This week, the Nobel Memorial Prize in Economic Sciences was jointly awarded to two American economists, Michael Woodford of Columbia University and Robert Hall of Stanford University, for their work on “microeconomic foundations of macroeconomic stabilization.” The prize committee concluded that Woodford and Hall each provided a theoretical foundation for the models now used by central banks and governments around the world.
What links Woodford’s and Hall’s work? What political context did it emerge from? And does U.S. Federal Reserve Chair Kevin Warsh reject Woodford’s model for central banking?
Those are just a few of the questions that came up in my recent conversation with FP economics columnist Adam Tooze on the podcast we co-host, Ones and Tooze. What follows is an excerpt, edited for length and clarity. For the full conversation, look for Ones and Tooze wherever you get your podcasts. And check out Adam’s Substack newsletter.
Cameron Abadi: Woodford is known for helping change what central bankers do, whereas Hall’s work is more far-ranging, from consumption theory to unemployment. More recently, he wrote about a flat tax. So, what holds Hall’s work and Woodford’s work together? Why was this a pairing in the first place?
Adam Tooze: This is the most technical Nobel prize in economics we’ve had in a while, and when trying to convey its general import, part of the problem is that Woodford’s and Hall’s theorizations are themselves very complicated and situated in very sophisticated ways in bodies of literature.
Yet they’ve entered the mainstream to such an extent that it’s quite difficult to pinpoint against the backdrop of our general, kitchen-sink economics what the brilliance of their contribution is. 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, opened 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.
In the simple models that Woodford uses, the entire economy is consumption. Then, in the ’90s, central bankers, 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. In 2003, Woodford published his foundational book, which founded a kind of modeling tradition that rationalized ex post what central bankers were doing.
So I think it’s that order. 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.
What are the key intuitions here? One way of setting this up would be to say it comes out of the radicalization of the neoclassical paradigm in the 1970s toward rational expectations. So toward 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 by the horizon of expectation, as one would say coming from the philosophy of history. Economists call it expectations.
That is really what shapes decision-making at the current moment. It’s the relationship—I almost said dialectic—between the current conditions and the future outlook.
Hall’s fundamental contribution in a very 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 making rational choices over futures they are imagining. Hall theorized that consumption is determined by the preferences of households, which were then shaped by their expectations of future income flows.
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 percent of demand anyway, into the driver of a whole economy in a simple model—then you arrive at the conclusion that the way in which central bank policy will affect the economy is by manipulating interest rate and price expectations, not just the current levels of prices and interest rates.
And if you model the economy as consisting of households that smooth their consumption over time and firms that are in, a Keynesian way, stuck in a world in which not everyone gets to adjust their price simultaneously, then to close the model, you add a central bank that has a policy rule that determines interest rates with regard to inflation and the unemployment rate, also known as the Phillips curve.
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. 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. Others are suddenly out of equilibrium, and you get real effects because not all prices can adjust.
The role of the central bank in a model like this is to stabilize prices. To do that, you stabilize expectations. And to do that, you stabilize confidence around policy. When I lay all of that out, that is the kitchen-sink economics that all of us have become accustomed to using.
CA: What exactly was the historical context for introducing these changed ideas of macroeconomics?
AT: Let’s go back to the ’70s: So, what’s happening 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 trade-off between unemployment and inflation embodied in the Phillips curve no longer appears very good. It seems that if you aim for a balance between unemployment and inflation, you think: Great, OK, this is an acceptable compromise. Unfortunately, the inflation rate starts drifting upwards.
Why? Because of wage-price spirals, because workers begin to realize you’re targeting that inflation and this unemployment rate. 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. It’s replaced by more or less radical answers.
The new Keynesians at MIT, of which these are key exponents, are trying in a rearguard action to save Keynesianism from this massive onrush. The massive onrush initially says, we’re basically going to take the central bank and we’re going to target inflation by targeting the money supply, first-generation monetarism. The logic that we’re seeing with this Nobel prize is actually the product not of one disappointment—that of classic Keynesianism in the ’70s—but a second disappointment with monetary targeting in the 1980s.
That’s the story—two failures: the ’70s failure of old Keynesianism and the manifest failure of monetarism to deliver a reasonable policy framework. The search for a new policy framework, which goes down a narrowing path, leads to price stability mandates with interest rates as the key policy variable. And Woodford delivers far and away the most sophisticated synthetic argument for that framework.
CA: It does seem as if there’s a democratic idea involved in introducing the sense that people’s cognitive understanding of the economy is itself the foundational factor in determining its development.
AT: 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, that we’ve talked about on the show. It’s 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.
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, and so the best thing for policy to do is aim for a certain stabilization. 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. Businesspeople 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. It’s not a bad model, and it reflects a politics of the interwar period. In many ways, it’s quite sympathetic because what we had in the ’70s is the reverse to the celebration, the almost deification of market logic and the logic of investors. But this is the level at which to read this.
This is absolutely a moment in the backlash against midcentury modernism or midcentury technocracy. It’s saying: No, no, no, it’s 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 if they exploit that knowledge. They are playing poker with you, so look them in the eyes, and they will start reading your eyes. Which is where all of these issues of credibility come from, of central bank communication, these kinds of things.
In many ways, the neo-Keynesian and post-Keynesian critiques coming from the left are quite on point, but they do underestimate this shift in the tone of policy, which is quite important.
In practice, it’s not really the consumers who 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. That’s where the interest rate moves by policy and where expectations of inflation do most of the work.
CA: The new Fed chief, Kevin Warsh, rejects the premise of forward guidance. Does that mean he rejects Woodford’s framework for central banks?
AT: The answer to your question is, in a sense, yes. What Warsh is wrestling with from a more fundamentalist conservative point of view is: Are the policy legacies of this era of central banking expectations-based, interest rate-based policy? Whether Warsh can formulate a coherent alternative or whether we are now fated to live in a world shaped so profoundly by central banking policy is another question.
But I think at least in Warsh’s opening pronouncements, this was part of his agenda. What he wants to do is pose 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 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 to achieve a kind of neutrality. Whereas Warsh is kind of cutting the Gordian knot and saying if we just stop talking, maybe that will get us there.
The question is: If you’re not going 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 is 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 management?
To which Warsh might say: Maybe that is what we are doing, 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 principal position of preserving the central banks as an outside actor to a more roundhouse critique of any kind of central bank governance at all.
But the Warsh move in cutting the Gordian knot is so far not convincing as an answer. That goes back to positions in the ’70s, which were saying we should have nondiscretionary monetary policy following a rule. What Woodford et al. show is: Insert that into a world in which you have all these other players, and then the question becomes, how do we derive optimum policy in that context? Their answer has been that it does depend on this forward guidance of expectations, more or less. You can’t get back out. There’s no way back to full innocence.