What's wrong with New Keynesian macroeconomics -- an MM perspective

There are many things right with New Keynesian macroeconomics. It is a very good synthesis of many strands in Monetarist, Keynesian, and New Classical macroeconomics. But this post is not about what's right with New Keynesian macroeconomics.

There are also many things wrong with current New Keynesian macroeconomics. New Keynesian macroeconomists are aware of many of those things. But this post is not about all the things that are wrong. It's about some of the things that are wrong. I'm coming at this from a "Market Monetarist" (aka Quasi Monetarist) perspective.

"New Keynesian macroeconomics" can mean a lot of things. What I have in mind here might better be called "Neo-Wicksellian" macroeconomics, because monetary policy is seen as interest rate policy.

1. New Keynesian macroeconomics makes no sense whatsoever in a barter economy. And yet nowhere is the assumption of monetary exchange made explicit. You can't see money in the model, but it must be there somewhere, or the model just wouldn't make any sense.

1a. The producers in New Keynesian models are imperfectly competitive. They choose to set price above marginal cost. If two producers have price above marginal cost, both could gain by a barter deal in which they both produce additional output and exchange it at the ratio given by their posted prices.

1b. Even if we replace imperfect with perfect competition, and assume prices are fixed, it would be impossible to have a recession with excess supply of all goods in a barter economy. Two producers who wanted to sell more but couldn't find customers would simply produce additional output and do a barter deal.

There is something fundamentally wrong with a model that implicitly assumes monetary exchange but does not make this assumption explicit, and does not even have money in the model.

2. New Keynesian models explicitly assume that money is the medium of account. But again, there is no money in the model. Prices are set in terms of a good that does not exist.

3. New Keynesian models explicitly assume that the nominal rate of interest is set by a central bank. Central banks have special power over monetary policy only because they issue irredeemable money. Yet that irredeemable money does not appear in the model.

4. New Keynesian models have only one transmission mechanism for monetary policy -- the effect of current and expected future interest rates on desired consumption and investment.

4a. We know that a permanent change in the stock of central bank money will change the long run equilibrium values of all nominal variables but will leave interest rates unchanged.

4b. We know that monetary policy will still affect nominal variables in the long run, and real variables in the short run (assuming sticky prices), even in a world with no interest rates, no borrowing or lending, or where interest rates are set by law. So the interest rate channel cannot be the only possible transmission mechanism for monetary policy.

4c. We can imagine a world in which central banks implement monetary policy in many different ways than by setting a rate of interest. For example, they can set the price of a commodity like gold, and vary that price. Or they can give away money for free, and vary the quantity they give away.

4d. Central banks that issue irredeemable money aren't even banks. A bank both borrows and lends. It has assets and liabilities. An irredeemable liability is not a liability, so central banks don't have liabilities. They don't even need assets, unless they choose to buy back some of their money in exchange for those assets. A central bank, since it is not a bank, does not have to borrow or lend, and need not have anything to do with interest rates.

5. New Keynesian macroeconomics asserts that central banks must lower current or expected future real interest rates in order to get an economy out of a recession. This assertion is, I believe, often false. The IS curve will probably slope upwards in a recession. Recovery from a recession is compatible with an increase in real interest rates.

6. This to me is the killer. New Keynesian models lead good economists, who correctly diagnose the monetary nature of the recession, at the same time to believe that monetary policy is powerless at the zero lower bound. And recommend fiscal policy instead. This is like correctly diagnosing magneto trouble, then recommending we all get out and push the car, rather than fixing the magneto. I just refuse to accept that that's the best we can do. We need to understand that monetary magneto better, and learn how to fix it. And it is my frustration with this lack of correspondence between diagnosis and policy prescription that has lead me on my three year search for something better.

I have been eclectic in my search, taking ideas that seem useful regardless of their source. Some are Monetarist. Some are Old Keynesian. And Clower is as much a Keynesian as a Monetarist. I side with Silvio Gessell against Keynes on the role of money in general gluts.

Like other "Market Monetarists" I think that monetary policy can cure what is at root a monetary problem. But we don't all agree on everything. Lars Christensen provides a good survey (pdf). This post is in part a response to Arash Molavi Vassei. Scott Sumner responds here. Josh Hendrickson here.

All equilibrium theories have a disequilibrium story on the side. If the demand curve for apples shifts right, that creates excess demand for apples at the old equilibrium price, so individual sellers can raise their prices above other sellers' prices and still sell their apples, and this process is what gets the price to the new equilibrium. In monetary economics we call this disequilibrium story the monetary policy transmission mechanism. The interest rate transmission mechanism is the New Keynesian disequilibrium story. It's not the only possible story. It's not even a very good story, as I argue above.

My MX6 developed "magneto" trouble last Summer, 100kms away from home. Replacing the alternator is a 2 hour job, and I didn't want to do it at the side of the road. So I bought a new battery at Canadian Tire, replaced the old battery when it finally died, and that got me home. I replaced the alternator the next morning. There are circumstances when a bodge job is the best you can do. But it's not really satisfactory.

Comments

[Greg Ransom]

Determinante, Hayek was essentially an advocate of Bagehot's rules when it came to monetary policy.

You are slashing apart a straw man -- a fictional Hayek who does not exist.

What does that benefit anyone?

[Determinant]

Because I will attack Keynes and Hayek with equal abandon.

The implication of Bagehot's Rules on gold-backed currency is wrong and especially wrong in the fiat-money economy: that the money supply cannot and should not be expanded in total. Saying that the money supply should not be expanded in a money-constrained economy because it is somehow "fixed" in terms of gold or some other reference is wrong. It is asking to be strangled by your own noose.

Expand the money supply. Get it into people's hands. In the presence of an output gap it is exactly what you should do.

Gold is a parallel to physics desire for an ultimate frame of reference. In reality there isn't one and you have to let that desire go. Once you do life gets much more complicated but much more reality-based.

Second, I was harping on about the balance sheet of central banks because we now have an example of the ECB and Greece where a central bank refused to take on assets from its client and said the client's debt was no good. We sent the idea that both sides of the balance sheet out the window with that one, though the possibility was hatched when the Euro was created.

Balance sheets and their assumptions are the rules which explain central bank's behaviour. You can't just armwave them away.

[Too Much Fed]

"Expand the money supply."

Does it matter if the amount of medium of exchange is expanded with currency denominated debt or in some other way?

[Too Much Fed]

Min's post said: "Too Much Fed: "Min, that is true, but there should be some people in their 50's or 60's who have worked long enough (30 years or so) they should be able to retire"

Ready or not, many of them are being forced to retire. And instead of talking about reducing the age for getting Social Security, politicians are talking about raising it!"

And why is that? Is it because congress is worried about the amount of gov't debt (and possibly private debt too) and appeasing the "rich treasury market"? I keep hearing about "stimulate" now and cut back later, which I believe means issue gov't debt now, and cut Social Security, Medicare, and Medicaid later. Economists keeping trying to find some way to get the economy "to snap back" so that it will go back to the way they want it to work (supply constrained, post WWII period) so their models look good. I don't believe this is an aggregate demand shock although in some ways it appears to be.

[OGT]

JW Mason- Great comment. It reminded me of Krugman's Gold posts a couple of weeks ago.

http://krugman.blogs.nytimes.com/2011/09/06/treasuries-tips-and-gold-wonkish/

In which Krugman models the price of gold as an asset:

"The logic, if you think about it, is pretty intuitive: with lower interest rates, it makes more sense to hoard gold now and push its actual use further into the future, which means higher prices in the short run and the near future...

For this is essentially a “real” story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation."

So, if behaviorally recessions are a function of hoarding MOE, why does it make sense to pay ever increasing amounts of MOE for shiny yellow metal?

It doesn't, because from a behavioral point of view recessions are about an excess desire to increase net claims on future consumption aka "savings" (accounting definitions of antique chairs aside). I add "net" claims, because credit constraints on the part of some potential borrowers is a part of the story, and from an empirical POV in the US post-war monetary policy has always worked by increasing net private borrowing through housing and cars.

Now Rowe will, probably, argue that it is only the spillover from the desire to increase net claims on future consumption into MOE that cause a problem. Maybe, but given the varieties of M's that we call money, I think its important to look at the behavioral issues causing the problem before claiming to divine a solution.
As an aside, is there a widely accepted definition of the delineation between fiscal and monetary?

[Greg Ransom]

Determinant -- your assumptions about Hayek implicit in your remarks are completely wrong.

What else can I say?

It ain't Hayek you are attacking. It's a made up position that you've attached his name to.

Sorry.

You simply aren't attacking Hayek if you are attacking someone else's position ...

[Determinant]

Too Much Fed:

First, as a person in my late 20's I have a slightly different take on aging than most. I had five great-grandparents when I was born and all four of my grandparents. I have seen people retire after 30 years of service and I can only ask "why"? They are entirely fit and able to work. With modern life expectancies working longer isn't necessarily bad, especially if it's phased-out retirement, a point we may need to consider as a method of training.

Second, I really, really think a good place to start is the Labour Terms of Trade. The Globe & Mail had an article on it yesterday which labelled it under the title "New Stagflation". What I mean is the divergence between the increase in GDP Deflator for Gross Domestic Income (what we make) and the Consumer Price Index (what we buy) where the latter has risen more than the former. We are making more stuff but can buy less and less with it.

I want to see a detailed study that breaks out what the difference is between the GDP Deflator basket and the CPI basket and what items are causing the difference. I want numbers. Where's an econometrician when you need one?

The Delfator/CPI divergence seems to be at the heart of our problems.

[Too Much Fed]

"I have seen people retire after 30 years of service and I can only ask "why"? They are entirely fit and able to work."

because the next generation can then find a job

"With modern life expectancies working longer isn't necessarily bad, especially if it's phased-out retirement, a point we may need to consider as a method of training."

That would be something to consider to counteract the "claims" from companies that we can't find the types of workers we need (especially at the wages the companies want to pay).

"The Delfator/CPI divergence seems to be at the heart of our problems."

I'd have to check that out. I like to focus on the difference between CPI and the price inflation rate of a lower/middle class person's budget.

"We are making more stuff but can buy less and less with it."

Including the foreign sector, I agree that most people can buy less and less but some people (including corporations) can buy more and more if they wanted to. That seems to me to be wealth/income inequality.

[Determinant]

I have a feeling the two issues are linked and to the discomfort of many economists the inequality issue will have to be addressed head-on. It opens up political debates many would rather not have, but such is the reality.

Strangely when it comes to retirement I have yet to see a direct correlation between retirement and hiring. In a world where companies don't commit to employees for life anymore, if they every really did (I have strong suspicions it was more marketing and belief than statistical fact) and the link between a retiree and the new entrant to the labour force is 10-people removed, the case for retirement causing hiring is weaker than it appears. All it takes is one cautious manager among ten and that employee won't be replaced in the labour force.

Since 1980 or so we have seen a trend in business that it is more profitable to cut costs including compensation to production workers and try to squeeze out more production from existing assets than invest in new assets and expanded production with new employees. So creating jobs isn't profitable anymore, not the way it used to be. The net result is that young workers like myself looking to enter the labour force get squeezed hard.

Part of the decline in defined-benefit pensions is that the attraction for the sponsor, promoting tenure and discouraging employees leaving isn't valued or wanted anymore. We want casual labour, not career-tenure labour. DB Pensions have no place in a casual labour model.

[Too Much Fed]

Determinant,

1st paragraph: I agree most economists don't want to tackle wealth/income inequality because they might find out one of the reasons the rich have excess savings and what it can be used for.

2nd paragraph: That sounds more like what I call forced productivity. To me that is another sign of an oversupplied labor market.

3rd paragraph: Is that because most markets have gone from supply constrained to demand constrained?

[Determinant]

You suggested measuring CPI against a representative low and middle household budget when I discussed the Labour Terms of Trade, that is the gap in GDI vs. CPI.

The GDP Deflator measures the prices of what the economy produces, CPI measures what it consumes. You need some measure of the value of production vs. the price of consumption and the gap that has opened up between the two where consumption has risen more than production.

I'm perfectly happy with GDP Deflator vs. representative low/middle income budget instead of CPI, but you need to measure income vs. expenditure.

Our problem is that our economy produces 8 apples and 5 oranges yet we want to consume 5 apples and 8 oranges. So we trade 3 apples for 3 oranges. But now 3 oranges costs 4 apples and we aren't producing 4 apples so we're squeezed.

I agree casualization is a partial byproduct of a demand-constrained economy but it has been going on for 30 years. More generally we have not designed our institutions to fail well. For instance a DB pension plan requires a solvent sponsor and a troubled company is not solvent. It is not a panacea but government policy since WWII has focused on encouraging welfare capitalism where the cost of most welfare for the middle class is actually born through employer-provided benefits. These benefits are partially funded through pooling among the employee base and partially through tax incentives. But you can't have a flexible company structure nor one that responds well to normal income fluctuations with that kind of welfare overhang. But employers bought into it as a method of encouraging loyalty and tenure, that is reducing employee movement.

I am much more comfortable with an employment structure that provides basic services like medical care out of taxes and pensions out of employee-based associations or trust companies (caveat about fees). I feel that employer involvement in welfare provision is at best vicarious and actually a mistake. An employer's role should be to provide pay, period.

Just to prove that economics is circular my reasoning is shared by the most far-left union in existence in the United States and Canada: the Industrial Workers of the World, the Wobblies. They do not permit automatic payroll deductions of union dues because they refuse to let an employer touch union funds. Their relationship is between the union and the member, period. They feel payroll tick-off is a conflict of interest for them. Payroll tick-off of union dues is no different from disability insurance, pension savings or any other form of payroll welfare. Same idea, but this time on the far, far left.

Just for absolute fun, see here: http://iww.ca/

[Too Much Fed]

Determinant, I believe the "gap" involves currency denominated debt and that is showing up in more corporate profits.

"Our problem is that our economy produces 8 apples and 5 oranges yet we want to consume 5 apples and 8 oranges. So we trade 3 apples for 3 oranges. But now 3 oranges costs 4 apples and we aren't producing 4 apples so we're squeezed."

I'm more of the opinion that our economy can produce 8 apples and 8 oranges, but there is only demand for 6 apples and 6 oranges.