On Economic Thought - 3

So, I happen to be excited about the New Keynesians these days. But before we latch on to the New Keynesians, a little background on Keynesians themselves may be in order.

Everyone has heard of John Maynard Keynes. But what many people do not know or realise is, none of the Keynesian macroeconomic models that economists quibble and debate about ad-infinitum were actually drawn by him. The IS/LM was formalised by John Hicks and Alvin Hansen. The Phillips curve, of course, came later. Keynes himself, wrote his magnum opus and a few other books, debated with intellectual rivals, and became a policy adviser. But much of post World War 2 macroeconomics was dominated by his thought, or more precisely, by various interpretations of his thought. If there is a single important takeaway from Keynesian economics, it is that government policy has the ability to manage aggregate demand (of goods, money and labour) and that demand is the key factor, supply will adjust. This is in opposition to the Neoclassical (or Classical, as Keynes chose to call it) view of aggregate supply being the key factor. The government could manage this demand through deficit spending or interest rates. Thus, it affords ample scope for both monetary and fiscal policy, though the reconstruction efforts after the Great Depression and after World War 2 largely focussed on fiscal initiatives.

The standard textbook interpretation of Keynes is what is called Neo-Keynesian macroeconomics. Paul Samuelson, Robert Solow, Franco Modigliani, John Hicks and James Tobin are probably the most important figures of Neo-Keynesian economics. At its core, it is a marriage of the Neoclassical macromodel of old to the insights from Keynes's opposition to it. Crudely, economists agreed that Keynesian insights were more relevant in the short-run, while the Neoclassical model held in the long run. Whenever assertions about human behaviour had to be made, the Neo-Keynesians turned to standard Neo-Classical microeconomics. In fact, on some important counts (growth theory, for example) Neo-Keynesian macroeconomics had almost nothing to do with the original Keynesian theory. Thus, there was a synthesis of the Neoclassical and the Neo-Keynesian view of markets and the economy. This combination is what introductory courses in economics at most places teach. It is also the academic thought underpinning mainstream right-of-centre capitalism, which supports freedom and efficiency at the individual market level, while allowing an important role for government intervention when dealing with aggregate variables and special situations.

The problem with this synthesis is, it can sometimes be ad-hoc and inconsistent. It talks of microeconomics when it wants to, else it ignores microfoundations. More pertinently, some of the Keynesian conclusions that it draws are logically at contradiction with the assumption of rationality in neoclassical economics. Plus, the demand boosting goverment initiatives that neo-Keynesians speak of are typically inflationary. The stagflation of the early 70's called into question the implied positive correlation between inflation and economic growth.

New Classical Economics arose as a result of these inconsistencies. Robert Lucas and Thomas Sargent insisted that macromodels be formed on grounds that are consistent with microeconomic foundations. They emphasised rational choice, rational expectations and real business cycles. They arrived at some pretty unbelievable conclusions, including one that crudely put, asserts that unemployment is always voluntary. In their view, in a recession, people are basically taking a vacation. There was bound to be some academic backlash to these outlandish theories. Enter the New Keynesians.

The New Keynesians tried to integrate most of the tenets of Keynesian, or neo-Keynesian economics with the neoclassical microfoundations, making room for some more market imperfections than traditional neoclassical economics allowed, while still allowing people to be rational in the long run (Actually, the idea of 'rationality' needs to explored in greater detail, but more on that later).

The details can be left for the serious academic, but one feature of New Keynesian economics (other than DSGE) needs to be talked about. The single most consequential market imperfection that the New Keynesians introduce is the idea of 'sticky' wages and prices. In short, this is the theory that when there is a supply-demand mismatch, it is the quantity rather than the prices that change. Neoclassical theory argues that if for some reason the supply of some product exceeds its demand, its price will drop, and there will be a supply-demand equilibrium at the new price. New Keynesians argues that these hardly happens in practice, and that it is much more common for the suppliers to re-adjust their supply, keeping the prices at their original level. This downward 'stickiness' of prices can be due to a multitude of reasons, from psychological resistance against revision of prices to the costs that are incurred in making this revision. Nowhere is this concept more beautifully illustrated than in the real estate market, where sticker prices continue to be the nearly the same though the developers have lost more than half of their market value.

So what's the big deal, you ask? There is a supply-demand equilibrium anyway, right? So where's the imperfection? Well, the informative role of prices is lost. At an elementary level, this is the single biggest takeaway from the idea of sticky wages and prices. Prices may no longer be indicative of true supply and demand scenarios. There could be extended booms and busts. Thus, while accepting most of the tenets of neoclassical microeconomics, it delivers a blow where it matters the most - on the theory of prices. But, more on the theory of prices and values later.

Prominent New Keynesians include Greg Mankiw, Michael Woodford, Jordi Gali, George Akerlof, Stanley Fischer & Olivier Blanchard.