As the Economist put it in a piece earlier this week, this year’s Nobel prizes for sciences are real life sci-fi. The Economics Nobel was not too far behind for its breakthrough quotient. Critics of macroeconomics have cited its chequered history with it being often very good at explaining events of the past but seldom influenced the future. But this year’s winners – Bob Hall and Mike Woodford whose work falls into the domain of New Keynesian economics had something to answer the critics. Here’s Noah Smith telling us all about New Keynesian economics — what it is, how it came about, why it’s important, and why it didn’t get a Nobel until now.
He begins with a brief history of modern macroeconomics showing how most economists in the 60s and early 70s looked at relationships between economic variables such as income and spending or inflation and unemployment. He argues that much of it was mistaking corelation for causation: “Suppose you see that when inflation rises, unemployment goes down. That correlation is called a Phillips Curve. So you think “OK, if we raise inflation, more people will get jobs”. But you try that, and it doesn’t work — you push inflation up (by printing more money), but unemployment stays high. The correlation you saw before has now broken down. Now you’ve got two problems instead of one!”
As a result, “…A lot of researchers asked: What parts of the macroeconomy are invariant to policy? What are the solid foundations we can stand on, so that when we try to make some sort of change, we don’t cause our own theories to crumble?
The answer most economists settled on was called “microfoundations”. They reasoned that the basic drivers of individual and corporate economic behavior shouldn’t change when macro policies like interest rates and government spending change. Most importantly, those drivers include:
1. Technology
2. Consumer preferences
3. The process by which people and businesses form expectations of the future”
These microfoundations of macroeconomics led to the establishment of New Keynesian Economics, to which Hall and Woodford contributed immensely among others.
“Whereas John Maynard Keynes and his successors thought a lot about fiscal policy — i.e. government spending and taxes — the New Keynesians of the 1990s and 2000s focused almost entirely on monetary policy. New Keynesian macro initially owed a lot more to Milton Friedman than it did to Keynes — everything was about the Fed, and the idea of fiscal stimulus initially fell by the wayside.”
Smith shows why Bob Hall’s contributions are important – whilst the basic New Keynesian theory explained how interest rates affect GDP, it didn’t explain how it influences employment: “After all, if growth slows down, it’s not immediately obvious why a bunch of people should be thrown out of their jobs. In a 2005 paper, Hall made a model explaining how wages might be slow to adjust to changes in demand — meaning that when there’s a downturn, companies can’t just cut wages, but instead have to lay off workers.”
He credits the other winner Woodford for synthesizing the ideas of a few other founders of New Keynesian economics, which could then be adopted by central bankers in real life. The first big application of the field was during the global financial crisis in 2008: “In 2008 and 2009, the U.S. and European economies were hit by such a huge negative demand shock that cutting interest rates all the way to zero failed to put things right. Something else was needed.
There were three basic ideas for what that “something else” should be. The first is contained in Woodford’s model, and draws on the basic idea in Hall’s papers. It’s the idea of “forward guidance”. If the central bank can promise to leave interest rates low for a long time even after the recession is over, that can prompt consumers to spend more today — thus hastening the end of the recession. The second is quantitative easing — having the Fed buy long-term bonds instead of just short-term ones, in order to push down long-term interest rates. QE isn’t in Woodford’s model, but he eventually came around to supporting it.
The third idea was fiscal stimulus. If interest rates go all the way to zero, then government spending can become a more effective way of raising demand (as long as the central bank doesn’t cancel out the stimulus by raising rates again). When the Great Recession hit, New Keynesian economists scrambled to put Keynes back into their theories, by adding a role for fiscal stimulus.”
Smith argues that New Keynesianism’s bigger success came in the post-pandemic inflation: “Inflation spiked to 9% in 2022, but then came down to around 3% in early 2023 after the Fed raised interest rates. But what’s remarkable is that unlike in the early 1980s, this happened without a big rise in unemployment!
The most likely explanation for this “immaculate disinflation” is that as soon as businesses realized that the Fed would do whatever it took to beat inflation, they stopped raising prices — and inflation simply ended.”
He concludes by saying: “There was always a question mark hanging over the theory — it was always unclear whether it could shape the future instead of simply telling a story about the past. Since 2022-23, the answer to that question looks like a much more unambiguous “yes”. I wouldn’t be surprised if that had something to do with this long-overdue Nobel.”
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