[UPDATE: See Nick Rowe’s comments in the post for further clarification, plus I tweaked a few things in the post itself in response to his comments.–RPM]
In a previous post, I explained that the academically respectable, formal New Keynesian model of the economy was collapsing before our very eyes. I mentioned that Nick Rowe was fully aware of–indeed was a chief contributor to–this collapse, and yet he didn’t think it a very big deal. Now I realize that the two go hand in hand: Precisely because Nick has the temperament of Confucius, he can afford to be completely frank about the state of mainstream macro theory. It’s not good.
What John Cochrane is saying is that inflation is indeterminate in the Neo-Wicksellian/New Keynesian model, even if you just assume that the output gap asymptotes to zero.
John Cochrane proposes an alternative solution to the same set of New Keynesian equations…
John Cochrane is not (as I read him) saying his solution is the right one. He is saying it is no less right than the standard solution.
Both those solutions are consistent with the IS curve and Phillips curve of the New Keynesian model. Both are mathematically correct. Neither of these solutions is “pathological” in the sense of causing inflation to go to plus or minus infinity. Both solutions would be equally stable or unstable in the sense of staying or not staying on that path if the central bank threatened to respond if they strayed from the equilibrium path. And those are just two solutions from an infinite number of solutions. And there is nothing in the model itself that tells us which of those solutions is the “right” one. There are multiple equilibria.
Now there are some models with multiple equilibria where the modeller knew there were multiple equilibria right from the start, and proudly called the readers’ attention to the fact that the model had multiple equilibria, because he thought it was an important and desirable feature of the model that reflected something about the world. The Diamond-Dybvig model of bank runs (which has two equilibria, one with a bank run and one without) is like that.
But the New Keynesian model is not like that. Nobody said “Hey look! I’ve just built this New Keynesian model which is a really neat model because it has an infinite number of equilibria, and so it can explain why sometimes we get recessions and sometimes we get booms, and those recessions and booms just happen; they aren’t caused by anything at all, except animal spirits, or sunspots! And you can get totally different responses to exactly the same shocks and exactly the same monetary policy responses to those shocks, just because!” The New Keynesian model was never taught that way. It was taught as saying that recessions and booms and inflation and deflation were caused by bad monetary policy which didn’t or couldn’t respond to shocks correctly and quickly enough.
How should we respond to all this?
…and then Nick lists some options.
Let me just shine the spotlight on Nick and say that this is really important, folks. Unfortunately, this is analogous to the Great Debt Debate, when a grumpy economist (Don Boudreaux then, John Cochrane now) challenged something very fundamentally that Krugman et al. have been saying throughout the crisis. Nick (then and now) joined in, with his own analogies and idiosyncratic way of putting it. However, I’m afraid that because Nick is so immersed in the literature, that only professional economists will really get what he’s saying. The problem there is that professional economists are the last people on earth to judge a dispute on whether a big chunk of professional economics has been spinning its wheels for the last few decades.
Some open questions that I would love to resolve if I had tenure:
1) Is Nick right that the standard New Keynesian model predicts that
a sudden an expected and large drop in future government spending can restore full employment in the present? If so, isn’t that kind of important? If both sides of the fiscal policy debate actually believed their rhetoric, this should solve everything: We cut announce cuts to government spending for next fiscal year and fix the debt problem, and we put everyone back to work right away.
2) Krugman has been claiming with a large degree of confidence that Keynesian models show that the normal laws of economics are turned upside down once we hit the zero lower bound. Cochrane and Nick Rowe are claiming that actually, if you write out the equations of a standard New Keynesian model, there are an infinite of equilibria. Yes, some behave the way Krugman says, but others behave the way Fama says. (Furthermore, Cochrane claims that the Krugman-esque equilibria have some really weird properties, such as things blowing up when you introduce epsilon of price stickiness, whereas the Fama-esque equilibria don’t blow up. But Nick didn’t confirm that aspect of Cohrane’s post.) So, is there a contradiction here? It’s true that Krugman doesn’t usually call himself a New Keynesian, but then again when he took Casey Mulligan out to the woodshed he was happy to lump “old or new, it doesn’t matter” into the same category of Keynesian models against Mulligan’s (alleged) ignorance.
3) Both Cochrane and Krugman (sic) have said that the standard Keynesian models (at least if we are looking at “liquidity trap-esque” equilibria) imply large price deflation in the kind of slump we’ve had. Krugman has dealt with that problem by adding what (to me) is analogous to Einstein’s cosmological constant: Krugman sees that prices aren’t falling as fast as the model originally predicted, so he plugs in an assumption that wages can’t fall fast. So, is it better to say–for economists who pride themselves on being good empiricists–that we should rule out the liquidity trap equilibria as being unfaithful to the data?
Unlike with the Great Debt Debate, I don’t think I can get sucked too much into this one, at least not until I clean off my consulting plate and that will take at least a month. So for those of you who can actually understand technical macro papers, do it for the children!