A common narrative: analysts who used traditional Keynesian tools to understand the crisis made better predictions and were in a better position to diagnose the problem. This narrative may be comforting to some but unfortunately it’s not correct.
In some sense, the truth of our predicament is even scarier. Macroeconomists were caught completely off-guard by the financial crisis. None of the models we were accustomed to use provided insights or policy recommendations that could be used for fighting the crisis. This is particularly true for New and Old Keynesian models. The New Keynesian model (particularly its DSGE manifestations) was the dominant macroeconomic paradigm in the pre-crisis period and judging by many of the presentations at the National Bureau of Economic Research (NBER) summer meetings, the New Keynesian or Old Keynesian (referred to as “paleo Keynesian” by some of the meeting participants) continue to serve as the primary lens through which we try to make sense of the macroecononmy.
It its standard form, neither the New Keynesian model nor its paleo-Keynesian antecedent feature a meaningful role for financial market failures. As a result, the policy response to the crisis was largely improvised. This is not to say that the improvised policy actions were bad. Improvisation guided by Ben Bernanke was about as good as we could hope for. Nevertheless, for the most part, the models we were accustomed to use to deal with business cycle fluctuations were simply incapable of making sense of what was going on. In one of Stefanie Kelton’s recent podcasts, economist Randy Wray makes exactly this point. While I typically do not grant much credence to heterodox economists, in this instance Professor Wray’s diagnosis is completely correct. Fortunately, as Noah Smith pointed out in an earlier column,macroeconomists have been working, and continue to work, on developing models that can be used to analyze financial market failures.
In addition to the fact that the prevailing business cycle theories did not incorporate financial sectors, the components that were featured prominently were not performing well. The cornerstone of pre-crisis macroeconomic theory was price rigidity. In New Keynesian models, price rigidity results in a Phillips curve relationship – more specifically, a New Keynesian Phillips curve. According to the Phillips curve, if inflation was unusually high then output would be above trend. If it was low then output would be below trend.
The financial crisis of 2007-2008 and the Great Recession that followed proved to be a particularly bad episode for the New Keynesian model. Contrary to Paul Krugman’s assertion that traditional Keynesian models performed well, the key mechanism in the New Keynesian framework – the Phillips curve – was a virtual failure. In a recent post commenting on John Cochrane, Noah Smith plots quarterly price growth during the recession and notes that inflation did fall a bit during the recession. In his words “inflation not only plunged during the recession, but remained low after the recession.” The chart below shows core inflation (inflation for all goods excluding food and energy) since 2004. Clearly inflation fell once the recession took hold. Prior to 2008 annual inflation had been roughly 2 percent. Inflation fell during the recession  to roughly 1 percent.
To put this change in perspective, the next chart plots annual inflation for the entire post-war period. The blue line is the inflation rate for all goods in the CPI. The red line is core inflation.
There have been many large swings in inflation during U.S. history. Compared to historical variations in inflation through the post-war, the changes in price growth during the Great Recession were quite mild. Notice that because the large drop in the overall inflation rate is not in the core measure, this movement reflects changes in food and energy (primarily oil prices). If the 1 percent reduction in core inflation is sufficient for the Keynesian model to generate the huge recession we just went through then where was the huge recession in the late 1990s? Where was the enormous recession in 1986?
In his 2011 AEA presidential address Bob Hall proposed modifying the Keynesian model by treating inflation as “nearly exogenous.” One might interpret this modification as a “hyper-Keynesian” element – the exogeneity of inflation arises because the Phillips curve is essentially flat so even minor variations in inflation cause sharp changes in output. Alternatively, one could interpret the modification as a capitulation of sorts. The inflation block of the model is incorrect and so Hall removed it, letting inflation march to its own beat, unaffected by developments within the system.
Traditional Liquidity Trap models predict that inflation should not only be low but it should be falling. Instead, even though interest rates were pushed to zero and even though economic activity contracted dramatically, the inflation rate barely budged. In his paper, Hall writes [of the New Keynesian Phillips curve] “luckily the theory is wrong.” Were the Phillips curve true, inflation would have fallen making the real interest rate even more negative, further depressing output and employment.
While commentators like Paul Krugman are correct to point to a few success stories of some models (like some aspects of the Liquidity Trap), they should also own up to the mounting evidence that the older models (even the paleo-Keynesian models that some prefer) clearly failed on some important dimensions. They couldn’t tell us much of anything about what caused the financial crisis itself and couldn’t really tell us how to deal with it and they made clear predictions about inflation that were supposedly at the center of the New Keynesian mechanism – predictions that never materialized.
 I am plotting the percent change in the price indices from year t-1 to year t.