New Old Keynesianism

The term “New Old Keynesian” was coined by Tyler Cowen a couple of years ago, to describe the revival of the view that the Keynesian analysis of recessions caused by lack of aggregate demand is relevant, not only in the short run (in this context, the time taken for wage contracts to reset, say 2-3 years) but in the long run (5 years or more) as well. When Cowen was writing, in September 2011, the New Depression could still, just about, be seen as a short run phenomenon[1]. In particular, the anti-Keynesian advocates of austerity in the US, UK and Europe were predicting rapid recovery.

As 2014 begins, it’s clear enough that any theory in which mass unemployment or (in the US case) withdrawal from the labour force can only occur in the short run is inconsistent with the evidence. Given that unions are weaker than they have been for a century or so, and that severe cuts to social welfare benefits have been imposed in most countries, the traditional rightwing explanation that labour market inflexibility [arising from minimum wage laws or unions], is the cause of unemployment, appeals only to ideologues (who are, unfortunately, plentiful).

So, on the face of it, Cowen’s “New Old Keynesianism” looks pretty appealing. But what are the alternatives? Leaving aside anti-Keynesian views for the moment, the terminology suggests four logical possibilities: Old Old Keynesianism, Old New Keynesianism, New Old Keynesianism and New New Keynesianism.

But do these logical possibilities correspond to actual viewpoints, and, if so, whose?

In Cowen’s “New Old” terminology, we can take New to mean “post Global Financial Crisis” and “Old” to refer to a belief that the economy can be in a long-run high unemployment equilibrum.

Old Old

So, “Old Old Keynesians” refers most naturally to the Keynesians who dominated the economics profession in the 1950s and 1960s (Hicks, Samuelson and Solow being obvious examples). They regarded Keynes as having refuted the errors of Classical economics, and saw the management of aggregate demand through fiscal policy as the key to macroeconomic stability. The Old Old Keynesians were discredited (or so it seemed at the time) in policy terms by their failure to respond adequately to the stagflation of the 1960s (correctly predicted by Milton Friedman), and in theoretical terms by the absence of consistent foundations in microeconomics, as demanded by the New Classical school led by Robert Lucas.

Old New

After the 1970s, the “Old Old Keynesians” became, or were replaced by “Old New Keynesians”. The Old New Keynesians tried to develop microeconomic foundations for models that would yield Keynesian conclusions. In general, this could only be done for the short term. The corollary was that fiscal policy (which typically takes the better part of a year to adjust) was too clumsy a tool and that the primary responsibility for macroeconomic stabilization should lie with interest rate adjustments by central banks like the Fed. Over time, as it became clear that the “Real Business Cycle” approach of the New Classical School was unrealistic in its pure form, New Classical and (Old) New Keynesian macroeconomists converged on the Dynamic Stochastic General Equilibrium (DSGE) approach

After the Global Financial Crisis, it became clear that the concessions made by the New Keynesians were ill-advised in both theoretical and political terms. In theoretical terms, the DSGE models developed during the spurious “Great Moderation” were entirely inconsistent with the experience of the New Depression. The problem was not just a failure of prediction: the models simply did not allow for depressions that permanently shift the economy from its previous long term growth path. In political terms, it turned out that the seeming convergence with the New Classical school was an illusion. Faced with the need to respond to the New Depression, most of the New Classical school retreated to pre-Keynesian positions based on versions of Say’s Law (supply creates its own demand) that Say himself would have rejected, and advocated austerity policies in the face of overwhelming evidence that they were not working

New Old

The failure of DSGE macroeconomics in the crisis gave rise to New Old Keynesianism, represented most notably by Paul Krugman, and rather less notably by me. I won’t presume to state Krugman’s position for him, but will give my own.

* In theoretical terms, New Old Keynesianism recognises that the Old Old Keynesians oversold the capacity of aggregate demand management to ‘fine-tune’ the economy, and select from a menu of macroeconomic outcomes represented by the Phillips curve[2], and that the Old New Keynesians provided valuable understanding of the way in which relatively minor deviations from standard microeconomic models could have significant macroeconomic consequences. Nevertheless, in conditions like those of the New Depression it is the ideas and policy prescriptions of Old Keynesianism that are needed. To the extent that microeconomic foundations are needed at all, they are likely to end up being radically different from those of current micro textbooks, incorporating bounded rationality and large-scale co-ordination failures

* In political terms, projects of convergence have been shown to be futile. As on all scientific issues, those on the political right are ideologues whose views are immune to empirical evidence. There is no value in intellectual debate with Classical macroeconomists, any more than with climate denialists (the overlap between the groups being large and growing)

* Relative to DSGE, the key point is that there is no unique long-run equilibrium growth path, determined by technology and preferences, to which the economy is bound to return. In particular, the loss of productive capacity, skills and so on in the current depression is, for all practical purposes, permanent. But if there is no exogenously determined (though maybe still stochastic) growth path for the economy, economic agents (workers and firms) can’t make the kind of long-term plans required of them in standard life-cycle models. They have to rely on heuristics and rules of thumb. (Update in response to comments This is, in my view, the most important point made by post-Keynesians and ignored by Old Old Keynesians).

New New

The prominence of New Old Keynesians like Krugman in the public debate contrasts with the situation in academic macroeconomics, which has gone on almost unchanged since the crisis (and in a state of massive intellectual retrogression relative to Old Old Keynesianism). It’s still the norm to assume that recessions can at most be transitory, and quite common to see New Classical/Real Business Cycle models that assume full employment at all times. Within this framework, the New Keynesian program (at least as I see it), is to incorporate a volatile financial sector into DSGE-style models, and aim to reproduce the observed outcome that financial crises are commonly followed by long and deep recessions. From the outside, I don’t see much progress being made here. But the sense of crisis that briefly gripped the profession in 2008 and 2009 is long gone.

There hasn’t been much overt conflict between New New and New Old Keynesians. That’s because nearly all Keynesians are in agreement on the need for more fiscal stimulus in the major economies, and because New Old Keynesians have, in general, confined themselves to policy debate while New New Keynesians have mostly steered clear of those debates. But the need to refound Keynesian macroeconomics on firmer foundations is every bit as clear as in the 1970s.

I haven’t said much about the other side of the debate: the New Classical/Chicago/austerity camp. That’s because, on this as on most issues (climate science, energy, environmental hazards etc), the political right has immunised itself against evidence that conflicts with its desired views. The difference between economics and the natural sciences is that natural scientists have almost uniformly rejected the Republican/right position (around 6 per cent of scientists identify as Republicans). By contrast, in economics, there are plenty of Nobel prizewinners (yes, yes I know) on both sides.

fn1. Although the NBER dated the recession as having started in Dec 2007 and ended in 2009, the Lesser Depression began later, with the financial meltdowns of 2008, and has never ended.