Mani Basharzad is a Junior Research Associate at the IEA.
Bryan Cheang is a Research Fellow at the London School of Economics and Director of the LSE Hayek Programme.
In a 2003 lecture, Nobel laureate in economics Robert Lucas said, “macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved”. Five years later came the 2008 financial crisis. Indeed, macroeconomics is arguably the subject over which economists disagree most. There is greater consensus on microeconomics, it is in macroeconomics that the rival schools of thought divide. It is easy to see why: macroeconomics has a history of failure, from the collapse of the Keynesian consensus in the 1970s to the 2008 crisis.
“There is no such thing as macroeconomics”, said Armen Alchian, an economist who many believe should have won the Nobel Prize in Economics. His work on property rights and the theory of the firm influenced several later Nobel laureates. Had he lived to see it, he would surely have welcomed this year’s Nobel Prize in Economics, awarded to Robert E. Hall and Michael Woodford for their work on the microeconomic foundations of macroeconomic stabilisation.
What was the failure of macroeconomics? In his 1974 Nobel lecture, ‘The Pretence of Knowledge’, F. A. Hayek warned that many people came to economists seeking solutions to inflation, forgetting that the solutions offered by those economists had helped create the mess in which they found themselves. The fatal error of macroeconomics was the illusion that exact relationships could be found between aggregates, such as the relationship between unemployment and inflation. Observed patterns led economists to believe that these outcomes could be controlled from the top down. Roger Scruton warned against the temptation to “pretend that there was an expert science that could amend and replace the findings of common sense”. That warning applies with particular force to macroeconomics.
The problem was the belief in macrofoundations: that we could identify relationships between aggregate outcomes and therefore control them. What was missing was the recognition that aggregate concepts such as unemployment and productivity have no meaning without microfoundations. This is what research into the microeconomic foundations of macroeconomic stabilisation has shown. In this respect, it echoes an older insight of economists such as Hayek, Ludwig Lachmann and Alchian, who took it much further. Taken seriously, microfoundations reveal the way in which various capital goods and resources are constantly being shuffled across a variety of ends by entrepreneurial agents serving consumers. Such micro-level activity cannot be planned, anticipated or manipulated by policy aggregates.
Robert E. Hall and Michael Woodford have helped develop modern macroeconomics through microfoundations. They sought to understand macroeconomics through the lens of microeconomics. Rather than simply blaming unemployment on insufficient demand, Robert Hall studied search and matching frictions in the labour market. He modelled unemployment as the result of individuals navigating information gaps and transaction costs. Michael Woodford, in his major work, Interest and Prices, brought the insights of microeconomics to the understanding of monetary policy. Individual firms adjust prices at different times and in response to localised information, meaning that changes in monetary policy can create relative price distortions.
Their work is often read as a guide to how central banks can stabilise the economy, and the Nobel committee praised it in those terms. But taking microfoundations seriously carries a broader lesson: economic policymakers have less power than is often assumed. They cannot simply solve our growth problems, and the power of monetary policy is limited. Growth comes from the decisions of individuals and firms. In simple terms, a top-down approach to managing the economy does not work as policymakers often imagine. What really creates growth is individuals having greater freedom to innovate, move their capital, trade and take risks. Rather than trying to engineer market forces, politicians should understand how restricted their power is. That, in our view, is the most important lesson of microfoundations for macroeconomics: in a world where people have expectations and change their behaviour accordingly, monetary policy has limited power. This difficulty stems from the diversity of human plans and their dynamic changes in an open society.
This is the insight behind the ‘Lucas critique’, named after Robert Lucas, one of the main figures behind this line of research. If a government tries to stimulate growth simply by pumping money into the economy to raise aggregate demand, a purely macroeconomic model might predict smooth and predictable growth. However, a microfounded view warns that individuals will change their behaviour in response to that policy. If business owners anticipate future inflation or higher tax rates as a result of government stimulus, they may freeze hiring and pull back on investment, undermining the intended growth.
The problem of macroeconomics is not solved, and perhaps it never can be. Economics is not an exact science, and there are no optimal solutions but, as Thomas Sowell said, “only trade-offs”. The sooner economists and policymakers understand this simple lesson, the better. The idea of macroeconomic policymakers as operating a stabilising hand that smooths business cycles at just the right time, with the right levers and at the right magnitude, is a technocratic fantasy.
Policymakers are once again learning this lesson the hard way, as governments that promise more than they can afford find bond markets less forgiving. In France, markets are losing confidence; in Britain, long-dated gilt yields have reached their highest levels in decades. We need to adjust to this reality. A government that wants to achieve everything may ultimately achieve nothing. Yes, market failure exists, but government failure is more common and costly.
In The Theory of Moral Sentiments (1759), Adam Smith used the example of chess to illustrate the danger of top-down planning. Social engineers, or what he called the “man of system”, are mesmerised by the “supposed beauty” of their top-down plans. They imagine they can manage society like a game of chess, moving its pieces as they please. But, as Smith said, on the “great chess-board of human society, every single piece has a principle of motion of its own”. The Nobel Prize has embraced microfoundations; perhaps it is time for our politicians to do so as well.
Thank you. I'm not a serious student of economics but there is a problem with macroeconomics that will be familiar to engineers. Governments and central banks attempt to provide "negative feedback" to dampen swings in economic activity. However, the information upon which they act is always out of date, and engineers know the dangers of feedback systems incorporating delay - they can go unstable. An easy thought experiment is to drive a vehicle based not on the view through the windscreen, but on a screen showing the view delayed by some seconds. It doesn't require much of an imagination to see there might be trouble.
Thomas Sowell, quoted in the article, contends that the US economy for its first 150 years, when the US government "sat and twiddled its thumbs", experienced recessions from which it recovered quickly, until 1929 and the Great Depression, which was accompanied by government intervention. So is at least some macroeconomics really an exercise in conceit?
most economic and financial problems are caused by economic and financial interference from governments and banks.