I’m writing a review article about Akerlof and Shiller’s new book, Animal Spirits. In doing so, it struck me that I had most of a new entry for my list of refuted economic doctrines, except that the target this time has not been refuted so much as rendered obsolete by events. I’m talking about New Keynesianism an approach to macroeconomics, to which Akerlof and Shiller have made some of the biggest contributions, but which they have now, on my interpretation, repudiated.
Here’s Akerlof and Shiller
The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works
Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith [needed to provide a plausible account of observed outcomes – JQ] but rather from the deviations that actually do occur and can be observed.
The central theme of new Keynesianism was the need to respond to the demand, from monetarist and new classical critics, for the provision of a microeconomic foundation for Keynesian macroeconomics.
As Akerlof and Shiller note above, the research task was seen as one of identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions, such as the possibility of significant welfare benefits from macroeconomic stabilization. Akerlof’s ‘menu costs’ arguments, showing that, under imperfect competition, small deviations from rationality generate significant (in welfare terms) price stickiness, are an ideal example of this kind of work.
New Keynesian macroeconomics has been tested by the current global financial and macroeconomic crisis and has, broadly speaking, been found wanting. The analysis of those Keynesians who warned of impending crisis combined an ‘old Keynesian’ analysis of mounting economic imbalances with a Minskyan focus on financial instability.
Similarly, the policy response to the crisis, which now seems to be having some positive effects, has been informed mainly by old-fashioned ‘hydraulic’ Keynesianism, relying on massive economic stimulus to boost demand, combined with large-scale intervention in the financial system. The opponents of Keynesianism have retreated even further into the past, reviving the anti-Keynesian arguments of the 1930s and arguing at length over policy responses to the Great Depression.
There is of course, still a need to explain why wages do not adjust rapidly to clear labour markets in the face of an external financial shock. But, in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality, and seeking to minimise those deviations. Rather, as Akerlof and Shiller suggest, a sensible theory of wage determination should be derived from behavior that actually occurs and can be observed.
To put things more simply (an oversimplification, but this is a blog post, after all), New Keynesianism (as with most other attachments of the word “New” to left/progressive terms in the 1980s and 1990s) was a defensive adjustment to the dominance of free market ideas such as new classical macroeconomics, and to the apparent success of a policy regime in which active fiscal policy played a minor role at most. The New Keynesians sought a theoretical framework that would justify medium-term macroeconomic management based on manipulation of interest rates central banks, and a fiscal policy that allowed automatic stabilisers to work, against advocates of fixed monetary rules and annual balanced budgets.
But now that both the intellectual foundations of post-1970s economic liberalism (most notably the efficient markets hypothesis) and the policy framework that brought us the Great Moderation have collapsed, there is no need for such a defensive stance. The big question for the crisis and after is how to develop and sustain a Keynesian system of macroeconomic management that can deliver outcomes comparable to those of the Bretton Woods era, while avoiding the excesses and imbalances that brought that system to an end in the 1970s.
I was partly stimulated by this piece from Gregory Clark (hat-tip Brad DeLong). It’s mostly a rant (a very entertaining one) about the state of academic economics, but includes the (only slightly overstated) observation that
The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.
The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s. There has essentially been no advance in our knowledge in 80 years.