There has been a lot written on the blogosphere in recent weeks
about the microfoundations of macroeconomics. Tony
Yates argues in favour of micro-founded structural models. Adam
Posen is sceptical of micro-foundations and Simon-Wren
Lewis, Noah
Smith and Nick
Rowe call for a more eclectic approach. For those looking for a neat
summary of these debates, Paul
Krugman traces the history of macroeconomic ideas. Responding to a piece by Brad
Delong, he argues that there has been a recent resurgence of what he calls
“neo-paleo-Keynesianism”. This is very useful concept and I have much in common with the ideas expressed in Paul's piece. This essay offers a novel definition of the term that Paul coined and an invitation to fellow academics to join me in pursuing an agenda based
on this definition.
I agree with Paul Krugman: macroeconomics has taken the wrong path. I disagree with Paul’s reading of when that
happened. The error has nothing to do with
new-classical versus new-Keynesian approaches; it is a more fundamental error
that pervades both new-classical and new-Keynesian schools of thought.
Macroeconomics took a wrong turn in Cambridge Massachusetts in 1955 when Paul
Samuelson, in the third edition of his textbook, introduced the idea of the
“neoclassical synthesis” (see Pearce
and Hoover for a discussion of the influence of Samuelson’s textbook). Everything
since then has been the economic equivalent of the scientific theory of
phlogiston.
Many economists are exposed to the philosophy of science through
Milton Friedman’s book, Essays in Positive Economics.
Friedman promoted the views of Karl Popper who argued (here)
that science progresses when theorists make bold conjectures that are
confronted by facts. Those conjectures stand until they are refuted by the
evidence. Occasionally, economics
students are exposed to the ideas of Thomas Kuhn who talks (here
) of paradigm shifts and scientific revolutions. Rarely does the economics curriculum
of a Ph.D. program have time to push much further into the methodology of
science. That’s a pity since there is
much to be learned from alternative philosophies.
Axel Leijonhufvud has argued persuasively (here)
that we have much to learn from Imré Lakatos, a philosopher of science who
spent much of his career at the London School of Economics. Lakatos, (here)
in contrast to Popper and Kuhn, sees science as a set of competing scientific
research programs. His approach is a
useful one for understanding the current debate amongst practicing
macroeconomists who are facing a series of natural experiments that provide
serious challenges to both new-classical and new-Keynesian agendas.
According to Lakatos, all tests of scientific theories are
necessarily tests of joint hypotheses. The
sciences, both physical and social, are best characterized as interacting
communities of scholars. Those scholars
adhere to research programs that interpret the evidence through different
lenses.
Each research program has a ‘hard core’ and a ‘protective belt’. When
an event in nature appears to refute a theory, the scientist must decide which
of the possible components of his theory should be rejected in order to
reconcile his worldview with the outcome he observed. Assumptions that make up the hard core of a
research program will never be rejected; instead, the scientist will amend one
of the assumptions in its protective belt.
The new-Keynesian research program is the descendent of Samuelson’s ‘neoclassical
synthesis’. According to that synthesis,
the economy is ‘Keynesian’ in the short-run when not all markets have had time
to clear: it is ‘classical’ in the long
run when all price adjustment has run its course. It is these twin propositions that form the
hard core of the new-Keynesian program. According to that program, market economies
are self-correcting, and although the adjustment to the long-run equilibrium
may take time, that adjustment will, eventually, occur.
Despite its name, the new-Keynesian research program is neither new,
nor Keynesian. The idea, that real economic activity may be different from its
long run steady state as a consequence of sticky prices, is firmly rooted in
monetarist tradition. It originated in
the eighteenth century and is summarised by David Hume in his delightful essay,
Of Money. Keynes argued, in
contrast, in the opening chapters of The General Theory, that high
unemployment of the kind that persisted in the Great Depression is one of many
possible steady state equilibria.
How can we recover this idea, without discarding three hundred years
of microeconomic principles? I will refer to a research agenda that maintains
the notion of unemployment as a steady-state equilibrium as paleo-Keynesianism. When combined with
general equilibrium theory in a way that provides a micro-foundation to this
key idea, I will refer to the resulting synthesis as neo-paleo-Keynesianism.
In contrast to new-Keynesian ideas, neo-paleo-Keynesianism does not
assume that ‘frictions’ prevent wages or prices from clearing markets. It does not deny that wages and prices move
slowly, relative to quantities. But that observation does not mean that we must
assume that there are menu-costs, contracting costs or any other artificial
barrier to price adjustment. As I explain (here),
sticky prices may simply be part of a rational expectations equilibrium. Robert Lucas was exactly right when he argued (here)
that markets are always in equilibrium. But accepting that proposition does not
require us to accept that equilibrium is unique; nor must we accept that
equilibrium is optimal, or that unemployment is voluntary.
The neo-paleo-Keynesian (NPK) research program is unashamedly
neo-classical. It seeks to reconcile Keynesian ideas with the microeconomics of
general equilibrium theory; and it does so in a new way. As with new-classical and new-Keynesian
economics, neo-paleo-Keynesianism constructs models of rational actors who interact
in markets. In contrast to new classical
and new-Keynesian programs, neo-paleo-Keynesianism contains two propositions that
are absent from the hard core of these agendas: 1) there is a continuum of
possible equilibrium unemployment rates and 2) the unemployment rate that
prevails is determined by the ‘animal spirits’ of investors.
How might one accomplish this agenda? One approach that I describe (here) combines
a search theory of unemployment with an asset-pricing model and (here) I develop a model driven
by animal spirits that returns to paleo-Keynesian ideas without invoking sticky
prices or wages. My survey paper (here)
explains what is different about neo-paleo-Keynesianism, from the new-Keynesian
alternative.[1]
What is wrong with new-Keynesian economics and why should we prefer
the NPK approach? Lakatos provides us with an answer. Research programs are not
refuted, as in Popper, nor are they dramatically overturned, as in Kuhn. They
simply attract more new adherents than their competitors. In the language of
Lakatos, research programs are progressive or degenerative.
In the normal course of events, a successful research program meets
challenges to its hegemony by modifying hypotheses in its protective belt. A progressive research program is one that
occasionally makes a prediction that is confirmed by experiment or, in the case
of macroeconomics, by history. A degenerative research program is one that
struggles with continued refutations by continually modifying its protective
belt in ever more inelegant ways.
The new-Keynesian research program, like the new-classical program
before it, is degenerative. Like Ptolemaician astronomy, it explains new data
by adding ever increasing layers of complexity. And like that theory; new-Keynesian
economics has not succeeded in making a single prediction that has been
confirmed by fresh evidence that was unavailable when the theory was
constructed.
So where does that leave the neo-paleo-Keynesian? What event is
explained by this approach? First and foremost, there is the persistence of
long-term unemployment in the wake of a financial crisis. For a new-Keynesian,
it is hard to explain why wages and prices have been so sticky that employment
still has not recovered more than five years after the onset of the stock
market crash. For a neo-paleo-Keynesian it is an expected outcome for a theory
in which high involuntary unemployment is an equilibrium state.
There are those who claim that we should return to the Keynes of the General Theory while rejecting the
attempt to build microfoundations. That is the message, for example, of post-Keynesians
like Paul
Davidson. While there are attractive elements to that path, I do not
believe that we should abandon all of
classical economics. There is much to
like in the ideas of demand and supply and several branches of economics have
had notable successes by following the idea that actors are rational and goal
oriented. Examples that come to mind are auction theory that was used
successfully to sell the rights to the electromagnetic spectrum in the UK and
matching theory that was used to develop kidney exchanges.
The path of combining multiple equilibria with ‘animal-spirits’ has
the potential to explain many of the puzzles thrown out by recent experience. I
showed (here)
that it offers an alternative explanation of the monetary transmission mechanism, one that outperforms the
new-Keynesian alternative, and I argue (here)
that active stabilization of financial markets offers an alternative approach
to traditional fiscal policy as a means of maintaining full employment.
If Keynes were alive today, one thing is certain; he would not be a
Keynesian in the sense in which that term is used today. Keynes was notorious
for changing his views on a daily basis and was said to be capable of holding
several conflicting opinions at the same time. Would he be a
neo-paleo-Keynesian? Who knows? What
seems certain, to me, is that existing ideas have failed us. For me, that’s enough to try something new.
[1] I am not the only one that is seeking a return to paleo-Keynesian
ideas. Others I would place in this category include Stephanie Schmitt Grohé
and Martín Uribe (here) who drop
classical principles of market clearing and return to the Keynesian concept of
involuntary unemployment. Narayana
Kocherlakota constructs (here)
a model of incomplete factor markets, Greg Kaplan and Guido Menzio (here)
combine search in the labor market with search in the product markets and Pascal
Michaillat and Emmanuel Saez (here)
takes prices as parametric. All of these papers are examples of multiple steady
state equilibria.