How New Keynesian economics betrays Keynes

Roger Farmer has an interesting essay on evolution of macro thought (HT: Cafe Economics). It is actually an extract from his book Prosperity for All.

He reviews the history of macro thought and says New Keynesians miss a basic point from Keynesian view:

The program that Hicks initiated was to understand the connection between Keynesian economics and general equi­librium theory. But, it was not a complete theory of the macro­economy because the IS- LM model does not explain how the price level is set. The IS- LM model determines the unemploy­ment rate, the interest rate, and the real value of GDP, but it has nothing to say about the general level of prices or the rate of inflation of prices from one week to the next.

To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical synthesis in 1955. According to this theory, if un­employment is too high, the money wage will fall as workers compete with each other for existing jobs. Falling wages will be passed through to falling prices as firms compete with each other to sell the goods they produce. In this view of the world, high unemployment is a temporary phenomenon caused by the slow adjustment of money wages and money prices. In Samuelson’s vision, the economy is Keynesian in the short run, when some wages and prices are sticky. It is classical in the long run when all wages and prices have had time to adjust.

Although Samuelson’s neoclassical synthesis was tidy, it did not have much to do with the vision of the General Theory. Keynes envisaged a world of multiple equilibrium unemploy­ment rates where the prevailing rate is selected by the propen­sity of entrepreneurs to take risks. He called this propensity animal spirits.

In Keynes’ vision, there is no tendency for the economy to self- correct. Left to itself, a market economy may never recover from a depression and the unemployment rate may remain too high forever. In contrast, in Samuelson’s neoclassical synthe­sis, unemployment causes money wages and prices to fall. As the money wage and the money price fall, aggregate demand rises and full employment is restored, even if government takes no corrective action. By slipping wage and price adjust­ment into his theory, Samuelson reintroduced classical ideas by the back door— a sleight of hand that did not go unnoticed by Keynes’ contemporaries in Cambridge, England. Famously, Joan Robinson referred to Samuelson’s approach as “bastard Keynesianism.”

The New Keynesian agenda is the child of the neoclassical synthesis and, like the IS- LM model before it, New Keynesian economics inherits the mistakes of the bastard Keynesians. It misses two key Keynesian concepts: (1) there are multiple equilibrium unemployment rates and (2) beliefs are funda­mental. My work brings these concepts back to center stage and integrates the Keynes of the General Theory with the mi­croeconomics of general equilibrium theory in a new way.


Lots more there..


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