New Keynesians believe that Say's Law is false. But they want the central bank to try to make Say's Law look true.
New Keynesians believe that real business cycle theory is false. But they want the central bank to try to make real buiness cycle theory look true.
New Keynesians believe that the loanable funds theory is false. But they want the central bank to manipulate liquidity preference to try to make the loanable funds theory look true.
New Keynesians believe that the economy has zero self-equilibrating tendencies. But they want the central bank to make it look like the economy has powerful self-equilibrating tendencies.
New Keynesian model + New Keynesian central bank = "classical" economy + random error (because no central bank is perfect).
New Keynesian model + non New Keynesian central bank (like one that sets interest rates on a whim) = godawful explosive or implosive mess.
New Keynesians are engaged in a terrible secret conspiracy to try to make the economy look very different from how they think it really is. Except it's not terrible, and not secret.
Simon Wren-Lewis and Paul Krugman maybe don't need my help; but they have got it anyway.
"Why [is mainstream New Keynesian economics] brackish? Because it has retained the nonsense of marginal productivity distribution theory while discarding the foundations of Keynesian economics. The essence of Keynes’ economics was the liquidity preference theory of interest rates and rejection of the claim that price and nominal wage flexibility would ensure full employment. New Keynesians abandon both. They replace liquidity preference theory with loanable funds interest rate theory and they use price and nominal wage rigidity to explain cyclical unemployment."
No they don't. But they want the central bank to try to make it look like that.
(Which is not to say I think New Keynesian macro doesn't have big problems. But these aren't them.)
Worthwhile Canadian Initiative 
Nick,
If everyone held the same model, which wasn’t correct in itself, but everyone believed, expected, and responded to it as if it were true, would that be enough to make it true? Does the model matter at all, or only our belief in it?
“whatever his other talents, Prescott is not a good monetary economist”
What does that even mean? Can someone be a good particle physicist but not a good condensed matter physicist? Of course a particle theorist would not be up to speed on the details of the frontier of condensed matter physics, but if he wanted he could do so. Furthermore, he wouldn’t comment on what condensed matter theorists should be doing if he wasn’t up to speed on what the problems were. They don’t just comment willy-nilly. Scientists actually care about truth. I suspect that Prescott does, too.
It’s ego and icon nonsense and about building camps of thought. OK, that gets nowhere – it’s just silly academic preening. Let’s try to understand truth as far possible and explicitly recognize the limits of our economic modelling. Part of the problem will allows spring from economic philosophy. To what extent should people be economically free? I choose more freedom over less, and I think that is the overarching message of economics.
I’m not sure what Sumner meant by that.
Avon: thanks re mortgages. Makes sense to me.
“From what I understand, traditional Keynesian economics tells us there is a permanent trade-off on the Phillips curve between employment and inflation. If people only think about current income, then inflation can “trick” them into working more.”
You have done some good reading in macro, but I think your understanding has slipped a little there. Even if people only cared about current income, you wouldn’t get a permanent trade-off without something like money illusion. And if they had something like money illusion, you would get a permanent trade-off even if they cared about permanent income. One is about the present vs future distinction; and the other is about the real vs nominal distinction. Basically different issues.
Lord: in this particular case, there is a large set of different self-fullfilling beliefs. Within that set, if everyone believes they are true, they will be true.
Avon, here’s an essay I liked by another physicist turned macro-dabbler. What do you think?
http://informationtransfereconomics.blogspot.com/2014/04/economics-is-neither-physics-nor.html
Yes, Tom, interpreting economics as a gauge theory is total BS. I agree that a lot of physicists think they can jump right in and do economics. That’s not true. Economics is every bit as hard as physics if not more so. I am attracted to economics (mostly finance and financial mathematics as opposed to pure macro) as a discipline and I spent a lot of time reading the best texts and papers in the field to figure out what was going on. The first book I read that piqued my interest was Burton Malkiel’s book A Random Walk Down Wall Street. I knew right then I had to figure this stuff out. I knew that I knew nothing, so I started with Mas Colell Whinston and Green, Cochrane, Romer, Sargent and Ljungqvist, and then a ton of the derivative pricing literature. Having a background in measure theory helps and actually most physicists don’t so it can lead to a lot of confusion for physicists. In the abstract, a gauge principle is not what economics is about, it’s about understanding which probability measure to do calculations under – the joint hypothesis of efficient markets is exactly this issue. It’s sad when I see physicists think that complicated models will help them beat the market. They are really saying that they have a probability measure for pricing assets and it appears different from the one the market is using. That’s all, and it really means that you’ve just picked up a risk premium – you just don’t know what it is yet. Alpha is Beta you don’t understand. If we were all risk neutral, life would be so much easier, but we’re not.
Avon,
Who is the Gauss of economics? Who is the Evariste Galois?
Avon, thanks for your review of that essay. I find Jason’s blog to be interesting, though I can’t claim I understand everything there… and I can’t even claim to think he’s on to something. Also I appreciate that you’re interested in finding the truth too. However, you write:
“To what extent should people be economically free? I choose more freedom over less, and I think that is the overarching message of economics.”
To play devil’s advocate a bit here: if you really want to find the truth, aren’t you afraid that this “prior” will color your view some? Maybe we’re all better off acting like ants in a colony. Again, not saying that’s what I believe, but why restrict the possibilities up front if you’re looking for the truth?
So far, I’ve come to the conclusion that economic freedom is important to prosperity. It didn’t have to, but it does, which I think is an amazing result in economics. However, there is a normative aspect to this position as well. Even if we could become more prosperous through slavery, I would not support slavery. I think that economists sometimes forget that simply writing down a giant utility maximization scheme is not the end of the story. We can’t decide on normative questions by calculation. But I find it wonderful that freedom does seem to improve society.
Avon Barksdale:
“No, the recession came first. People didn’t decide to start defaulting on mortgages because they thought it would be fun. The recession started in 2007 and the way mortgage contracts had been written set the stage for a catastrophe.”
No, it didn’t. I intentionally referred to the NBER definition since it is broader than what is usually understood as a recession (two quarters of negative growth). In the particular instance you refer to, the recession only started in Dec 2007, while the problems in the mortgage market were felt in August 2007 AT THE LATEST. This is well documented, you can google the timeline. No matter what people like Scott Summer might wish.
That doesn’t imply that people simply decided to start defaulting. My tip would be: the time has simply come to pass, in the sense that the mortgages had been written in such a way as to explode in two to three years (adjustable rates), and the really bad ones were written from roughly 2005 onwards. Plus incremental rate hikes by the FED from roughly 2004 until the start of the crisis.
I’d be really interested to see what empirical data you can provide to support your claim that “people don’t base their decisions [on their current and shor-run income]”.
“we could solve unemployment by increasing inflation – this strategy failed miserably in the 1970s”
No, that certainly wasn’t the strategy in the 70s, inflation was a by-product, not the intention. And sure we could solve unemployment, not by increasing inflation (inflation is always just a symptom, not a driver per se), but simply by providing jobs for the unemployed. Just like in WW2. That’s a political (distributional), not a technical problem (I mean, it’s not easy but we did it before).
“So, it must be the case that at least some forward looking thinking is going on by the public.”
Yes, there IS some anticipation (I never denied that), but not in the all-knowing sense assumed by REH, Ricardian equivalence, etc. Giving everyone a hundred thousand dollars while promising to tax them hundred thousand dollars plus interest a year later IS NOT the same thing as not giving them anything. I think the problem with RBC people and New Keyensians is that they don’t understand this, as they either entirely ignore nominal coordination problems or focus on the almighty interest rate. But it is income that matters.
On the provision of insurance, in particular in health care (I thought of health care since that seems to be the only area where Bush II added some welfare state), I refer you to the WHO comparision of the quality of health systems from across the world. The US does not fare very well in terms of the price/performance ratio; in fact, despite being the most profligate spender and one of the most fervent adherents of private insurance, it laggs behind most European countries with government sponsored universal health systems.
The problem with mortgages was that the quality of the loans was falling. Each year of issuance group had a faster rising default curve.
You can see a classic boom and bust pattern in the private issue loan market. The volume goes up and the quality goes down. This is the pattern going back to the South Sea bubble.
The dynamic was simple, the lower the quality of the loan, the higher the interest rate charged. The higher the interest rate charged, the more attractive the interest rate on the resulting securities. The magic of financial engineering would buffer and transfer the risk.
The decline in issuance from around $1 trillion to close to $0 in two years is remarkable.
JKH,
I think Galois would have problems getting tenure.
Nick,
A comment on your double pole dancing post that you linked to above.
Suppose a conventional monetary policy cycle – when expressed in interest rate terms – looks like this:
The economy starts coming out of recession when the policy rate is at 3 per cent. As the economy recovers and eventually shows signs of overheating, the CB in stages raises the rate from 3 to 6. The economy eventually slows down. The CB in stages then subsequently lowers the rate back to 3 as the economy weakens.
(That can all be translated to money terms as you wish.)
I think your postively sloped IS curve corresponds to what’s going on in the first half of that cycle.
I think the conventional negatively sloped IS curve is in play in the second half.
I think the first half of the cycle is characterized as monetary tightening – whether expressed in terms of interest rates or money terms. And the second half is characterized as monetary easing. And I think this is where there is a languaging issue relative to how you and Scott Sumner like to associate low rates with tight monetary policy. No problem with that association. But I think its true in respect of a specific sequence of causality and I think it should be time specific as I described.
I associate a high rate of 6 per cent with the outcome of monetary tightening as a dynamic process.
I also associate a low rate of 3 per cent with monetary tightening as the later consequence of having tightened earlier from 3 to 6.
I.e. I do associate the low rate in that sense with earlier tight money, but I also associate it with more recent policy easing in response to overly tight money.
And somehow I think all this can be reflected in your pole analogy.
So I do think there’s a languaging issue. The association of high or low rates with tight or easy money is not incorrect in my view. But neither is the opposite. It all depends on your specification of time sequencing.
Moreover, low rates at the zero bound do reflect easy money – compared to a counterfactual of positive rates such as might happen in a misguided neo-Fisherite interest rate policy. They’re just not easy compared to where the real rate might be instead.
I think your leftward shift in a vertical LM curve against a postively sloped IS curve describes what the CB has achieved on a cumulative basis at the final point of my interest rate cycle example – i.e. a decline in rates from 6 per cent back to 3 per cent. That is what the CB does when compared to a counterfactual where it hasn’t done “anything” more (or interest rates haven’t done anyhing more) after rates have reached 6 per cent.
But the problem I see is that the positively sloped IS curve should have become “conventionally” fully negative by the time that leftward shift is complete. There is an inflection point process for the IS slope associated with that leftward LM shift.
The LM dynamic causes the slope of IS to rotate from positive to negative. That rotation starts when LM starts to move left.
Does this description make any sense to you?
JKH: It makes some sense to me. I think I am mostly following you. What you say sounds more right than wrong. But I think we are now stretching my pole analogy farther than it can go. The poles do not have expectations. If you know where a pole is now, and where it was a second in the past, you can figure out where it will be a second in the future. But the economy has expectations, so where it goes now depends on what it expects the central bank to do in future.
Nick
Good post as always. Just wanted to say that
Avon Berksdale
“If the US ends up with Canadian productivity over then next few decades, permanent income will look like a good explanation. ”
This is just a general pet peeve of mine, but its something which is all too prevalent in the “econoblogosphere”. If a model gives a numerical prediction, then the way to test this model is by testing the numerical predictions out of sample. There is no other way. Yet, time and again, I see people arguing that some vaguely defined long term trend, be it in productivity, inflation, unemployment can yield useful information about these kind of models, which just makes no sense.
It is especially frustrating because econometricians test DSGE all the time. And almost every time the result is the same: they predict almost nothing. And this goes for all of the different types, from RBC to NK. They all perform horribly. Just plain horribly. There might be nothing better (admittedly Macro is hard, I decided I was not smart enough for it long ago), but that doesn’t change the fact that they are horrible.
And this doesn’t even adress the more underlying questions of whether stuff like expectations is actually even measurable, or from the more mathematical angle, if stuff like permanent income is Turing computable.
On the plus side, this means that Nick won’t (or at least shouldn’t, if there is any justice in this world) lose his Macro cred to the more super-mathy people, because as of now, I see no reason that all this fancy stuff is much better than the kind of rigorous analytical approach that is used on this blog.