Posts Tagged Keynes
I have previously referenced my support for the idea, advocated by Keynes and Adam Smith, that low long term interest rates are a desirable stance for monetary policy. The claim about the effect of low rates is two fold:
(1) Low rates reduce the cost of investment and so encourage it.
(2) Low rates reduce the yields required to pay back debt incurred, and hence encourage more sustainable, less speculative investments. To phrase it conversely: high rates push people into speculation as they attempt to recoup the money they owe.
Commenter Roman P. is not convinced by this argument. I am willing to admit I have, thus far, provided insufficient evidence for this, mostly due to lack of data. However, I have assembled what data I can below, and believe it offers broad – though not definitive – support for this hypothesis.
A few caveats. First, let me establish clear criteria for what I consider to be ‘low rates.’ John Maynard Keynes wanted the long term interest rate to be as low as 2.5%; he even remarked that 3.5% would be too high for full employment:
There is, surely, overwhelming evidence that even the present reduced rate of 3½ per cent on long-term gilt-edged stocks is far above the equilibrium level – meaning by ‘equilibrium’ the rate which is compatible with the full employment of our resources of men and equipment.
For most of the data, the rate is above even the 5% that Adam Smith thought should be the cap, lest the capital of a country be “wasted.” Obviously we shouldn’t believe something simply because Keynes and Smith did, but hopefully the evidence I present below will lend some credibility to their arguments.
Second, what matters will not be just the interest rate; expectations – and the realised trajectory – of the interest rate will also be important. If the rate is rising then it will have a similar impact on investment decisions as an already high rate. If the Central Bank (CB) is committed to a policy of low rates, then it will be far more stabilizing than if rates happen to hit a low point and subsequently bounce back. We do have a test for an explicit low rate policy: the post-WW2 arrangements. It is common knowledge that the stability in that period was unprecedented.*
Third, let me make obligatory correlation =/= causation remarks. Nevertheless, correlation at least gives us a clue about causation. A further clue is if what we think is the causal variable (interest rate) moves first, and the dependent variable (growth) moves second. It is also true that we have a valid theoretical link for our causation. Lastly, it is empirically verified that businesses consider long term rates the most important interest rate in their borrowing decisions.
So what does the evidence look like? Let’s start by taking a look at the ‘Prime Loan Rate’ in the US for the second half of the 20th century. This is the interest rate banks offer to their most stable customers, mostly big businesses:
Every single recession is preceded by an increase in rates. Not every rise in interest rates create a recession – there is one peak without a recession from around 1983-4. However, this may well be explained by movements in the base rate; it dropped from 11% to 8% in that period. By the next recession it had settled at about 6%; that recession seems to have ended when it was reduced down to 3%.
The data for the prime rate only go as far back as 1955, so I’ll use two of Moody’s corporate bond measures for the first half of the 20th century:
Again we observe a similar pattern with rate increases and recessions. Furthermore, the high rate, high volatility period between WW1 and WW2 sits in stark contrast with the low rate, low volatility period post-WW2. It’s interesting to note that rates – though high, relative to our benchmark of 2.5% – were not that high during the stock market boom of the 1920s. Certainly the spike in rates after the first crash is what seemed to bury the economy.
Update: commenter Magpie helpfully pointed out that the Moody’s data could be lagged, which is why it falls inside recessions instead of before them. Indeed, this is what we see when we compare it to the prime rate post-WW2: the spikes are late.
Overall, it seems high or rising rates accompany periods of substantial periods of economic turmoil, else periods where speculation is rampant and bubbles are building up. It is possible the speculation fuels further rises in the interest rate as the perpetrators become overconfident about their potential gains – a positive feedback loop.
Clearly the central bank does not control corporate borrowing rates directly. However, it does control government bond rates, and I would argue that this rate, as a benchmark, has a significant impact on other interest rates in the economy. Indeed this is borne out by the data:
(For a more comprehensive, but uglier, graph of the correlation between government and corporate bond yields, see here).
A central bank committed to low rates could help quell this, as we observe in the data post-WW2. Naturally, such a policy requires a degree of monetary autonomy that central banks have not had since the Bretton Woods system was in place, else rates be disrupted by international flows.
I think the evidence presented here is a blow to the ‘too low for too long‘ meme that pervades discussion of the crisis. There seems to be a belief that low rates are somehow ‘artificial’ (relative to what, exactly?) and we need to ‘get back to reality.’ In fact, it seems that ‘checking’ a bubble may both fuel speculation and needlessly invalidate potential investments, hence creating the situation that the central bank purportedly wanted to prevent.
It is my opinion that major areas of neoclassical economics rest on misinterpretations of original texts. Though new ideas are regularly recognised as important and incorporated into the mainstream framework, this framework is fairly rigid: models must be micro founded, agents must be optimising, and – particularly in the case of undergraduate economics – the model can be represented as two intersecting curves. The result is that the concepts that certain thinkers were trying to elucidate get taken out of context, contorted, and misunderstood. There are many instances of this, but I will illustrate the problem with three major examples: John Maynard Keynes, John Von Neumann and William Phillips.
Keynes, in two lines
It is common trope to suggest that John Hicks‘ IS/LM interpretation of Keynes’ General Theory was wrong. It is also true, and this was acknowledged by Hicks himself over 40 years after his original article.
IS/LM, or something like it, was being developed apart from Keynes by Dennis Robertson, Hicks and others during the 1920s/30s, who sought to understand interest rates and investment in terms of neoclassical equilibrium. Hence, Hicks tried to annex Keynes into this framework (they both, confusingly, called neoclassicals ‘classicals’). Keynes’ theory was reduced to two intersecting lines that looked a lot like demand-supply. The two schedules were derived from the equilibrium points of the demand and supply for money (LM), and the equilibrium points of the demand and supply for goods and services (IS). In order to reach ‘full employment’ equilibrium, the central bank could increase the money supply, or the government could expand fiscal policy. Unfortunately, such a glib interpretation of Keynes is flawed for a number of reasons:
First, Keynes did not believe that the central bank had control over the money supply:
…an investment decision (Prof. Ohlin’s investment ex-ante) may sometimes involve a temporary demand for money before it is carried out, quite distinct from the demand for active balances which will arise as a result of the investment activity whilst it is going on. This demand may arise in the following way.
Planned investment—i.e. investment ex-ante—may have to secure its ” financial provision ” before the investment takes place…There has, therefore, to be a technique to bridge this gap between the time when the decision to invest is taken and the time when the correlative investment and saving actually occur. This service may be provided either by the new issue market or by the banks;—which it is, makes no difference.
Since Hick’s model relies on a ‘loanable funds’ theory of money, where the interest rate equates savings with investment and the central bank controls the money supply, it clearly doesn’t apply in Keynes’ world. An attempt to apply endogenous money top IS/LM will result in absurdities: an increase in loan-financed investment, part of the IS curve, will create expansion in M, part of the LM curve. Likewise, M will adjust downwards as economic activity winds down. So the two curves cannot move independently, which violates a key assumption of this type of analysis.
Second, Keynes did not believe the interest rate had simple, linear effects on investment:
I see no reason to be in the slightest degree doubtful about the initiating causes of the slump….The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest.
But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing…
…A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.
So, again, the simple, mechanistic adjustments in IS/LM are inaccurate. The magnitude of the interest rate will not change just the level, but also the type of investment taking place. Higher rates increases speculation and destabilise the economy, whereas low rates encourage real capital formation. This key link between bubbles, the financial sector and the real economy was lost in IS/LM, and also in neoclassical economics as a whole.
Third – and this is something I have spoken about before - Hicks glossed over Keynes’ use of the concept of irreducible uncertainty, which was key to his theory. The result was a contradiction, something Hicks noted in the aforementioned ‘explanation’ for IS/LM. The demand for money was, for Keynes, a direct result of uncertainty, and in a time period sufficient to produce uncertainty (such as Keynes’ suggested 1 year), expectations would be constantly shifting. Since both the demand for money, savings and investment depended on expectations, the curves would be moving interdependently, undermining the analysis. On the other hand, in a time period short enough to hold expectations ‘constant’ and hence avoid this (Hicks suggested a week), there would be no uncertainty, no liquidity preference and therefore no LM curve.
Hicks’ attempt to shoehorn Keynes’ book into his pre-constructed framework led to oversimplifications and a contradiction, and obscured one of Keynes’ key insights: that permanently low long term interest rates are required to achieve full employment. The result is that Keynes has been reduced to ‘stimulus,’ whether fiscal or monetary, in downturns, and the reasons for the success of his policies post-WW2 are forgotten.
Phillips and his curve
Another key aspect-along with IS/LM-of the post-WW2 ‘Keynesian’ synthesis was the ‘Phillips Curve,’ an inverse relationship between inflation and unemployment observed by Phillips in 1958. Neoclassical economists reduced this to the suggestion that there was a simple trade-off between inflation and unemployment, and policymakers could choose where to select on the Phillips Curve, depending on circumstances.
Predictably, this is not really what Phillips had in mind. What he observed was not ‘inflation and unemployment,’ but inflation and money wages. Furthermore, it was not a static trade off, but a dynamic process that occurred over the course of the business cycle. During the slump, society would observe high unemployment and low inflation; in the boom, low unemployment would accompany high inflation. This is why, if you look at the diagrams in his original paper, Phillips has numbered his points and joined them all together – he is interested in the time path of the economy, not just a simple mechanistic relationship. The basic correlation between wages and unemployment was just a starting point.
Contrary to what those who misinterpreted him believed, Phillips was not unaware of the influence of expectations and the trajectory of the economy on the variables he was discussing; in fact, it was an important pillar of his analysis:
There is also a clear tendency for the rate of change of money wage rates at any given level of unemployment to be above the average for that level of unemployment when unemployment is decreasing during the upswing of a trade cycle and to be below the average for that level of unemployment when unemployment is increasing during the downswing of a trade cycle…
…the rate of change of money wage rates can be explained by the level of unemployment and the rate of change of unemployment.
Finally, whatever Phillips’ theoretical conclusions, it is clear he did not intend even a correctly interpreted version of his work to be the foundation of macroeconomics:
These conclusions are of course tentative. There is need for much more detailed research into the relations between unemployment, wage rates, prices and productivity.
Had neoclassical economists interpreted Phillips correctly, they would have seen that he thought dynamics and expectations were important (he was, after all, an engineer), and we wouldn’t have been driven back to the stone age with the supposed ‘revolution‘ of the 1970s.
An irrational approach to Von Neumann
In microeconomics, the approach to ‘uncertainty’ (a misnomer) emphasise the trade-off between potential risks and their respective payoffs. Typically, you will see a graph that looks something like the following (if you aren’t a mathematician, don’t be put off – it’s just arithmetic):
The question is whether a company will invest at home or abroad. There is an election coming up, and one candidate (B) is an evil socialist who will raise taxes, while the other one (A) is a capitalist hero who will lower them. Hence, the payoffs for the investment will differ drastically based on which candidate wins. Abroad, however, there is no election, and the payoff is certain in either case; the outcome of the domestic election is irrelevant.
The neoclassical ‘expected utility’ approach is to multiply the relative payoffs by the respective probability of them happening, to get the ‘expected’ or ‘average’ payoff of each action. So you get:
For investing abroad: £200k, regardless
For investing at home: (0.6 x £300k) + (0.4 x £100k) = £220k
Note: I am assuming the utility is simply equal to the payoff for simplicity. Changing the function can change the decision rule but the same problem – that what is rational for repeated decisions can seem irrational for one – will still apply.
So investing at home is preferred. Supposedly, this is the ‘rational’ way of calculating such payoffs. But a quick glance will reveal this approach to be questionable at best. Would a company make a one off investment with such uncertain returns? How would they secure funding? Surely they’d put off the investment until the election, or go with the abroad option, which is far more reliable?
So what caused neoclassical economists to rely on this incorrect definition of ‘rationality’? A misinterpretation, of course! One need look no further than Von Neumann’s original writings to see that he only thought his analysis would apply to repeated experiments:
Probability has often been visualized as a subjective concept more or less in the nature of estimation. Since we propose to use it in constructing an individual, numerical estimation of utility, the above view of probability would not serve our purpose. The simplest procedure is, therefore, to insist upon the alternative, perfectly well founded interpretation of probability as frequency in long runs.
Such an approach makes sense – if the payoffs have time to average out, then an agent will choose one which is, on average, the best. But in the short term it is not a rational strategy: agents will look for certainty; minimise losses; discount probabilities that are too low, no matter how high the potential payoff. This is indeed the behaviour people demonstrate in experiments, the results of which neoclassical economists regard as ‘paradoxes.’ A correct understanding of probability reveals that they are anything but.
Getting it right
There are surely many more examples of misinterpretations leading to problems: Paul Krugman’s hatchet job on Hyman Minsky, which completely missed out endogenous money and hence the point, was a great example. The development economist Evsey Domar reportedly regretted creating his model, which was not supposed to be an explanation for long run growth but was used for it nonetheless. Similarly, Arthur Lewis lamented the misguided criticisms thrown at his model based on misreadings of misreadings, and naive attempts to emphasise the neoclassical section of his paper, which he deemed unimportant.
This is not to say we should blindly follow whatever a particularly great thinker had to say. However, indifference toward the ‘true message’ of someone’s work is bound to cause problems. By plucking various thinker’s concepts out of the air and fitting them together inside your own framework, you are bound to miss the point, or worse, contradict yourself. Often a particular thinker’s framework must be seen as a whole if one is truly to understand their perspective and its implications. Perhaps, had neoclassical economists been more careful about this, they wouldn’t have dropped key insights from the past.
I have a couple of thoughts on libertarianism that I can’t manage to squeeze a whole post out of. So, well, here they are.
Institutionalised law breaking
A major problem I have with the (minarchist) libertarian approach to law enforcement is that it fails to take repeated and systemic violation of laws into account. Libertarians, generally speaking, think that the state should prevent ‘force, theft and fraud‘, but they don’t seem to think this through: these three things are incredibly pervasive and do not only occur as isolated incidents that can be prosecuted on a case-by-case basis. When discussing problems with capitalism, libertarians seem to presuppose a virtually infallible police state where all the problems with regulatory capture melt away and any violations of these three are ‘outside’ the libertarian ideal.
The libertarian blind spot on this point can be seen in Milton Friedman’s view on corporations. Corporations have no social responsibility, except to maximise profit whilst ‘playing by the rules.’ But Friedman failed to realise that, like the regulations he disapproved of, corporations are happy to work around whichever ‘rules of the game’ happen to be in place. Moral considerations tend to melt away under competitive conditions, when things become ‘just business.’ Corporations have long history of force, fraud and theft, and as abstract entities these things simply don’t factor into their considerations. In a system based on private accumulation, they will use their profits to corrupt the legal system, hijack public funds, get the best lawyers, and make their operations as opaque as possible to avoid prosecution, no matter the charge. None of this is a bug of capitalism; it is a feature.
Fraud in particular is an incredibly common phenomenon, and characteristic of any market system – even grocery stores regularly mislabel products to trick consumers into buying more than they otherwise would. At a higher level, there are occurrences like the LIBOR scandal and general fraud surrounding the crisis. Furthermore, the Leveson Inquiry has revealed quite how many resources society has to pour into uncovering past wrongdoing by corporations. It is far more sensible to advocate various transparency standards and requirements that prevent these things from happening in the first place.
The consequence of this is that many regulatory agencies are actually compatible with libertarian aims for what is needed for a functioning market economy. Libertarian counters about regulatory capture simply beg questions about capitalism itself, questions which they surely don’t want to get into.
Governments versus markets, yet again
All too often, I see libertarians respond to a purported problem with markets by saying ‘well government has that problem, too.’ But this is a superficial treatment that can be used as a cookie cutter for any issue, without actually exploring it.
Sometimes we might identify a problem and ask how the government can alleviate it – e.g. information asymmetry can be partially dealt with by various transparency standards. However, more often the correct debate is not ‘x is a problem, what can government do about x’, but ‘x is a problem that causes y - what can government do about y?’
For example, The Radical Subjectivist asks what governments can do to eliminate uncertainty. The answer is: not a lot! Of course they can’t alter the fundamental fact that the future is unknowable. But this doesn’t really get us anywhere; what we really need to ask is what uncertainty leads to. And according to Keynes’ theories, it leads to a rate of interest that is too high to precipitate full employment; it also leads to the use of rules of thumb and waves of optimism and pessimism in financial markets. So policymakers should act to lower the rate of interest, and also stop trade when financial markets become too heated. Notice that at this point the issue we were originally discussing - uncertainty – has become largely irrelevant.
This can be seen particularly with libertarian economist’s reaction to behavioural economics. They respond by saying policymakers have the biases too (and the even more pathetic response that the people who study the biases also have them). But any real treatment of a particular bias will reveal that they create systemic problems that can be identified and remedied through alternative means – for example, Type 1 and Type 2 thinking apply to all people, but somebody who is using Type 1 thinking can easily be exploited by somebody using Type 2 thinking. This is a big problem when signing contracts and requires that people are protected when doing so. The same person who writes the law (and writes the book about the bias) will have the bias. But this doesn’t impede their ability to deal with it on a systemic level.
Of course, it is entirely possible that government cannot do anything about problem ‘y’, or that it would be too expensive, intrusive or what have you. It’s also true that policymakers themselves will suffer from certain biases that will affect their decisions making. But libertarians cannot dismiss every purported problem with markets by suggesting that it also applies to government – this does not engage the specific issue at all, but is a superficial attempt to escape important challenges to their reasoning.
I’ve previously spoken about how many great insights supposedly ‘discovered’ by economists – classical and modern – had really been known for a long time, but had been ignored or perverted before they were put in terms neoclassical economists approved of. The more I learn, the more it seems that this is the case with a vast amount of critical ‘insights’ on which macroeconomists pride themselves.
The fact is that 1970s ‘anti-Keynesian revolution’ was really just a restatement of things already stated by Keynes and Phillips – who were incidentally two of the main targets of the revolution, but both completely misinterpreted.
The psychological time-preferences of an individual require two distinct sets of decisions to carry them out completely. The first is concerned with that aspect of time-preference which I have called the propensity to consume, which, operating under the influence of the various motives set forth in Book III, determines for each individual how much he will reserve in some form of command over future consumption.
But this decision having been made, there is a further decision which awaits him, namely, in what form he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings.
Furthermore, the Lucas Critique itself – the idea that macroeconomic aggregates cannot be used as a guide to future policy because a change in policy will change behaviour and therefore relationships between variables – was also stated by Keynes:
There is first of all the central question of methodology—the logic of applying the method of multiple correlation to unanalysed economic material, which we know to be non-homogeneous through time. If we are dealing with the action of numerically measurable, independent forces, adequately analyzed so that we were dealing with independent atomic factors and between them completely comprehensive, acting with fluctuating relative strength on material constant and homogeneous through time, we might be able to use the method of multiple correlation with some confidence for disentangling the laws of their action…in fact we know that every one of these conditions is far from being satisfied by the economic material under investigation.
Even more ironically, it was stated by the primary target of Lucas’ criticisms, the much misunderstood Edmund Phillips:
In my view it cannot be too strongly stated that in attempting to control economic fluctuations we do not have two separate problems of estimating the system and controlling it, we have a single problem of jointly controlling and learning about the system, that is, a problem of learning control or adaptive control.
One might argue that Lucas deserves credit for formalising this point, but in reality I think Phillip’s one sentence formulation is better – it emphasises continual change and vigilance in recognising the feedback loop between policy and the real world. In contrast, it seems the Lucas Critique has become little more than a tool with which to cling to outdated methodology despite empirical falsification.
This is why I am frustrated when people like Krugman say that they “don’t care” what Keynes or others “really meant,” and people like Scott Sumner and Robert Lucas pay barely any attention at all to the history of thought. Ignoring the history of thought just means you are condemned to rediscover the same insights over and over – often, it seems, in a far less enlightened way than they were originally stated.
As we expand debt in the process of want creation, we come necessarily to depend on this expansion. An interruption in the increase in debt means an actual reduction in demand for goods.
In fairness to Keen, I wouldn’t paint him with the same brush as the above – he readily acknowledges that this insight was noted by Schumpeter and Minsky before him.
Recently, a debate erupted between Austrians and Keynesians on Daniel Kuehn’s blog, and then later elsewhere, concerning matters that I, in my naivete, had long thought were settled. Sadly, it appears that once again, Henry Hazlitt’s supposed chapter by chapter ‘refutation‘ of TGT has been dredged up from the gutters of history, along with assertions about Keynes’ alleged totalitarianism.
I will start by briefly addressing some comments on Robert Vienneau’s previous exposition of Hazlitt’s book. There seems to be some confusion among the commenters who criticise Vienneau. It is quite clear that Hazlitt does not understand the concept of the marginalist supply curve, which posits that workers trade off leisure for work. Here he mistakenly asserts:
The ‘supply schedule’ of workers is fixed by the wage-rate that workers are willing to take. This is not determined, for the individual worker, by the ‘disutility’ of the employment – at least not if ‘disutility’ is used in its common-sense meaning.
He blatantly confuses the equilibrium between demand and supply with the curves themselves, an incredibly elementary mistake. Vienneau is correct to say that:
Obviously, then, the equality of the wage and the marginal productivity of labor is not enough to determine either wages or employment.
The marginalist theory require us to know both the wage rate and the hours worked to determine employment. Do these people really expect us to take Hazlitt seriously when he can’t even describe the marginalist theory of employment?
Anyway, let’s move on to another section – hopefully everyone can agree that Liquidity Preference is central to Keynes’ theory, so I will focus on Hazlitt’s criticisms of this. Here is Keynes:
Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it.
Hazlitt begins with a typically snarky comment:
The economic system is not a Sunday school; its primary function is not to hand out rewards and punishments.
How petty. Keynes’ use of the word ‘reward’ is irrelevant in this case; he’s merely saying that interest is an incentive to get people to part with liquidity. Hazlitt is latching onto something quite meaningless here. Let’s continue:
If you wish to sell me tomatoes, for example, you will have to offer them at a sufficiently low price to “reward” me for “parting with liquidity”—that is, parting with cash. Thus the price of tomatoes would have to be explained as the amount necessary to overcome the buyer’s “liquidity-preference” or “cash preference.”
Keynes is obviously saying that cash has a role as a store of value as well as a medium of exchange. If it is not currently being used for the latter then it will be stored; should it be stored, a certain rate of interest will be necessary to make the buyer part with their liquidity and buy a bond or deposit it in a bank. Hazlitt completely fails to distinguish between the two uses and offers up a false equivalence based on this misunderstanding.
Hazlitt then appears to agree with Keynes for a while:
[People] hold cash (beyond the needs of the transactions-motive) because they distrust the prices of investments or of durable consumption goods; they believe that the prices of investments and/or of durable consumption goods are going to fall, and they do not wish to be caught with these investments or durable goods on their hands.
Here Hazlitt isn’t actually criticising Keynes at all, but simply restating his theory of the speculative motive. He tries to paint this as a disagreement by splitting hairs over the word ‘speculative’ – which is fairly typical of the blunderbuss contrarianism you will find throughout his book – but it’s quite clear that this is simply a restatement of Keynes.
Hazlitt goes on:
If Keynes’s theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash—to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest.
That interest rates move pro-cyclically is no sufficient to disprove the LP theory of interest, as it is not the only factor determining the interest rate – in a boom demand rises and this pushes up interest rates; the latter happens in a depression. This is entirely compatible with Keynes’ economics and does not mean LP effects are absent or unimportant.
It is worth noting at this point that Keynes was mostly concerned with long term rates, which are what businesses actually use when making investment decisions. To this end, Hazlitt resumes agreeing with Keynes:
It is true that in a depression many long-term bonds tend to sell at low capital figures (and therefore bear a high nominal interest yield), but this is entirely due, not to cash preference as such, but to diminished confidence in the continuation of the interest on these bonds and the safety of the principal.
Right, in other words: their preference for cash or liquidity over more uncertain bonds. Which is what Keynes said.
As a brief note on Keynes totalitarianism: this seems to be based on Keynes mentioning several times that certain policies – both flexible wages (of which he disapproved) and various exchange rate mechanisms & capital controls, as well as active fiscal & monetary policy (of which he approved) – are more easily applied under totalitarian conditions. These observations are quite clearly true - any economic policy, implemented word for word, is easier to apply under totalitarian conditions. This does not mean that totalitarianism is desirable, and you will not find Keynes saying anything of the sort. Furthermore, even if he did say such things, this is irrelevant to his economics.
There are good criticisms of Keynes to be made, but you will not find them with the likes of Hazlitt and Rothbard, who were quite clearly motivated by an overarching desire to ‘own’ Keynes, rather than debate. Rothbard actually wrote an entire book attacking Keynes as a person, which really is all you need to know about what he had to say. These people were not scholars, and their work is best consigned to the dustbin of history.
Addendum: Daniel Kuehn strengthens the argument about Keynes’ preface to the German edition of TGT.
I thought I’d offer a brief note on Scott Sumner’s latest offering to the field of economics – the ‘Sumner Critique.’ Sumner offers an apt example of why macroeconomists who ignore TGT are basically wasting their time – virtually every macroeconomic insight is already in The General Theory. Sumner says he has ‘never been able to take the book seriously.’ Maybe he just needs to read it properly.
The ‘Sumner Critique’ states that if the path of NGDP is stable, all macroeconomic effects become classical in nature. Sumner and others appear to think this is new and original, but, unfortunately for them, it was stated 76 years ago by Keynes:
Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. If we suppose the volume of output to be given, i.e. to be determined by forces outside the classical scheme of thought, then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them. Again, if we have dealt otherwise with the problem of thrift, there is no objection to be raised against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively. Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before.
There you go. Replace ‘NGDP’ with full employment, and Keynes said it a long time ago. Keynes’ primary policy prescription of long term interest rates also has the benefit of being tried, and of working, after WW2. Conversely, NGDP targeting relies on expectations fairies and continually pumping up the value of asset prices. In other words: Keynes said it, but better.
Addendum: The riposte the NGDP and full employment are sufficiently different to make my criticism void does not hold. As Jonathan Catalan points out, for Keynes, ‘full employment’ was synonymous with ‘maximum effective demand, given potential output constraints.’ It’s hard to deny that Sumner uses something very similar.
Steve Randy Waldman has a good post on Interfluidity in which he attempts to form a synthesis between New Keynesians (NKs), post-Keynesians (PKs) and Market Monetarists (MMs).
Waldman actually exposes a bit of a fault with post-Keynesianism: what exactly are the policy prescriptions? Or, more specifically: how should monetary policy be conducted? PKs generally want to channel bank’s lending to the right people; we’re generally in favour of fiscal stimulus during downturns; Steve Keen has a policy prescription for redefining shares that I’m not entirely sure I understand the implications of, but it would be hard to say anything about a shared stance on monetary policy.
Waldman fills this gap by assuming that PKs don’t have a problem with NGDP targeting in principle, though they may doubt its practicality at the zero bound. However, I have spoken before about how NGDP targeting ignores the role of interest rates in determining not only the rate but the type of investment that takes place – instead assuming that macroeconomic policy can only reliably influence nominal variables. Scott Sumner, in fact, appears to believe that under NGDP targeting, the interest rate would be irrelevant.
Sumner is actually incredibly vague about why NGDP is the correct indicator for monetary policy: he has previously refused to discuss transmission mechanisms, and appears to think the the general public understand what the monetary base is, a position that goes hand in hand with his emphasis on expectations. In fact, I’d go so far as to say the entire thing is becoming circular: the CB controls NGDP so it should target NGDP – we will judge this by the level of NGDP.
PKs & MMTers, contrary to MMs & NKs, view interest rate policy as exogenous, and the only monetary variable that the CB can reliably control. In fact, as Edward Harrison notes, this is probably the major difference between exogenous versus endogenous money.
The endogenous view lends itself to the views of Keynes himself, who saw low rates as the appropriate monetary stance. In this view, interest rates are a cost of investment and so if they increase it will have two effects:
(1) Net investment will decrease;
(2) Businesses that do invest will be forced to seek higher returns and therefore take more risk. This can lead to speculative bubbles.
However, evidence suggests that businesses making investment decisions do not look at short term interest rates – both because they are prone to changes, and because they are too, well, short term. The Radcliffe Report, for example, emphasises that business decisions are far more heavily influenced by long term rates of interest, and also by expectations over the future path of the long term rate of interest. Thus, successful monetary policy lies in a credible commitment to, and execution of, permanently low long term rates. This also entails that monetary authorities have discretion over their jurisdiction, so capital controls would be a requirement.
As PKs & MMTers generally reject the IS/LM approach to the interest rate, generally sympathise with the views of Keynes himself and generally disregard ‘libertarian’ considerations when discussing international stabilisation, I do not see much of a reason that they should object to such a policy prescription.
Update: When I am talking about nominal and real effects, insert the word ‘reliable’ as appropriate. My point was that MMs hold the distribution between RGDP/inflation to be impossible to determine, rather than that there can be no real effects.
At the centre of arguments for NGDP targeting is the implicit assumption that macroeconomic policy can only have nominal impacts. I believe this to be false.
‘Market Monetarists’ (MMs) hold that macroeconomic policy can only have nominal or ‘cash’ effects, and the effect on the actual production of goods and services is uncertain. To put it intuitively, they are saying (or believe they are saying) that the amount of cash we inject into the economy can only affect the amount of cash flowing around the economy. There are two reasons this is flawed.
Firstly, MMs use a standard AD/AS framework for their analysis. When you respond that fiscal stimulus can be spent on roads and the like, which benefits the economy in more ways than one, they suggest that you are confusing the AD side of the equation with the AS one. However, this is a problem for MMs: fiscal stimulus can simultaneously boost AD and AS (not to mention LRAS), which means that even if the CB offsets the increase in spending, fiscal policy can ensure that a higher percentage of the spending is a real increase in production. In other words, fiscal policy can impact RGDP better than monetary stimulus, at least in certain circumstances.
My second point, however, is more important and applies universally. MMs neglect of the role of the RoI in determining not only the rate but the type of macroeconomic activity that takes place (New Keynesians are also guilty of this; at least, I’ve never seen them mention it).
In a capitalist economy, the rate of interest not only determines the amount of investment, but also the nature of that investment. Here’s Adam Smith, whom I can never resist quoting on the subject:
If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into the those which were most likely to waste and destroy it.
High interest rates mean that there is less investment and also that the investment that does take place is less sustainable. Speculative investment causes bubbles and price inflation, reducing the CB’s control over both the nominal and real economy. By keeping long term rates low, the CB is hence able to impact the real activity in the economy.
For an example, see this poorly taken photograph of long-term corporate bond yields from Geoff Tily’s excellent book Keynes Betrayed:
High interest rates are correlated with downturns, whilst steady low interest rates are correlated with the ‘Golden Age’. Rates weren’t massive in the recent crisis, though there were plenty of ‘hidden’ sources of funding such as the repo and Eurodollar markets, and expectations were not anchored downwards.
Of course this evidence is far from exhaustive but Tily’s book has much more, and I don’t want to flood this post with too many poorly taken photographs.
If macroeconomic policy can have real effects, that blows a significant hole in the arsenal of NGDP target advocates. For whilst most critiques of NGDP targeting focus on how it isn’t feasible, particularly at the ZLB, this one is compatible with its feasibility, but questions its efficacy.
Sticky wages are the reason for unemployment. The standard academic explanation of this can be found here:
Unemployment is just a labor surplus; since wages are the price of labor, the fundamental cause of unemployment has to be excessive wages.
The fact that wages are an essential component of AD is completely ignored here. Suppose we cut wages across the economy. Following this, there are two possibilities:
(1) Prices fall. Real wages remain unchanged and all that happens is that real private debt increases and the money stock increases, the former being negative and the latter achievable with expansionary monetary policy.
(2) Prices do not fall. Profits and rents are increased by reducing wages, but that effectively means redistributing to the rich, who have a lower MPC. It would not be right to assert that consumption will always fall by reducing nominal wages, but it is fair to expect a drop. And in the face of this falling consumption, are businesses really going to invest their profits?
Number (2) rests on a lot of introspection and supposition. But the fact is that there are no examples in the real world of wage cuts leading to falling employment, quite simply because wages drive demand, which is what drives employment. Nominal cuts didn’t work in the Great Depression, and the period with sustained real wage increases (1945-1973) coincided with very low unemployment, whilst the period of stagnant median wages (1980-present) has generally coincided with higher unemployment.
And, of course, no, Keynes did not argue that sticky wages explained demand side recessions. He argued the exact opposite - that they actually help to nullify them. Sometimes I wonder if anybody has even read TGT.
It is well known that fiscal expansion was used long before Keynes, and I have noted that it wasn’t his main policy conclusion. But what did he actually think of it? Always ambiguous, it is difficult to decipher ‘what he really meant’. But he certainly supported it to some extent, particularly in depressions. Here he is in his letter to FDR:
In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months.
Interestingly, in this letter he places fiscal stimulus at the forefront of his analysis, before he goes on to talk about reducing the long-term rate of interest. However, he had been less enthusiastic just two years earlier, saying that he was:
In favour of an admixture of public works, but my feeling is that unless you socialise the country to a degree that is unlikely, you will get to the end of the public works program, if not in one year, in two years, and therefore if you are not prepared to reduce the rate of interest and bring back private enterprise, when you get to the end of the public works program you have shot your bolt, and you are no better off.
This could be interpreted as a fairly harsh evaluation of fiscal stimulus – Keynes did not believe that it alone could ‘kick’ the economy into full employment equilibrium as many of his modern day proponents claim. But why the disparity between the letter and the speech? One reason could be that he changed his views, as he was known to do. However, here is another instance of him being skeptical of fiscal expansion, this time in 1941:
Although the U.S. was not yet at war, Keynes urged increased fiscal restraint in the U.S. in order to be better prepared to prevent inflation resulting from our defense build-up and Allied purchases of war materials…Walter Salant and Don Humphrey, who sat opposite Keynes at the inside of the U-shaped table, argued strongly that increased fiscal restraint was not then needed in America as it would inhibit further progress in reducing unemployment…Finally Keynes, obviously somewhat displeased, pushed his chair back from the table and brought the debate to an end as he said, rather sharply, “On this point you are more Keynesian than I.” It was an electrifying moment, never to be forgotten!
Personally, I think the reason for the disparity between the letter and other times is two-fold:
(1) Keynes advocated stimulus more strongly in periods of severe depression, such as 1933.
(2) Keynes’ letter to FDR was actually incredibly critical, particularly of the NIRA, and Keynes was at pains to stress his sympathies:
You may be feeling by now, Mr President, that my criticism is more obvious than my sympathy. Yet truly that is not so. You remain for me the ruler whose general outlook and attitude to the tasks of government are the most sympathetic in the world.
Thus the slightly overstated support for fiscal expansion may well have been politically motivated.
Overall, it is clear that Keynes remained more concerned with monetary policy, which is why he was devoted to reducing rates at the Bank of England, despite the massive austerity program at the time. Keynes viewed fiscal stimulus as a short-term stop-gap more than anything; viable to get the economy going and keep people in employment, but not sustainable in the long run. In many respects, this would resonate more with Keynes’ modern day opponents than his supporters.