From neoclassical economics to the masking of it with New-Keynesian economics

Tyrone Keynes

Economists often begin by making assumptions that bear little resemblance to reality. The foundations of modern macroeconomics were laid when Kenneth Arrow and Gerard Debreu proved that under perfect competition, markets would always clear and reach equilibrium. It was a triumph of pure mathematics (Arrow & Debreu 1954). But in the process, unemployment, money, power, and institutions vanished from the picture.

The education pipeline ensures these assumptions are learned early. Undergraduates are introduced to models in which supply always equals demand, markets are perfectly competitive, and any unemployment that appears is voluntary. Students are told these are “simplifying assumptions”, but they are also the backbone of the discipline. By the time those same students arrive in graduate school, they are already accustomed to thinking of the real world as a deviation from this imaginary ideal. What follows is less a questioning of the framework than a training in how to add “frictions” to it without disturbing its core logic.

Graduate students are then pushed deeper into the formalism. They work with models where unemployment doesn’t exist, where all firms are powerless clones, and where money plays no role beyond scaling the equations. Robert Lucas’s rational expectations revolution pushed this even further, treating money as neutral and unemployment as the product of misperceptions (Lucas 1972). Real Business Cycle theory then portrayed recessions as efficient reallocations of time between “work” and “leisure” (Kydland & Prescott 1982).

The result is a sterile, frictionless core. Mainstream economists rarely defend this baseline openly anymore, so instead it is wrapped in what is now called “New Keynesian economics.” Here, a veneer of realism is added, like sticky wages, monopolistic competition, maybe some credit frictions, but the skeleton remains Neoclassical. The models are still built on Arrow-Debreu general equilibrium, still dominated by representative agents, and still organized around the assumption that economies gravitate toward equilibrium. The “Keynesian” label is misleading; the substance is neoclassical theory with cosmetic patches.

Michael Woodford’s Interest and Prices (2003) captures this approach perfectly. Begin with the clean, frictionless economy, then introduce rigidities so that central banks have a role to play. The method is internally consistent and mathematically elegant, but completely disconnected from how real economies evolve. The label “Keynesian” functions as cover, creating the impression of continuity with Keynes’s concerns about instability and uncertainty, even though the substance is the opposite.

Critics have long pointed out the problems of mainstream economics. Alan Kirman asked the obvious question: who does the representative agent actually represent? (Kirman 1992). Colander, Holt, and Rosser (2004) showed how mainstream economics has narrowed itself by privileging what is mathematically tractable over what is empirically relevant. Robert Solow, hardly a radical, argued that the obsession with formalism had led macroeconomics away from realism (Solow 2008). Olivier Blanchard has admitted that the models have been “too tight,” serving their own internal logic rather than the economy they purport to explain (Blanchard 2018). And Steve Keen has forcefully argued that the equilibrium obsession is not just unrealistic but dangerously misleading, producing theories blind to crises, credit dynamics, and instability (Keen 2001).

The deeper problem is not just unrealistic assumptions. It is that these assumptions shape what economists see and also ignore. If unemployment is assumed away in the baseline, then it becomes an afterthought, a friction rather than a central reality. If money is neutral, then financial crises appear as external shocks, not outcomes of the system itself. By calling this package “New Keynesian economics,” the profession convinces itself it has absorbed Keynes, when in reality it has domesticated him inside the very neoclassical system he rebelled against.

The economy we inhabit is unstable, institutionally complex, and riddled with power asymmetries. No amount of cosmetic patching will make the neoclassical core fit that reality. A more honest economics would start from the world as it is, not from a fable dressed up in equations.

Source: Relearning Economics 27 Sep 25 https://www.patreon.com/posts/from-economics-139428680

Tyrone Keynes is Chief Research Officer at Modern Macro Technologies.

Reproduced with the author’s permission

References

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Keen, S. (2001). Debunking Economics: The Naked Emperor of the Social Sciences. Zed
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