Economics / History

Keynes to Krugman

Since reading this a week ago, I was tempted to abandon my attempts and model-making:

David Glasner has some thoughts about macroeconomic methodology, reacting to my own previous piece, that I mostly agree with, but not entirely. So, a bit more.

Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”. This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago.

So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful.

What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equilibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket.

What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes.

My previous model undertaking led me to believe a dynamic disequilibrium model would be far more accurate, but that doesn’t lead me to decry IS-LM. Economics seems hemmed in by an issue that only a handful of economists such as Krugman understand:

The truth is that the quiescence of interest and inflation rates was predicted by everyone who understood the obvious — that we had entered a liquidity trap — and thought through the implications. I explained it more than five years ago. When central banks have pushed policy rates as low as they can, and the economy is still depressed, what that tells you is that the economy is awash in excess desired savings that have nowhere to go. And as I wrote:

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

So no crowding out, no reason interest rates should rise.

If any prominent economist ever came across this posting, I ask a question for him or her—have there ever been historical circumstances where rapidly escalating interest rates were coupled with disinflation so entrenched full-on deflation is threatening? I cannot find any, and believe inflation and interest rates tend to track one another. My belief was redoubled when I read this:

Consider the extremism of Lucas and Sargent (pdf) in the early days, declaring Keynesian economics a complete failure – or Lucas talking about how Keynesian papers were greeted with “giggles and whispers”. As Wren-Lewis notes, the actual empirical failures of Keynesian economics weren’t nearly bad enough to justify that kind of total rejection – and as Waldmann says, the new classicals themselves turned their backs on empirical evidence when it began rejecting their own models. So why the utter rejection of anything Keynesian?

Well, while the explicit message of such manifestos is intellectual – this is the only valid way to do macroeconomics – there’s also an implicit message: from now on, only my students and disciples will get jobs at good schools and publish in major journals. And that, to an important extent, is exactly what happened; Ken Rogoff wrote about the “scars of not being able to publish sticky-price papers during the years of new neoclassical repression.” As time went on and members of the clique made up an ever-growing share of senior faculty and journal editors, the clique’s dominance became self-perpetuating – and impervious to intellectual failure.

OK, I know the members of the clique will be outraged – distorting incentives only apply to other people, only bureaucrats hijack institutions to serve their personal aggrandizement, etc.. As they say in Minnesota, ya sure, you betcha.

But what about me and my friends? Why, we’re pure and selfless seekers of truth. How dare anyone suggest otherwise?

OK, I think there is a sense in which I’m part of a counterclique. In fact, if you look at just about every economist in my cohort playing an influential role in formulating or discussing macroeconomic policy — Rogoff, Bernanke, Draghi, Blanchard, Summers — you’ll find that they studied macroeconomics at MIT or Harvard, and were formally or informally advised by Rudi Dornbusch and his good friend Stan Fischer.

As I said, international macro went in a different direction. I’ve written in the past that this had a lot to do with the overwhelming international evidence against a new classical view, although that view persisted on the domestic side despite compelling evidence after 1980. It also had to do with events. For domestic macro types, the big event of the 70s was stagflation; in international macro it was the collapse of Bretton Woods, and the shocking volatility in both nominal and real exchange rates that followed.

I nearly did a spit-take at the statement that stagflation drove New Classical economics and the destruction of Bretton Woods drove international macro. For God’s sake, both events were interrelated! Perhaps I should put my historian hat back on…

The Post World War Stagflations

War-related inflation topping 20% was a major problem after the Armistice:

Historical Data Chart

…requiring the horrific Depression of 1921 to defend the gold standard’s P=20.67. Stagflation was even more acute following the Second World War:

Historical Data Chart

…yet somehow post-Vietnam stagflation:

Historical Data Chart

 

…perplexes even Keynesian economists that “the collapse of Bretton Woods, and the shocking volatility in both nominal and real exchange rates that followed.” It probably shouldn’t have shocked anyone, given a precedent had been set when the GBP was devalued over 30% to stave off a massive collapse in 1949. The graph that inspired that posting:

https://www.creditwritedowns.com/wp-content/uploads/2014/02/GDP-decline-history-500x268.gif

…indicates a truth that is lost to history—Bretton Woods (and the gold and silver standards stretching back centuries) was an imposition of world-wide price controls. The volatility that emerged after the 19 March 1973 collapse was reality intruding, as it always does when price controls inevitably fail.

David Glasner lists a quotation that’s worth including:

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

The system should be violently unstable. Humanity imposes a sense of order on the current economic system in vogue around the world—a system of price controls just like the gold standard and the silver standard that preceded it. Today’s price controls are more of a slogan:

The standard response in the minimum-wage debate, made by Republicans and their business backers and plenty of Democrats as well, is that raising the minimum wage costs jobs. Businesses will have to lay off workers. This argument reflects the orthodox economics that most people had in college. If you took Econ 101, then you literally were taught that if wages go up, employment must go down. The law of supply and demand and all that.

(Bold font mine)

Hanauer mentions San Francisco and his home of Seattle put the wage-employment tradeoff in questionable terrain. The better question: where did the Econ 101 presumption come from?

***Answer—the wage-price spiral, a convenient bogeyman versus the 7.6 MEGATONS OF ODRANCE DROPPED ON INDOCHINA***

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One thought on “Keynes to Krugman

  1. Pingback: Harvard Business Papers | AnjumsList

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