TY - JOUR
AU - Trautwein,, Hans-Michael
AB - Abstract The theme that Axel Leijonhufvud has extracted from the economics of Keynes is the potential for failures in the intertemporal coordination of activities in complex market systems. In his path-breaking book of 1968, he attacked standard Keynesian Economics for its view on frictions, which reduces the causes of macroeconomic pathologies to nominal rigidities. With the rise of DSGE-based New Keynesian Economics, Leijonhufvud has pointed out that ‘standard macroeconomics’ is still stuck in the frictions view. Referring to recent financial crises, he considers DSGE modelling to be hopelessly inadequate for dealing with such macroeconomic instability. Yet, the financial frictions literature in New Keynesian Economics claims to have found ways to incorporate financial crises into DSGE frameworks. The article describes continuity and change in Leijonhufvud’s critique of Old and New Keynesians, and assesses contrary claims to progress made in the DSGE world. 1. Introduction In a famously unpublished paper entitled The Uses of the Past, Axel Leijonhufvud compared the evolution of economic thinking to the growth of a decision tree (Leijonhufvud, 2006). The basic understanding is that currently predominant theories have developed out of earlier decisions about modelling standards that, at the time of their making, appeared feasible and plausible for reducing complexity. Those conventions may create blind spots that critically limit their scope. In his semi-centennial classic On Keynesian Economics and the Economics of Keynes (1968) and later writings, Leijonhufvud has amply demonstrated that blind spots can be detected by looking at research questions in theories that branched off at lower forks of the Econ decision tree. Climbing out on those older branches by way of analytical reconstruction or other methods may even lead to new ideas. The theme that Leijonhufvud has extracted from the economics of Keynes and other writers in the inter-war period is the incompleteness of information in complex market systems that may lead to failures in the intertemporal coordination of activities. Half a century ago, Leijonhufvud attacked Keynesian Economics (the Old Neoclassical Synthesis) for its adherence to a view on frictions that reduces macroeconomic pathologies to deviations from full-employment equilibrium, caused by nominal rigidities or other spanners in the works of the price mechanism. With the rise of New Keynesian Economics as an integral part of the New Neoclassical Synthesis and based on dynamic stochastic general equilibrium (DSGE) modelling, Leijonhufvud has pointed out, time and again, that though macroeconomics may have made much technical progress since the 1960s, it is still stuck in the frictions view. Referring to the global financial crisis of recent vintage, he considers DSGE modelling conventions to be fundamentally obstructive to the analysing of core problems of macroeconomic coordination and instability. However, some New Keynesians claim that they have found ways to deal with those problems within their DSGE frameworks. The aims of this article are to describe continuity and change in Leijonhufvud’s critique of Old and New Keynesians, and to assess contrary claims of progress made in the DSGE world. Section 2 summarizes Leijonhufvud’s reinterpretation of Keynes in a critique of Old Keynesian Economics. Section 3 provides an account of his criticism of New Keynesian Economics which, in comparison with his systematic assessments of older Keynesianism, he has made in more scattered remarks; here, they are related to the representative DSGE model of pre-crisis New Keynesianism. Section 4 outlines recent attempts to deal with financial instability within DSGE frameworks, which can be described as returns to lower forks of the Econ decision tree. Section 5 takes stock of the progress made or forgone in the light of Leijonhufvud’s interpretation of Keynes. For the sake of simplicity, his first name Axel (a trademark of its own) will serve as substitute for his complicated surname (the old Swedish spelling for Lionhead) in the following, while Leijonhufvud remains for the purposes of referencing. 2. Keynes and the Keynesians: Axel’s suggested interpretation Leijonhufvud’s 1968 treatise On Keynesian Economics and the Economics of Keynes was based on the dissertation that had earned him a doctoral degree at Northwestern University the year before.1 His original intention was to construct a debt deflation theory that would explain the difference between ordinary recessions and great depressions (Leijonhufvud, 1998: 174; Snowdon, 2004: 123). The 1960s were when it was commonly claimed that ‘we are all Keynesians now’, in the belief that Keynesian Economics had helped to eliminate economic depressions once and for all. Axel found it unacceptable that standard Keynesianism lacked a convincing framework for understanding the emergence of grave system failures such as the Great Depression. Learning that Irving Fisher had already developed a debt deflation theory in a then half-forgotten article (Fisher, 1933), Axel gave up on the original plan. Still wondering why debt deflation could not be accommodated in standard macroeconomics, he took his time for a close reading of John Maynard Keynes’s Treatise on Money (1930) and General Theory of Employment, Interest and Money (1936). This resulted in an accumulation of notes and manuscripts that would not make a coherent thesis before time was up for Axel’s acting assistant professorship at the University of California, Los Angeles (UCLA). To avoid going home to Sweden without a PhD degree, Axel reorganized his writings into an admissible dissertation. As he would jokingly put it ex post, he made the footnotes of his unfinished manuscripts into text and the text into footnotes. 2.1 The more general theory The result was an interpretation of Keynes that differed substantially from the conventional understanding. This was already apparent in a preview article, published in the American Economic Review under the title ‘Keynes and the Keynesians: a suggested interpretation’ (Leijonhufvud, 1967), echoing John Hicks’s famous essay on ‘Mr Keynes and the “Classics”; a suggested interpretation’, the birthplace of IS-LM analysis. Axel’s interpretation was diametrically opposed to Hicks’s downgrading of Keynes’s General Theory to a special case, characterized as ‘Economics of Depression’ (Hicks, 1937: 155): To be a Keynesian, one need only realize the difficulties of finding the market-clearing vector [of prices]…The only thing which Keynes ‘removed’ from the foundations of classical theory was the deus ex machina—the auctioneer which is assumed to furnish, without charge, all the information needed to obtain the perfect coordination of the activities of all traders in the present and through the future. Which, then, is the more ‘general theory’ and which the ‘special case’? Must one not grant Keynes his claim to having tackled the more general problem? (Leijonhufvud, 1967: 404, 410; italics in the original.) The positive answer to the latter question became the leitmotif of the dissertation, which earned Axel international recognition and, as collateral benefit, tenure at UCLA. The removal of the Walrasian auctioneer assumption was a key point, since his critique of Keynesian Economics centred on the latter’s implicit use of neo-Walrasian logic.2 By the mid-1960s, macroeconomists had come to regard the IS/LM model in the tradition of Hicks (1937) and Hansen (1949: ch. 5) as a framework that accommodated both Walrasian general equilibrium and Keynesian underemployment. It represented the workhorse model of the Neoclassical Synthesis. Many of its contributors were concerned with temporary equilibria or out-of-equilibrium behaviour of the system below the full employment position. The Walrasian auctioneer was not invoked in standard IS/LM analysis. In Axel’s view, however, its reduction of Keynes’s general theory of unemployment to special cases—liquidity traps, investment traps, and nominal wage rigidities—was implicitly based on the ‘Walrasian perfect information model’ as a benchmark position, in which all intertemporal plans for consumption and production are fully coordinated (Leijonhufvud, 1968: 67–81, 130–31, 393–95). He argued that the fashion in which liquidity and investment traps were presented in the IS/LM framework made them, indeed, look like belonging within the special category of depression economics, in which inscrutable market psychology does the trick. Keynesian economics would hardly survive on such flimsy foundations. Following Modigliani (1944) and Patinkin (1965), explanations of Keynesian underemployment were consequently reduced to wage rigidities and other frictions in the price mechanism (Leijonhufvud, 1968: 327–43). For Axel, the trouble with the rigidities approach was its tacit assumption of system stability. In the absence of such impediments, the price mechanism would automatically return the economy to full employment with perfect coordination, as if the Walrasian auctioneer or other contrivances of costless re-contracting had matched all plans before any transactions would take place. Leijonhufvud (1968) argued that the innovative content of Keynes’s General Theory (1936) followed from eschewing any such heroic assumptions and turning attention to information problems that hamper the intertemporal coordination of activities in interdependent markets. In a range of variations, Axel made this the principal theme of his own work for decades to come—note the titles of his essay collections Information and Coordination (1981) and Macroeconomic Instability and Coordination (2000): Will the market system ‘automatically’ coordinate economic activities? Always? Never? Sometimes very well, but sometimes pretty badly? If the latter, under what conditions, and with what institutional structures, will it do well or do badly? I regard these questions as the central and basic ones in macroeconomics. (Leijonhufvud, 2000: 45) 2.2 The stickiness of wages and prices: a non-problem Despite the continuity in Axel’s work on these big questions, there was some change in his treatment of the ‘Economics of Keynes’ that will be of interest for his critique of the New Keynesians. In 1968, Axel believed that Keynes’s essential contribution to macroeconomics could be characterized by turning the basic market mechanism in the doctrines of Keynes’s teacher, Marshall, upside down: In the Keynesian macrosystem the Marshallian ranking of price- and quantity-adjustment speeds is reversed: In the shortest period flow quantities are freely variable, but one or more prices are given, and the admissible range of variation for the rest of the prices is thereby limited. The ‘revolutionary’ element in the General Theory can perhaps not be stated in simpler terms. (Leijonhufvud, 1968: 52) Referring to John Hicks’s concept of ‘false trading’ (1939: 128–9) and Robert Clower’s dual-decision hypothesis (1965: 287–90), Axel emphasized that effective demand is co-determined by income effects ‘caused by the transactions which do not take place because of false prices’ (Leijonhufvud, 1968: 55; italics in the original). The transactions forgone tighten budget constraints and reduce effective demand in positive feedback loops that produce involuntary unemployment. This argument created a strong contrast to the (neo-)classical view that, in freely competitive markets, prices and wages always adjust fast enough to prevent unemployment from emerging, or to remedy it quickly in negative feedback loops. Before long, Axel began to regret his emphasis on Keynes’s reversal of the Marshallian ordering of adjustment speeds, because it had become a reference for Barro and Grossman (1971) and others in their quest for a Neo-Keynesian Synthesis (Leijonhufvud, 1998: 178, Backhouse and Boianovsky, 2014: 60, 72). Their models of rationing equilibria were based on the assumption of fixed prices, taking the rigidities approach of the Neoclassical Synthesis to the extreme. Axel went in the opposite direction: referring to Keynes’s General Theory (ch. 19), he argued that price flexibility might increase involuntary unemployment when interest rates fail to coordinate intertemporal plans for consumption and production. The flexibility (volatility) of asset prices in financial markets poses a threat to macroeconomic stability, while conventional rigidities of wages and prices may prevent aggregate demand and output from spiralling downwards. Financial markets clear even when interest rates diverge from values consistent with general equilibrium, as market makers (such as banks and stockbrokers) stand by to lend, buy or sell, and speculative investors take their chances. Such interest rate gaps not only produce imbalances between planned saving and investment, they also tend to produce adjustment pressure on prices and wages in goods and labour markets, even if these happen to be at the ‘right levels’ in terms of equilibrium. A market rate of interest below the value consistent with general equilibrium creates inflationary pressure on the other markets, a market rate above the equilibrium rate generates deflationary pressure. If prices and wages respond to the interest rate gaps, they tend to push goods and labour markets out of equilibrium. Price flexibility may thus cause or exacerbate rationing, rather than being its cure. Axel described this as ‘the radical discovery of Keynes’ (Leijonhufvud, 1998: 178): [A]n excess supply in one market does not necessarily have a counterpart in an excess demand elsewhere. Hence, the contractionary impulse in one part of the system need not be offset by an expansionary stimulus elsewhere. 2.3 Corridors and connections In two companion pieces written in the 1970s, Axel elaborated on this key point of the special Neo-Keynesian Synthesis proposed by ‘the group known euphoniously as the Leijonhufvudians’, which is ‘all chief and no injuns’ (Leijonhufvud, 1981: 195). The first piece is on ‘Effective Demand Failures’ (1973), the second on ‘The Wicksell Connection: Variations on a Theme’ (1981: 131–202). The first paper is well-known for the concept of ‘corridor stability’. This part of the Leijonhufvudian Synthesis is based on Adam Smith’s and Friedrich Hayek’s classical characterizations of market economies as complex dynamic systems, in which large numbers of agents coordinate their plans in a variety of activities while having only dispersed local knowledge of the markets. Axel set the focus on the limits of the system’s self-regulatory capacities; that is, the stabilizing properties of price flexibility: The system is likely to behave differently for large than for moderate displacements from the ‘full coordination’ time-path. Within some range from the path (referred to as ‘the corridor’ for brevity), the system’s homeostatic mechanisms work well, and deviation-counteracting tendencies increase in strength. Outside that range, these tendencies become weaker as the system becomes increasingly subject to ‘effective demand failures’…Inside the corridor, multiplier-repercussions are weak and dominated by neoclassical market adjustments; outside the corridor, they should be strong enough for effects of shocks to the prevailing state to be endogenously amplified. (Leijonhufvud 1973: 32–33) In the early 1970s, when macroeconomics was divided in the camps of old-style Keynesians and Monetarists, Axel used the corridor metaphor to suggest that Neoclassical optimism and Keynesian pessimism can be reconciled. The boundaries of the corridor represented the borderline between the domains of ‘monetarist’ and ‘fiscalist’ policies, between rule-based stabilization of the price level (‘hands off otherwise’) inside the corridor, and active demand management outside of it. Four decades later, when the world was hit by a global financial crisis while macroeconomics had converged on a New Neoclassical Synthesis with New Keynesian flavour, Axel shifted from his quest for a synthesis to confrontational reflections on the ‘economics of the crisis and the crisis of economics’ (Leijonhufvud, 2014). Critical developments in the real world had prompted him to expand the corridor concept to a broader range and the deeper reaches of macroeconomic instabilities, such as stagflation, high inflation, financial crises, and mismanaged transitions from central planning to market economies (Leijonhufvud, 2000; Trautwein, 2018). He questioned the critical choices of modelling strategies in the ruling paradigms of macroeconomics that made it difficult to address the coordination problems underlying these instabilities. Before turning to Axel’s use of the corridor concept for criticizing the New Keynesians, a brief look at the companion piece on the Wicksell Connection (Leijonhufvud, 1981) will help to set the scene. This influential essay describes the evolution of monetary macroeconomics in the 20th century with regard to the role of the interest rate mechanism in intertemporal allocation. It contains a fundamental critique of Keynes’s liquidity preference theory of interest, reconstructing a loanable funds approach to Keynes’s macroeconomics ‘in the direction of…a synthesis’ that embeds the concept of corridor stability in ‘an understandable relation between what then remains of Keynesianism and Monetarism’ (1981: vii). Leijonhufvud (1981: 132–33) illustrates the Wicksell Connection with a ‘family tree of major twentieth-century macroeconomists’ that has inspired similar mapping exercises with a variety of updates (e.g., Sandelin et al., 2014; Spahn, 2018). Figure 1 contrasts the Wicksell Connection, in which ‘the interest rate mechanism fails to coordinate saving and investment decisions appropriately’, with Fisherian Quantity Theory, in which ‘saving and investment have to do with the allocation of output but nothing to do with the determination of aggregate income or the price level’ (Leijonhufvud, 1981: 132). Inter-war macroeconomics was dominated by saving-investment theories, proceeding from Wicksell’s observation that the market rate of interest equates both the supply and demand of credit and aggregate saving and investment (Wicksell [1898] 1936). In an economy with a banking system in which loans make deposits, it cannot always do both jobs simultaneously. The interest rate level at which the credit market clears may deviate from the ‘natural rate’ that brings investment in line with intended saving. Ensuing saving-investment imbalances tend to create macroeconomic instability. While Wicksell set the focus on cumulative inflation, his followers in Stockholm, Cambridge, and Vienna developed a variety of theories of cumulative change in the levels and structures of prices, production, and income. Fig. 1 Open in new tabDownload slide Wicksell and Fisher connections in macroeconomics. Source:Leijonhufvud (1981: 133) Fig. 1 Open in new tabDownload slide Wicksell and Fisher connections in macroeconomics. Source:Leijonhufvud (1981: 133) Axel pointed out that the Keynes of the Treatise (1930) belongs to this Wicksell Connection, analysing deflation without quantity adjustments, while the Keynes of the General Theory (1936) let deflationary pressure result in contractions of output and employment. In Axel’s view, this was a move in the right direction which, however, ended up in taking a wrong turn: Keynes so obfuscated the interest rate mechanism that the later Keynesian literature almost entirely lost track of Wicksell’s theme. The basic idea remains central in the General Theory. (Its middle name was ‘Interest’, after all.) In Keynes’s last variation, however, the theme comes in a guise that has proven the almost perfect disguise. The failure to recognize its presence and role has proved productive of much later misunderstanding and confusion. (Leijonhufvud, 1981: 134) In his dissertation (Leijonhufvud, 1968: 28 and passim), Axel had already noted that much of the confusion originated from Keynes’s insistence on aggregate saving being a ‘mere residual’ (Keynes, 1936: 64) of aggregate income adjustment to investment, irrespective of the level of interest rates. The ‘almost perfect disguise’ of Wicksell’s theme is Keynes’s liquidity preference theory of interest, in which beliefs about future rates determine its present level. Axel denounced this as a bootstrap theory: ‘theoretically unsound, empirically false, and practically dangerous’ (Leijonhufvud, 1981: 171, 195). He suggested its replacement with a ‘Z-theory’: an interpolation between the Treatise and the General Theory that retains a key role for the interest rate mechanism. ‘Z’ is reminiscent of Keynes’s notation for the aggregate supply function, which, at its intersection with aggregate demand, serves to define ‘effective demand’, the key concept in the General Theory (Keynes, 1936: 25). Axel does not explicitly refer to that, however; neither is his Z-theory a historical reconstruction based on textual evidence from Keynes’s writings between 1930 and 1936. It is a purely analytical reconstruction of the modelling choices that Keynes made and those that he did not make on his decision tree in those years. ‘It may be described either as “the Treatise plus quantity-adjustments” or as “the General Theory minus the Liquidity Preference theory of interest”’ (Leijonhufvud, 1981: 134). The point of departure for Axel’s Z-theory is his criticism of the ‘two-stage approach’ of the earlier Wicksellian literature. In the first stage, ‘relatively formal’ theories of saving-investment imbalances were used to discuss price-level movements and their causes on the presumption of full employment. At the second stage, the Wicksellians then gave ‘informal, ad hoc recognition to “frictions”’ (Leijonhufvud, 1981: 168) in order to discuss how much of the nominal income change, determined at stage 1, translates into a real output change—presuming ‘in effect, that allowing real income to vary should not significantly affect the Stage 1 analysis’ (ibid.). Hence, the dependence of real savings (and their share in the loanable funds supply) on real income was overlooked. According to Axel, Keynes’s key insight on the way from the Treatise to the General Theory was to abandon that two-stage procedure, and to work out quantity adjustments to pressures on nominal income within one and the same period: We get a measure of the extent to which we have lost track of what Keynes was about, therefore, when in the context of a controversy over what distinguishes Keynesian economics from other doctrines, today’s macroeconomists revert to the two-stage approach that was in general use in the 1920’s. After some forty years, the two-stage approach reappears in the Monetarist controversy and is used, without objection, by both sides: nominal income changes are predicted or analysed first and then some Phillips-curve notion is brought in to decide their breakdown into price- and quantity adjustments. (Leijonhufvud, 1981: 168) Some forty years later, Axel would have reason to complain about a reoccurrence of such procedures in New Keynesian Economics. As mentioned above, Axel criticised Keynes for using liquidity preference to cover up the gap that would otherwise be left by replacing the Wicksellian interest rate mechanism with the aggregate income mechanism. He did not develop his own Z-theoretical views of this interplay in detail, but hinted at elements from pre-Keynesian theories that could be combined to give the interest rate mechanism an appropriate role in the analysis of corridor stability: My views on the interest mechanism consist of a basic D.H. Robertson Loanable Funds theory, complicated, when needed, by Keynesian bear/bull speculation (as in the Treatise) and/or Fisherian inflation rate speculation. (Leijonhufvud, 1981: 195) This combination would provide Axel’s preferred line of research within the ‘cybernetics’ approach, which he had proposed earlier as an alternative to the standard Keynesian Economics (1968: 396–9). In such ‘study of communication and control of dynamic systems’, the economy would be modelled as ‘an algorithm that determines how the state evolves from any given initial position’ (Howitt, 2002: 84), where the ‘state’ describes the transactors’ sets of information, expectations, endowments, contractual obligations, rules of behaviour, and so on. The evolution of the system is to be explored without any presumption about equilibrium, to find out under which conditions the algorithm of a decentralized market economy may produce convergence on a full employment equilibrium. Axel’s Z-theory set the focus more narrowly on the consequences of ‘Wicksellian interest maladjustment’, depending on whether the system remains at full employment or not: At full employment, there will be unrelenting pressures towards correction of any ‘unnatural’ rate of interest—but otherwise not…With the interest rate at the right level, market forces should make unemployment converge on its ‘natural’ rate—but otherwise not. (Leijonhufvud 1981: 168–9) 2.4 Qualification, and an ironic turn Axel’s reinterpretation of Keynes was broadly welcomed as an alternative to mainstream macroeconomics. However, as a piece of ‘doctrinal history’ it has attracted severe criticism.3 One point of criticism is Axel’s juxtaposition of Keynes and the Keynesians in terms of a Walrasian frictions view. This was rejected as a gross exaggeration of the differences, as there is evidence that Keynes accepted the interpretation of his General Theory in terms of Hicksian IS/LM. Moreover, many Keynesians endorsed the view that downward inflexibility of wages would stabilize employment, rather than jeopardizing it. A second point relates to Axel’s 1981 radical critique of Keynes’s liquidity preference theory, taking it to indicate a substantial break with Keynes that casts doubts on the characterization of Axel as a defender of Keynes against the mainstream interpretation.4 The turn in the ‘Wicksell Connection’ paper was a matter of emphasis, rather than substance. As mentioned above, Axel had criticized Keynes’s residual definition of saving in his opus magnum, and there is ample evidence that he had already then come to consider Keynes’s liquidity preference hypothesis as misleading, blurring the key issue of intertemporal coordination (Leijonhufvud, 1968: 29–30, 173–5, 213–14). In that early stage, however, Axel described Keynes’s concept of liquidity preference in the General Theory as an unfortunate oversimplification of valuable insights from the Treatise. In the 1981 paper, he marked a conceptual break between the Treatise and the General Theory in order to insert his own ‘Z-theory’ for clarification of what he considered to be the key insight in the economics of Keynes. This is also expressed in Axel’s response to the first point of criticism. His intention was never to argue ‘that Keynes “was right all along”’ (Leijonhufvud, 2000: 24). His return to those lower forks of the Econ decision tree served to demonstrate ‘that there had existed in 1936 an “alternative future” for Keynesian economics to the one realized’ (2000: 25), starting from what he held to be the core idea of the General Theory: The ‘market forces’ governing the adjustment of prices (and of rates of output, employment and consumption) will not always drive prices toward the equilibrium configuration where the desired transactions of all parties are consistent. Although there are no obstacles to price movements, the price system may thus fail to communicate all the information required to enable agents to exhaust potential gains from trade…[E]ven in the absence of significant ‘frictions’, the adjustment process may fail to home in on the equilibrium price vector because of effective excess demand failures. (Leijonhufvud, 2000: 25, 29) That alternative future of the past (or ‘road not taken’) was the study of the disequilibrium dynamics of economies with costly information (Howitt, 2002). Axel’s general characterization of (old) Keynesian economics as a Walrasian frictions view may not have been fair to all of the contributors to that tradition. Yet, there is some irony in the fact that his line of criticism came to be right on target, when the mainstream of macroeconomic theorizing began to address issues of informational dynamics by taking the turn towards rational expectations, first in New Classical and then also in New Keynesian Economics. 3. Axel in DSGE Wonderland Axel’s cybernetic Z-theory was not the sole attempt to create a Neo-Keynesian alternative to the Neoclassical Synthesis. As mentioned with reference to Barro and Grossman (1971), there were other approaches to restoring Keynes’s message that full employment equilibrium is, at best, a special case. The lines of thinking were so different that it seems appropriate to speak of Neo-Keynesian Syntheses, in the plural. Clower and Leijonhufvud (1975) set the focus on disequilibrium states that result from coordination failures of the price mechanism. Barro and Grossman, as well as Jean-Pascal Benassy and other (predominantly European) economists, turned to ‘non-Walrasian (temporary) equilibrium modelling’ under the assumption of fixed prices (cf. Backhouse and Boianovsky, 2014: ch. 5; De Vroey, 2016: ch. 7). 3.1 New Keynesian Economics I and II A similar divergence of approaches can be observed in the development of New Keynesian Economics which came in two stages. In stage I, the term refers to ‘a somewhat loose cluster of models’ (Leijonhufvud, 2009: 750), formed in the 1980s and early 1990s, opposing the New Classical paradigm that had evolved from Robert Lucas’s monetary theory of the business cycle and the Real Business Cycle (RBC) approach of Finn Kydland and Edward Prescott. While the New Classicals insisted on what they considered as standard Walrasian microfoundations, the New Keynesians made use of more modern microeconomics for rigorous modelling of involuntary unemployment and other Keynesian themes.Greenwald and Stiglitz (1987: 121–23) postulated in their New Keynesian manifesto that a general theory must account for persistent unemployment, make careful distinctions between saving and investment, and show that disturbances in demand underlie the cyclical behaviour of macroeconomic aggregates. They claimed that this can be achieved by models based on imperfect information (incomplete and/or asymmetric), containing such ingredients as efficiency wages, capital market imperfections, credit rationing, and a view of the central bank as an institution for stabilizing credit, not just the price level. The stage I manifesto of Greenwald and Stiglitz was based on a view of Keynes’s economics that had much in common with Axel’s approach. Yet, their agenda was soon relegated to the periphery, as the reference collection of Mankiw and Romer (1991) divided New Keynesian Economics along two lines: ‘Imperfect Competition and Sticky Prices’ and ‘Coordination Failures and Real Rigidities’. As the blurb reads: Volume 1 focuses on how friction in price setting at the microeconomic level leads to nominal rigidity at the macroeconomic level, and on the macroeconomic consequences of imperfect competition, including aggregate demand externalities and multipliers. Volume 2 addresses recent research on non-Walrasian features of the labor, credit, and goods markets. The description of volume 2 looks like a vacuous reference to an assortment of partial analyses, and it was the literature of volume 1 that set the stage for New Keynesian Economics, stage II. The frictions line gradually converged with New Classical RBC theory. Ever since the survey of Goodfriend and King (1997), it has become customary to use the label ‘New Keynesian Economics’ (NKE) interchangeably with ‘New Neoclassical Synthesis’ (NNS). Axel criticized the frictions line of NKE all along its way, although his preferred target for attack in the 1980s and 1990s was New Classical Economics, the then-reigning paradigm. While his comments on Old Keynesian Economics are easily accessible in systematic and comprehensive assessments, his criticism of NKE is more dispersed in sections of pieces written with other purposes, commenting on the state of the economy, reviewing particular publications, or outlining the evolution of macroeconomics in longer perspective. They contain few specific references to the literature.5 In order to map out Axel’s views on NKE and to assess the claims to progress made in the DSGE world after the global financial crisis, it is useful to identify a New Keynesian reference model to which Axel’s criticism can be systematically applied. 3.2 The New Keynesian reference model Figure 2 presents an update on Leijonhufvud’s map of Wicksell and Fisher connections (Fig. 1). It shows that the NKE-NNS consensus view has an explicit Wicksell connection in a landmark contribution to its pre-crisis evolution: Michael Woodford’s Interest and Prices (2003). Apart from recycling the title of Knut Wicksell’s pathbreaking Geldzins und Güterpreise ([1898] 1936), Woodford made explicit use of Wicksell’s concepts of a natural rate of interest, a cashless economy and a feedback-rule for monetary policy that moves interest rates in reaction to inflation. He describes his version of NKE-NNS as a ‘neo-Wicksellian framework’ (Woodford, 2003: 49). It has been argued that Woodford’s approach is fundamentally different from Wicksell’s and Keynes’s concerns about failures of market systems to coordinate intertemporal plans (Boianovsky and Trautwein 2006, Tamborini et al., 2014). On the Econ decision tree, it is perched at large distance from the Wicksellian offshoot represented by Axel’s Z-theory.6 Since Woodford’s (2003) framework set a standard for DSGE modelling with claims to representing an all-encompassing synthesis of 20th-century macroeconomics (Woodford, 2009), it serves as reference for the following summary of Axel’s comments on New Keynesian DSGE.7 Fig. 2 Open in new tabDownload slide Wicksell and Fisher connections, update. Source: Adapted from Sandelin et al. (2014: 81) Fig. 2 Open in new tabDownload slide Wicksell and Fisher connections, update. Source: Adapted from Sandelin et al. (2014: 81) The core model in Woodford (2003: 243–7) is a system of three equations that determine the dynamics of output, inflation, and the key interest rate. The first equation is superficially similar to the IS equation of the Old Neoclassical Synthesis, but claimed to rest on rigorous microeconomic foundations. It is obtained by deriving the first order condition for the representative (infinitely lived) household’s intertemporal optimum of consumption and leisure. The IS relation describes a negative relation between output and interest rate variables in terms of gaps. The gap between actual output and the ‘natural rate’ (potential output) is related to the gap between the ‘natural rate of interest’ and the actual rate that may emerge from shocks to technology and policy. The ‘natural rate of output’ is defined as the fictitious level that monopolistic competition would produce under flexible prices, in analogy to the growth path in the perfect competition setting of RBC theory. The natural rate of interest is ‘just the real rate of interest required to keep aggregate demand equal at all times to the natural rate of output’ (Woodford, 2003: 248). Assuming that the representative household holds (Muth-)rational expectations, the output gap is determined by the expected values for future output and inflation, by contemporaneous shocks to the real rate of interest, and by shifts of the nominal rate of interest, the policy variable in the system. The second equation is an aggregate supply function (AS). Current inflation corresponds to rationally expected future inflation plus the current output gap, modified by a rigidity parameter. The firms act in monopolistic competition and set their prices in a staggered fashion, ‘conveniently’ modelled as the result of a Calvo lottery. A significant proportion of the profit maximizing firms reacts to shocks by varying their output, rather than prices. Price stickiness increases with the degree of strategic complementarity between suppliers. The output effects of shocks can thus become large and persistent. The third equation is a Taylor rule for monetary policy (MP). The central bank reacts to output gaps and to deviations of inflation from its target value by varying the nominal rate of interest, its control instrument, in the same direction. Resembling a dynamic and output augmented version of Wicksell’s rule, the Taylor rule closes the model, permitting the simultaneous determination of interest, inflation, and the output gap. It leads to the conclusion that targeting (near) zero inflation maximizes social welfare, since price level stability disarms the critical friction, preventing nominal rigidities from taking effect. Woodford (2003: 238) argues that ‘[i]n this way it is established that a nonmonetarist analysis of the effects of monetary policy does not involve any theoretical inconsistency of departure from neoclassical orthodoxy’. 3.3 The trouble with DSGE Discussing ‘the state of macrotheory’ shortly after the outbreak of the global financial crisis, Axel notes that the New Neoclassical Synthesis ‘has brought us back full circle to [the] notion of the economy as a stable equilibrium system with frictions’ (Leijonhufvud, 2011b: 2): The Old Neoclassical Synthesis, which reduced Keynesian theory to a general equilibrium model with ‘rigid’ wages, was an intellectual fraud the widespread acceptance of which inhibited research on systemic instabilities for decades. Insofar as the New Synthesis represents a return to this way of thinking about macroproblems it risks the same verdict. (Leijonhufvud, 2009: 750) Axel concedes that macroeconomics has made technical progress since the times of the Old Neoclassical Synthesis (see, e.g., 1998: 181–2; 2011a: 1; 2011b: 2, 8). Yet, he does not see much change in substance. The IS relation is the prime target of his attacks, because it reduces intertemporal coordination to the optimizing choice of a representative household that holds rational expectations. This makes it impossible, in his view, to analyse the coordination problems that cause financial crises, mass unemployment and other explananda of macroeconomic theory (Colander et al., 2008: 236, Leijonhufvud, 2014: 770–2). Savings-investment imbalances cannot be addressed in this framework: DSGE models are…peculiarly prone to fallacies of composition, most particularly so, of course, in their representative agent versions. The models are blind to the consequences of too many people trying to do the same thing at the same time. The representative lemming is not an intertemporal optimising creature. (Leijonhufvud, 2009: 753) The route to analysing macroeconomic instabilities is blocked by further requirements that DSGE modelling imposes on the private sector agents, such as extremely high cognitive competence: The logic of optimizing choice is essentially timeless. It does, however, require all the utility-relevant consequences of alternative decisions to be taken into account. When the step from an atemporal to a temporal context is taken, this comes to mean all possible alternative futures for all time. (Leijonhufvud, 1998: 182) Under the rational expectations assumption, NKE treats ‘the evolution of an economy as if it were a fully determined (albeit stochastic) process accurately foreseen by all inhabitants’ (Leijonhufvud, 2014: 773). Yet, even this assumption is not sufficient to make intertemporal optimization fully consistent. A standard requirement of DSGE models with infinitely lived agents is that budget constraints are binding all the time. To satisfy the requirement of optimality, the transversality condition must hold: no capital, no debt is left over at the end (whatever that means in infinity): [T]rusting in the transversality condition is surely nothing but pure and utter superstition. This figment of economic imagination simply has no counterpart in the world of experience. Every bubble that ever burst is proof of this fact. It should be removed from our models. From the standpoint of the DSGE tradition, the consequences would of course be drastic…Remove the transversality condition from DSGE models and everything unravels. Without it, there is nothing to guarantee that individual intertemporal plans are consistent with one another. The system lacking an empirical counterpart to the mathematical economist’s transversality condition is likely to experience periodic credit crises. Such crises reveal widespread, interlocking violations of intertemporal budget constraints. (Leijonhufvud, 2014: 772) In the New Keynesian twist of DSGE modelling, intertemporal optimization does not directly coincide with the social optimum. Output gaps are derived from frictions in the price mechanism that are introduced with the rigidity parameter in the AS relation, also known as the New Keynesian Phillips curve. Axel’s objections to this frictions approach are twofold. In regard to theoretical substance, it suffers from a lack of macrofoundations: Economists talk freely about ‘inflexible’ or ‘rigid’ prices all the time, despite the fact that we do not have a shred of theory that could provide criteria for judging whether a particular price is more or less flexible than appropriate to the proper functioning of the larger system. (Leijonhufvud, 2009: 750) In regard to empirical relevance, Axel doubts that ‘a little stickiness’ of the kind introduced by the Calvo lottery device plus some strategic complementarity, ‘could account for the behaviour of real rates and the real distortions in all the years since the recovery from the dotcom crash’ (2009: 749, n. 2). [A] single ‘rigidity’ does not take us very far in making the models ‘fit’ the data. So we now have large-scale DSGE models with more than a dozen ‘frictions’ and ‘market imperfections’ with more to be added, you can be sure, when the models do not fit outside the original sample. (Leijonhufvud, 2014: 761–2) With such ad-hocery, the links to the ‘rigorously microfounded’ core model of the NNS are loosened far beyond what used to be acceptable by earlier modelling conventions. When it comes to monetary policy (MP), Axel has many things to say, whereof only two are mentioned here. The first is that the real rate of interest, on which the IS and MP equations in the representative model interact, is a constructed variable without correspondence to reality: What does exist is the money rate of interest from which one may construct a distribution of perceived ‘real’ interest rates given some distribution over agents of inflation expectations. Intertemporal non-monetary general equilibrium (or finance) models deal in variables that have no real world counterparts. (Leijonhufvud, 2009: 749) Woodford’s cashless DSGE economy is such a model, and it evades the issue by assuming identical inflation expectations across the economy. Distributional neutrality of inflation targeting is ensured by excluding heterogeneity among the households. Axel points out that this will no longer apply in situations ‘when monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of guaranteeing some private sector liabilities and not others, of allowing or preventing banks to collude' (Leijonhufvud, 2009: 748–9). This is a comment on the situation in 2008/09 when the global financial crisis made the distributional consequences of monetary policy evident. Years before the outbreak of the crisis, Axel had already suspected that ‘modern macroeconomics leaves too little room for the extremes of instability’ (Leijonhufvud, 2004: 821). The pre-crisis consensus view of NKE-NNS was blind to its cause: a balance sheet recession in the banking sector that followed from excessive leverage, maturity mismatch, and increased interconnectivity. In order to make room for this in his own framework, Axel has refined his original corridor concept, now identifying three regions of state-space representation of the private sector in the economy (Leijonhufvud, 2011b: 6–7, 2014: 766–8): Region 1: Self-stabilization of the market system inside the corridor; price mechanisms work to the extent that ‘negative feedback controls dominate in all markets and “stabilisation policies” in the conventional sense are not useful’ (Leijonhufvud, 2011b: 6). Region 2: Destabilization outside the corridor, but deviation amplification is bounded in ‘business cycles’ such that conventional macroeconomic policies can ensure market liquidity and stabilize aggregate demand. Region 3: Destabilization with unbounded interaction of positive feedback loops, ‘dangerous instabilities, such as default avalanches…[t]he worst outcome in this region of dangerous instability’ being ‘the “black hole” of a Fisherian debt-deflation catastrophe’ (Leijonhufvud, 2014: 767); such situations require unconventional strong and fast measures to stabilize the economy, but Axel warns that not all kinds of unconventional policies will get it right (Leijonhufvud, 2009: 753; 2014: 772). In addition to this refinement of his earlier corridor concept, the financial crisis also urged Axel to think about wider consequences of false trading, the pinpoint on which his reinterpretation of Keynes had started turning. False trading makes budget constraints diverge from their hypothetical path in continuous general equilibrium. To put it in an Edgeworth-Bowley box: The disequilibrium trade shifts the initial endowment. In a financial crisis, this problem becomes infinitely worse. Not only do defaults shift the endowments about, but they keep changing the dimensions of the box. Furthermore, a great many agents will suffer Knightian uncertainty about what their endowments may be and what they may end up being. The probability that the system would settle in any one of its multiple initial equilibria is basically zero. (Leijonhufvud, 2014: 771) This leads Axel to the conclusion that DSGE modelling has shown itself ‘an intellectually bankrupt enterprise’ (Leijonhufvud, 2008: 6), ‘hopelessly inadequate for dealing with financial crises and their aftermaths’. Certainly, the claims that these models have sound microtheoretical foundations and are particularly suitable for forecasting and policy analysis’ are without merit. It is particularly unfortunate at this time that so many central banks have sunk so much intellectual capital in the DSGE enterprise.’’ (Leijonhufvud, 2011a: 6) 4. What progress on coordination failures in the DSGE world? Axel was by no means alone in criticizing the NSS after the outbreak of the financial crisis in 2007/08. With the widely acclaimed indictments of intellectual bankruptcy and squandering of intellectual capital, one would have expected DSGE macro soon to be declared a dead horse. But not so: it is alive and kicking. A decade after the critical events, DSGE continues to be the workhorse technology for macroeconomic modelling. Right after the crisis, V.V. Chari asserted in a US Congress hearing that, ‘[a] useful aphorism in macroeconomics is: “If you have an interesting and coherent story to tell, you can tell it in a DSGE model. If you cannot, your story is incoherent”’ (Chari, 2010: 35). New Keynesians argued that they failed to see the crisis coming because they considered ‘financial frictions’ empirically irrelevant.8 Accordingly, they have now set their focus on such frictions in a booming literature that tells stories about financial crises in DSGE models. To which extent do these models disprove Axel’s verdict of hopeless inadequacy? 4.1 Financial frictions For the purposes of this article, it is not necessary to survey the vast and complex literature on credit cycles and financial crises in DSGE frameworks.9 It suffices to outline major anatomical differences from the pre-crisis standard (or ‘NKE, stage II-A’, as in Woodford, 2003) and to take a closer look at a representative model that demonstrates the state of the art in ‘financial frictions DSGE’ (or ‘NKE, stage II-B’, as in Gertler et al., 2016). The basic requirement for modelling financial crises is a distinction between lenders and borrowers plus the introduction of frictions in credit markets. For this, post-crisis NKE II-B invokes information asymmetries and moral hazard problems that were modelled in the market imperfections literature of NKE, stage I. The new literature builds explicitly on the credit cycle approach of Kiyotaki and Moore (1997) and the financial accelerator mechanism in the tradition of Bernanke and Gertler (1989). The former refers to borrowing constraints produced by collateral requirements related to borrowers’ net worth, which fluctuates with asset prices. The latter approach revolves around external finance premia that reflect changing costs of monitoring loan projects and create a time-varying wedge between the risk free (policy) rate of interest and the market price of credit. As net worth moves procyclically and external finance premia move countercyclically, both approaches can be combined to construct critical feedbacks between fluctuations in real economic activity and balance sheet constraints. They provide straightforward routes to introducing banks (as representative intermediaries) into DSGE models by giving them an ambiguous key role. Banks help lenders to solve problems of costly state verification and repossession of collateral; this provides a microeconomic rationale for having them as intermediate agents in the model. However, they typically undertake borrowing and lending with leverage, with a tendency to increase the exposure to systemic risk, a source of macroeconomic coordination failures. Banks can thus be modelled as amplifying transmitters of real shocks, and originators of financial shocks that affect real economic activity. DSGE models with financial frictions vary widely in their deviations from the pre-crisis framework. Some, such as Cúrdia and Woodford (2010), minimize the difference by dividing the household sector into savers and borrowers who give and receive loans through competitive banks that provide monitoring and other services. Growth in the volume of loans increases default risks and intermediation costs, leading to variations in the spread between deposit rates and lending rates that feature a basic financial accelerator mechanism. In this type of framework, the financial friction is simply superimposed on the nominal rigidities of the pre-crisis standard. Many advanced DSGE models with financial frictions do, however, without nominal rigidities. Some even collapse households and goods producing firms into one (non-financial) sector that is juxtaposed to more sophisticated structures of the financial sector. Policy analysis is no longer confined to variations of the Taylor rule. Some papers compare them with quantitative easing, lending of last resort, and macroprudential regulation in terms of effectiveness; others study the interaction of these instruments. There is an enormous variety of model specifications to account for balance sheet constraints that emerge from mechanisms affecting net worth in different sectors. On the whole, financial frictions DSGE in NKE II-B has differentiated itself strongly from the canonical IS-AS-MP anatomy of NKE II-A. Given such variety: is it possible to refer to a representative model for testing the validity of Axel’s claim that the DSGE approach is inadequate for dealing with financial crises and their aftermaths? In their contribution to the Handbook of Macroeconomics, Mark Gertler and Nobuhiro Kiyotaki (two pioneers of the credit cycle and financial accelerator literatures of NKE, stage I) claim to ‘present a simple canonical macroeconomic model of banking crises that…is representative of the existing literature’ (Gertler et al., 2016: 1348; their work is subsequently referred to as ‘GKP’). In addition, their model extends this literature ‘to feature a role for wholesale banking’. The aim is to provide an account of the mechanisms underlying the global financial crisis in the years 2007–09, when ‘highly leveraged financial institutions along with highly leveraged households…were most immediately vulnerable to financial distress’ (Gertler et al., 2016: 1347), more so than non-financial firms, which had been at the centre of attention in the earlier literature. Accordingly, Gertler and colleagues set the focus on the interaction between households (the non-financial sector) and a financial sector that is disaggregated into retail banks and wholesale banks. The latter correspond roughly to the shadow banks of the pre-crisis boom, with institutions that originated loans to households, securitized them, and funded them by borrowing short-term from more regulated retail banks. In the GKP framework, retail banks take deposits from households and lend them to wholesale banks. While the latter have a cost advantage over retail banks in making standardized loans to the non-financial sector, the former have a cost advantage over wholesale banks in making non-standard loans to the non-financial sector, and over households in lending to wholesale banks. Efficient specialization and regulatory arbitrage make the interbank loan market grow endogenously, improving the liquidity of the system, but making it more vulnerable to crisis. The growth of the interbank loan market increases leverage in the wholesale banks. To derive a limit to their ability to raise funds, Gertler and colleagues introduce a moral hazard problem: bankers can choose between operating ‘honestly’ or diverting assets for personal use. Taken together, leverage and moral hazard make the financial sector susceptible to runs, unanticipated or anticipated by the households, that spill over into the retail bank segment. Varying the constellations, Gertler and colleagues show how such runs can turn small shocks, which would produce only minor recessions at ‘normal’ times, into major disasters in the dimension of the Great Recession. The wide-ranging fall in the net worth of banks in both segments constrains their ability to issue safe liabilities and reduces real economic activity by means of a strong rise in the costs of finance. Gertler et al. (2016) end their exploration of realistic extensions to the ‘canonical DSGE model of financial crisis’ with an examination of options for counter-acting government policy. They model and simulate two types of intervention: ex ante in terms of macroprudential leverage restrictions, and ex post in terms of lending of last resort. They show how unconventional policies of the latter type (large-scale asset purchases in the interbank market) can prevent runs from happening, if agents anticipate the intervention on the base of a rule that relates to a threshold in the spread between the deposit rate and the wholesale banks’ return on assets. Complementing the ‘management of expectations’ by a Taylor rule in normal times (as defined by the canonical Woodford model), this rule may be considered the ‘financial frictions’ equivalent in times of crisis. 4.2 Achievements and limitations Considering the progress that New Keynesians have made in modelling financial crises, they appear to have refuted Axel’s verdict on the hopeless inadequacy of DSGE. Moreover, they can claim to have done so in a Leijonhufvudian spirit by returning to lower forks of the Econ decision tree and generating novel approaches from NKE-I concepts that had been temporarily discarded. Various contributions to the financial frictions branch of NKE take an even wider historical perspective and reflect on theories of financial instability in the traditions of Fisher (1933), Keynes (1930, 1936), Minsky, Kindleberger, and others.10 Yet, it can be argued that some of Axel’s critique of DSGE remains valid even with respect to the present NKE literature on financial crises. The following assessment moves from points of criticism that may be considered as outmoded to those that still have some force. The rigid architecture of pre-crisis DSGE, as represented by Woodford’s IS-AS-MP framework, has given way to a variety of structures in which nominal rigidities are no longer essential for explaining deviations of actual from optimal output. The single-minded reliance on unexplained price inflexibility has been replaced by emphasis on credit market imperfections that are more appealing in terms of theoretical foundations and empirical plausibility. They, too, are described as ‘frictions’, but appear to come closer to Axel’s theme of coordination failures that stem from incomplete information. In NKE II-B, the key sources of short-term adjustment problems in the economy are not rigidities of goods prices or wages but, rather, asset price volatility and credit rationing. Financial frictions DSGE introduces some heterogeneity by splitting the representative household into sub-classes of savers and borrowers, and by letting additional classes and sub-classes of agents (financial intermediaries) solve different optimization problems with behavioural choices (‘honesty’ or ‘cheating’). Some models even seem to invalidate Axel’s quip that 'the representative lemming is not an intertemporal optimizing creature’; the GKP construction of anticipated runs may serve as an example for a model of herd behaviour (Gertler et al., 2016, s. 5; and appendix C). The NKE II-B literature is clearly able to model balance sheet recessions. So much for new elements of NKE that refute Axel’s criticism. Now to some points that are more ambiguous. Axel’s charge of ad-hocery against DSGE frameworks that add frictions to frictions until the model fits the data applies to much work in the ‘financial frictions’ line, even if many modellers proceed from a baseline model to introduce the frictions step-by-step, so as to isolate the net effects of each friction; Gertler and colleagues’ distinction between unanticipated and anticipated runs is a case in point. Yet, that same example betrays another problem: unanticipated runs are hardly compatible with the rational expectations assumption that Gertler and colleagues use for intertemporal optimization even in this case. In general, the financial frictions literature in NKE II-B is rather casual about distinctions and interactions between asymmetric and incomplete information that ought to have consequences for assumptions about the cognitive competence required for intertemporal optimization. NKE II-B has developed a strand of literature on DSGE models with learning, but it is not obvious (so far) what, if anything, that literature could contribute to make financial frictions DSGE more rigorous and plausible. While the IS-AS-MP framework of NKE II-A postulated distributional neutrality of monetary policy by construction, the NKE II-B literature permits some explicit analysis of non-neutral effects of policy interventions, as balance sheets of different classes of agents are affected in different ways. Yet, the general architecture of financial frictions DSGE implies strong limitations of the distributional effects. So, to the things in NKE to which Axel’s fundamental objections still apply. Financial frictions DSGE may be taken to model deviation amplifying feedbacks that lead to severe financial instability of the kind defined by Region 3 in Axel’s taxonomy of system behaviour ‘outside the corridor’. Yet, basic assumptions and procedures restrict the frameworks from dealing fully with the dynamics of violations of interlocking budget constraints that typically follow from financial crises in the real world. The standard assumption in financial frictions DSGE is an infinite horizon for the intertemporal optimization of the representative household/s. The combination with rational expectations necessitates the setting of a transversality condition that rules out rational bubbles, leftovers of ‘useless capital’, and unsettled debt from defaults. As Goodhart and Tsomocos (2011: 51) express it, this requires that: whatever happens in the future, the debtor will still be able [and willing] to repay. This must logically require complete financial markets, wherein all eventualities, including Donald Rumsfeld’s famous ‘unknown unknowns,’ can be hedged. How can you price and hedge the unknown? Since the number of potential future outcomes is infinite, any transaction cost, however minute, would make the whole exercise infeasible. Even though most DSGE models with financial frictions come with a large formal apparatus in the text parts and appendices, transversality conditions have become invisible bolts that keep the structures from falling apart but that are hidden somewhere deeper down in the machine room.11 Apart from such heroic assumptions, the standard DSGE technology prevents the models from veering far into Axel’s region of financial instability. The basic philosophy is to study financial crises in terms of perturbations around a non-stochastic steady-state growth path of the economy. The models are typically log-linearized around the steady state path that represents optimal output. This procedure excludes multiple equilibria and further (in)stability problems to which Axel refers as ‘violations of interlocking intertemporal budget constraints’ and ‘changing dimensions of the [Edgeworth] box’. In the impulse-response graphs of the representative model, for which Gertler and colleagues claim stronger persistence of critical effects than in other studies, the system is back on the original track after ten years (40 periods corresponding to quarters) if not impacted by new shocks (Gertler et al., 2016: secs 4.3–7). Even the recent advances into exploring financial crises do not dispel Axel’s impression that NKE ‘has brought us back full circle to [the] notion of the economy as a stable equilibrium system with frictions’ (Leijonhufvud, 2011b: 2). 5. Conclusion This article describes continuity and change in Axel Leijonhufvud’s critique of Old and New Keynesians, and assesses contrary claims of progress made in the DSGE world. Taking stock, the following changes have been identified in Axel’s approach to Keynesian economics, Old and New. First, his critique of NKE is mostly embedded in the discussion of real-world problems, notably the global financial crisis and its aftermath. It is more cursory and less systematic than the thorough treatments that he gave Old Keynesian Economics and New Classical Economics. Second, Axel has abandoned his search for a Keynesian synthesis as opposed to the Old Neoclassical Synthesis. Third, he has expanded his corridor concept to a distinction between regions of instability, in which Region 2 contains cycles that can be mitigated by conventional macropolicies, whereas Region 3 features disastrous instability that needs to be countered by unconventional policies. More fundamentally, there is much continuity in Axel’s critique of Old and New Keynesians. Having made his name by attacking Old Keynesian Economics for its view of the economy as a ‘stable [full employment] equilibrium system cum frictions’ that is blind to financial instability, he sees the new(er) brand of DSGE Keynesianism as beset by the same problems. A closer examination of recent New Keynesian literature that centres on ‘financial frictions’ suggests that Axel’s critique of DSGE is partly outmoded, but partly still valid. New Keynesians no longer (exclusively) rely on price inflexibility for modelling deviations of actual from potential output. They are now capable of modelling problems that generate ‘excessive’ asset price flexibility, or derive from it. Yet, even in the most sophisticated New Keynesian models of financial crises the system is bound to return to the predetermined steady-state path. In this respect, DSGE remains inadequate in analysing the effects of violations of interlocking budget constraints, keeping NKE stuck in a ‘stable equilibrium system cum frictions’ view. The underlying problem can be described using another dual taxonomy by which Axel has structured forks in the Econ decision tree, in addition to the Wicksell and Fisher connections (illustrated by Fig. 1). In an essay on Mr Keynes and the Moderns, Axel contrasted the ‘British Classical School’ with modern macroeconomists, classifying Keynes as ‘the last of the great classical theorists’ and the General Theory ‘as a generalization of classical theory’ (Leijonhufvud, 1998: 170). He characterized the Classicals as seeking to uncover the laws of motion of the economy, in which the agents follow specified aims, but do not always achieve them; they adapt and learn by trial and error. Time matters, both in the understanding of adaptive behaviour as a process in which the sequencing of decisions is important, and in thinking about the evolution of the institutions that condition the agents’ behaviour. The Moderns, by contrast, focus on ‘the logical principles of efficient allocation’ in which behaviour is ‘optimizing ex ante’ (Leijonhufvud, 1998: 170), not only by intent, but also in terms of outcome, unless they are hindered by institutions and other types of frictions. In order to bring the relevant innovations in the economics of Keynes to further fruition, Axel has pleaded for a return to the Classical region on the Econ decision tree. He has continued to pursue his vision of a ‘cybernetic’ approach by advocating studies of adaptive behaviour in agent-based computational macroeconomics (ABM) (e.g., Leijonhufvud, 2006). Axel’s influence on the ‘financial instability’ strand of ABM is perceptible,12 and central bank economists who favourably compare ABM to DSGE have him in their references (Haldane and Turrell, 2018). There are even attempts to marry DSGE with ABM (Gobbi and Grazzini, 2017). It remains to be seen whether any such synthesis will be able to meet Axel’s concerns. However, half a century after making an impact in terms of critique, the positive contribution of Axel Leijonhufvud’s backtracking on the Econ decision tree may have begun to take effect on the mainstream of macroeconomic theorizing. Footnotes 1 " This section is largely based on Trautwein (2018). 2 " Later on, Axel (Leijonhufvud, 199858: 177) admitted that ‘“getting rid of the auctioneer” was…a big part of [his] own “struggle to escape” from the neo-Walrasians,’ while ‘it cannot have been a problem that Keynes had with his own classical mentor, Marshall.’ 3 " Some of the criticism is discussed in the historical literature on Axel’s contributions; see Howitt (2002), Backhouse and Boianovsky (2013: ch. 4), and De Vroey (2016: ch. 6). Axel has responded to various critics in Leijonhufvud (2000: 24–9). 4 " Two anonymous referees have rightfully stressed that both points ought to be addressed in this context, even though it is mainly concerned with Axel’s critique of New Keynesian Economics. 5 " An exception is his comment on the New Keynesian model of unemployment presented by Galí et al. (2012); see Leijonhufvud (2011a and 2014: 769–72). 6 " As pointed out in section 2.3, Axel’s Z-theory is an analytical interpolation of Keynes (1930) and (1936), not a historical reconstruction of writings in the years between. It is thus an exception from the chronology of works otherwise suggested by the vertical order of names and schools in Fig. 2. The exception is made to emphasize the pivotal role of the Z-theory for Axel’s critique of macroeconomists’ recourse to frictions for explaining deviations from optimal general equilibrium. 7 " References to Woodford are made in Leijonhufvud (2007: 3 and 2009: 750). Christiano et al. (2005), and Smets and Wouters (2007) are often cited as standard pre-crisis DSGE models, but they are less ‘foundational’. For another ex post construction of a pre-crisis ‘New Keynesian benchmark DSGE model’, see Vines and Wills (2018). 8 " Christiano et al. (2018: 13) maintain that, ‘guided by the post-war data from the U.S. and Western Europe, and experience with existing models of financial frictions, DSGE modelers emphasized other frictions.’ It is an odd defence to argue that macroeconomists who routinely postulate that agents in their models have forward-looking rational expectations themselves worked on backward-looking expectations. 9 " For surveys see, for example, Brunnermeier et al. (2013), Claessens and Kose (2017), Christiano et al. (2018), and Vines and Wills (2018). 10 " See, for example, Brunnermeier et al. (2013), and Jakab and Kumhof (2015); for a comparative survey of the NKE-I literature and older credit views see Trautwein (2000). 11 " Exceptions are found in papers by Brunnermeier and co-authors; for example, in Brunnermeier et al. (2012: 17). Models with overlapping generations of finitely lived agents (OLG), which were frequently used in the NKE-I literature (e.g., by Bernanke and Gertler 1989), can handle asset price bubbles without transversality conditions; they are beyond the scope of this paper. 12 " See, in particular, the works of Peter Howitt and Domenico Delli Gatti with their respective co-authors; for example, Delli Gatti et al. (2011) and Ashraf et al. (2017). Acknowledgements The author gratefully acknowledges helpful comments from participants at the THETS 2018 meeting at Balliol College, Oxford University, from Roger Backhouse and James Forder, and from two anonymous referees. Almost all of the usual disclaimers apply. References Ashraf Q. , Gershman B., Howitt P. ( 2017 ) Banks, market organization, and macroeconomic performance: an agent-based computational analysis , Journal of Economic Behavior & Organization , 135 , 143 – 80 . Google Scholar Crossref Search ADS WorldCat Backhouse R. , Boianovsky M. 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TI - Leijonhufvud on New Keynesian Economics and the economics of Keynes
JF - Oxford Economic Papers
DO - 10.1093/oep/gpaa013
DA - 2011-08-01
UR - https://www.deepdyve.com/lp/oxford-university-press/leijonhufvud-on-new-keynesian-economics-and-the-economics-of-keynes-4bHUQ2mbRw
SP - 1
VL - Advance Article
IS - 
DP - DeepDyve
ER -