Over at the Economix blog, Binyamin Appelbaum has a post about Stan Fischer’s role in the early development of New Keynesian macroeconomics. I was a student at MIT at the time, and remember Stan assigning papers on long-term contracts, which he viewed as one possible way to think about the sources of nominal price and wage stickiness – which he obviously considered both a clear fact about the world and important.

What’s interesting, as Appelbaum notes, is that the revival of Keynesian ideas was taking place at a time when Chicago was proclaiming Keynes gone, vanquished, consigned to the dustbin of history, pushing up the daisies, joined the choir invisible (hand invisible?). So why was Stan not willing to go with the seemingly triumphant paradigm?

One answer, I’d suggest, was his friendship and collaboration with Rudi Dornbusch, who was leading international macroeconomics in a direction very different from where Lucas and later Prescott were taking the domestic side of the field.

You can argue that even without Rudi’s leadership, international macro would probably have rejected the perfectly-flexible-prices, it’s-all-equilibrium tendency. For even a cursory look at international data makes a compelling case for short-run price stickiness. Exchange rates behave like asset prices, swinging wildly year to year; goods prices move much less, which means that the real exchange rate – the relative price of two currencies, deflated by the ratio of price levels in the two countries, fluctuates wildly too. But the real exchange rate is the relative price of two bundles of goods; it’s a real variable. It’s very hard to tell a story about why it should move the way it does without invoking some kind of price stickiness.

Look, for example, at the Japan-US real exchange rate, defined as yen per dollar * US CPI / Japan CPI:

Photo

The nominal rate and the real rate have swung wildly, and always in tandem, which makes perfect sense if you think of the exchange rate as an asset price and goods prices as sticky, but is very hard to justify in a neoclassical model.

So international macro was probably going to stay relatively Keynesian, simply because the facts had such a well-known Keynesian bias. But Rudi Dornbusch brought something extra: he showed how to bring rational expectations, at least as a hypothesis, into the sticky-price paradigm, and showed that you could do interesting, fun stuff with the combination.

I was Rudi’s student when he was working out the classic “overshooting” model, and got to see a bit of the struggle involved – because like almost all seemingly simple ideas in economics, it was the product of a lot of hard thinking. What emerged, however, was hugely influential, even though I don’t think many people regard it as the main explanation of currency volatility.

Rudi asked what would happen if a central bank for some reason suddenly and permanently increased the money supply. In the long run, just about all economists agreed that this would lead to an equal proportional rise in the price level and depreciation of the currency. In the short run, however, prices are clearly sticky, and expansionary monetary policy reduces interest rates. So what happens to the currency? As Rudi pointed out, the fall in the interest rate would induce investors to move their money abroad unless they expected the currency to rise. And the only way that could happen was for the currency to depreciate past its long-run value – to overshoot – so that it could be expected to appreciate back to that value over time.

As I said, this isn’t the real reason currencies fluctuate so much, but no matter. Rudi showed that you could produce interesting, provocative analyses by recognizing the role of forward-looking financial markets while retaining a realistic view of price behavior in goods markets. This, in turn, meant that the best and brightest students in international macro didn’t throw Keynes out the window. And at MIT, where Rudi’s influence was strong, it meant that even those in domestic macro, like Olivier Blanchard – and Stan Fischer – retained a skeptical attitude toward the neoclassical takeover.

Ken Rogoff had a very good paper on all this, in which he also says something about the state of affairs within the economics profession at the time:

The Chicago-Minnesota School maintained that sticky prices were nonsense and continued to advance this view for at least another fifteen years. It was the dominant view in academic macroeconomics. Certainly, there was a long period in which the assumption of sticky prices was a recipe for instant rejection at many leading journals. Despite the religious conviction among macroeconomic theorists that prices cannot be sticky, the Dornbusch model remained compelling to most practical international macroeconomists. This divergence of views led to a long rift between macroeconomics and much of mainstream international finance … There are more than a few of us in my generation of international economists who still bear the scars of not being able to publish sticky-price papers during the years of new neoclassical repression.

Notice that this isn’t the evil Krugman talking; it’s the respectable Rogoff. Yet he too is in effect describing neoclassical macro as a sort of cult, actively suppressing alternative approaches. What he gets wrong is in the part I’ve elided with my “…”, in which he asserts that this is all behind us. As we saw when crisis struck, Chicago/Minnesota had in fact learned nothing and was pretty much unaware of the whole New Keynesian enterprise — and from what I hear about macro hiring, the suppression of ideas at odds with the cult remains in full force.

Anyway, the point was that international macro — which was my home within macro — never bought into the nonsense, largely thanks to the Dornbusch influence.Thank you, Rudi.