Old Keynesian Economics and Equilibrium Theory

Noah Smith refers to a vintage piece by Robert Barro that pours scorn on the New Keynesian agenda. I am grateful to Noah for drawing our attention to it. I find much to agree with in Barro’s critique of the New Keynesians and those who would attack his position would be wise to heed the proverb: those who live in glass houses should not throw stones.

Much of the modern debate between classical and Keynesian economics is framed around equilibrium theory. In the red corner is a class of reactionary equilibrium theorists who are blind to the reality of mass unemployment. In the blue corner, is a class of enlightened new Keynesians who are champions of the unemployed. These progressives recognize that nominal rigidities prevent the labor market from equating demand and supply and the obvious remedy is large-scale fiscal expansion. The failure of the reactionaries to recognize the obvious merits of this argument must be due to their political motivation.

This is a simplistic description of reality, not just because both new-Keynesian and new classical economists span both sides of the political aisle. It is also simplistic because it misunderstands the modern meaning of the equilibrium assumption. Using general equilibrium theory, broadly defined, one can build sensible equilibrium models where high unemployment exists as one of many possible labor market equilibria.

Most of the macro-economists I know, and all of the macro-economists I respect, learned a huge amount from the rational expectations revolution, initiated by Robert Lucas. Drawing on Chapter 7 of Gerard Debreu’s Theory of Value, Lucas taught us to assume that markets are always in equilibrium. That observation was a game changer that is still playing out in the research community and its implications were not, in my view, fully understood by early adopters of classical economic models.

Most modern macroeconomic theorists use dynamic stochastic general equilibrium models, DSGE, for short. These models are direct descendants of John Hicks' classic book, Value and Capital, which developed the idea that economies evolve as a series of ‘weeks’, each of which is characterized by markets that are in what Hicks called a ‘temporary equilibrium’.

After reading Keynes’ General Theory, Hicks renounced the equilibrium assumption (see Michel De Vroey) and argued instead, that for some commodities, demand may not equal supply in any given week. That ‘disequilibrium’ assumption, came to dominate the subsequent development of macroeconomics and it manifests itself today in new-Keynesian models of sticky prices.

The disequilibrium assumption favored by Hicks came under attack in the 1970s because simple models of that era could not account for the simultaneous occurrence of inflation and unemployment.

The main tool used to understand macroeconomics in 1970 was the IS-LM model. That model was widely perceived to be unsatisfactory, in part, because it is purely static. The IS-LM model does not explain the interaction of prices and expectations and, for that reason, it is an unsatisfactory model if one is interested in understanding inflation, which is an inherently dynamic process. That problem was solved by the introduction of mathematical techniques that were unavailable to previous generations of theorists. Those techniques were introduced to macroeconomics in the rational expectations revolution.

The rational expectations revolution made two changes to the temporary equilibrium agenda as it was understood in 1972. First, rational expectations theorists insisted that markets are in equilibrium every period. According to this approach, the demand equals the supply for every commodity; including labor. Second, rational expectations theorists insisted that expectations of future prices are correct in the sense that no agent is systematically fooled into making decisions that he subsequently regrets. Early versions of rational expectations models also assumed a single agent, perfect competition, linear technologies, etc., etc., etc.

These early equilibrium models, (the RBC model of Kydland and Prescott is a good example), carried with them a very strong implication. There is nothing that government can do to improve the welfare of the agents in the model. In the language of economics; these models have a unique equilibrium and that equilibrium is Pareto Optimal.1

Many economists have recognized for a long time that the RBC model of Kydland and Prescott is not a good description of the real world. Larry Summers, for example, tells us that the classical vision of economics is nonsense because it disregards some basic facts; primary among them is the existence of large-scale unemployment that persists for decades. I agree whole-heartedly. But accepting equilibrium theory as an organizing principle does not require that we accept all of the assumptions of the RBC model.

The problem with classical models is not the equilibrium assumption; it is the optimality implication. The idea that the current state of affairs is socially optimal is so obviously at odds with the existence of mass unemployment that it has given equilibrium theory a bad name. In very simple models, equilibrium and optimality are the same thing. But that conclusion is a very special implication of some equilibrium models. It does not hold in general. That idea is key to reconciling Keynesian economics with equilibrium theory.

The sceptical reader will reasonably ask how equilibrium can be consistent with unemployment. Surely the existence of unemployment requires us to assume that the demand and supply of labor are not equal to each other. Not so: By modelling the process by which unemployed workers are matched with jobs, we can use search theory (for which Dale Mortensen, Chris Pissarides and Peter Diamond were awarded the 2010 Nobel prize) to understand how unemployment varies over time.

To understand the persistence of high unemployment, we do not need to assume that prices are sticky or that markets are in disequilibrium. Mass unemployment does not occur because markets are in disequilibrium: Mass unemployment occurs because the market equilibrium is not socially optimal. Recognizing that simple fact has important implications for our understanding of the current state of the world economy.

This post would not be complete without commenting on a claim that Paul Krugman recently made on his blog in the New York Times. In Krugman’s view we should return to what he refers to as Neo-Paleo-Keynesianism which, according to Krugman, involves
…turning away from hard math back toward rough-and-ready assumptions based on empirical observation. Aspiring up-and-coming economists may be able to publish empirical papers in this vein, but theoretical analyses are likely to be met with giggles and whispers. Just because the stuff works doesn’t mean that it will be publishable.
I disagree and in a recent blog post I suggested a different definition of Neo-Paleo-Keynesianism from Krugman's initial use of that term.  In 2008 I defined a way of reconciling Keynesian economics with equilibrium theory that I called Old-Keynesian Economics. Both of these links describe ways of reconciling the essence of Old Keynesian economics with equilibrium theory that go well beyond “rough-and-ready assumptions based on empirical observation”.

The challenge for aspiring up-and-coming economists is to reconcile the observation of persistent mass unemployment with the tools of economics by building on the foundation provided by the recent work of DSGE theorists. Often, that will involve mastering ‘hard math’ because hard math offers the best way of consistently formalizing the logic that underlies economic theory. The combination of search theory with temporary equilibrium theory offers the tools to do just that. No-one would use an abacus when offered a computer. For the same reason, it would be unwise for an aspiring up-and-coming economist to cling to the static IS-LM model when there are alternative tools available that are better suited to the task of explaining financial crises.
1. To the unsuspecting natural scientist reading this blog -- economists use the word equilibrium to mean that plans of agents are internally consistent. There is no implication in an ‘equilibrium’ that observable variables are constant through time. Instead, they are typically described by a stationary probability measure.