Uneasy Money

UPDATE: Re-upping this slightly revised post from July 11, 2011

Paul Krugman recently gave a lecture “Mr. Keynes and the Moderns” (a play on the title of the most influential article ever written about The General Theory, “Mr. Keynes and the Classics,” by another Nobel laureate J. R. Hicks) at a conference in Cambridge, England commemorating the publication of Keynes’s General Theory 75 years ago. Scott Sumner and Nick Rowe, among others, have already commented on his lecture. Coincidentally, in my previous posting, I discussed the views of Sumner and Krugman on the zero-interest lower bound, a topic that figures heavily in Krugman’s discussion of Keynes and his relevance for our current difficulties. (I note in passing that Krugman credits Brad Delong for applying the term “Little Depression” to those difficulties, a term that I thought I had invented, but, oh well, I am happy to share the credit with Brad).

In my earlier posting, I mentioned that Keynes’s, slightly older, colleague A. C. Pigou responded to the zero-interest lower bound in his review of The General Theory. In a way, the response enhanced Pigou’s reputation, attaching his name to one of the most famous “effects” in the history of economics, but it made no dent in the Keynesian Revolution. I also referred to “the layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes.” One large element of those dynamics was that Keynes chose to make, not Hayek or Robbins, not French devotees of the gold standard, not American laissez-faire ideologues, but Pigou, a left-of-center social reformer, who in the early 1930s had co-authored with Keynes a famous letter advocating increased public-works spending to combat unemployment, the main target of his immense rhetorical powers and polemical invective.  The first paragraph of Pigou’s review reveals just how deeply Keynes’s onslaught had wounded Pigou.

When in 1919, he wrote The Economic Consequences of the Peace, Mr. Keynes did a good day’s work for the world, in helping it back towards sanity. But he did a bad day’s work for himself as an economist. For he discovered then, and his sub-conscious mind has not been able to forget since, that the best way to win attention for one’s own ideas is to present them in a matrix of sarcastic comment upon other people. This method has long been a routine one among political pamphleteers. It is less appropriate, and fortunately less common, in scientific discussion.  Einstein actually did for Physics what Mr. Keynes believes himself to have done for Economics. He developed a far-reaching generalization, under which Newton’s results can be subsumed as a special case. But he did not, in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers. The example is illustrious: but Mr. Keynes has not followed it. The general tone de haut en bas and the patronage extended to his old master Marshall are particularly to be regretted. It is not by this manner of writing that his desire to convince his fellow economists is best promoted.

Krugman acknowledges Keynes’s shady scholarship (“I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way”), only to absolve him of blame. He then uses Keynes’s example to attack “modern economists” who deny that a failure of aggregate demand can cause of mass unemployment, offering up John Cochrane and Niall Ferguson as examples, even though Ferguson is a historian not an economist.

Krugman also addresses Robert Barro’s assertion that Keynes’s explanation for high unemployment was that wages and prices were stuck at levels too high to allow full employment, a problem easily solvable, in Barro’s view, by monetary expansion. Although plainly annoyed by Barro’s attempt to trivialize Keynes’s contribution, Krugman never addresses the point squarely, preferring instead to justify Keynes’s frustration with those (conveniently nameless) “classical economists.”

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.

Not so, as I pointed out in my first post. Frederick Lavington, an even more orthodox disciple than Pigou of Marshall, had no trouble understanding that “the inactivity of all is the cause of the inactivity of each.” It was Keynes who failed to see that the failure of demand was equally a failure of supply.

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.

Supply does create its own demand when economic agents succeed in executing their plans to supply; it is when, owing to their incorrect and inconsistent expectations about future prices, economic agents fail to execute their plans to supply, that both supply and demand start to contract. Lavington understood that; Pigou understood that. Keynes understood it, too, but believing that his new way of understanding how contractions are caused was superior to that of his predecessors, he felt justified in misrepresenting their views, and attributing to them a caricature of Say’s Law that they would never have taken seriously.

And to praise Keynes for understanding the difference between accounting identities and causal relationships that befuddled his predecessors is almost perverse, as Keynes’s notorious confusion about whether the equality of savings and investment is an equilibrium condition or an accounting identity was pointed out by Dennis Robertson, Ralph Hawtrey and Gottfried Haberler within a year after The General Theory was published. To quote Robertson:

(Mr. Keynes’s critics) have merely maintained that he has so framed his definition that Amount Saved and Amount Invested are identical; that it therefore makes no sense even to inquire what the force is which “ensures equality” between them; and that since the identity holds whether money income is constant or changing, and, if it is changing, whether real income is changing proportionately, or not at all, this way of putting things does not seem to be a very suitable instrument for the analysis of economic change.

It just so happens that in 1925, Keynes, in one of his greatest pieces of sustained, and almost crushing sarcasm, The Economic Consequences of Mr. Churchill, offered an explanation of high unemployment exactly the same as that attributed to Keynes by Barro. Churchill’s decision to restore the convertibility of sterling to gold at the prewar parity meant that a further deflation of at least 10 percent in wages and prices would be necessary to restore equilibrium.  Keynes felt that the human cost of that deflation would be intolerable, and held Churchill responsible for it.

Of course Keynes in 1925 was not yet the Keynes of The General Theory. But what historical facts of the 10 years following Britain’s restoration of the gold standard in 1925 at the prewar parity cannot be explained with the theoretical resources available in 1925? The deflation that began in England in 1925 had been predicted by Keynes. The even worse deflation that began in 1929 had been predicted by Ralph Hawtrey and Gustav Cassel soon after World War I ended, if a way could not be found to limit the demand for gold by countries, rejoining the gold standard in aftermath of the war. The United States, holding 40 percent of the world’s monetary gold reserves, might have accommodated that demand by allowing some of its reserves to be exported. But obsession with breaking a supposed stock-market bubble in 1928-29 led the Fed to tighten its policy even as the international demand for gold was increasing rapidly, as Germany, France and many other countries went back on the gold standard, producing the international credit crisis and deflation of 1929-31. Recovery came not from Keynesian policies, but from abandoning the gold standard, thereby eliminating the deflationary pressure implicit in a rapidly rising demand for gold with a more or less fixed total supply.

Keynesian stories about liquidity traps and Monetarist stories about bank failures are epiphenomena obscuring rather than illuminating the true picture of what was happening.  The story of the Little Depression is similar in many ways, except the source of monetary tightness was not the gold standard, but a monetary regime that focused attention on rising price inflation in 2008 when the appropriate indicator, wage inflation, had already started to decline.