The biggest mistake in the history of macroeconomic thought8 May, 2016 at 15:35 | Posted in Economics | 6 Comments
The Keynesian economics of the General Theory is static. It purports to explain how employment, GDP and the interest rate are determined at one weekly meeting, taking the price level as fixed. Modern macroeconomics is dynamic. It purports to explain how employment, GDP, the interest rate and the price level are determined in a sequence of weekly meetings. To knit together the temporary one-week Keynesian equilibria, Samuelson, in the new-classical synthesis, used the Phillips curve, which he saw as a price adjustment mechanism in which the wage adjusts in response to an excess demand or supply of labor. This was the biggest mistake in the history of macroeconomic thought and we are still suffering the consequences as central banks work with false ideas and broken models.
In Prosperity for All I articulate the evolution of an alternative research agenda. I argue that it is beliefs that are sticky: not prices. At each weekly meeting, the auctioneer finishes his job. The demands and supplies of all goods are equal and all markets clear; including the labor market …
The differences of this theory from all of modern macro, both classical and New-Keynesian, are profound. In my view, high involuntary unemployment is an equilibrium phenomenon. A market economy can get stuck in a Pareto inefficient equilibrium with high unemployment forever. It is the job of government to design political institutions that provide the equilibrating mechanisms that are missing from laissez-faire market economies.
Farmer has always — as did e. g. Wicksell and Keynes — made a point of the fact that equilibrium and optimality are not the same thing. That also implies that the economy being in equilibrium does not have to be inconsistent with high and persistent unemployment rates. Farmer uses a search theoretical approach to underpin this view. Although yours truly do not share his faiblesse for the Mortensen-Pissarides-Diamond modeling of Keynesian ideas re labour markets and unemployment, it will sure be interesting to take part of his hopefully more fully-fledged argumentation for his view when the book is out in September.