Krugman and Keynes, Part II

I am currently on vacation in the back woods west of Ottawa, but my brother just had internet service put in, and I made the mistake of catching up on my email. Someone was urging me to write something about this emission by Paul Krugman, who is writing about a piece he read by Ezra Klein in the Washington Post. Let's just work from the last paragraph:

Klein suggests that what went wrong in the Great Depression was that people hadn’t read Keynes yet; well, what went wrong and continues to go wrong in the Lesser Depression is that eminent economists, or at those so judged by their peers, turned their back on everything Keynes learned.

First, what do you think Keynes actually learned? No one really seems clear on this. In what profession are people still arguing about the meaning of a book written in 1936? As best we can make out, there are two more-or-less coherent modern versions of Keynesianism. One model is the multiple-equilibrium coordination failure version of Keynes, that comes to us by way of John Bryant, Peter Diamond, Russ Cooper, Andy John, Roger Farmer, Jess Benhabib, etc. A calibrated version of this type of model was fit to the data by Farmer and Guo. A second model is that developed by Mike Woodford, and subsequently (with many bells and whistles) fit to data by Smets/Wouters and Christiano/Eichenbaum/Evans.

Both of these modern Keynesian models are actually versions of a basic Cass-Koopmans-Brock-Mirman-Kydland-Prescott neoclassical growth model - the basic framwork we teach to graduate students as a starting point in all serious contemporary macroeconomics core courses for PhD students. As such, modern Keynesianism is just another tweak. Add some increasing returns and you get multiple equilibria, and maybe some role for government in coordinating on good equilibria. Add some sticky prices and wages, and you get some role for government in correcting relative price distortions.

Of course, these are not the only tweaks we might want to think about. Search frictions are useful for thinking about the dynamics of the labor market and unemployment. Private information and limited commitment are useful for thinking about the role of assets in exchange, monetary policy, and how credit markets work (or do not work).

Now, if you were to choose your tweaks in order to make sense of the financial crisis and the recent recession, what would those tweaks be? Well, I am not a betting person, but if you forced me to put up some cash, it would not be riding on sticky wages and prices. I've thought about that (go back and search my posts) and I can't force it to make sense. As for multiple equilibria, maybe one could get some mileage out of that, but I don't see anyone trying. Want to learn about financial crises and what governments should do about them? Want to understand unemployment and why it so high? Turn your back on Keynes.