Amidst all the artillery fire, it's easy to forget that the New Classical and New Keynesian "schools" of macroeconomics were once ...well...new. (Hence the names.) The New Classical school arose as a response to (a) real defects in conventional macro-econometric practice and (b) the failure of conventional macro theorists to make progress towards an actual explanation of the observed behavior of modern economies. The New Keynesian school arose as a response, taking on board both the econometric critique (yay) and the proposed solution (boo, hiss) more or less in toto. The New Keynesians also "fixed" the most obvious defect in the New Classical models -- the fact that depressions are ruled impossible by assumption -- but did so in a manner that largely failed to advance our actual understanding of the economy (1).
The seeds of disaster, in retrospect, lay in how easily New Classical-style models could be tweaked to get Keynesian behavior. Failing that, the New Classical-style models could never have achieved the near-monopoly position they now hold in macroeconomics (2). And the mess in macro did not come about because some economists committed to a modelling style which turns out to yield little insight. The mess is a consequence of the universality of this commitment -- the macro-mono-culture, if you will.
It is the danger of mono-culture that should be uppermost in our minds as we try to figure out the next "New" macro. So much so that convergence on anything purporting to be the Next New Macro any time in the next five years (at a minimum) should be regarded with alarm.
The fact is that, right now, we do not know the way forward, and no approach, no matter how promising (or how congenial to our pre-conceptions and policy preferences) should be allowed to dominate the field until it has proven itself empirically successful.
It's important to remember that the New Classicals didn't claim that their models were successful -- only that they were more "sound" on theoretical and econometric grounds. They were quite clear at the outset that their approach was in its infancy, and that a great deal of work remained to be done before its value could be determined (3). Why, then, did the entire discipline latch on to the New Classical approach?
In a word: panic.
Whatever the flaws in the New Classicals' positive program, their negative critique of existing econometric practice was both true and devastating. You can't just say, "I feel in my heart that A, B, and C cause D, so here's a regression," and claim to be doing social science. And when you're constantly saying, "Did I say 'B'? I meant X! A, X, and C cause D. Also, maybe the log of B. Here's another regression!" your credibility does not improve (4).
So imagine the plight of the working macro-economist, circa 1978 or so. The demand for policy advice is intense -- CPI inflation had spiked to 9% by the end of the year (compared with 4.7% at the end of 1968), and unemployment seemed to have bottomed out at a floor of around 6% (compared with 3.4% in 1968). From the President on down, your bosses want to know what the hell is going on and -- scarier still -- how to fix it. At the same time, the terrible truth has begun to sink in: there's no particular reason to believe that your working models actually tell you anything about how the economy works, particularly under these conditions. (It turns out that you've actually got a pretty good idea what to do about a demand-failure depression, but this isn't that.) Similarly, in academe, economists are scrambling to produce policy-relevant results, which is difficult with your colleagues pointing out the gaping flaws in your econometric logic. (They literally point and laugh. Jerks.)
So with the desperation of a drowning man, macroeconomics latched on to the first floating object to drift within reach. Which, regrettably, then carried us all out to sea.
So here's the lesson: don't panic. The basic Keynesian premise ("demand matters") is firmly established. The key policy implications (monetary policy affects the real economy as well as prices; in a demand constrained economy, public spending can increase output) are pretty much conventional wisdom, buttressed with a slew of new evidence emerging from the recent unpleasantness. Disputes over monetary and fiscal policy are, today, largely political rather than technical (5). The world will probably muddle through more-or-less adequately long enough for us to verify that this research agenda or that one actually leads someplace worth going.
The good news is that we have more, more detailed, higher quality, and more diverse data available than ever before. (Example: we've only been systematically estimating the number of job openings in the U.S. for about fifteen years. Previously, we relied on weak proxies like the volume of help-wanted advertising. Seriously.) So the discipline is much better prepared to weed out models that just don't work than it was forty years ago. We just need to get out of the bad habit, acquired back when data was scarce and unreliable, of claiming that it's "too soon" to abandon "promising" models, just because they're empirically false.
I have my own notions about the best way forward, of course, and I'll post about those soon. But I could easily be wrong and so could anyone else. I hope we bear that in mind. Maybe we'll be able to retire the Robert E. Lucas Jr. Award For Derailing An Entire Discipline without ever bestowing it on a second recipient.
(1) Short version: In New Classical-style models, prices are perfectly flexible and markets (including the labor market) always clear, so there's no such thing as involuntary unemployment. To generate depressions -- you know, like in real life -- New Keynesian models introduce some form of inflexible pricing by assumption. (Example: "Calvo pricing," named after economist Guillermo Calvo, assumes that firms only alter their prices when granted permission by an imaginary magical being -- traditionally known as the Calvo Fairy -- who periodically bestows such permission at random. No, seriously; I am not making the Calvo Fairy up.)
(2) Well, in academic macroeconomics, anyway. Professional forecasters still use Big Macro models, the large, complex systems which attempt to model the actual economy on a sector-by-sector basis. (It turns out that Big Macro was not fundamentally "discredited" in the 1970's, as the New Classicals liked to claim, but was simply infeasible with the datasets and computers available circa 1975. We're better at it now.) And central banks tend to employ a mix of Big Macro, Paleo-Keynesian, and New Keynesian DSGE models. (Though one might suspect that the function of the DSGE models at central banks is to merely prove that we can tweak a DSGE model to yield the same results as the Big Macro models and Paleo-Keynesian models. Houdini lives!)
(3) Today, forty years later, we know the answer: nope, doesn't really work. (And the claim of theoretical soundness was always...tenuous.)
(4) Note also that there was nothing especially "anti-Keynesian" about the critique. It applied with equal force to Monetarism, the other theoretical school of the day. The New Classical critique was about method, not theory. The anti-Keynesian theoretical program slipped in quietly behind it, using the disrepute of mainstream econometrics to tar the reputation of mainstream Keynesianism. But the two were, in fact, quite unrelated.
(5) Largely. However. Note to central banks: if your forecast for a variable (inflation, for example) is wrong in the same direction (e.g. too high) every quarter for more than five years...your model has technical problems. Fix, please.