‘New Keynesianism’ — the art of making relevance irrelevant

from Lars Syll

There really is something about the way macroeconomists construct their models nowadays that obviously doesn’t sit right.

Empirical evidence still only plays a minor role in mainstream economic theory, where models largely function as a substitute for empirical evidence. One might have hoped that humbled by the manifest failure of its theoretical pretences during the latest economic-financial crises, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics would give way to methodological pluralism based on ontological considerations rather than formalistic tractability. That has, so far, not happened.

Fortunately — when you’ve got tired of the kind of macroeconomic apologetics produced by ‘New Keynesian’ macroeconomists and other DSGE modellers — there still are some real Keynesian macroeconomists to read. One of them — Axel Leijonhufvud — writes:

For many years now, the main alternative to Real Business Cycle Theory has been a somewhat loose cluster of models given the label of New Keynesian theory. New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of shortterm adjustment problems in the economy. The ‘New Keynesian’ label refers back to the ‘rigid wages’ brand of Keynesian theory of 40 or 50 years ago. Except for this stress on inflexibilities this brand of contemporary macroeconomic theory has basically nothing Keynesian about it …

I conclude that dynamic stochastic general equilibrium theory has shown itself an intellectually bankrupt enterprise. But this does not mean that we should revert to the old Keynesian theory that preceded it (or adopt the New Keynesian theory that has tried to compete with it). What we need to learn from Keynes … are about how to view our responsibilities and how to approach our subject.

If macroeconomic models — no matter of what ilk — build on microfoundational assumptions of representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. Incompatibility between actual behaviour and the behaviour in macroeconomic models building on representative actors and rational expectations-microfoundations is not a symptom of ‘irrationality’. It rather shows the futility of trying to represent real-world target systems with models flagrantly at odds with reality.

A gadget is just a gadget — and no matter how brilliantly silly DSGE models you come up with, they do not help us working with the fundamental issues of modern economies. Using DSGE models only confirms Robert Gordon‘s  dictum that today

rigor competes with relevance in macroeconomic and monetary theory, and in some lines of development macro and monetary theorists, like many of their colleagues in micro theory, seem to consider relevance to be more or less irrelevant.