‘New Keynesianism’ — neat, plausible and wrong

11 Jan, 2015 at 17:10 | Posted in Economics | 8 Comments

Maintaining that economics is a science in the “true knowledge” business, yours truly remains a skeptic of the “New Keynesian” pretences and aspirations of people like Paul Krugman, Simon Wren-Lewis and Greg Mankiw.

kKeynes basically argued that it was inadmissible to project history on the future. Consequently an economic policy cannot presuppose that what has worked before, will continue to do so in the future. That macroeconomic models could get hold of correlations between different “variables” was not enough. If they could not get at the causal structure that generated the data, they were not really “identified.” Dynamic stochastic general euilibrium (DSGE) macroeconomists — including “New Keynesians” — has drawn the conclusion that the problem with unstable relations is to construct models with clear microfoundations where forward-looking optimizing individuals and robust, deep, behavioural parameters are seen to be stable even to changes in economic policies. As yours truly has argued in a couple of posts (e. g. here and here), this, however, is a dead end.

Where “New Keynesian” economists think that they can rigorously deduce the aggregate effects of (representative) actors with their reductionist microfoundational methodology, they have to put a blind eye on the emergent properties that characterize all open social systems – including the economic system. The interaction between animal spirits, trust, confidence, institutions etc., cannot be deduced or reduced to a question answerable on the individual level. Macroeconomic structures and phenomena have to be analyzed also on their own terms.

In microeconomics we know that aggregation really presupposes homothetic an identical preferences, something that almost never exist in real economies. The results given by these assumptions are therefore not robust and do not capture the underlying mechanisms at work in any real economy. And models that are critically based on particular and odd assumptions – and are neither robust nor congruent to real world economies – are of questionable value.

Even if economies naturally presuppose individuals, it does not follow that we can infer or explain macroeconomic phenomena solely from knowledge of these individuals. Macroeconomics is to a large extent emergent and cannot be reduced to a simple summation of micro-phenomena. Moreover, even these microfoundations aren’t immutable. The “deep parameters” of “New Keynesian” DSGE models – “tastes” and “technology” – are not really the bedrock of constancy that they believe (pretend) them to be.

So I cannot concur with Paul Krugman, Simon Wren-Lewis, Greg Mankiw and other sorta-kinda “New Keynesians” when they more or less try to reduce Keynesian economics to “intertemporal maximization modified with sticky prices and a few other deviations”. ” As John Quiggin so aptly writes:

If there is one thing that distinguished Keynes’ economic analysis from that of his predecessors, it was his rejection of the idea of a unique full employment equilibrium to which a market economy will automatically return when it experiences a shock. Keynes argued that an economy could shift from a full-employment equilibrium to a persistent slump as the result of the interaction between objective macroeconomic variables and the subjective ‘animal spirits’ of investors and other decision-makers. It is this perspective that has been lost in the absorption of New Keynesian macro into the DSGE framework.


  1. Thornton, Keynes discusses induction at length in his Treatise. My reading is that there is a trade-off between the strength of an induction claim and the extent to which one is justified in making it. He regards typical inductive arguments of his day as ‘pseudo-mathematical’ in that they use the language of mathematics without regard to validity. But he also gives examples of more justified inductiion. I give links, quotes and some interpretation at https://djmarsay.wordpress.com/bibliography/rationality-and-uncertainty/broader-uncertainty/keynes-treatise-on-probability/keynes-on-the-principle-of-uniformity-from-his-treatise/ .

    • Thanks!

      • Let me just add the eminent science philosopher Stathis Psillos’s text on Induction here where he also discusses Keynes’s contribution on the issue.

      • Yes!And this one! Stathis Psillos- Realism and the ‘Pessimistic Induction’
        Philosophy of Science, Vol. 63, n. Part I: Contributed Papers (Sep., 1996), pp. S306-S314

        Click to access Psillos1996.pdf

  2. Government is not there to be efficient as it’s primary goal. It is there to be effective – to create what is the population has asked it to create as the monopoly provider of those things within the currency area.

    Efficiency is great to have and competitive markets are great at creating efficiency in areas here markets are appropriate (primarily those areas where ‘no deal’ is an option).

    Beyond that you have to be effective first. In other words form should follow function.

  3. Lars,

    great post. However, this crucial sentence doesn’t seem to make sense, as it stands:

    “Dynamic stochastic general euilibrium (DSGE) macroeconomists — including “New Keynesians” — has drawn the conclusion that the problem with unstable relations is to construct models with clear microfoundations where forward-looking optimizing individuals and robust, deep, behavioural parameters are seen to be stable even to changes in economic policies.”

    …the problem with… is to construct.. This sentence construction doesn’t make sense.

    I hope you will correct this as this is an important post which I might like to refer others to in future.



  4. In economics, sticking to the facts is heterodox…By Merijn Knibbe
    January 10, 2015

    “New Keynesian models often negate sound empirical evidence in favor of hard-right, market fundamentalist assumptions. That’s why so-called heterodox economists, who chose to use models which are more consistent with the facts and the concepts of the data (stock-flow consistent modelling comes to mind), criticize these models. Paul Krugman and Simon Wren-Lewis are therefore wrong to complain that heterodox economics “gives aid and comfort to the wrong people” (Krugman) and “When you are trying hard to convince policy makers and journalists that what those on the right are arguing for is not implied by mainstream thought, people from the left pop up to undermine what you say.” .

    There are good reasons, consistent with the policy ideas of Wren-Lewis and Krugman, why ‘New Keynesian Models’ are criticized. Let’s for instance take this article by Kühn, Muysken and Van Veen,titled:

    The Adverse Effect of Government Spending on Private Consumption in New Keynesian Models
    The summary:

    Empirical evidence shows that government spending crowds in private consumption, a Keynesian phenomenon. The current, state of the art, New Keynesian models based on optimizing households and firms are not able to predict such a result. In this paper, we critically analyse fiscal policy in these models using a graphical framework as well as a formal model. Extensions aimed at generating crowding in, like useful government spending or rule of thumb consumers, turn out to be inappropriate. We argue that introducing productivity enhancing government spending could potentially lead to crowding in.

    The hard-right, market fundamentalist assumption of the New Keynesian models is that government spending is, by definition, wasteful while government investments are, by definition, not productive (hell, without the dikes, which in my country have been a government or at least a public responsibility for as long as the record stretches, the Netherlands would not even exist). The point: other assumptions can be made and are being made. The hard-right stance is a choice. Just like the choice, in the New Area Wide Model of the ECB to (quote) “abandon” money in the model, and therewith also, of course, debt. Or the weird idea that the unemployed are happier than the employed. Look here for an empirical example of the large difference between voluntary and involutary declines in labor supplied. Or the funny fact that this ‘representative consumer’, which does not know gender, inequality (there is just one consumer/capital owner/worker), class (heshe is the only worker as well as the owner of all capital, which is rented to companies which are owned by… you guess it) or whatever, by implication does know national borders. Heshe is, in most of the models, a citizen of the USA. Which is puzzling…

    In reality, money exists. Inequality exists. Governments do make productive investments. And some people are 100% employed while others are 100% unemployed. Government subsidized and produced primary and secondary education might have to become more efficient – but people do learn to read and write. And there are differences between people selling their labor and rentiers. I don’t think that bringing this to the fore undermines the policy arguments of Wren-Lewis and Krugman – see the Kühn, Muysken and Van Veen article. But if so – let it be.”

  5. This is where I get really confused. What, exactly, did Keynes say about projecting the past into the future and where did he say it?

    Because stated the way you state it, Keynes seems to be rejecting all inductive reasoning. That sounds wrong. But it would justify axiomatic-deductive reasoning as the only way to go.

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