Assessing New Keynesian Theory Part I

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I have spent most of my career using macro theory to help government and private-sector policymakers understand how the economy, writ large, works. During the mainstream run of New Keynesians (NK) that task required substantial reconstruction of textbook analysis. The dirty secret of the profession is NK macroeconomics fails to usefully explain the most crucial instability evidence; it is not stabilization-relevant.

Despite obvious failures, prominent NK theorists have for some time been waging an aggressive campaign to make their general-market-equilibrium (GME) modeling settled doctrine. Contrary research is not needed, barely tolerated. A requirement of this crusade is convincing enough economists to overlook the fundamental problems and accept that NK macro is in good shape. A famous example of that messaging from a leading NK theorist is an article entitled “The State of Macro” in the Annual Review of Economics (2009): “For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time, however, mainly because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and it suffers from extremism and herding. None of this is deadly, however. The state of macro is good.”

Olivier Blanchard published that assessment at the nadir of the devastating 2008-09 Great Recession. During that crisis stabilization authorities made clear that they did not share his contentment with NK modeling. In a particularly blunt example Jean-Claude Trichet, then Governor of the European Central Bank, publicly attacked mainstream modeling for providing little useful guidance on how to respond to the global extreme instability that began gathering steam in 2007. From Trichet (November 2010): “When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policymaker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.” It’s pretty clear that Trichet believed that the state of macro was bad.

It tells us something important that, in the 2009 article, Blanchard recognized that NK theory was in fact unable to adequately explain macro instability: “One striking (and unpleasant) characteristic of the basic NK model is that there is no unemployment!” Come on. Is it really acceptable to peddle a macro theory, especially one the state of which you want your audience to believe is good, that has no involuntary job loss? Undeterred, Blanchard continues: “Movements take place along a labor supply curve, either at the intensive margin (with workers varying hours) or at the extensive margin (with workers deciding whether or not to participate). One has a sense, however, that this may give a misleading description of fluctuations, in positive terms and, even more so, in normative terms: The welfare cost of fluctuations is often thought to fall disproportionately on the unemployed. As the reader may guess from the heavier prose, I am trying to present informally some results from my own research (Blanchard & Gali 2007). My excuse is that I see these results as a good example of what can be learned from the NK model that could not be learned from the IS-LM model or its textbook extension, the AD-AS model.”

One should have a sense that any theory unable to accommodate involuntary job loss cannot be relied upon when confronting extreme instability that is threatening to morph into depression. Pull out a keystone and you should not expect a structure to remain standing. Fortunately, in the Great Recession, policymakers understood that general market equilibrium cannot explain causation from contracting nominal demand to mass involuntary job loss. Unfortunately, leading NK theorists have bet the ranch that it could be made to do so. (For elaboration, see next week’s blog.)

The state of macro, during the decades of dominant New Keynesian GME modeling, has not been good. It has been really bad. But there is good news. The GEM Project has identified the fundamental flaw in NK theory: restricting rational exchange to the marketplace when, after the Second Industrial Revolution, a great deal of critical exchange occurs in workplaces restricted by asymmetric employer-employee information. Evidence and policy-relevant modeling moves a substantial share of wage setting inside large, highly specialized firms. Profit-seeking managements construct mechanisms of exchange and equity-based workplace rules. In such circumstances, rational labor pricing differs substantially from what occurs in the marketplace, most notably in producing microfounded wage rigidities capable of suppressing wage recontracting. The implications for policy are greatly altered. Most fundamentally, aggregate demand contractions in the context of optimizing wage rigidities are the overwhelming cause of periodic involuntary job loss in the millions. Market frictions play a greatly subordinate role. Until that fact is recognized by NK theorists, their macroeconomics will remain stabilization-irrelevant.

Blog type: New Keynesians  

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