Grasping Reality on TypePad, by Brad DeLong

...Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law–the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: “The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand”….

I’m basically a Part 1er, with a lot of Chapters 13 and 14 in there too, of which more shortly. Chapter 12 is a wonderful read, and a very useful check on the common tendency of economists to assume that markets are sensible and rational. But what I’m always looking for in economics is intuition pumps…. And as it turns out, Keynes-as-equilibrium-theorist–whether or not that’s the “real” Keynes–has a lot to teach us to this day. The struggle to liberate ourselves from Say’s Law, to refute the “Treasury view” and all that, may have seemed like ancient history not long ago, but now that we’re faced with an economic scene reminiscent of the 1930s and we’re having to fight those intellectual battles all over again. And the distinction between loanable funds and liquidity preference theories of the rate of interest–or, rather, the ability to see how both can be true at once, and the implications of that insight – seem to have been utterly forgotten by a large fraction of economists and those commenting on economics.

Old fallacies in new battles: When you read dismissals of Keynes by economists who don’t get what he was all about–which means many of our colleagues you fairly often hear his contribution minimised as amounting to no more than the notion that wages are sticky, so that fluctuations in nominal demand affect real output. Here’s Robert Barro (2009):

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall…

If that’s all that it was about, the General Theory would have been no big deal. But of course, it wasn’t just about that. Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained. They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested. And they had a theory of interest that thought solely in terms of the supply and demand for funds, failing to realise that savings in particular depend on the level of income, and that once you take this into account you need something else liquidity preference–to complete the story.

I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way. But I’m inclined to believe that he was right. Why? Because you can see modern economists and economic commentators who don’t know their Keynes falling into the very same fallacies. There’s no way for me to make this point without citing specific examples, which means naming names. So, on the first point, here’s Chicago’s John Cochrane (2009):

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about ‘crowding out’…

That’s precisely the position Keynes attributed to classical economists “the notion that if people do not spend their money in one way they will spend it in another.” And as Keynes said, this misguided notion derives its plausibility from its superficial resemblance to the accounting identity which says that total spending must equal total income….

Keynes’s discussion of interest rate determination in Chapter 13 and 14 of the General Theory is much more profound than, I think, most readers realise…. The proof of its profundity lies in the way so many people including highly reputable economists–keep falling into the fallacies Keynes laid out, both in discussions of fiscal policy and in discussions of international capital flows. The natural inclination of practical men… is to think of the interest rate as being determined by the supply and demand for loanable funds…. In those terms, it’s only natural to suppose that any increase in the demand for or fall in the supply of loanable funds must drive up interest rates; and it’s easy to imagine that this, in turn, would hurt prospects for economic recovery. Again, I need to name names to assure you that I’m not inventing straw men. So here’s Niall Ferguson (in Soros et al 2009):

Now we’re in the therapy phase. And what therapy are we using? Well, it’s very interesting because we’re using two quite contradictory courses of therapy. One is the prescription of Dr Friedman Friedman, that is which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I’m fine with that. That’s the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr Keynes–John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12% of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.

There is a clear contradiction between these two policies, and we’re trying to have it both ways. You can’t be a monetarist and a Keynesian simultaneously – at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them. It’s certainly not going to be the Chinese. That worked fine in the good times, but what I call ‘Chimerica’, the marriage between China and America, is coming to an end. Maybe it’s going to end in a messy divorce.”

What’s wrong with this line of reasoning? It’s exactly the logical hole Keynes pointed out, namely that the schedules showing the supply and demand for funds can only be drawn on the assumption of a given level of income…. As Hicks told us and as Keynes himself says in Chapter 14–what the supply and demand for funds really give us is a schedule telling us what the level of income will be for a given rate of interest…. It’s possible that the interest rate required to achieve full employment is negative, in which case monetary policy is up against the zero lower bound, that is, we’re in a liquidity trap. That’s where America and Britain were in the 1930s – and we’re back there again…. A zero-lower-bound economy is, fundamentally, an economy suffering from an excess of desired saving over desired investment. Which brings me back to the argument that government borrowing under current conditions will drive up interest rates and impede recovery. What anyone who understood Keynes should realise is that as long as output is depressed, there is no reason increased government borrowing need drive rates up; it’s just making use of some of those excess potential savings–and it therefore helps the economy recover….

I’m not quite done here. If much of our public debate over fiscal policy has involved reinventing the same fallacies Keynes refuted in 1936, the same can be said of debates over international financial policy. Consider the claim, made by almost everyone, that given its large budget deficits the US desperately needs continuing inflows of capital from China and other emerging markets. Even very good economists fall into this trap. Just last week Ken Rogoff declared that “loans from emerging economies are keeping the debt-challenged US economy on life support.” Um, no: inflows of capital from other nations simply add to the already excessive supply of U.S. savings relative to investment demand. These inflows of capital have as their counterpart a trade deficit that makes America worse off, not better off; if the Chinese, in a huff, stopped buying Treasuries they would be doing us a favour. And the fact that top officials and highly regarded economists don’t get this, 75 years after the General Theory, represents a sad case of intellectual regression…

#books #economics #historyofeconomicthought #macro #moralphilosophy #politicaleconomy #2019-12-03