In a previous post, I gave Narayana Kocherlakota a hard time about his stand on New Keynesian economics. A couple of commenters characterized this as unnecessarily vitriolic and personal. Of course it was personal. I have an enormous amount of respect for Narayana, but he is a public figure now, with some influence on public policy in this country, and I expect a lot from him. I have said nice things about him before (see this piece), but if I disagree with what he says, I think I should say so. Economists need thick skins to survive, and I can assure you that Narayana has one as well.
Now, some of you seem to think, like Narayana, that New Keynesian economics is coherent. A while back I took the time to study what New Keynesians were doing. This research program was getting a lot of attention, and I wanted to see if there was something to it. I came to the conclusion that New Keynesian Economics had nothing to offer in its current form, and since then I have taken the opportunity to criticize this stuff whenever the opportunity arises. Here are some critical pieces I have written (two of these with Randy Wright, which also provide a constructive alternative):
1. Richmond Fed Economic Quarterly piece.
2. "New Monetarist Economics: Methods"
3. "New Monetarist Economics: Models"
What is incoherent about New Keynesian Economics? As represented in Woodford's "Interest and Prices," the paradigm has the following problems, among others:
1. Firms whose prices are "stuck" in the current period behave suboptimally, and in ways that drive all of the results.
2. These models are stated to be immune from the Lucas Critique, but for a number of reasons (e.g. fixed decision rules for price-setting) they are not.
3. The framework is supposed to be about analyzing monetary policy, but does not contain the most basic elements of what monetary policy is about, i.e. the quantities on the central bank's balance sheet. Recent work by Curdia and Woodford tries to correct this problem, but in a somewhat pathetic way.
Some people wondered what I meant by the current predictions of New Keynesian models being laughable. I'm not sure why this was not obvious. The example I gave, which is typical, was of a New Keynesian model that was currently predicting that the nominal interest rate should be less than -5%. What would you think if I offered up a model that predicted that the unemployment rate should be -5%, and tried to interpret this in terms of what policymakers should actually do? Should you take me seriously? Of course not. We all know that arbitrage dictates that "the" nominal interest rate cannot fall below zero. The zero lower bound should be in the model, as should "quantitative easing," if we think that is important.
In my comment in reply to a commenter to "Kocherlakota Sells Out," I mentioned that I wasn't currently concerned about the unemployment rate, which of course drew the reaction that I was insensitive to the plight of the poor. As I have pointed out in a number of previous posts, I think that the US economy is recovering nicely. However, the behavior of the labor market and productivity is unusual. My conjecture, based on readily available aggregate observations and nothing more, is that this unusual behavior (including the high unemployment rate) is due to sectoral reallocation in the United States, away from manufacturing and housing, and toward services, and within the manufacturing sector. As such, there is little the government can do about it, except to wait for the reallocation to work itself out, and ease the transition with relatively generous unemployment insurance benefits.