First, let me acknowledge my utmost respect for Greg Mankiw, not only professionally, but as an individual. I’ve been reading Professor Mankiw’s work as published and blog since its inception and have never observed him treat others with disrespect, including those with whom he disagrees. In the public forum of his blog, Mankiw comes across as humble and is not derisive to others simply because he disagrees with contrary ideas and opinions. As the old saying goes, he’s both a gentleman and a scholar.
Second, let me berate Bob Murphy for the snarky, condescending attitude toward Mankiw in his critique of Mankiw’s recent New York Times op-ed. Bob and I were colleagues a few years back and I came to know him as an intelligent and lucid debater. Never did I observe him treating others disrespectfully. I know Bob is above this and believe his arguments would have been better received had he not taken on the condescending tone in his critique.
That being said, Mankiw fails to address Murphy’s argument. The gist of what Murphy is arguing is not the classical paradigm purporting perfectly efficient markets and instantaneous market clearing. Instead, Murphy is arguing that 1) the FED policies of the past, which Mankiw professes will bring the U.S. economy out of the current recession, were at least partly responsible for getting us into this mess in the first place; 2) that markets need to recover from the sectoral imbalances caused (at least largely) by FED policies in addition to other poor investment decisions; 3) that this recovery is effectuated through changes in prices and interest rates; 4) that markets do this naturally and manipulation of either prices or interest rates by the FED or the government undermine this process; and 5) that the Keynesian AD theory fails to understand and/or appreciate the complex nature of markets. Consequently, Mankiw's prescription is not only bad policy, it is according to Murphy, bad economics.
The way I read Murphy is not that markets rapidly clear, but
that the sectoral imbalances take time to run their course. This will
result in prices and interest rates
declining adjusting over some unspecified time, enabling markets to subsequently recover. This recovery process will result in resources being
diverted away from sectors of the economy that are contracting and toward
sectors that are expanding. Which is which is not known to anybody, but changes in relative prices, including interest rates, signal to where these resources should be diverted. This change entails complex processes that take time to work through and attempts to
manipulate the process lead to unintended consequences, the most recent being the FED's response to the events of 2001, which resulted in a housing boom and bust, the cause of our current recession.
The Mankiw neo-Keynesian approach is to view all macro disequilibria as an aggregate demand issue that can be simply rectified by changes in nominal money. Prices and wages and interest rates do not fall rapidly enough to equilibrate markets, a process that can be jump started by increasing nominal balances. Any uncertainty or sectoral shifts are secondary to the problem of returning the macroeconomy to its full-employment equilibrium. Yes, market corrections take time, but during this time some people are unemployed, which creates great hardship, at least for those people, and probably many others. We can therefore circumvent this painful process by returning aggregate demand to its full-employment level through these changes in nominal money.
If this is the case, however, maybe we shouldn’t even be teaching economics at all. If the problem is only that unemployment causes hardship in the short run and that as a consequence we need to minimize this hardship, it’s a simple solution: put people to work digging holes or using scarce resources to build airports few people use. If, however, the problem is a misallocation of scarce resources, and, given the complex nature of markets, nobody has the necessary information (nor, necessarily, the proper incentives) to correct this misallocation, then maybe (likely) the neo-Keynesian (as well as Keynesian and monetarist) solution(s) are likely to exacerbate the problem, certainly in the long run.