to be taken into account by, by policymakers, uh, and can't be ignored, I guess.

20:27Cameron Abadi: I think that's, I think that's a key idea. And it's very much of the 1970s moment, right? This is the moment of reflexive modernization of risk society, Ulrich Beck's work we've talked about on and off at various points on the show. It's definitely a move beyond the simple hydraulic technocratic view of the economy that says the economy is basically modeled as a series of flows of demand, which we technocrats standing outside that world can manipulate using the following variables. And this framework pushes back fundamentally at that by saying actually policy can only really work because the economy cannot adjust as quickly as it would like to adjust.

21:09Cameron Abadi: And so the best thing for policy to do is actually to aim for a certain sort of stabilization. And that stabilization, exactly as you say, acts on and through the rationality of the agents. Whereas if you think about Keynes, in the general theory, consumers don't have any agency. They're just behavioral functions of their income. And business people who do the investing are the victims of beauty contests and animal spirits. So there's no rationality anywhere except in the head of the Mandarin bureaucrat who's going to do the stabilizing. And there's a first cut. It's not a bad model and it reflects the politics of the insular period that in many ways is quite sympathetic because where we head in the 70s is the reverse, is to the celebration, the deification almost of market logic and the logic of investors of different types.

21:58Cameron Abadi: But it is certainly, this is the level at which to read this. This is absolutely a moment in the backlash against mid-century modernism, if you like, or mid-century technocracy. And it's saying, no, no, no, no, it's like so much more complicated. If you let the smart, cynical, manipulative actors in civil society know what's on your technocratic mind, don't be surprised that they exploit that knowledge because they're playing poker with you. They're not like a dumb, you know, fruit machine where you just keep pressing the button. They're playing poker with you. So look them in the eyes, and they will start reading your eyes, which is where then all of the, where was all of the issues credibility come from of central bank communication, all these kinds of things.

22:40Cameron Abadi: So it's a, in many ways, you know, the the Neo-Keynesian and post-Keynesian critiques coming from the left, you know, are quite on point in various ways, but they do underestimate this shift in the tone of policy, which is quite important. In practice, of course, in the end, it's not really the consumers that are the drivers here. Though they are the big aggregate of demand, of course, the main sounding board of central bank policy in this model are financial markets and particularly bond markets, which is why we talk about them all the time on the show, because that's where the interest rate moves by policy and where expectations of inflation do most of the work.

23:19Adam Tooze: Yeah, it's interesting. I mean, I guess it's almost maybe a new conception of technocracy in terms of the role that central banks then assume. Yeah, that's an interesting kind of new...

23:30Cameron Abadi: It's more Hayekian. I mean, there's a Burkean feel to this, like, you know, don't scare the horses. It's all about just creating a kind of settlement in which... And this is where, you know, you have these meta definitions of price stability. Price stability isn't just when prices are stable. Price stability is the situation in which no one's ever thought about prices because they are stable. And as soon as anyone starts thinking about prices, you're in trouble. And it's a fragile situation at that moment. And the BIS and people like that will actually even rationalize these cycles where preemptive aggressive policy is valid because it will take prices off the salience agenda.

24:07Cameron Abadi: So there's a lot of quite subtle and interesting politics embedded in this. So, you know, the exponents themselves aren't interested in that, really. They're interested in the formal modeling, which is impressive. But for the rest of us, I think that's another way of approaching this and understanding what they're trying to do. They really, it is not, you know, it's not wrong to think of this in the context of the so-called great moderation, which is kind of the macroeconomic equivalent of the end of history kind of thesis. You know, with the end of history is not just when history has stopped happening.

24:35Cameron Abadi: It's like when you can't even remember there was history. And that's a little bit like what the ideal of this kind of policy would just actually remove nominal price movement. Because with sticky prices, you don't want nominal price movement.

24:51Adam Tooze: Okay, we're going to take a quick break right here, but we'll be back in a second to continue talking about this year's Nobel Prize winners for economics.

25:37We'll see you next time. Plus. This episode is brought to you by Indeed. You're ready to level up your business, but the pressure to find the right person to make that happen is intense. Indeed Sponsored Jobs can help carry the load. It boosts your job post to help it reach quality talent fast. Cut through the chaos with Indeed Sponsored Jobs. Get a$75 sponsored job credit at indeed.com slash podcast. Terms and conditions apply. Hiring now? Then this is a job for Indeed Sponsored Jobs.

26:10Adam Tooze: You mentioned the critiques that emerge of this framework. And yeah, I mean, this sense that technocracy could sort of be abdicating maybe too much of its role to financial markets in general is, I suppose, an idea that comes up. And I was trying to read about critiques of Woodford's model. you know, I came across one essay by Ricardo Caballero in which he seems to be, yeah, suggesting that this model is sort of blind to how finance actually works in practice. And I'm curious how, you know, if we were to use the 2008 financial crisis as an example, how that played out and how that may have exposed weaknesses in this technocratic political model of central banking that we've been talking about.

27:01Cameron Abadi: Yeah, we go even deeper into the weeds here. So Caballeros, it's very important to realize that, you know, one of the central legitimacy crises of the 08 financial crisis, not widely felt and not on the streets and Donald Trump and Bernie Sanders aren't raising this, but inside the technocratic bubble is that these models were really not well designed to handle the 08 moment. and a lot of the most interesting monetary theory. We're remembering today, I don't know whether you saw, listeners may know that Perry Merling, the great monetary theorist died earlier this week, unexpectedly, it's an incredible shock.

27:42Cameron Abadi: But Perry was amongst a group of theorists who were saying already in the 2000s, look, the problem here is the workhorse model of monetary policy, which is moving one of the variables, which is absolutely crucial to the financial system, doesn't have a financial system in it. In fact, he's so explicitly designed to exclude it. The entire point of this model is to separate money and real economies radically from each other, all the while invoking a theorist like Vixell, for whom a cumulative logic by which too low interest rates generates investment and change the world permanently. They invoke Vixel and yet evacuate the actual logic of that kind of thinking about the economy in which money has real effects.

28:22Cameron Abadi: The whole aim of this framework is to ensure that money is neutral. It's telling us that in a real distorted world, money won't be neutral because as prices move, people can't adjust their individual prices. You get relative price change between businesses. Some businesses are stuck with too high or too low prices. Some workers have too high or too low wages. But that didn't turn out to be the 08 problem at all. The 08 problem was an endogenously generated huge surge in credit, which changed the structure of the US real economy by boosting construction even more radically in countries like Spain, much more cumulative causation logic.

29:02Cameron Abadi: And then it came crashing down in 08 because all of the emergent surgery that needed doing was within a financial system, which this model had really no way of describing. And then we slid in the 2010s into a world in which interest rates were largely not working as policy instruments, because it was theorized then as our star being below zero, you actually would need to have set a negative interest rate, which some central banks experimented with. But we slid out of this world. And so the Caballero critique is sort of double-sided. I mean, It takes its title from a Hayek essay from the early 70s, The Pretense of Knowledge.

29:40Cameron Abadi: And it says in a kind of twisty way, look, we started in the 70s by critiquing technocratic pubris. The whole point of rational expectations was in a sense to say, take civil society, take the economy seriously. What you ended up building in the 2000s was an even more elaborate, even more confidence inspiring technocratic model that told you you had to stabilize the economy with just this one variable. And guess what? But your model in its hubris didn't even include the crucial sector that was going to do the damage. You just literally don't have a financial sector in your model. And you've designed it specifically to not have it there.

30:15Cameron Abadi: And then Woodford tried to respond to this by saying, OK, let's introduce a financial sector which also has stickinesses. Like the other way, which this is the classic New Keynesian move, right? Assume a neoclassical reality and then tweak it by introducing a stickiness. But that, of course, doesn't get either to the hubris problem. It doesn't get to the fact that the modeling in and of itself had seduced central bankers into thinking they had this thing under control and the risks were manageable. And B, it introduces finance, but in a way which captures only, as it were, its most milquetoast elements.

30:52Cameron Abadi: and you know this is the second novel recently which in a sense you know there was the one for the banking theorists you know we're seeing a generation of theorists who were in the end hit by 08 09 and who seemed to be talking about these issues but none of whom really in a substantial way addressed addressed the the infrastructure of financial capitalism that the blew up in 08 so So this is all of Krugman's writing in this period, the return of Minsky, who would, of course, argue that the longer you have financial stability, the greater the risk of building up to some absolutely epic crisis. Hard to theorize within this framework, which fetishizes stability as the absolute goal of policy, minimizing welfare losses.

31:38Cameron Abadi: you know that that whole backlash the the burst of heterodoxy in the which you know the interest in my work comes out of or the crashed book all of this implicitly is pitched against this kind

31:50Adam Tooze: of modeling yeah i mean i guess it seems like the fault line of this kind of theoretical critique maybe is that the model seems to then maybe assume that the financial actors uh in general are I guess rational ultimately and sort of making rational decisions. It's worse, Kemp.

32:10Cameron Abadi: There are no financial actors in the standard model.

32:13Adam Tooze: Yeah.

32:13Cameron Abadi: Just aren't any. And the models that were widely used before 2008, there just weren't any. You have a household sector, which does the smoothing. You have a business sector, which is struggling to find how it can adjust its prices as the overall price level moves, which of course is an abstraction from the aggregate of all individual prices. And so those businesses are just trying to, there's no space in this model for credit creation as a dynamic driving force. And that's because, you know, they're aiming for simplicity. This is like these kinds of critiques in a sense go past what these folks are trying to do because they are actually trying to create parsimonious, simple frameworks, which they think capture the essence of the situation.

32:51Cameron Abadi: In this case, they just, you know, they looked past the elephant in the room and said, we should be talking about the, you know, the bunny rabbit in the corner.

33:00Adam Tooze: I mean, I guess if we were to consider maybe a critique from a completely different side, we've talked obviously on this podcast about the new Fed chief, Kevin Warsh, and how he rejects the premise of forward guidance. That's sort of been one of his big points in coming into his post. I mean, does that mean he rejects Woodford's framework for central banks?

33:26Cameron Abadi: The beauty of this is that this Nobel, at the same moment of Walsh's inauguration as Fed Chair and his first speech at Jackson Hole, which was widely thought of, I think, as in August, as a kind of effort by Walsh to re-ingratiate himself with the policy community that had begun to get really jittery about him over the summer. The beauty of this Nobel Prize is from a teaching point of view is the answer to your question is, in a sense, yes, what Walsh is wrestling with from a more kind of fundamentalist conservative point of view is are the policy legacies of this era of central bank expectations based interest rate based policy.

34:11Cameron Abadi: And whether or not Walsh can really formulate a coherent alternative or whether in a sense we are now fated to live in a world shaped so profoundly by central banking policy is another question. But I think Walsh, at least in his opening pronouncements, this was part of his agenda. And what he wants to do is affect, if you like, an even more radical separation. He wants the real economy to do the real economy stuff. And he wants the central bank to not mess with that. What Woodford and Woodford et al. are saying is, no, that's not going to work. The central bank has to be in the game. It can, however, optimize its policy so as to achieve a kind of neutrality.

34:57Cameron Abadi: Whereas Walsh is kind of cutting the Gordian knot and saying, well, if we just stop talking, maybe that'll get us there. Yeah. And then the question is, well, if you're not going to talk, are we just going to do this randomly? We can't just randomly on the whim make policy, right? You're going to have to have some sort of data determination. When you have some sort of data determination, everyone's going to assume you've got a rule. If you've got a rule and you announce the rule, effectively you are doing it. Is that the expectations manager? Is that what we're actually doing? To which Walsh might say, well, maybe that is what we're doing.

35:33Cameron Abadi: But maybe it's even true that the central bank is not really able to fully forecast its own rule. Maybe we aren't actually capable of stabilizing our rule, which would slide from a kind of principal position of preserving the central bank as an outside actor to a kind of more roundhouse critique of any kind of central bank governance at all. But it is the wash move in cutting the Gordian knot, you know, is so far not convincing as an answer. Because that goes back to much more principal positions in the 70s, which were saying we should have non-discretionary monetary policy following a rule. And what Woodford et al.

36:11Cameron Abadi: show is, well, yes, insert that into a world in which you have all these other players. And then how do we derive optimum policy in that context becomes the question. And their answer, and the answer has been, it's like, actually, it does depend on this forward guidance of expectations, more or less. So you can't get back out, you can't escape, there's no way back really to full innocence.

36:34Adam Tooze: Well, it's interesting, though, because, you know, if we take these two critiques that we've just discussed, right, I mean, the kind of Warsh critique that's implicit in his comments about forward guidance and the general, you know, leftist critique represented by this Ricardo Caballero perspective. I mean, it seems like together they kind of depict this theory that just won the Nobel Prize as kind of like perched on this ledge, you know, between where central banks are trying to intervene, but in a really, yeah, kind of restraining themselves to intervene in a kind of technocratic way. by just sort of restricting themselves to managing expectations.

37:26Adam Tooze: And I guess these critiques from different perspectives are sort of suggesting this is not stable, right? That in one way or another, this kind of, this is an unstable, ultimately, intersection of politics and finance. And that, you know, whether it gets resolved in one way or another, whether it's sort of resolved in the direction of becoming more explicitly political and interventionist or the opposite, I guess sort of even taking a step back from politics in order to let markets sort of be more autonomous. It seems like these critiques are suggesting this is an unstable intersection. But is that a kind of correct way of looking at these critiques?

38:03Cameron Abadi: I think that's fair. And that could be seen as a critique of the, you know, Woodford, New Keynesian sort of synthesis. but I think in defense of Woodward and after all it's an incredible achievement to win a prize like this I'm not just saying that because he's a colleague of mine I think it might to an extent be missing the point because there are three things there's the political economy and the history that you're invoking and I think there evidently you're absolutely right that this is an inherently unstable relationship and then there's the use that are made of these models that, as I was arguing right at the very beginning, developed independently of central banking practice.

38:45Cameron Abadi: And central banking practice went down this route before the models came along. And then there was a kind of elective affinity between the models and the central banking practice. That's understating it a little bit because monetary economics is done heavily in central banks, so there's a close affinity. But they're separate processes of development. And then there is what the models, fairly read, actually are attempting to do and say. and though it is hard I think to take in and to assimilate to any common sense understanding of what economics ought to be about overwhelmingly what these models are doing are asking questions and it's a very strange hypothetically formulated question but it goes all the way back to Lucas in the 1970s and the question they're asking is something along the lines of and it's hard to get this right so I'm going to give it an attempt though so if the world is shaped a certain way, given the way in which consumers optimize over the long run and there's price stickiness, and there is a central bank, a policymaker of some type in it, is there anything meaningful that we can say about optimal policy under these circumstances?

39:54Cameron Abadi: Which is not the same thing as, you know, if you're actually in the real world, should you do this? It is the question, is this model determinate with regard to optimality? That's the question. It's a very formal question, right? If you've got three equations, do they produce a determinate equilibrium? And can we, by manipulating different parameters and those equations, make coherent, reliable statements about what optimality would look like? And Lucas was saying that no discretionary policy in the 70s will ever allow you to make robust statements about optimality, because you may think it's good right now, but A, other people will second guess you and change the parameters.

40:38Cameron Abadi: And B, no one will believe that if they change the parameters, you will reliably stick on your policy as the policymaker. And furthermore, once you have, as policymaker, fooled them into staying in the world that you want to manipulate, you will have an overwhelming impulse to revise the term so you'll have time and consistency of policy. And if all of those things are true, what they're saying is your best bet is to institutionalize and constitutionalize, because that's the way to manage discretion. And if you do that and you abstain from doing discretionary policy, you might even be able to say something reliable and meaningful about optimality as a general thing, but only if we get out of the discretionary game.

41:18Cameron Abadi: Now, that doesn't mean you can't achieve good effects with discretionary policy. It's just you can't say anything general about that. That could just be sometimes it'll work. Sometimes it won't work. There might be a very good case for doing it right now. But don't ask me as an economist, and my job is generality as an economist, to tell you in general terms whether this policy is going to be good or bad. And what Woodford and Co are doing is elaborating that with a new Keynesian framework in which they're saying, well, if you have price inflexibility, the monetary policy will not be neutral. So what under those circumstances would be the best policy?

41:49Cameron Abadi: And what can we say in general about what a good policy under those circumstances would be? Not in a particular case, but in general with models of this type of the economies generally like this. And they drive the conclusion that we actually converge back to a very conventional understanding that the optimal policy would be price stabilization by means of the interest rate and the management of expectations. And that's all they're doing. They're not, you know, in fairness to them, that's the game they're involved in is not specifically, is this policy right or wrong? That's absolutely not their project.

42:18Cameron Abadi: Their project is, is there a science here? In other words, are the abiding general properties that we can distill on the basis of which then we can make timeless, if you like, recommendations, non-specific recommendations about the proper ordering of these relationships. And the minimal 70s program was independent central bank, non-discretionary policy. And what they're saying was, well, that presumed that the real economy is basically mutual with regard to money. That's not true. Once you've got fixed prices, New Keynesian style, you've got a problem. So how, if you're in a world with a problem, do you manage this best?

42:53Cameron Abadi: And that is all they're saying, really. So that's the kind of minimalism of the claim, I think, in its own terms. It's not what we want from it. It's not what's been made out of it. But I think in fairness, that's kind of what it's trying to do.

43:07Adam Tooze: No, I mean, that's actually a useful description because listening to you, it strikes me that in a sense, this is about the technocratic posture per se, right? I mean, this is about whether models work at all or are worthwhile, right? I mean, it seems like the critique is rather that modeling is itself a hubristic act. And for a technocrat to even do as much as is kind of like indulging in something that is kind of maybe you can psychoanalyze in some way.

43:36Cameron Abadi: Yeah, they're new Keynesians because they believe there are sort of problems that Keynes described, but they're in their academic intellectual hearts so deeply wedded to the neoclassical paradigm that they have to rationalize their answers in those terms. And so that leads them to this sort of moderated version of technocratic hubris, or rather it causes them to formulate models which actual technocrats then turn into policy, but that can be very hubristic.

44:03Adam Tooze: To me, it's interesting that both the kind of leftist critique and the kind of, you know, more rightist critique from the Warsh perspective, say, are both kind of anti-modeling in that sense almost. It's almost as if like, yeah, you know, it's almost anti-technocratic.

44:18Cameron Abadi: And I'm trying to add the further element, which is beyond the question of modelling. There is the question of what kind of conclusions do you want to be able to draw? And what I think is really distinctive about this type of highly formal economics is the sort of conclusions they want to draw are of the type, what can we reliably say about optimal policy under the following assumptions? And that is not saying what can we reliably say about what you should do at this particular moment. In fact, it might very well be the case that your conclusion is that those sorts of statements are in fact systematically that you can make them, you can drive the conclusion, but you will not by way of the model be able to vindicate them by saying, you know, by following the general rule we ended up in there.

45:04Cameron Abadi: That path is foreclosed, right? So because of these reflexivity loops, the only sort of optimality statements we can make are about these policies of institutionalized stability, which is a which is a interesting refusal of logic of history and has much in common with conservative ideas about constitutionalism and, you know, and Hayek as well in a deep sense.

45:27Adam Tooze: interesting i i think we need to end the conversation here uh for now but yeah this was definitely one of the more technical uh nobel prize conversations we've had of course we'll do the same in a year uh we'll see who wins you know and uh go from there but for now we'll be back next week with new data points ones and twos is written and edited by adam and me and produced by claudia tady the show is made possible through the support of foreign policy readers and Ones and Twos listeners. As always, we love getting listener feedback. You can leave voice messages on the Ones and Twos homepage on foreignpolicy.com or email us.

46:09Adam Tooze: That's podcasts at foreignpolicy.com. Or you can tweet us. That's at Ones and Twos pod. I'm Cameron Abadi. Thank you very much for listening. And we'll be back in your feed next week.

46:50We'll see you next time.