There are three most damning facts about New Keynesianism, the mainstream macro school that coalesced in the 1990s as the compromise solution to prolonged macro war between the great Early Keynesians and the upstart New Classicals. First, rational-behavior NK modeling is not stabilization-policy relevant. Second, it is not consistent with the most important instability evidence. Third, despite those limitations, it refuses to do better. After decades of obvious failure, it still dominates macro textbooks and cutting-edge journals. Leading NK theorists have campaigned for its acceptance as the final word in macro modeling with models that do not work, while arguing that research on alternatives is a waste of time.
The three facts are egregious, bordering on unbelievable. But they are demonstrably true. There have been instability episodes, most notably the 2008-09 Great Recession, when NK model’s cluelessness about what was actually happening caused Fed policymakers to ignore the macro academy’s analysis a useless. (I was there.) How mainstream macro theorists responded to that humiliation is the subject of this post. It provides insight into the curious third fact that is central to the on-going mainstream damage to evidence-consistent, policy-relevant macroeconomics.
In 2010 a prominent New Keynesian, Olivier Blanchard, co-authored the most immediate post-mortem on the NK failure to recognize the flaws in the mainstream understanding of macro instability. He begins by describing the core NK model of proper monetary policy before the Great Recession. “There was one target, stable inflation, and there was one instrument, the policy rate, or more precisely the policy rate rule, and that was basically enough.” The bedrock idea here – believed to be so obvious it is treated as axiomatic – is that inflation stability implies output-gap stability. If so, the output gap is determined by the policy rate. That extraordinarily simplistic notion is very convenient for theorists who rely on FGME modeling, but it never came close to adequately describing how the economy actually works. Adequate theory and evidence agree that the output gap has other, more significant determinants than inflation stability. Believing otherwise presaged debilitating trouble for the policy aspirations of NK theorists. A large number of economists, including me, thought betting the ranch on an unlikely “divine coincidence” (Blanchard and Gali’s term) was both foolish and dangerously naïve.
And here’s the really galling rub. The NK silly framework model of macro stability replaced the robust analytic framework of the Early Keynesians. The EK macro school, demonstrably more accomplished and honest than the replacement New Keynesians, argued that instability is largely rooted in significant fluctuations in aggregate nominal demand that is restricted by meaningful wage rigidity (MWR). Their principal research problem was rooting MWR in rational behavior, an aspiration once shared by the younger generation NK theorists. Both found microfounding MWR a tough nut to crack and brash NK theorists, after effectively banishing their EK elders from cutting-edge research, effectively gave up. They settled on using convenient MWR assumptions combined with the Real Business Cycle analytic framework. A significant number of macroeconomists, many in government and the private sector, were troubled by the RBC’s distant relationship with almost all of the critical instability evidence, objecting to the new-found reliance on RBC thinking.
Given that backdrop, Blanchard begins his analysis of 2008-09 debacle: “We learned two main lessons from the current crisis. The first is that even with stable inflation and a stable output gap, things might not be going well behind the – macroeconomic – scene. For example, tensions can build up in the financial sector, and financial instability eventually translates into major problems in terms of output and activity. This realization has led to a general consensus that the list of targets must include financial stability as well as macroeconomic stability…. The second lesson is that the link between inflation stability and the output gap is probably much weaker than was originally thought. In a number of countries, the behavior of inflation appears to have become increasingly divorced from the evolution of the output gap…. If this is the case, then central bankers who care about macro stability cannot be content be content just to keep inflation stable. They have to watch both inflation and the output gap, measured as best they can. Nobody will watch the output gap for them.”
The NK lessons learned boils down to return to business as usual but with a new research effort to anticipate financial breakdowns and fix them before they crash the economy. The short response to that plan is to cite its inadequacy, especially its deliberate ignorance of all the other obvious, robust sources of aggregate demand instability. In the real world, adequate stabilization theory defaults to the Early Keynesian model. EK theorists focused on significant adverse total-spending disturbances that combined with readily apparent downward nominal wage rigidity. Their research prioritized rooting such rigidity in optimization and equilibrium. It should be celebrated, rather than ignored, that the GEM Project has solved that crucial problem.
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