‘New Keynesian’ haiku economics

13 Jan, 2015 at 15:51 | Posted in Economics | 7 Comments

The neoliberal hegemony of the Reagan-Thatcher certainly decreased the debate among mainstream economists decline:

It is clear that the Great Depression and the Keynesian Revolution seemed to increase debate within the mainstream, and that as Joe says, the: “decline in debate… appears to have been associated with the emergence of a ‘neoliberal’ hegemony from the 1970s onwards.” That’s essentially correct.

And the decline in debate explains why Lucas could say in the early 1980s that: “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” And also why if you wanted to publish you basically had to accept the crazy New Classical models. Krugman admitted to that before, as I’ve already noticed. He argued that: “the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable.” You must remember, you don’t publish, you don’t get tenure. So crazy models became the norm.

haiku-in-japaneseNot only heterodox economists were kicked out of mainstream departments, and had to create their own journals in the 1970s, but also the pressure within the mainstream to conform and silence dissent was strong indeed. Note that many, like Blanchard and Woodford for example, in the mainstream continue to suggest that there is a lot of consensus between New Keynesians, and Real Business Cycles types. In fact, the say there is more agreement now than in the 1970s. How is the consensus methodology in macroeconomics, you ask. From Blanchard’s paper above:

“To caricature, but only slightly: A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.”

And yes that is also the basis of New Keynesian models. The haiku basically describes the crazy models in which reasonable results must be disguised if you’re to be taken seriously in academia. When everybody agrees, there is little need for debate. And you get stuck with crazy models. The lack of debate within the mainstream to this day is also, in part, what provides support for austerity policies around the globe, even when it is clear that they have failed.

Matias Vernengo/Naked Keynesianism

“Stuck with crazy models”? Absolutely! Let me just give one example.

A lot of mainstream economists out there still think that price and wage rigidities are the prime movers behind unemployment. What is even worse — I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension — is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view.

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …
The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemploy-ment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

J M Keynes General Theory

People calling themselves ‘New Keynesians’ ought to be rather embarrassed by the fact that the kind of microfounded dynamic stochastic general equilibrium models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with microfunded representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. The kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility. Maybe that’s also the reason prominent ‘New Keynesian’ macroeconomist Simon Wren-Lewis can write

I think the labour market is not central, which was what I was trying to say in my post. It matters in a [New Keynesian] model only in so far as it adds to any change to inflation, which matters only in so far as it influences central bank’s decisions on interest rates.

In the basic DSGE models used by most ‘New Keynesians’, the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

To Keynes this was self-evident. But obviously not so to haiku-rule-following ‘New Keynesians’.

7 Comments

  1. Nice post. Note that one way for New Keynesians has been to change the nature of the equilibrium in the labor market. So now the natural rate is time varying. Soon the US will be at full employment (nudge, nudge, wink, wink) at around 5.2%.

  2. I find it really irritating when economists use percentages to talk about unemployment.

    I prefer to talk in term of the *millions* of people that represents – usually by referring to the size of well know cities. Only then do you actually get a sense of the scale of waste built into these economic models – which you will recall they can do *nothing* about.

  3. More error than trial
    Comment on ‘”New Keynesian” haiku economics’
    .
    Science is a trial-and-error process and that means that the quantitatively greater part of what scientists produce eventually turns out to be waste. This is no problem at all — provided there is a method of, so to speak, separating gold from gravel.

    In science we have two criteria: formal and material consistency. Theories that are logically defective or are refuted by facts end on the waste heap. The separation process does not work, of course, with an immediate 100 percent efficiency. So, at any point of time there are some false theories held and defended in the public domain by honest scientists. However, by sticking to the scientific method we develop in the course of time what Popper called verisimilitude, i.e., an approximation to the truth.

    What we can observe is, indeed, that this process does not seem to work properly in economics. What we see is the refinement of an approach that has been wrong-footed from the very beginning. Everyone who looks closely into the matter cannot fail to recognize that the heterodox critique of Orthodoxy is to the point.

    The curious thing, however, is that there seems to be a lack of serious attempts to overcome the Jevons-Walras-Menger paradigm.

    “Yet most economists neither seek alternative theories nor believe that they can be found.” (Hausman, 1992, p. 248)

    The best-known exception was, of course, Keynes. The problem with Keynes is that he often had the right intuition but could not translate his ideas into the form of a logically consistent theory. Yet, this is the very task of the economist.

    “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)

    While Keynes did not succeed with the intended paradigm shift it is certainly the case that with his educated common sense he was closer to the real world than the ‘crazy models’ of contemporary New Classicals or New Keynesians.

    When one advances in Keynes’s innovative spirit and avoids his conceptual and logical errors/mistakes then one can derive a macroeconomic employment equation (2014, eq. (22)) which is reproduced here:

    From this equation follows a confirmation of Keynes’s intuitive arguments:

    “So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.”

    “During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.” (see intro)

    The final conclusion appears a bit paradox: The formal part of the General Theory is defective, however, Keynes’s assertions with regard to the interrelation of wage rate and employment are correct. The sticky-wages argument of New Keynesianism on the other hand is far beside the point (not to speak of its theoretical poverty). There has been no real scientific progress in economics since Keynes.
    .
    Egmont Kakarot-Handtke

    .
    References
    Hausman, D. M. (1992). The Inexact and Separate Science of Economics. Cambridge: Cambridge University Press.
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics:
    Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
    Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic
    Method in Economics and Econometrics. Cambridge, MA: MIT Press.

  4. Gobsmacked?

    • Absolutely!

  5. I think that wage stickiness may be an ‘entropic’ force (like osmosis or the stickiness of glue), which implies there is no microfoundation for it; it only exists if there are many agents.

    http://informationtransfereconomics.blogspot.com/2014/10/wage-stickiness-is-entropic-force.html

  6. (Cross-post from Naked Keynesiasm): I’m intrigued by the haiku-economics modeling analogy used by Blanchard in his thoughtful paper on “The State of Macro” (NBER 2008). In the first publication of “Haiku Economics” (Rethinking Marxism 14 (3), 2002), I offered the following haiku:

    III. Economic Man/ Homo economics/ Ricardo revealed.

    IV. Invisible Hand:/Mother of inflated hope,/Mistress of despair!

    VII. Lucas supply curve:/Rational reconstruction,/of glory seeking.

    Pity that Blanchard spoils the analogy. He makes haiku sound like the art of trapping reason in a little box of crazy. Perhaps that caricature fits some parts of macro. But a student of haiku history, from Basho to Barthes, knows better.

    – Steve Ziliak

    http://www.poetryfoundation.org/poetrymagazine/article/240970


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