Shaky New Keynesian Foundations

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Michael Woodford has long been a leader in rooting New Keynesian (NK) macroeconomics in friction-augmented general-market-equilibrium theory. In late 2008, when his market-centric thinking was being fundamentally challenged by events, Woodford participated in a symposium entitled “Convergence in Macroeconomics’’. With the threat of a collapse into 21st-century version of the 1930s Great Depression as background, he proposed five core elements of consensus aggregate theory. It is interesting to reconsider those pillars in the context of this Blog’s on-going effort to compare and contrast mainstream market-centric general-equilibrium modeling and the GEM Project’s generalization of rational exchange from the marketplace to information-challenged workplaces.

From Woodford: “What do macroeconomists, at least those macroeconomists concerned with understanding the determinants of national income, inflation, and the effects of monetary and fiscal policy, generally agree on? Here, I briefly list some of the most important examples of formerly contentious issues about which there is now fairly-wide agreement.”

Woodford’s Elements

First is the most fundamental building block of modern theory. “It is now widely agreed that macroeconomic analysis should employ models with coherent intertemporal general-equilibrium foundations. These make it possible to analyze both short-run fluctuations and long-run growth within a single consistent framework.”

NK theorists certainly give this element enthusiastic lip service. However, a powerful exception is typically carved out when they test their theory against instability data. They have learned that acceptable correspondence with important evidence requires nominal wage rigidity, which Blog readers know cannot be rationally accommodated in general-market-equilibrium modeling. Sufficient suppression of wage recontracting must be assumed. A reasonable assessment is that NK analysis is as inconsistent with optimization and equilibrium, the core tenets of economic theory, as is Early Keynesian (EK) modeling constructed on irrational time-inconsistent labor pricing. By contrast, GEM modeling produces meaningful wage rigidity (MWR) happily rooted in optimizing exchange governed by continuous general decision-rule equilibrium.

“Second, it is also widely agreed that it is desirable to base quantitative policy analysis on econometrically validated structural models. A primary goal of theoretical analysis in macro-economics is to determine the data-generating process implied by one structural model or another in order to allow consideration of the extent to which the model’s predictions match the properties of aggregate time series.” As already noted, this essential characteristic of adequate macro modeling forces NK theorists to violate Woodford’s first element. That fundamental inconsistency is unsurprisingly familiar, having dogged all Keynesian attempts to construct macro models that are simultaneously rooted in rational behavior and practical relevancy. It is enormously consequential that the GEM extension of macro analysis to information-challenged workplaces has solved that longstanding problem.

“Third, it is now widely agreed that it is important to model expectations as endogenous, and, in particular, that it is crucial in policy analysis to take into account what V. V. Chari and Patrick J. Kehoe (2007) refer to a ‘big-tent approach to data analysis’ that allows us to look for clues about the quantitative magnitudes of various mechanisms in a wide variety of sources using a wide variety of methods.”  Both the market-centric and the generalized-exchange model classes being assessed in this post make expectations endogenous, strictly governed by rational behavior. However, the Chari-Kehoe addendum that the evidence used to validate model predictions be drawn from all available sources is rarely adhered to by New Keynesians. Most egregious is their frequent reliance on voluntary joblessness to explain cyclical unemployment when the BLS Current Population Survey clearly demonstrates that unemployment in recession mostly result from involuntary job loss. Ignoring the most important cyclical evidence is consistent with the unfortunate NK practice of cherry-picking data to be examined based on the support provided to market-centric modeling. The Project’s two-venue model also makes but uniquely keeps the promise of consistency with data from all reliable sources of relevant evidence.

“Fourth, it is now widely accepted that real disturbances are an important source of economic fluctuations. The hypothesis that business fluctuations can be largely attributed to exogenous random variations in monetary policy has few if any remaining adherents. While studies such as those of Julio Rotemberg and Woodford (1997) or Christiano, Eichenbaum, and Evans (2005) estimate the effects of exogenous disturbances to monetary policy and assess the ability of structural models to account for these effects. This is because of the usefulness of this particular empirical test as a way of discriminating among alternative models and not because of any assertion that such disturbances are a primary source of aggregate variability.” Here the GEM Project is fundamentally, and thankfully, at odds with Woodford. Generalized exchange recognizes that the most powerful influence on cyclical contractions of employment and production is the propagation of original (real or nominal) shocks by weakening total nominal spending. From the perspective of competent modeling, we must accept that total nominal demand largely drives business cycles. Attention to that fact must not be diverted by limiting nominal influences to “exogenous random variations in monetary policy”. Woodford’s need to do so is rooted in the inability of his market-centric theory to accommodate MWR and its unique capacity to rationally suppress wage recontracting.

“Fifth, monetary policy is now widely agreed to be effective, especially as a means of inflation control. The fact that central banks can control inflation if they want to (and are allowed to) can no longer be debated after the worldwide success of disinflationary policies in the 1980s and 1990s. It is also widely accepted that it is reasonable to charge central banks with the responsibility of keeping the inflation rate within reasonable bounds. In this respect, the monetarist school has won an important debate with the postwar Keynesians. But this does not mean that variations in real activity, in capacity utilization, and in other determinants of supply costs are not still viewed as important proximate causes of changes in the general level of prices.”

In this last crucial element of useful macro theory, Woodford goes off the rails, demonstrating for anyone paying attention the failure of friction-augmented market-centric general-equilibrium modeling to be policy relevant. Suffice it to note that if Woodford’s bet on the singular importance of price inflation in stabilization policymaking had been adopted by the Federal Reserve in 2008-09, the economy would have collapsed into an unimaginably costly depression. Fortunately, Ben Bernanke – informed by his deep understanding of the 1930s depression – dismissed mainstream NK advice as profoundly dangerous. GEM Project analysis identifies both nominal and real-side objectives of monetary policymaking as independently important. However, if for some reason you need to choose one as more vital, it must be the real-side goal.

Blog Type: New Keynesians Chicago, Illinois

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