Simon Wren-Lewis asks whether New Keynesians made a Faustian bargain by accepting the New Classical dictat that models must be grounded in intertemporal optimization — whether they purchased academic respectability at the expense of losing their ability to grapple usefully with the real world.

Wren-Lewis’s answer is no, because New Keynesians were only doing what they would have wanted to do even if there hadn’t been a de facto blockade of the journals against anything without rational-actor microfoundations. He has a point: long before anyone imagined doing anything like real business cycle theory, there had been a steady trend in macro toward grounding ideas in more or less rational behavior. The life-cycle model of consumption, for example, was clearly a step away from the Keynesian ad hoc consumption function toward modeling consumption choices as the result of rational, forward-looking behavior.

But I think we need to be careful about defining what, exactly, the bargain was. I would agree that being willing to use models with hyperrational, forward-looking agents was a natural step even for Keynesians. The Faustian bargain, however, was the willingness to accept the proposition that only models that were microfounded in that particular sense would be considered acceptable. It’s one thing to accept that models with an Euler condition at their core can sometimes be useful; it’s quite different to restrict your discourse to models with that characteristic, while ruling out everything else.

Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin. In the 1960s Tobin developed and elaborated a sophisticated view (pdf) of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more. I’ve found myself using Tobinesque analysis a lot since the financial crisis hit, because it offers a sophisticated way to think about the role of finance in economic fluctuations.

But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.

Then came the financial crisis, and many economists apologetically admitted that they had erred by not incorporating finance into their models, and announced plans to try to do that in the future. But why wasn’t finance in the models? Because a promising, once-influential approach to doing that, an approach that was in important ways much more sophisticated than what came later, was driven out because it didn’t conform to a particular, highly restrictive definition of what was considered valid theory.

So it was the acceptance of the unique virtue of one concept of microfoundations that constituted the Faustian bargain. And one thing you should always know, when making deals with the devil, is that the devil cheats. New Keynesians thought that they had won some acceptance from the freshwater guys by adopting their methods; but when push came to shove, it turned out that there wasn’t any real dialogue, and never had been.