For those who do not follow the ins and outs of academic macroeconomics, it is perhaps useful to say that there has been an ongoing struggle in recent decades between what is sometimes called freshwater and saltwater economics.
At risk of being struck dead by lightning for gross oversimplification, I’ll just say that freshwater economists tended in the 1970s and 1980s to cluster around places like the University of Chicago, the University of Minnesota, the University of Rochester, and Carnegie Mellon University. Their version of macroeconomics tended to emphasize the themes that economic fluctuations were caused by shocks to supply (like technology) and that discretionary federal macroeconomic policy was likely to have weak or even counterproductive effects. In contrast, the saltwater economists at that time tended to congregate at places like Harvard, Yale, and Berkeley. Their version of macroeconomics tended to emphasize that economic fluctuations were caused by shocks to demand (like bank failures or credit boom-and-bust cycles) and that discretionary federal macroeoconomic policy was not only useful but also necessary in helping to offset such shocks.
Over the decades, the two schools have become somewhat intertwined in the form of what is sometimes called “New Keynesian” economics (for discussions, see here and here). But the spirit of the old dividing lines still remains. The saltwater economists accuse their freshwater siblings of being slaves to models that assume excessively rational people and excessively perfect markets; in response, the freshwater economists accuse their saltwater kinfolk of promiscuously adding theoretical restrictions for immediate convenience, without digging deeply enough into their foundations and implications.
Paul Krugman, as a certified salt-water economist, offers a thoughtful explanation of the merits of this approach as exemplified in the macroeconomics of another certified salt-water economist in “The Godley–Tobin Memorial Lecture: The Second Coming of Tobinomics ” (Review of Keynesian Economics, Spring 2023, vol. 11: issue 1)). Krugman writes:
James Tobin was, obviously, a Keynesian in the sense that he believed that workers can and do suffer from involuntary unemployment, and that government activism, both monetary and fiscal, is necessary to alleviate this evil. But he wasn’t what people used to call a hydraulic Keynesian, someone who imagined that you could analyse the economy by positing mechanical relationships between variables like personal income and consumer spending, leading to fixed, predictable multipliers on policy variables like spending and taxes. …
Instead, Tobin was also a neoclassical economist. That is, he believed that you get important insights into the economy by thinking of it as an arena in which self-interested individuals interact, and in which the results of those interactions can usefully be understood by comparing equilibria — situations in which no individual has an incentive to change behaviour given the behaviour of other individuals.
Neoclassical analysis can be a powerful tool for cutting through the economy’s complexity, for clarifying thought. But using it well, especially when you’re doing macroeconomics, can be tricky. Why? It’s like the old joke about spelling ‘Mississippi’: the problem is knowing when to stop.
What I mean is that it’s all too easy to slip into treating maximising behaviour on the part of individuals and equilibrium in the sense of clearing markets not as strategic simplifications but as true descriptions of how the world works, not to be questioned in the face of contrary evidence. Notably … perfectly clearing markets wouldn’t have involuntary unemployment. So if you’re a neoclassical economist who doesn’t know when to stop, you end up denying that there can be recessions, or that, say, monetary policy can have real effects, even though it takes only a bit of real-world observation to see that these propositions are just false.
So part of the art of producing useful economic models is knowing when and where to place limits on your neoclassicism. And strategic placing of limits is a large part of what Tobinomics is about.
What do I mean by placing limits? Tobin was, first of all, willing to ditch the whole maximisation-and-equilibrium approach when he considered it of no help in understanding economic phenomena — which was the case for his views on labour markets
and inflation, which I’ll get to later in this paper.
Where he did adopt a neoclassical approach, he did so using two strategies that economists need to relearn. First, he was willing to be strategically sloppy — to use the idea of self-interested behaviour as a guide to how people might behave without necessarily deriving everything from explicit microfoundations. Second, he was willing to restrict the domain of his neoclassicism — applying it to asset markets but not necessarily to goods markets or the labour market.
Krugman illustrates his argument with a detailed example from Tobin’s work, but for my purposes, I’ll stop there.
I like the old joke about the problem with spelling “Mississippi,” which seems applicable to me in a number of real-world and academic situations. In a number of situations it can be a useful exercise to start with a pure theory, and then take a steam shovel to dig into its foundations and a telescope to look out at its possible implications. But when you reach the stage of bringing a pure theory to data, especially in the social sciences, it becomes necessary and practical to introduce a degree of strategic sloppiness; for example, the data or the setting you have to work with often will not exactly match the pure theoretical assumptions. The choice of which kinds of real-world strategic sloppiness are most relevant to a given question will often be central to the real-world controversy.