New Keynesian Flimflam

Simon Wren-Lewis, seeks a serious debate with our heterodox colleagues, and judging by the excellent comment thread that appears on his post, there are plenty of heterodox economists who are ready and willing to take up the challenge. This is a welcome debate.

Simon defends his view of orthodoxy, by which he means New Keynesian economics. In its simplest form, New Keynesian economics is a three-equation model that explains the behavior of the nominal interest rate, the "output gap" and the inflation rate.

I agree firmly with Simon, that from a policy perspective, we should not care one iota if NK economics has anything to do with what Keynes might or might not have thought. But from the perspective of the history of thought, we should not mislead our students with false labels. The New Keynesian model is neither new nor Keynesian. It is a beautiful formalization of David Hume's verbal argument in his 1742 essay "Of Money"; an early piece on the Quantity Theory of Money  that every macroeconomics student should read at least once.

Let me take up just one point from Simon's post. Are the demand and supply of labor always equal and should we care?

In the NK model, the answer to this question is YES: the demand and supply of labor are always equal. There is no involuntary unemployment as defined in the General Theory. Why does that matter?

The notion of continuous market clearing adds a mechanism to the NK model that works to restore full employment through wage and price adjustment. That mechanism is the basis for the NK Phillips curve which asserts that prices will rise whenever output is above potential. Since potential output cannot be independently measured, that assertion becomes a tautological definition of the output gap.

The NK economist accepts Milton Friedman's concept of the natural rate of unemployment which asserts that, in the long run, there is a unique equilibrium level of unemployment associated with stable inflationary expectations. If inflation appears, following a recession, a policy maker who accepts NK economics will infer that the economy is operating above potential. If unemployment is now 6%, rather than 3%, it must be that the natural rate of unemployment has increased.

If the NRH hypothesis is wrong, as I have argued here, the NK policy maker will allow the economy to operate permanently below its long-run potential and society will suffer permanent non-recoverable losses in output. 

Orthodox economics is not homogenous nor is it static. It evolves in response to historical events like the Great Depression and the 2008 Financial Crisis.  Now is a good time for all of us to be open to new ideas.