Krugman comes directly to the core of the matter: “So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium.” (See intro)
And that is exactly why neo-classics is a failed approach: because it is based on two nonentities. For good methodological reasons, economics cannot take a behavioral assumption (constrained optimization or otherwise) and equilibrium into the premises. Economics is, to begin with, not a science of the behavior of humans but of the behavior of the economics system.#1 As a matter of principle, no way leads from the understanding of human behavior to the understanding of how the economic system works. Neoclassical economics is a casualty of the Science-of-Man Fallacy.#2
So, the whole of economics has to be based on an entirely new set of foundational propositions. This operation is commonly known as a paradigm shift. Keynes understood this very well: “The classical theorists resemble Euclidean geometers in a non-Euclidean world ... Yet, in truth, there is no remedy except ... to work out a non-Euclidean geometry. Something similar is required to-day in economics.” (1973, p. 16)
Non-Euclidean means in this context: Krugman’s two nonentities have to be left out of the formal foundations. This, by the way, makes all of Lars Syll’s microfoundations critique of DSGE redundant.
When we start from purely objective structural premises, then the most elementary version of the correct Employment Law reads as follows (Wikimedia AXEC62)
(i) An increase in the expenditure ratio ρE leads to higher employment. An expenditure ratio ρE>1 indicates credit expansion, a ratio ρE<1 indicates credit contraction/debt repayment of private households.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase of the factor cost ratio ρF≡W/PR leads to higher employment. This implies that a higher average wage rate W leads to higher employment. This is, of course, contrary to conventional economic wisdom. It is, though, easy to prove that conventional wisdom is a mere Fallacy of Composition (2015).
(iv) The complete Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and the trade balance with the rest of the world.
Point (i) and (ii) constitute a Keynesian multiplier. Let us focus here alone on the factor cost ratio ρF as defined in (iii). This variable embodies the price mechanism which, however, does not work as the representative economist hallucinates. As a matter of fact, overall employment increases if the average wage rate W increases relative to average price P and productivity R. The factor cost ratio is what is missing in Keynes’s original employment function (2012).
The correct employment theory states that the average wage rate must rise in order to prevent unemployment and deflation. To this day, the representative economist has not realized that the overall systemic interdependencies establish a positive feedback loop between ‘the’ product and ‘the’ labor market, that is, wage rate down - employment down - wage rate down - and so on. Vice versa with an increasing average wage rate. This is exactly what Keynes said in ‘The Great Slump of 1930.’
The market system is no equilibrium system (2015). And because of this, all equilibrium models are a priori false. This includes all variants of DSGE. Employment is determined according to the extended Employment Law in the most elementary case by the expenditure ratio, investment, and the factor cost ratio which in turn depends on the (average) wage rate, price, and productivity. Interest is brought into the picture as soon as the relationships between investment and the lending rate and the expenditure ratio and the deposit rate (if ρE<1) is formally established.
The extended Employment Law sorta-kinda fully replaces the New Keynesian sorta-kinda maximization-with-equilibrium garbage.
Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
#1 From PsySoc to SysHum
#2 The Science-of-Man Fallacy
Related 'The key relationship between employment and wage rate' and 'The key relationship between employment and growing/shrinking debt'. For details of the big picture see the cross-references Employment
All heterodox economists agree 'New Keynesian economics needs to be replaced'. Therefore, the one and only interesting question is wherewith?
Take the formula Wikimedia AXEC06:
Again: replacement is the issue and not one more superfluous discussion about New Keynesian moronomics.