My former class mate Nick Rowe, in a comment on Saturday's blog post, asks:

Start with a standard model with perfectly flexible prices and wages. Delete one equation, for example the labour market clearing condition. We are now one equation short of a solution, so we have multiple equilibria. Does that mean we are now free to add any additional equation we feel like? Mathematically, we can do that, of course. But one would like some sort of intuition for that extra equation. Why, for example, should it be an equation for stock prices? Why not a different equation for wages?

That's a great question. Until recently, new-Keynesian economists didn't bother to model unemployment. Instead, they followed the new-classical approach in which all that matters is labor hours spent in paid employment. More recently, a number of authors including Bob Hall, and Mark Gertler and Antonella Trigari have incorporated explicit models of search unemployment into otherwise standard macroeconomic DSGE models. That idea is not new; David Andolfatto and Monika Merz introduced search to RBC models in the 1990s. What is different about more recent work, building on Hall's 2005 paper, is the way the model is closed.

Bob Hall was following up on an insight from Peter Howitt and Preston McAfee: When a firm meets a worker in a search model, the worker and the firm enter a bilateral bargaining situation. The worker would be willing to accept a job, and the firm would be willing to employ the worker, for any wage that is greater than the worker's reservation wage and less than the worker'r marginal product. In his 2005 paper, Bob showed that one way to close the model,is to assume that the wage is fixed.

Presto. Search in a DSGE model has equilibria with rigid wages. That idea has led to a huge industry as new-Keynesians seek to study different bargaining protocols in an effort to explain slow wage adjustment endogenously.

That way of attacking the problem is, in my view, a mistake. The new-Keynesians are squeezing the square peg of labor market search theory into the round hole of Samuelson's neoclassical, synthesis.

There is an alternative approach that has a better shot at understanding the data. By dropping the bargaining assumption completely and assuming that firms and workers are price takers in the labor market, we arrive at a microfoundation to a model we used to teach to undergraduates. The Keynesian Cross.

The Textbook Cross Keynesian Model

The Keynesian story for this picture is that upward sloping green line, at 45 degrees to the origin, is a Keynesian aggregate supply curve. It represents the assumption that whatever is demanded will be supplied. The upward sloping red line is the Keynesian aggregate demand curve. The aggregate demand curve slopes up because consumption increases with income. Shifts in the aggregate demand curve call forth shifts in aggregate supply as the equilibrium moves up and down the 45 degree line.

According the parable of the Keynesian Cross, the Great Depression was caused by a downward shift in the aggregate demand curve as investors lost confidence in the value of assets. The labor search theory, with its continuum of possible equilibria, offers a way to tell this story that is consistent with microeconomic theory. All we need, is an explanation for what causes shifts in aggregate demand. And for that, we need to think carefully about market psychology and animal spirits.

That takes me full circle; and back to Nick's question. One way of closing the model is to assume a bargaining protocol that explains why wages are sticky. A second way, is to provide a theory of animal spirits that explains movements in aggregate demand. Why is one way of closing the model better than another?

I show here, that these two ways of closing the model are observationally equivalent. For every theory of wages, there is a sequence of asset price movements that is consistent with those we observe in the data. And for every theory of animal spirits there is a sequence of bargaining weights that rationalizes wage movements in the data. But these theories have very different implications for what caused the Great Recession.

If the sticky wage theory is correct, movements in labor market fundamentals cause movements in the stock market. Standing in 2008, savvy investors, looking forward at future returns, must have foreseen some fundamental event that would shift bargaining power in favor of workers. That prescience caused them to downgrade expectations of future profitability leading a to a big crash in the stock market.

If the animal spirits story is correct, movements in the animal spirits of investors cause movements in the labor market. Standing in 2008, investors lost confidence in the value of assets. The resulting destruction of paper wealth caused households and firms to cut back on spending and firms to layoff workers. We are, only now, digging our way out of the hole.

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.

Roger Farmer's Economic Window