Failures of New Keynesian Economics

The wreck of an elegant model!                Photo Credit: Flickr.com/Kevin Hutchinson

The New Keynesian economics is such an elegant mental construct that it is almost disappointing that it gives such a counter-productive set of policy recommendations! I say this as a fervent believer in free-markets who could be expected to cheer its failures. Its greatest triumph is that it could do what its neo-Keynesian predecessor could not: give a coherent and believable explanation for the stagflation of the 1970s, as we saw in the post How New Keynesians Explain 1970s Stagflation.   

Yet fail it has, mostly with its prescriptions for Federal Reserve monetary policy. Read the posts Quantitative Easing and Its Effects, Why have ZIRP and QE Failed, and Economic Damage Created by the Fed for more on the failure of New Keynesian monetary policy. Also, its Keynesian heritage led the New Keynesians to recommend Barack Obama’s federal government stimulus programs of 2009, which have had underwhelming effect on the economy. Proponents of government stimulus programs may protest that Obama’s administration faced the largest financial crisis since the Great Depression of the 1930s, and based on the length of time to recover from the Great Depression, they may claim that it takes longer to recover from a financial crisis. Nevertheless, Obama’s stimulus spending has resulted in a definitely sub-par recovery from the Great Recession, as can be seen in the yellow curve in the figure below.

In fact, the current recovery from the Great Recession is the most anemic at the least since and including the Great Depression. New Keynesians might well protest (if they were not Keynesians!) that Keynesian policies are not the only programs that have hurt our current recovery. In addition, there are all the new federal government regulations imposed on the economy with justifications completely independent of Keynesian economics. For examples read the posts The Burden of Government Regulations, The Debilitating Effects of Obamacare, Economic Effects of the Dodd-Frank Act, and The EPA, CO2, Mercury Emissions, and “Green” Energy, Nevertheless, the evidence of the destruction of national savings and of asset bubble inflation by monetary policy can not be ignored.

So why have New Keynesian policy recommendations had such bad effects? I suspect these bad effects have less to do with the Keynesians’ elegant mathematical tools for describing changes in the economy, and more to do with their biases and predilections for activist government policies. Everyone likes to have more control over their environment than less, so they can feel like they have control over their problems rather than the other way around.

Academics all around the world, particularly academic economists, can find that control through influencing government policies. Conversely, professional politicians of all the leftist species can seize on Keynesian doctrine as yet another reason for controlling human society by control of the economy. As I have noted before on these pages, at least since the times of Woodrow Wilson, American progressives have chafed under the restrictions the U.S. Constitution put in their way to prevent the immediate imposition of their solutions to human problems. The result over time has been an increasingly autocratic Democratic Party. Read also Bernie Sanders and the Road to Serfdom, Progressives’ Basic Assumptions, The Complexity of Reality, and The Proper Functions of Government for more on the autocratic tendencies of leftists in general and of the Democratic Party in particular. As Friedrich Hayek warned us about 70 years ago, the path the Democratic Party is treading is The Road to Serfdom, the road to dictatorship.

There are some technical problems with the New Keynesian mathematical formulations as well. Almost everything in their formalism depends on knowing the output gap, the fractional difference from a potential GDP, which of course means they need to accurately know the potential GDP.  In the post on the New Keynesians’ explanation of the 1970s stagflation, we found the basic problem leading to stagflation was that the neo-Keynesians had not recognized that the potential GDP had changed. Often, New Keynesians tend to assume potential GDP to be constant throughout the process of analyzing the effects of economic shocks. Another problem is that there is no single, agreed upon way of defining, calculating, or measuring potential GDP. The Organization for Economic Co-operation and Development (OECD) defines  potential GDP as “the level of output that an economy can produce at a constant inflation rate”.  Others define potential GDP (aka potential output) as “what an economy can produce when all its resources such as workforce, equipment, technology, natural resources and others are fully utilized; or the GDP that the economy can attain upon proper application of its resources.”  A very imprecise definition that fails to inspire confidence. How can we tell whether any of those factors of production are fully utilized? For the Congressional Budget Office’s take on the pros and cons of various means of determining potential GDP, read their report A Summary of Alternative Methods for Estimating Potential GDP. For the moment let us take the Federal Reserve definition as provisionally correct and plot their value of the output gap, the blue curve in the plot below, versus time. On the same plot we overlay the inflation rate determined from the CPI.

In this graph the output gap is expansionary if it is above the horizontal black zero line and contractionary if it is below it. Notice that in the 1970s there were two periods of expansionary output , each followed about a year later by significantly large inflation peaks (about 12% and 14% inflation respectively). Also as each of those inflation peaks were existing, the output gap became negative, leading to stagflation. This agrees with the New Keynesian explanation for the 1970s stagflation. Also note for the entire period  after the end of the Great Recession, and almost for the entire term of Obama’s Presidency, the output gap has been contractionary. Nevertheless, with imprecise definitions and methods of determining it, the interpretation of any particular output gap is problematical.

If we retained the New Keynesian mathematical apparatus for determining changes in the economy and changed the policy recommendations to those of neoclassical economics, we might well end up with economic policies that any neoclassical economist might endorse. One needed change would be to target inflation and only inflation with monetary policy; no account would be taken of output gap. In fact, to insure that money retained a constant value, we would need to use the relationship between the inflation rate, quantity of money in the system, velocity of money, and GDP growth rate given by

where   is the fractional change of a price index and therefore the interest rate;   is the fractional change in the money supply;  is the fractional change in the velocity of money; and  is the fractional change in the GDP. i.e. the GDP fractional growth rate. We can then postulate that as the velocity of money increases, the Federal Reserve will want to increase the real interest rate, r_t , in order to hold down inflation. In periods of inflation people will try to get rid of their money as quickly as possible (money velocity goes up) while it still holds value; in periods of deflation, people will try to hang on to their money as much as possible (money velocity goes down) while it appreciates in value. Also, there is reason to believe that if the velocity of money is increasing, so is the amount of money in the system, and as the money in the system increases so will inflation. Therefore we can postulate

where α and β are positive parameters to be determined. Setting the inflation rate to zero in our inflation rate equation, using our two postulates for the changes in money velocity and money stock in terms of real interest rate, and solving for the interest rate, we obtain

Therefore as the GDP growth increases so does the real interest rate. As the growth rate falls, so does the interest rate. This is the equation with which we would replace the Taylor rule as our Policy Reaction Function in the New Keynesian framework.

This monetary policy, however, is guaranteed to do only one thing: to keep the value of the currency relatively constant. What should we do to fight recession? The very last thing a neoclassical economist would want to do is to “stimulate” the economy with federal government expenditures. As we have noted in a number of posts, the government has an almost certain probability of upsetting supply and demand relationships by doing that. See the posts The Keynesian-Neoclassical Ideological Conflict (2), Adam Smith’s Invisible Hand, Adam Smith’s “Invisible Hand” and Evolution, and Why Socialism Does Not Work.  Instead, an analysis of the specific  microeconomic reasons for the recession should be made. If government regulations or taxes are to blame, the regulations should modified or removed as required and the taxes (and possibly spending) should be reduced. If government is not a cause of the economy’s problems, the government should do absolutely nothing but wait for the economy to heal itself, as Calvin Coolidge did with the recession of 1920-1921. With these neoclassical responses to problems revealed with the New Keynesian analytical tools, we would be far better off.

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