Refuted/obsolete economic doctrines #7: New Keynesian macroeconomics

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.

40 thoughts on “Refuted/obsolete economic doctrines #7: New Keynesian macroeconomics

  1. I am reading Akerlof/Shiller at the moment – most enjoyable.

    I am interested in their critique of Hicks’ reinterpretation of Keynes which eradicated the ‘animal spirits’ bit. People don’t have good foresight at all but employ heuristics based on plausible ‘stories’ that reflect overall pessimism/optimism. We will invest if things seem good and will save a lot if things look bad.

    The way I was taught macro in first year was very much based on lots of national income accounting and the multiplier:

    autonomous spending/(1-MPC).

    This kinda captures a bit of Keynes but it removes the drama, the ‘animal spirits’ which drive weird and wild investment booms and busts and shifts in long-term savings/consumption. The intrinsic instability of a system not based on dedicatedly rational behaviour but which, in other respects, delivers good economic outcomes.

    This provides the cutlery and plates without the main course.

    I can remember being fascinated (as a 1st year) by how one person’s spending becomes another’s income but the radical essence of Keyne’s thought did not come through to me. Even later the academic squabbles were about the relative size of elasticities rather than the core Keynesian view.

    I liked Akerloff/Shiller’s view of a ‘confidence multiplier’ that was based on decision-making under nearly pure ignorance. I also liked A/S’s comments on how ‘stories’ spread like a virus to create overwhelming moods of confidence/ pessimism. Sounds like a fairly accurate description of the trade cycle.

    I’d be interested in your view John on A/S’s critique of mathematical modelling and particularly of econometrics. Maths sometimes clarifies economics but sometimes it distorts it or encourages misrepresentation. Or maybe it is just that quantitative approaches are sometimes badly taught.

  2. hc – its built into the Investment function I = Ibar – er where r is the interest rate, e is the sensitivity of investment to changes in r and Ibar itself, to the best of my knowledge, captures animal spirits in terms of optimism / pessimism, future expectations, movements in mass psychology etc ie exogenous determinants investment ie it causes the Investment demand curve to shift (itself based on the MEC theory). This is captured in a shift in the Keynesian Cross model (automous spending rises or falls).

    There is a good discussion on the state of long term expectation in Chapter 12 which follows from the chapter on MEC in the general theory.
    The actual quote is found on page 161
    “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”[p.161)

    Wikipaedia sees animal spirits as affecting consumer confidence (again consumer expectations can be taken to be included the consumption function Cbar variable). There would appear to be no reason to assume “Animal spirits” dont also affect consumption, however,the original references to animal spirits by Keynes are surrounding his discussion on Investment and long term expectations.

  3. “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.”

    I don’t think we need to explain this because the financial shock(s) is (are) not ‘external; but endogeous to the system.

  4. I meant “external to labor markets”, but it was maybe not the happiest of phrasing.

  5. “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.”

    The fact that he portrays Smith as an adherent of rational choice theory makes we wonder if he has actually every read Smith.

  6. It is interesting how, when push comes to shove in a crisis, policy makers have resorted to the old Keynesian verities. It could be 1959 with Paul Samuelson at the height of his powers. If this represents a failure of New Keynesianism, what does it say about the doctrines that have been ascendant in universities for the past 35 years – first Lucas and Sargent’s New Classical Macroeconomics, then Kydland and Prescott’s real business cycles, then Dynamic General Equilibrium models?

    The answer I think is that policy making institutions around the world never adopted these doctrines.

    Paddy McGuinness in 1981 published an article in the Economic Record in which he reviewed the RBA’s annual report and Treasury’s Statement No 2, the documents which then set out those two institution’s approach to policy making. He described them, characteristically, as (from memory)

    “Keynes without the liquidity trap … monetarism without rational expectations … a true bastard product of both schools”.

    It was true then and remains true, not just in Australia. Policy making is pretty much a product of Samuelson’s textbook, Klein’s econometrics and Friedman’s 1968 AEA Presidential Address (where he set out why there is no long run trade off between inflation and unemployment).

  7. Good post ProfQ.

    One of the things that strikes me most when I recollect macroeconomics from university was the complete absense of the individual or collective acting irrationally. Aminal Spirits (and the other Shiller popular economics book Irrational Exurberance) tries to bring back some understand of the fallibility of humanity into economic thinking.

    I think that is why the next big surge in economic research should be uncertainty and human action stemming from impacts of events. Behavioural finance and economics (along with ecological/environmental economics) are topics of the next ten years IMHO.

    One thing that still annoys me is the efficient market hypothesis. No one truly believes it. That is why the creators of the EMH (can they be called creators?) tried their hand at investment banking and trading. Ultimately they tried to find where prices diverted from their supposedly efficient course.

    This concept of a mathematical efficiency is problematic and can be applied to the whole of economics and finance. Mathematics provides rigour and logic but it does not and should not be considered an end in itself.

  8. The alleged failure of rational expectations does not imply that the new (or old) Keynesians are correct. Nor does it imply that fiscal stimulus will work. It is not “either-or”. It may be neither. Note: I say “alleged” because I am not a macroeconomist and thus not able to judge this issue. I just know that showing that X does not work does not imply that Y will work. Proof is needed.

  9. on the subject of Hicks’ distortion of Keynes, there is a very good introduction in Steve Keen’s ‘Debunking Economics’ (obviously a book a few years ahead of its time!)

  10. There is an issue beyond the technical/theoretical for economics. That is, the dominant paradigm “just happened” to dovetail nicely with the political agenda of the corporate class. This reminds me of ‘regulatory capture’. What conditions in the profession allowed this?

  11. ” 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.”

    If they can pull this off, it will probably mark the biggest transformation ever in macro. The first step towards making macroeconomics a branch of science rather than theology.

    WalterW Says:

    The alleged failure of rational expectations does not imply that the new (or old) Keynesians are correct. Nor does it imply that fiscal stimulus will work. It is not “either-or”. It may be neither.

    Rational expectations are central to New Keynesian models but not the old. Agree on other points. But building a new macro staring from assumptions about human behaviour that are true may be a better bet than starting from assumptions that are false, esp. if the models based on false assumptions have implications that also turn out to be false. To believe in things despite the evidence one has to be either a theologian or a Chicago economist.

  12. Some of the old discussions make interesting reading now..this one is from Samuelson and Solow (May 1960)- Analystical Aspects of Anti Inflation Policy.

    “Common Fallacies”
    “the simplest mistake – to be found in almost any newspaper discussion of the subject – is the belief that if money wages rise faster than productivity, we have a sure sign of cost-inflation. Of course the truth is that in the purest of excess demand inflation wages will rise faster than productivity…

    “one sometimes sees statements to the effect that increases in expenditure more rapid than increases in real output necessarily spell demand inflation. It is simple arithmetic that expenditure outrunning output by itself spells only price increases and provides no evidence at all about the source of or cause of the inflation. Much of the talk about “too much money chasing too few goods” is of this kind.
    A more solemn version of the fallacy goes: An increase in expenditure can only come about through an increase in the stock of money or an increase in the velocity of circulation. Therefore the only possible causes ofinflation are M and V and we need look no further.

    One thinks authomatically of looking at the timing relationships. Do wage increases seem to precede price increases? Then the general rise in prices is caused by wage push. Do price increases seem to precede wage increases? Then more likely the inflation is of the excess demand variety, and wages are being pulled up by brisk demand for labour or they are responding to prior increases in the cost of living.

    There are at least three difficulties with this argument. The first is suggested by replacing “wage increase” by “chicken” and “price increase” by “egg”….

    “In a closely interdependent economy, effects can precede causes. Prices may begin to ease up because wage rates are expected to. And more important, as wage and price increases ripple through the economy, aggregation can easily distort the apparent timing relations.”

  13. I also find it strange that the discussion about policy during the current financial and economic difficulties does not seem to incorporate all the “innovations” in macro over the past forty years or more. On the other hand, if indeed the proof of the pudding is in the eating then there have been few advances in fact. I conjecture that this is in no small part due to the highly formalistic nature of the recent research. There is a tradeoff between relevance and “precision.” Might I refer to my own reflections on this issue?

  14. Hopefully we can finally realize that Milton Friedman took the entire economics profession on a 60 year dead end. Never has a man proven to be wrong about so much still held in high regard. His lasting contribution will be what, that Keynes was too quick to say monetary policy is useless but even here we end with Keynesian money demand functions not some Monetarist quantity theory.

  15. I’m with Mark Q.

    Macro-economics is treated by too many as a kind of morality play. You can see it in the language we use, heavily loaded with value judgments. (‘Regressive’ taxation, a ‘strong’ dollar, ‘growth vs stagnation’ … ) Constructing a framework for economic policy that looked more like other branched of social policy — which, for all their flaws, at least place evidence before theorizing –would be a huge change.

  16. 16# Rob – on Milton Friedman – maybe he was not all wrong so much just not always right. It seems to me that inflation is not “always and everywhere” a monetary phenomenon but only “sometimes” a monetary phenomenon.

  17. I have read Akerlof and Shiller. I was shocked at just how much relevant literature in heterodox economics was ignored by these economists. So we have two New Keynesians reinventing post-Keynesian economists after many years of dismissing and ridiculing it along with other New Keynesians. They will sell lots of copies of the book but some more intellectual honesty would have gone a long way. New Keynesians were always people who didn’t have the guts to reject the neoclassical synthesis, preferring to stay respectable using questionable analytics and a lot of story-telling. In sense, I have more respect for New Classical economists who, despite being in cloud cuckoo land, stuck to their analytical guns.

  18. I doubt that Akerlof and Shiller are even aware that the Post Keynesian school exists, let alone what the literature says. At best, they might be vaguely aware of James Galbraith.

  19. Menu costs, efficiency wages, overlapping contracts, etc., were only Keynesian at two removes at best. In the General Theory, Keynes noted that money wages were inflexible, but insisted that this wasn’t crucial to his argument. Samuelson knew this, but went on to develop a version of Keynesian economics based on the ‘useful fiction’ that wage rigidity was the key assumption. This is the origin of the horiziontal AS schedule of the textbooks, which is supposed to represent the ‘Keynesian case’. New Keynesian economics was a race bewteen various bright young things (most of whom probably hadn’t read Keynes) to devise ingenious justifications for this assumption. Finally, when theoreticians hunting for ‘nominal rigidities’ extended their terms of reference and discovered real rigidites as well, Keynesian explanations had become indistinguishable from the ‘classical’ ones they were supposed to refute. A new consensus formed around the NAIRU hypothesis, whereby there was a certain average rate of unemployment that could be lowered only by means of labour market reforms if at all, and symmetrical fluctuations around that average, which could be stabilised by monetary policy. Meanwhile, animal spitrits, secular stagnation, fiscal policy, and all the really Keynesian ingredients, had long disappeared from the paradigm.

  20. John,

    I find your criticisms of New Keynesian economics too vague and general. Exactly which rational expectations, forward looking models of the Phillips curve or the IS curve have been refuted by data arising from the crisis?

    I think New Keynesian economics owes less to an ideological rear guard action against the excesses of the right than to the need to deal with the empirically verifiable facts of pervasive price rigidity and cylical involuntary unemployment in a way that is responsive to the Lucas critique. This and the earlier success of Friedman’s micro-grounded NAIRU model versus the ungrounded old Phillips curve.

    Paleo Keynesianism has been dusted off of late, as far as I can see in response to the zero lower bound on interest rates. Empirically, though, old Keynesian ideas (a fixed marginal propensity to consume (*), and a trade off between inflation and unemployment) are as dead as a dodo.

    I was rather disappointed to find out that Romer’s policy evaluations of Obama’s stimulus package were done with a creaky old fashioned Keynesian model, and with the assumption of zero interest rates out into the indefinite future. Expectations formation may indeed not be perfectly rational, but I think enough people in the actual economy are aware of the implications of a pure interest rate peg for such a policy to have a profoundly destabilizing effect on expectations (and buy gold!).

    In re-evaluating (long neglected) activist fiscal policy, we are in danger of throwing the baby out with the bath water if we go back to Samuelson and neglect all of the empirical results (eg Hall’s later results on consumption; policy variance of the Phillips curve etc) and useful theoretical contributions (*: I think Mankiw and Campbell’s synthesis of old Keynesian and inter-temporal consumption models stand out here) of the last 30 years.

    Having said that, and in responding to the main, Minskian thrust of your post, I must say that I am to a certain extent skeptical about the efficient market hypothesis, and interested in behevioural models of decision making under uncertainty (eg Prospect theory) as the basis for an alternative.

    – Tim

  21. Tim,
    You’d be hard pressed to find anyone who didn’t want some kind behavioural foundations. The problem is which foundations to use. There are an infinite number of plausible models of irrationality and no clear framework for distinguishing them. Rejecting a non-substantive null hypothesis of rationality is not very informative.

  22. “Keynes noted that money wages were inflexible, but insisted that this wasn’t crucial to his argument”

    Yes, provided you’re in a liquidity trap, because then wages and prices move down one for one. But not otherwise.

  23. Joseph,

    It is a mistake to think that all this is about ‘irrationality’. What is happening is that people are faced with Knightian uncertainty, yet they have to make decisions. So they have little choice but to base them on subjective beliefs (more often than not looking over their shoulders to discover what others believe). They try to make rational choices based upon these beliefs. Of course, many mistakes are made, but this is not irrationality. The problem with conventional definitions of rationality is that they are based upon far too strong assumptions concerning access to knowledge. Keynes understood this, so did Hayek. The New Keynesian macroeconomics literature that Tim Peterson summarises is based upon the shakiest of empirical foundations. And whenever the term ‘micro-grounded’ is used, there has to be extreme care in defining what is actually mean’t. Keynes would never have been foolish enough to use GE neoclassical microeconomics in the way that Friedman did (and New Keynesians did in such an illogical manner). Its time that more economists looked at the evidence coming out of experimental economics and began to use it in their models(in this regard, I highly recommend Vernon Smith’s book, Rationality in Economics – don’t waste your time reading Akerlof and Shiller)


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s