Paul Krugman's recent posts on his New York Times blog have revealed that a subtle, but remarkable change is happening in the economics profession. Krugman, one of the leading economists in the New Keynesian tradition, has recently eschewed the so-called 'neoclassical synthesis' with Keynesianism which became economic orthodoxy after Keynes' death in 1946.
This was the conventional Keynesianism taught in high school and university textbooks, with ISLM models, Phillips Curves and Solow-Swan neoclassical growth models. These neo-Keynesians believed that with the appropriate fine-tuning of aggregate demand, capitalist economies could strike an optimum balance between inflation and unemployment, while market forces would operate effectively to distribute resources efficiently, ensuring stable and consistent growth.
Of course, as we all know, the neo-Keynesian theory collapsed in the 1970s under the successive tides of stagflation, the monetarist 'counter-revolution' of Friedman and then Bob Lucas' rational expectations 'new classical' theory. The freshwater economists of Chicago, in pursuit of non-inflationary general equilibrium, re-asserted the old classical and neoclassical ideas that capitalism works best with only as much government as is necessary to provide law, order and national security. Say's Law was restored as the centrepiece of economics, the idea that supply creates its own demand, alongside such theories as Ricardian Equivalence - the idea that government spending has no real effect on an economy, as the rational representative agent, homo economicus, knows that any government borrowing today must be paid back tomorrow (through tax), and therefore does not spend any additional money. The new classical school came crashing down the first time when the General Equilibrium theorists, those system builders who had allegedly provided the microeconomic foundations for new classical theory, proved resolutely that inflationary (and disinflationary) equilibriums exist in the Gen. Eq. Arrow-Debreu model. Thus, the free-market god that the monotheistic new classical economists had worshipped, the non-inflationary equilibrium, was revealed to be one of an infinite number of inflationary and disinflationary gods, to whom they would, and theoretically could not bow down.
And thus, most of new classical macroeconomics had to be abandoned too (excepting, of course, an unsurprisingly large number of zealots from the Chicago School, who continue to worship their non-inflationary god to this day, with the unfortunate and absurd by-product of their theory being the idea that unemployment is merely a frictional and structural phenomenon, the natural consequence of technological advances). The scene was set for the rise of a 'new Keynesianism', a welcome attempt at providing sound neoclassical micro-foundations for Keynesian macro-theories. And thus was born the new Keynesian synthesis, and, at its core, the Dynamic Stochastic General Equilibrium (DSGE) model. This was the infamous model that guided the 'steady' hands of central bank boards in the years prior to the Global Financial Crisis. And then, when the crisis did hit, it was revealed that the DSGE models, which bankers such as Ben Bernanke were relying on, were completely ineffectual. Not only did they fail to predict the GFC, they failed to anticipate the proper response to the crisis. It took knee-jerk reactions from skittish politicians who finally, after years of anti-Keynesian policies, turned to fiscal policy as the remedy to a sharp economic downturn, to save the capitalist world-economy from itself.
And so now we are left, as Joseph Halevi says, drifting in the debris of macroeconomics. Every major system of macroeconomics thus far has crumbled and ultimately ended up in the dustbin of history for one reason or another. From Ricardo, to Marx, to Samuelson and Solow, to Friedman, and finally, to Lucas and Sargent - they all had two things in common: (1) they were all great system builders; and (2) they were all abject failures.
So, why the huge - but extremely brief - history of economic thought from 1946? And how does this relate to Krugman's recent blogs? Well, this whole thing is partially because I'm trying to recollect and summarise very briefly what I learned in one of my courses last semester, but also partially to set the scene for what is happening behind the scenes in the world of academia today, and hopefully soon in the world of policymaking and central bank policy-setting.
Krugman was, for years, a champion of the old Keynesianism, seeking to bring it up to modern standards by providing it with solid microfoundations - the mission of the New Keynesians. But now he's tossing it into the dustbin of history too. But what is he eschewing it for? There are two ways he can go. He can return to the safety of the neoclassical strongholds of general equilibrium theory and microeconomic industry-analysis (e.g. externality theory, etc.), or he can venture into the great unknown of empirical, non-positivist macroeconomics. This is the realm of post-Keynesians, neo-Marxians and Schumpeterian-Hard-New-Keynesians, who use disequilibrium and agent-based behavioural models. From his recent posts, it looks like he's slowly lurching towards the latter. He even linked a journal article by Michał Kalecki, the Marxist co-founder of Keynesian economics, published on the website of Monthly Review, a respectable (although disreputable to bourgeois economics) socialist journal. Needless to say, this is a controversial move from one of the key figures in modern mainstream economic thought.
And thus, the stage is set for a revolution in economics. The one that was initiated in the 1930s by Kalecki and Keynes was ultimately incomplete and fizzled out in 1946 with the death of the master. But now that the mainstream as been all but obliterated by its internal contradictions and the events of 2008, the debate between Keynes and Hayek which began in the context of the Great Depression is about to reignite. And thus we find ourselves on the verge of battle - the battle to win the hearts and minds of central bank governors everywhere.
This is actually Keynes vs Hayek 2.0. And everything, this whole damn, contradictory, crisis-prone, suicidal world-system is at stake. It may surprise you to know that I don't know where I stand in this battle.
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