The following are excerpts from Paul Krugman’s latest summary of the macro debates:
But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world — there was a terrible financial and macroeconomic crisis in much of Asia in 1997-8 and a depression-level slump in Argentina in 2002 — wasn’t reflected in the mainstream of New Keynesian thinking.
Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul-searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?
I focus on these two excerpts for the following reasons:
(a) Krugman went over very familiar territory re the divide between freshwater (neoclassical + efficient markets a la Lucas) macro, and saltwater macro (New Keynesians, which is really old Keynes plus efficient financial markets, aka Modern Macro).
(b) The essential difference between the two schools is simple (and should be “textbook” by now). Freshwater assumes wage and price flexibility (the territory of Say’s Law), while saltwater assumes old-time Keynesian wage-price rigidity.
(c) Implicitly, Krugman acknowledges the validity of the irrationality school exemplified by Richard Shiller today, but which goes back to Kindleberger, Keynes (“animal spirits”), and Minsky. Explicitly, Krugman says that mainstream economics was (irrationally?) seduced by mathematical beauty built on rationality as truth, despite the obvious empirical disconnect. The unanswered question remains as to how we can capture irrationality in economic models.
Krugman is now on record as a severe critic of Modern Macro or New Keynesian economics, as can be seen from the excerpts. I agree with Paul. But I find that in the blogosphere the arrogance of Modern Macro fancy-math proponents seems undiminished.
But at least two things are missing from Krugman’s piece.
There is still no admission that perhaps Hayek and his recent quasi-protégé Nassim Taleb are correct in stating another (by now) obvious fact: That macroeconomics (whether freshwater or saltwater) cannot predict precisely enough to be considered hard science. Taleb at least points to a possible way out of the methodological problem. He thinks economists have to look closely at the nature of the error term of their models, echoing Hayek’s claim that the Law of Large Numbers does not hold for these models. Here, the economics establishment (both schools of macro) is still in denial and far away from acceptance.
There is also no recognition that the Austrian School may have something to say about how macro went astray all these decades since Keynes.
And for the discredited economists, Frank and Ernest sympathize: