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There Are Microfoundations, and There Are Microfoundations; They’re Not the Same

Published March 7, 2012 Keynes , monetary theory , rational expectations 46 Comments

Microfoundations are latest big thing on the econoblogosphere. Krugman, Wren-Lewis (and again), Waldmann, Smith (all two of them!) have weighed in on the subject. So let me take a shot.

The idea of reformulating macroeconomics was all the rage when I studied economics as an undergraduate and graduate student at UCLA in the late 1960s and early 1970s. The UCLA department had largely taken shape in the 1950s and early 1960s around its central figure, Armen Alchian, undoubtedly the greatest pure microeconomist of the second half of the twentieth century in the sense of understanding and applying microeconomics to bring the entire range of economic, financial, legal and social phenomena under its purview, and co-author of the greatest economics textbook ever written. There was simply no problem that he could not attack, using the simple tools one learns in intermediate microeconomics, with a piece of chalk and a blackboard. Alchian’s profound insight (though in this he was anticipated by Coase in his paper on the nature of the firm, and by Hayek’s criticisms of pure equilibrium theory) was that huge chunks of everyday economic activity, such as advertising, the holding of inventories, business firms, contracts, and labor unemployment, simply would not exist in the world characterized by perfect information and zero uncertainty assumed by general-equilibrium theory. For years, Alchian used to say, he could not make sense of Keynes’s General Theory and especially the Keynesian theory of involuntary unemployment, because it seemed to exclude the possibility of equilibration by way of price and wage adjustments, the fundamental mechanism of microeconomic equilibration. It was only when Axel Leijonhufvud arrived on the scene at UCLA, still finishing up his doctoral dissertation, published a few years after his arrival at UCLA as On Keynesian Economics and the Economics of Keynes that Alchian came to understand the deep connections between the Keynesian theory of involuntary unemployment and the kind of informational imperfections that Alchian had been working on for years at the micro-level.

So during my years at UCLA, providing microfoundations for macroeconomics was viewed as an intellectual challenge for gaining a better understanding of Keynesian involuntary unemployment, not as a means of proving that it doesn’t exist. Reformulating macroeconomic theory (I use this phrase in homage to the unpublished paper by the late Earl Thompson, one of Alchian’s very best students) based on microfoundations did not mean simply discarding Keynesian theory into the dustbin of history. Unemployment was viewed as a search process in which workers choose unemployment because it would be irrational to accept the first offer of employment received regardless of the wage being offered. But a big increase in search activity by workers can have feedback effects on aggregate demand preventing a smooth transition to a new equilibrium after an interval of increased search. Alchian, an early member of the Mont Pelerin Society, was able to see the deep connection between Leijonhufvud’s microeconomic rationalization of Keynesian involuntary unemployment and the obscure work, The Theory of Idle Resources, of another member of the MPS, the admirable human being, and unjustly underrated, unfortunately now all but forgotten, economist, W. H. Hutt, who spent most of his professional life engaged in a battle against what he considered the fallacies of J. M. Keynes, especially Keynes’s theory of unemployment.

Unfortunately, this promising approach towards gaining a deeper and richer understanding of the interaction between imperfect information and uncertainty, on the one hand, and, on the other, a process of dynamic macroeconomic adjustment in which both prices and quantities are changing, so that deviations from equilibrium can be cumulative rather than, as conventional equilibrium models assume, self-correcting, has yet to fulfill its promise. Here the story gets complicated, and it would take a much longer explanation than I could possibly reduce to a blog post to tell it adequately. But my own view, in a nutshell, is that the rational-expectations revolution — especially the dogmatic view of how economics ought to be practiced espoused by Robert Lucas and his New Classical, Real Business Cycle and New Keynesian acolytes — has subverted the original aims of the microfoundations project. Rather than relax the informational assumptions underlying conventional equilibrium analysis to allow for a richer and more relevant analysis than is possible when using the tools of standard general-equilibrium theory, Lucas et al. developed sophisticated tools that enabled them to nominally relax the informational assumptions of equilibrium theory while using the tyrannical methodology of rational expectations combined with full market clearing to preserve the essential results of the general-equilibrium model. The combined effect of the faux axiomatic formalism and the narrow conception of microfoundations imposed by the editorial hierarchy of the premier economics journals has been to recreate the gap between the Keynesian theory of involuntary unemployment and rigorous microeconomic reasoning that Alchian, some forty years ago, thought he had found a way to bridge.

Update (1:16PM EST): A commenter points out that the first sentence of my concluding paragraph was left unfinished. That’s what happens when you try to get a post out at 2AM. The sentence is now complete; I hope it’s not to disappointing.

Kuehn, Keynes and Hawtrey

Published March 7, 2012 Cassel , Hawtrey , Hayek , Keynes 5 Comments

Following up on Brad DeLong’s recent comment on his blog about my post from a while back in which I expounded on the superiority of Hawtrey and Cassel to Keynes and Hayek as explainers of the Great Depression, Daniel Kuehn had a comment on his blog cautioning against reading the General Theory either as an explanation of the Great Depression, which it certainly was not, or as a manual for how to recover from the Great Depression. Although Daniel is correct in characterizing the General Theory as primarily an exercise in monetary theory, I don’t think that it is wrong to say that the General Theory was meant to provide the theoretical basis from which one could provide an explanation of the Great Depression, or wrong to say that the General Theory was meant to provide a theoretical rationale for using fiscal policy as the instrument by which to achieve recovery. Certainly, it is hard to imagine that the General Theory would have been written if there had been no Great Depression. Why else would Keynes have been so intent on proving that an economy in which there was involuntary unemployment could nevertheless be in equilibrium, and on proving that money-wage cuts could not eliminate involuntary unemployment?

Daniel also maintains that Keynes actually was in agreement with Hawtrey on the disastrous effects of the monetary policy of the Bank of France, citing two letters that Keynes wrote on the subject of the Bank of France reprinted in his Essays in Persuasion. I don’t disagree with that, though I suspect that Keynes may have had a more complicated story in mind than Hawtrey did. But it seems clear that Hawtrey and Keynes, even though they were on opposite sides of the debate about restoring sterling to its prewar parity against the dollar, were actually very close in their views on monetary theory before 1931, Keynes, years later, calling Hawtrey his “grandparent in the paths of errancy.” They parted company, I think, mainly because Keynes in the General Theory argued, or at least was understood to argue, that monetary policy was ineffective in a liquidity trap, a position that Hawtrey, acknowledging the existence of what he called a credit deadlock, had some sympathy for, but did not accept categorically. Hawtrey is often associated with the “Treasury view” that holds that fiscal policy is always ineffective, because it crowds out private spending, but I think that his main point was that fiscal policy requires an accommodative monetary policy to be effective. But not having studied Hawtrey’s views on fiscal policy in depth, I must admit that that opinion is just conjecture on my part.

So my praise for Hawtrey and dismissal of Keynes-Hayek hype was not intended to suggest that Keynes had nothing worthwhile to say. My point is simply to that to understand what caused the Great Depression, the place to start from is the writings of Hawtrey and Cassel. That doesn’t mean that there is not a lot to learn about how economies work (or don’t work) from Keynes, or from Hayek for that matter. The broader lesson is that we should be open to contributions from a diverse and eclectic range of sources. So despite superficial appearances, there really is not that much that Daniel and I are disagreeing about.

PS (8:58 AM EST): I pressed a button by mistake and annihilated the original post. This is my best (quick) attempt to recover the gist of what I originally posted last night.

PPS (11:07 AM EST): Thanks to Daniel Kuehn for reminding me that Google Reader had protected my original post against annihilation. I have now restored fully whatever it was that I wanted to restore.

Brad Delong Likes Bagehot and Minsky Better than Hawtrey and Cassel

Published March 2, 2012 Cassel , gold standard , Hawtrey , Keynes , monetary history 13 Comments

It seems as if Brad DeLong can’t get enough of me, because he just quoted at length from my post about Keynes and Hayek even though he already quoted at length from the same post a month ago. So, even though Brad and I don’t seem to be exactly on the same page, as you can tell from the somewhat snarky title of his most recent post, I take all this attention that he is lavishing on me as evidence that I must be doing something right.

After his long quote from my post, Brad makes the following comment:

As I have said before, IMHO Cassel and Hawtrey see a lot but also miss a lot. The Bagehot-Minsky and the Wicksell-Kahn traditions have a lot to add as well. And Friedman was a very effective popularizer of most of what you can get from Cassel and Hawtrey.

But, as I have said before, those of us who learned this stuff from Blanchard, Dornbusch, Eichengreen, and Kindleberger–who made us read Bagehot, Minsky, Wicksell, Metzler, and company–have a huge intellectual advantage over others.

I left a reply to Brad on his site, (which, as I write this, is still awaiting moderation so I can’t reproduce it here); the main point I made was that Hawtrey (who coined the term “inherent instability of credit”) was not outside the Bagehot-Minsky tradition, or, having invented the fiscal-multiplier analysis before Richard Kahn did (as documented by Robert Dimand), and having relied extensively on the concept of a natural rate of interest in most of his monetary writings, was he outside the Wicksell-Kahn tradition. But, while acknowledged the importance of the two traditions that Brad mentions and Hawtrey’s affinity with those traditions, I maintain that those traditions are not all that relevant to an understanding of the Great Depression, which was not a typical cyclical depression of the kind that those two traditions are primarily concerned with. The Great Depression, unlike “normal” cyclical depressions, was driven by powerful worldwide deflationary impulse associated with the dysfunctional attempt to restore the gold standard as an international system after World War I. Hawtrey and Cassel understood the key role played by the demand for gold in causing the Great Depression. That is why Brad’s reference to Friedman’s popularization “of most of what you can get from Cassel and Hawtrey” is really off the mark. Friedman totally missed the role of the gold standard and the demand for gold in precipitating the Great Depression. And Friedman’s failure — either from ignorance or lack of understanding — to cite the work of Hawtrey and Cassel in any of his writings on the Great Depression was an inexcusable lapse of scholarship.

Daniel Kuehne picks up on Brad’s post with one of his own, defending Keynes against my criticisms of the General Theory. Daniel points out that Keynes was aware of and adopted many of the same criticisms of the policy of the Bank of France that Hawtrey had made. That’s true, but the full picture is more complicated than either Daniel or I have indicated. Perhaps I will try to elaborate on that in a future post.

Advice to Scott: Avoid Accounting Identities at ALL Costs

Published January 22, 2012 Keynes , monetary theory 33 Comments

It must have been a good feeling when Scott Sumner saw Karl Smith’s blog post last Thursday announcing that he had proved that Scott was right in asserting that Simon Wren-Lewis had committed a logical blunder in his demonstration that Robert Lucas and John Cochrane made a logical blunder in denying, on the basis of Ricardian equivalence, that government spending to build a bridge would be stimulative. I don’t begrudge Scott such innocent pleasures, and I feel slightly guilty for depriving him of that good feeling, but, you know the old saying: a blogger’s gotta do what a blogger’s gotta do. For any new readers who haven’t been following this twisted tale of claim and counterclaim, charge and countercharge, response and rejoinder, see my three previous posts (here, here, and here, and the far from comprehensive array of links in them to other posts on the topic).

My main problem with Scott’s argument against Wren-Lewis was that, at a crucial stage in his argument, he relied on the national income accounts identity that savings equals investment. Now in the General Theory, Keynes himself also asserted that savings and investment were identically equal and made a rather strange argument that the identity between savings and investment had a deep economic significance because there had to be an economic mechanism operating to ensure the ultimate satisfaction of the identity. That was a nonsense statement by Keynes, as pointed out by Robertson, Haberler, Hawtrey, Lutz and others, because if two magnitudes are identically equal, there is no possible state of the world in which the two magnitudes would not be equal, so there obviously is no mechanism required (or possible) to ensure equality between the magnitudes. The equality is simply a consequence of how we have defined the terms we are using, not a statement about what can or cannot happen in the world. The nonsense statement by Keynes did not invalidate his theory, it merely meant that Keynes was confused about how to interpret his theory.

I cannot resist observing that this is just one example of many showing that the notion that the original intent of the Framers of the Constitution has any special authority in Constitutional interpretation and adjudication is totally wrong, based on the misconception that the original inventor, discoverer, or articulator of a concept has any power to control its meaning and interpretation. Keynes, let us posit, invented the income-expenditure theory. But his understanding of the savings-equals-investment equilibrium condition of the theory was obviously wrong and defective. The Framers of the Constitution may have invented or may have first articulated any number of concepts mentioned in the Constitution, e.g., the prohibition against cruel and unusual punishment, due process of law, the right to bear arms, equal protection. That they invented or articulated those terms first does not give the Framers ownership over the meaning of those terms in the sense that their understanding of the meaning of those terms cannot establish an immutable understanding of what the terms mean any more than Keynes could impose the notion that savings is identically equal to investment simply because he provided the first articulation of a model that hinged on the equality of savings and investment. Sorry for that digression, but I just couldn’t help myself.

Now back to Scott. Based on the presumed identity between savings and investment, Scott asserted that the reduction in savings by which households would seek to smooth their consumption in response to a temporary increase in taxes would necessarily imply a reduction in spending on capital goods (i.e., a reduction in investment). But savings and investment are not identical; their equality is a condition of equilibrium. If savings fall, there has to be an economic mechanism (perhaps, but not necessarily, the one posited by the Keynesian model) that restores equality between saving and investment. The equality cannot be established by invoking an identity between savings and investment that is purely conventional and is the result of a special definition that ensures the equality of savings and investment in every conceivable state of the world, a definition that drains the identity of any and all empirical content.

Here’s what Karl Smith had to say on the subject on his blog:

Scott says

In a perfect world I’d lay out a concise logical proof that Simon Wren-Lewis and Paul Krugman are wrong. And number each point. They’d respond saying which of my points were wrong, and why. Then I’d reply. . . .

Perhaps I can help.

Wren-Lewis said:

DY = DC + DS + DT = DC + DS + DG Λ DG > 0 Λ -DC < DT ==> DY > 0

Karl’s notation is a bit cryptic. This is how I understand it:

DY = change in Y (income)

DC = change in C (consumption)

DS = change in S (saving)

DT= change in T (taxes)

DG = change in G (government spending)

The first equation says that a change in income can be decomposed into a change in consumption plus a change in savings plus a change in tax payments. This is derived from the definition of income in the income-expenditure model, namely that income is disposed of either by spending it on consumption, paying taxes or saving it. There is nothing else (in the model) that one can do with his income.

The next equation simply makes the substitution of G for T, which in the example under consideration were assumed to change by equal amounts.

The symbol “Λ” means something like “and furthermore,” so that we are supposed to assume that DG > 0, i.e., that government spending has increased. Then we are given another assumption, -DC < DT, which means that, because of consumption smoothing, the temporary increase in taxes is not financed entirely by a reduction in consumption, but partly by a reduction in consumption and partly by a reduction in savings, so that the reduction in consumption is less than the increase in taxes. This is Karl’s rendition of Simon Wren-Lewis’s argument that a temporary increase in taxes to finance the construction of a bridge would imply an increase in Y because G will increase by more than C falls. Karl continues:

Which is false.

Proof by example:

Let DG = DT = 2, DC = -1, and DS = –1

Here Karl is saying let us assume that G and T both increase by 2. That part is fine. The problem is what comes next. He assumes that to finance the increase in taxes, consumption goes down by 1 and savings goes down by 1. Why is that a problem? Because he is reasoning in terms of an accounting identity rather than in terms of an economic model. Wren-Lewis was making an argument in terms of the implications of the income-expenditure model which consists of (yes!) definitions, causal or empirical functions (consumption, investment, etc.) and an equilibrium condition. The change in income cannot be derived from a simple definition, it is derived from the solution of the model. The model has a solution. You can solve for Y by taking the initial conditions and the empirical functions and applying the equilibrium condition. You can also express the equilibrium value of Y in a single equation as a reduced form in terms of all the parameters and initial conditions. If you want to solve for DY in terms of a change in one of the other initial conditions, like G and T or consumption function, you have to do so in terms of the reduced-form equation for Y, not in terms of the definition of Y. Doing that leads to the nonsense result that, I am sorry to say, Karl arrives at below.

Then both inequalities are satisfied and by the first equation.

DY = –1 –1 + 2 = 0

Which is what we were required to show.

It’s a nonsense result, because his solution does not correspond to the equilibrium condition of the model, which is either savings equals investment or expenditure equals income. In Karl’s nonsense result, savings is not equal to investment (because investment has not changed while savings has fallen by 1) and expenditure is not equal to income (because DC + DG + DI > DC + DS + DT). This is just the ABCs of comparative-statics analysis.

Now in a subsequent post, Karl seems to have retracted his “proof,” admitting:

S = –1 is not allowed [because investment has not changed].

Karl actually has interesting things to say about how to think about the effects of an increase in government spending and taxes in terms of a neo-classical analysis which is worth reading and thinking about. But the point is that to make any statement about the consequences of a change in the initial conditions or parameters of a model, one must reason in terms of the equilibrium solution of the model, not in terms of the definitions within the model, and certainly not in accounting identities that are completely separate from the model.

Finally, just one comment about Lucas and Cochrane. As Karl points out in his more recent post, Lucas and Cochrane offered reasons for rejecting the stimulative effect of building a bridge that were themselves couched in the very terms of the Keynesian income-expenditure model that they were criticizing. Thus, Lucas offered as his explanation for why building the bridge would have no stimulative effect that the increase in spending associated with building the bridge would be offset by a reduction in consumption associated with the taxes needed to finance the bridge as if that were an obvious internal contradiction within the model. Karl suggests a better response that Lucas and Cochrane might have given, but their response was simply an attempt to show that there was some gap in the logic of the model. That is why they invited such a brutal counter-attack from the Keynesians.

PS Have a look as well at Brad DeLong who has a new post quoting Paul Krugman quoting Noah Smith on the dangers of accounting identities, and also quoting moi.

PPS Just to be clear, as Scott notes in a comment below, Noah did not mention Scott in his post.

Why Am I Arguing with Scott Sumner?

Published January 19, 2012 Keynes , monetary theory 27 Comments

This is going to be my third consecutive post about Scott Sumner (well, not only about Scott), and we seem to be arguing about something, but it may not be exactly clear what the argument is about. Some people, based on comments on this and other blogs, apparently think that I am defending the Keynesian model against Scott’s attacks. Others even accuse me of advocating – horrors! – tax and spend policies as the way to stimulate the economy. In fact, Scott himself seems to think that what I am trying to do is defend what he calls the hydraulic Keynesian model. That’s a misunderstanding; I am simply trying to enforce some basic standards of good grammar in arguing about economic models, in this case the hydraulic Keynesian model. I am not a fan of the hydraulic Keynesian model, but most economists, even anti-Keynesians like Hayek (see here), have acknowledged that in a severe recession or depression, when there is substantial unemployment of nearly all factors of production, the model does provide some insight. I have also explained (here and here) that it is possible to translate the simple Keynesian model of a depression and a liquidity trap into the language of the supply of and demand for money. So at some level of generality, the propositions of the Keynesian model can be treated as fairly trivial and non-controversial.

So what do I mean when I say that I am just trying to enforce basic standards of good grammar? I mean that good grammar is not about what you choose to say; it is about how you say it. Using good grammar doesn’t prevent you from saying anything you want to; it just prevents you from saying it in certain not very comprehensible ways. If you use good grammar, you enhance your chances of saying what you want to say coherently and avoiding needless confusion. Sure some grammatical rules are purely conventional or nitpicks, but good writers and speakers know which grammatical rules can be safely ignored and which can’t. Using bad grammar leads you make statements that are confusing or ambiguous or otherwise incoherent even though the point that you are trying to make may be perfectly clear to you. Making the point clear to someone else requires you to follow certain semantic rules that help others to follow what you are saying. It is also possible that when you make an ungrammatical statement, you are disguising (and at the same time revealing) some confusion that you yourself may not be aware of, and had you made the statement grammatically you might have become aware that you had not fully thought through what you were trying to say. So in a discussion about the Keynesian model, I regard myself as a neutral observer; I don’t care if you are making a statement for or against the model. But I want you to make the statement grammatically.

That’s right; my problem with Scott is that he is using bad grammar. When Scott says he can derive a substantive result about the magnitude of the balanced-budget multiplier from an accounting identity between savings and investment, he is making a theoretically ungrammatical statement. My problem is not with whatever value he wants to assign to the balanced-budget multiplier. My problem is that he thinks that he can draw any empirically meaningful conclusion — about anything — from an accounting identity. Scott defends himself by citing Mankiw and Krugman and others who assert that savings and investment are identically equal. I don’t have a copy of any of Krugman’s textbooks, so I don’t know what he says about savings and investment being identically equal, but I was able to find the statement in Mankiw’s text. And yes, he does say it, and he was speaking incoherently when he said it. Now, it is one thing to make a nonsense statement, which Mankiw obviously did, and it is another to use it as a step – in fact a critical step — in a logical proof, which is what Scott did.

The unfortunate fact is that the vast majority of economics textbooks starting with Samuelson’s classic text (though not until the fourth edition) have been infected by this identity virus, even including the greatest economics textbook ever written. The virus was introduced into economics by none other than Keynes himself in his General Theory. He was properly chastised for doing so by Robertson, Hawtrey, Haberler, and Lutz among others. Perhaps because the identity between savings and investment in the national income accounts reinforced the misunderstanding and misconception that the Keynesian model is somehow based on an accounting identity between investment and savings, the virus withstood apparently conclusive refutation and has clearly become highly entrenched as a feature of the Keynesian model.

The confusion was exacerbated because, in the most common form of the Keynesian model, the timeless, lagless form with the instantaneous multiplier, the model has meaning only in equilibrium for which the equality of savings and investment is a necessary and sufficient condition. This misunderstanding has led to completely illegitimate attempts to identify points on the Keynesian cross diagram away from the point of intersection as disequilibria characterized by a difference between planned (ex ante) and realized (ex post) savings or planned and realized investment. It is legitimate to refer to the equality of savings and investment in equilibrium, but you can’t extrapolate from a change in one or the other to determine how the equilibrium changes as a result of the specified change in savings or investment, which is what Scott tried to do. So, yes, the mistaken identification of savings and investment is distressingly widespread, but unfortunately Scott has compounded the confusion, taking it to an even higher level. Let me again cite as the key source identifying and tracking down all the confusions and misconceptions associated with treating savings and investment (or expenditure and income) as identically equal the classic paper by Richard Lipsey, “The Foundations of the Theory of National Income,” originally published in 1972 in Essays in Honour of Lord Robbins and reprinted in Lipsey Macroeconomic Theory and Policy: The Selected Essays of Richard G. Lipsey, vol. 2.

That’s all for now. I still need to respond to some of Scott’s arguments in detail, clear up a mistake in my previous post and say some more about the savings is identically equal to investment virus.

On Multipliers, Ricardian Equivalence and Functioning Well

Published January 3, 2012 fiscal policy , John Cochrane , Keynes , monetary policy , monetary theory 4 Comments
Tags: John Cochrane, Paul Krugman, Ricardian equivalence, Robert Barrow, Robert Lucas

In my post yesterday, I explained why if one believes, as do Robert Lucas and Robert Barro, that monetary policy can stimulate an economy in an economic downturn, it is easy to construct an argument that fiscal policy would do so as well. I hope that my post won’t cause anyone to conclude that real-business-cycle theory must be right that monetary policy is no more effective than fiscal policy. I suppose that there is that risk, but I can’t worry about every weird idea floating around in the blogosphere. Instead, I want to think out loud a bit about fiscal multipliers and Ricardian equivalence.

I am inspired to do so by something that John Cochrane wrote on his blog defending Robert Lucas from Paul Krugman’s charge that Lucas didn’t understand Ricardian equivalence. Here’s what Cochrane, explaining what Ricardian equivalence means, had to say:

So, according to Paul [Krugman], “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

Cochrane was a little careless in defining Ricardian equivalance as a theorem about stimulus, when it’s really a theorem about the equivalence of the effects of present and future taxes on spending. But that’s just a minor slip. What I found striking about Cochrane’s statement was something else: that little qualifying phrase “in a well-functioning economy,” which Cochrane seems to have inserted as a kind of throat-clearing remark, the sort of aside that people are just supposed to hear but not really pay much attention to, that sometimes can be quite revealing, usually unintentionally, in its own way.

What is so striking about those five little words “in a well-functioning economy?” Well, just this. Why, in a well-functioning economy, would anyone care whether a stimulus works or not? A well-functioning economy doesn’t need any stimulus, so why would you even care whether it works or not, much less prove a theorem to show that it doesn’t? (I apologize for the implicit Philistinism of that rhetorical question, I’m just engaging in a little rhetorical excess to make my point a little bit more colorfully.)

So if a well-functioning economy doesn’t require any stimulus, and if a stimulus wouldn’t work in a well-functioning economy, what does that tell us about whether a stimulus works (or would work) in an economy that is not functioning well? Not a whole lot. Thus, the bread and butter models that economists use, models of how an economy functions when there are no frictions, expectations are rational, and markets clear, are guaranteed to imply that there are no multipliers and that Ricardian equivalence holds. This is the world of a single, unique, and stable equilibrium. If you exogenously change any variable in the system, the system will snap back to a new equilibrium in which all variables have optimally adjusted to whatever exogenous change you have subjected the system to. All conventional economic analysis, comparative statics or dynamic adjustment, are built on the assumption of a unique and stable equilibrium to which all economic variables inevitably return when subjected to any exogenous shock. This is the indispensable core of economic theory, but it is not the whole of economic theory.

Keynes had a vision of what could go wrong with an economy: entrepreneurial pessimism — a dampening of animal spirits — would cause investment to flag; the rate of interest would not (or could not) fall enough to revive investment; people would try to shift out of assets into cash, causing a cumulative contraction of income, expenditure and output. In such circumstances, spending by government could replace the investment spending no longer being undertaken by discouraged entrepreneurs, at least until entrepreneurial expectations recovered. This is a vision not of a well-functioning economy, but of a dysfunctional one, but Keynes was able to describe it in terms of a simplified model, essentially what has come down to us as the Keynesian cross. In this little model, you can easily calculate a multiplier as the reciprocal of the marginal propensity to save out of disposable income.

But packaging Keynes’s larger vision into the four corners of the Keynesian cross diagram, or even the slightly more realistic IS-LM diagram, misses the essence of Keynes’s vision — the volatility of entrepreneurial expectations and their susceptibility to unpredictable mood swings that overwhelm any conceivable equilibrating movements in interest rates. A numerical calculation of the multiplier in the simplified Keynesian models is not particularly relevant, because the real goal is not to reach an equilibrium within a system of depressed entrepreneurial expectations, but to create conditions in which entrepreneurial expectations bounce back from their depressed state. As I like to say, expectations are fundamental.

Unlike a well-functioning economy with a unique equilibrium, a not-so-well functioning economy may have multiple equilibria corresponding to different sets of expectations. The point of increased government spending is then not to increase the size of government, but to restore entrepreneurial confidence by providing assurance that if they increase production, they will have customers willing and able to buy the output at prices sufficient to cover their costs.

Ricardian equivalence assumes that expectations of future income are independent of tax and spending decisions in the present, because, in a well-functioning economy, there is but one equilibrium path for future output and income. But if, because the economy not functioning well, expectations of future income, and therefore actual future income, may depend on current decisions about spending and taxation. No matter what Ricardian equivalence says, a stimulus may work by shifting the economy to a different higher path of future output and income than the one it now happens to be on, in which case present taxes may not be equivalent to future taxes, after all.

Keynes v. Hayek: Enough Already

Published December 12, 2011 Cassel , Hawtrey , Hayek , Keynes , monetary history , monetary policy , monetary theory 78 Comments

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters. (The accuracy of the representations signaled in its portrayal of Hayek as bald and Keynes with a full head of hair when in real life it was the other way around.) Then came a debate broadcast by the BBC at the London School of Economics, and then another sponsored by Reuters with a Nobel Prize winning economist on the program arguing for the Hayek side. Now comes a new book by Nicholas Wapshott Keynes Hayek, offering an extended account of the fraught relationship between two giants of twentieth century economics who eventually came to a sort of intellectual détente toward the end of Keynes’s life, a decade or more after a few years of really intense, even brutal, but very high level, polemical exchanges between them (and some of their surrogates) in the pages of England’s leading economics journals. Tyler Cowen has just reviewed Wapshott’s book in the National Review (see Marcus Nunes’s blog).

As I observed in September after watching the first Keynes-Hayek debate, we can still learn a lot by going back to Keynes’s and Hayek’s own writings, but all this Keynes versus Hayek hype creates the terribly misleading impression that the truth must lie with only one side or the other, that one side represents truth and enlightenment and the other represents falsehood and darkness, one side represents pure disinterested motives and the other is shilling for sinister forces lurking in the wings seeking to advance their own illegitimate interests, in short that one side can be trusted and the other cannot. All this attention on Keynes and Hayek, two charismatic personalities who have become figureheads or totems for ideological movements that they might not have endorsed at all — and certainly not endorsed unconditionally — encourages an increasingly polarized discussion in which people choose sides based on pre-existing ideological commitments rather than on a reasoned assessment of the arguments and the evidence.

In part, this framing of arguments in ideological terms simply reflects existing trends that have been encouraging an increasingly ideological approach to politics, law, and public policy. For an example of this approach, see Naomi Klein’s recent musings about global warming and the necessity for acknowledging that combating global warming requires the very social transformation that makes right-wingers oppose, on ideological principle, any measure to counter global warming. Those are just the terms of debate that Naomi Klein wants. Thus, both sides have come to see global warming not as a problem to be addressed or mitigated, but as a weapon to be used in the context of a comprehensive ideological struggle. Those who want to address the problem in a pragmatic, non-ideological, way are losing control of the conversation.

The amazing thing about the original Keynes-Hayek debate is not only that both misunderstood the sources of the Great Depression for which they were confidently offering policy advice, but that Ralph Hawtrey and Gustav Cassel had explained what was happening ten years before the downturn started in the summer of 1929. Both Hawtrey and Cassel understood that restoring the gold standard after the demonetization of gold that took place during World War I would have hugely deflationary implications if, when the gold standard was reinstated, the world’s monetary demand for gold would increase back to the pre-World War I level (as a result of restoring gold coinage and the replenishment of the gold reserves held in central bank coffers). That is why both Hawtrey and Cassel called for measures to limit the world’s monetary demand for gold (measures agreed upon in the international monetary conference in Genoa in 1922 of which Hawtrey was the guiding spirit). The measures agreed upon at the Genoa Conference prevented the monetary demand for gold from increasing faster than the stock of gold was increasing so that the world price level in terms of gold was roughly stable from about 1922 through 1928. But in 1928, French demand for gold started to increase rapidly just as the Federal Reserve began tightening monetary policy in a tragically misguided effort to squelch a supposed stock-price bubble on Wall Street, causing an inflow of gold into the US while the French embarked on a frenzied drive to add to their gold holdings, and other countries rejoining the gold standard were increasing their gold holdings as well, though with a less fanatical determination than the French. The Great Depression was therefore entirely the product of monetary causes, a world-wide increase in gold demand causing its value to increase, an increase manifesting itself, under the gold standard, in deflation.

Hayek, along with his mentor Ludwig von Mises, could also claim to have predicted the 1929 downturn, having criticized the Fed in 1927, when the US was in danger of falling into a recession, for reducing interest rates to 3.5%, by historical standards far from a dangerously expansionary rate, as Hawtrey demonstrated in his exhaustive book on the subject A Century of Bank Rate. But it has never been even remotely plausible that a 3.5% discount rate at the Fed for a little over a year was the trigger for the worst economic catastrophe since the Black Death of the 14^th century. Nor could Keynes offer a persuasive explanation for why the world suddenly went into a catastrophic downward spiral in late 1929. References to animal spirits and the inherent instability of entrepreneurial expectations are all well and good, but they provide not so much an explanation of the downturn as a way of talking about it or describing it. Beyond that, the Hawtrey-Cassel account of the Great Depression also accounts for the relative severity of the Depression and for the sequence of recovery in different counties, there being an almost exact correlation between the severity of the Depression in a country and the existence and duration of the gold standard in the country. In no country did recovery start until after the gold standard was abandoned, and in no country was there a substantial lag between leaving the gold standard and the start of the recovery.

So not only did Hawtrey and Cassel predict the Great Depression, specifying in advance the conditions that would, and did, bring it about, they identified the unerring prescription – something provided by no other explanation — for a country to start recovering from the Great Depression. Hayek, on the other hand, along with von Mises, not only advocated precisely the wrong policy, namely, tightening money, in effect increasing the monetary demand for gold, he accepted, if not welcomed, deflation as the necessary price for maintaining the gold standard. (This by the way is what explains the puzzle (raised by Larry White in his paper “Did Hayek and Robbins Deepen the Great Depression?”) of Hayek’s failure to follow his own criterion for a neutral monetary policy, stated explicitly in chapter 4 of Prices and Production: stabilization of nominal expenditure (NGDP). However, a policy of stabilizing nominal expenditure was inconsistent with staying on the gold standard when the value of gold was rising by 5 to 10% a year. Faced with a conflict between maintaining the gold standard and following his own criterion for neutral money, Hayek, along with his friend and colleague Lionel Robbins in his patently Austrian book The Great Depression, both opted for maintaining the gold standard.)

Not only did Hayek make the wrong call about the gold standard, he actually defended the insane French policy of gold accumulation in his lament for the gold standard after Britain wisely disregarded his advice and left the gold standard in 1931. In his paper “The Fate of the Gold Standard” (originally Das Schicksal der Goldwahrung) reprinted in The Collected Works of F. A. Hayek: Good Money, Part 1, Hayek mourned the impending demise of the gold standard after Britain tardily did the right thing. The tone of Hayek’s lament is struck in his opening paragraph (p. 153).

There has been much talk about the breakdown of the gold standard, particularly in Britain where, to the astonishment of every foreign observer, the abandonment of the gold standard was very widely welcomed as a release from an irksome constraint. However, it can scarcely be doubted that the renewed monetary problems of almost the whole world have nothing to do with the tendencies inherent in the gold standard, but on the contrary stem from the persistent and continuous attempts from many sides over a number of years to prevent the gold standard from functioning whenever it began to reveal tendencies which were not desired by the country in question. Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the “rules of the game” by the breakdown of their gold standard.

So what do we learn from this depressing tale? Hawtrey and Cassel did everything right. They identified the danger to the world economy a decade in advance. They specified exactly the correct policy for avoiding the danger. Their policy was a huge success for about nine years until the Americans and the French between them drove the world economy into the Great Depression, just as Hawtrey and Cassel warned would happen if the monetary demand for gold was not held in check. Within a year and a half, both Hawtrey and Cassel concluded that recovery was no longer possible under the gold standard. And as countries, one by one, abandoned the gold standard, they began to recover just as Hawtrey and Cassel predicted. So one would have thought that Hawtrey and Cassel would have been acclaimed and celebrated far and wide as the most insightful, the most farsighted, the wisest, economists in the world. Yep, that’s what one would have thought. Did it happen? Not a chance. Instead, it was Keynes who was credited with figuring out how to end the Great Depression, even though there was almost nothing in the General Theory about the gold standard and a 30% deflation as the cause of the Great Depression, despite his having vilified Churchill in 1925 for rejoining the gold standard at the prewar parity when that decision was expected to cause a mere 10% deflation.

But amazingly enough, even when economists began looking for alternative ways to Keynesianism of thinking about macroeconomics, Austrian economics still being considered too toxic to handle, almost no one bothered to go back to revisit what Hawtrey and Cassel had said about the Great Depression. So Milton Friedman was considered to have been daring and original for suggesting a monetary explanation for the Great Depression and finding historical and statistical support for that explanation. Yet, on the key elements of the historical explanation, Hawtrey and Cassel either anticipated Friedman, or on the numerous issues on which Friedman did not follow Hawtrey and Cassel — in particular the international gold market as the transmitter of deflation and depression across all countries on the gold standard, the key role of the Bank of France (which Friedman denied in the Monetary History and for years afterwards only to concede the point in the mid to late 1990s), the absence of an explanation for the 1929 downturn, the misplaced emphasis on the contraction of the US money stock and the role of U.S. bank failures as a critical factor in explaining the severity of the Great Depression — Hawtrey and Cassel got it right and Friedman got it wrong.

So what matters in the success in the marketplace of ideas seems to be not just the quality or the truth of a theory, but also (or instead) the publicity machine that can be deployed in support of a theory to generate interest in it and to attract followers who can expect to advance their own careers in the process of developing, testing, or otherwise propagating, the theory. Keynes, Friedman, and eventually Hayek, all had powerful ideologically driven publicity machines working on their behalf. And guess what? It’s the theories that attract the support of a hard core of ideologically motivated followers that tend to outperform those without a cadre of ideological followers.

That’s why it was very interesting, important, and encouraging that Tyler Cowen, in his discussion of the Keynes-Hayek story, felt the need to mention how Scott Sumner has shifted the debate over the past two years away from the tired old Keynes vs. Hayek routine. Of course Tyler, about as well read an economist as there is, slipped up when he said that Scott is reviving the Friedman Monetarist tradition. No, Scott is reviving the Hawtrey-Cassel pre-Monetarist tradition, of which Friedman’s is a decidedly inferior, and obsolete, version. It just goes to show that one person sometimes really can make a difference, even without an ideologically driven publicity machine working on his behalf. Just imagine what Hawtrey and Cassel could have accomplished if they had been bloggers.

Understanding the Balanced-Budget Multiplier Theorem

Published November 8, 2011 Keynes , monetary policy 4 Comments
Tags: Keynes

Scott Sumner recently linked to David Henderson who cited the following comment by Professor T. Norman Van Cott of Ball State University to an op-ed by Alan Meltzer trashing Keynesian economics.

Particularly egregious is something labeled “the balanced budget multiplier.” To wit, an equal increase in government expenditures and taxes leads to an increase in national output equal to the additional government expenditures and taxes. Mr. Samuelson, et al., gives the notion a scientific aura by packaging it in equations and graphs.
Economic surrealism? You bet. Note that national output and taxes rising by the same amount means producers’ after-tax incomes are unchanged. How or why would producers produce more for no increase in after-tax income? Hint: They won’t. Never mind the smoke screen of graphs and equations.

I posted the following comment on Henderson’s blog, but my comment came three days after the previous comment so no one seemed to notice. So I thought I would post it here to see what people think.

David, Just saw a link to your question on Scott Sumner’s blog. I think that the simple answer is that the balanced-budget multiplier presumes that there is involuntary unemployment. The additional output is produced by the employment of those previously unemployed; those previously employed experience a reduction in their real wage. I am not necessarily endorsing the analysis, but I think that is logic behind it.

A further elaboration is that under Keynes’s definition of involuntary unemployment, the way in which you re-employ the involuntarily unemployed is by raising the price of output while holding the wage constant. So, under Keynes’s (economic) logic you need inflation to get the involuntarily unemployed reemployed. That logic somehow gets lost in “the smoke screen of graphs and equations.”

Keynes v. Hayek: Advantage Hawtrey

Published September 6, 2011 Hawtrey , Hayek , Keynes , monetary policy , monetary theory 21 Comments

On Labor Day, I finally got around to watching the Keynes v. Hayek debate at the London School of Economics on August 3 between Robert Skidelsky and Duncan Weldon on behalf of Keynes and George Selgin and Jamie Whyte on behalf of Hayek. Inspired by the Hayek-Keynes rap videos, the debate, it seems to me, did not rise very far above the intellectual level of the rap videos, with both sides preferring to caricature the other side rather than engage in a debate on the merits. The format of the debate, emphasizing short declaratory statements and sound bites, invites such tactics.

Thus, Robert Skidelsky began the proceedings by lambasting Hayek for being a liquidationist in the manner of Andrew Mellon (as rather invidiously described by his boss, Herbert Hoover, in the latter’s quest in his memoirs for self-exculpation), even though Skidelsky surely is aware that Hayek later disavowed his early policy recommendations in favor of allowing deflation to continue with no countermeasures. Skidelsky credited FDR’s adoption of moderate Keynesian fiscal stimulus as the key to a gradual recovery from the Great Depression until massive spending on World War II brought about the Depression to a decisive conclusion.

Jamie Whyte responded with a notably extreme attack on Keynesian policies, denying that Keynesian policies, or apparently any policy other than pure laissez-faire, could lead to a “sustainable” recovery rather than just sow the seeds of the next downturn, embracing, in other words, the very caricature that Skidelsky had just unfairly used in his portrayal of Hayek as an out-of-touch ideologue. George Selgin was therefore left with the awkward task of defending Hayek against both Skidelsky and his own colleague.

Selgin contended that it was only in the 1929-31 period that Hayek argued for deflation as a way out of depression, but later came to recognize that a contraction of total spending, associated with an increasing demand by the public to hold cash, ought, in principle, to be offset by a corresponding increase in the money supply to stabilize the aggregate flow of expenditure. Larry White has documented the shift in Hayek’s views in a recent paper, but the argument is a tad disingenuous, because, despite having conceded this point in principle in some papers in the early to mid-1930s, Hayek remained skeptical that it could be implemented in practice, as Selgin has shown himself to be here. It was not until years later that Hayek expressed regret for his earlier stance and took an outspoken and unequivocal stand against deflation and a contraction in aggregate expenditure.

I happen to think that one can learn a lot form both Hayek and Keynes. Both were profound thinkers who had deep insights into economics and the workings of market economies. Emotionally, I have always been drawn more to Hayek, whom I knew personally and under whom I studied when he visited UCLA in my junior year, than to Keynes. But Hayek’s best work verged on the philosophical, and his philosophical and scholarly bent did not suit him for providing practical advice on policy. Hayek, himself, admitted to having been dazzled by Keynes’s intellect, but Keynes could be too clever by a half, and was inclined to be nasty and unprincipled when engaged in scholarly or policy disputes, the list of his victims including not only Hayek, but A. C. Pigou and D. H. Robertson, among others.

So if we are looking for a guide from the past to help us understand the nature of our present difficulties, someone who had a grasp of what went wrong in the Great Depression, why it happened and why it took so long to recover from, our go-to guy should not be Keynes or Hayek, but the eminent British economist, to whose memory this blog is dedicated, Ralph Hawtrey. (For further elaboration see my paper “Where Keynes Went Wrong.”) It was Hawtrey who, before anyone else, except possibly Gustav Cassel, recognized the deflationary danger inherent in restoring a gold standard after it had been disrupted and largely abandoned during World War I. It was Hawtrey, more emphatically than Keynes, who warned of the potential for a deflationary debacle as a result of a scramble for gold by countries seeking to restore the gold standard, a scramble that began in earnest in 1928 when the Bank of France began cashing in its foreign exchange reserves for gold bullion, a move coinciding with the attempt of the Federal Reserve System to check what it regarded as a stock-market bubble by raising interest rates, attracting an inflow of gold into the United States just when the Bank of France and other central banks were increasing their own demands for gold. It was the confluence of those policies in 1928-29, not a supposed inflationary boom that existed only in the imagination of Mises and Hayek and their followers that triggered the start of a downturn in the summer of 1929 and the stock-market crash of October 1929. Once the downturn and the deflation took hold, the dynamics of the gold standard transmitted a rapid appreciation in the real value of gold across the entire world from which the only escape was to abandon the gold standard.

Leaving the gold standard, thereby escaping the deflation associated with a rising value of gold, was the one sure method of bringing about recovery. Fiscal policy may have helped — certainly a slavish devotion to balancing the budget and reducing public debt – could do only harm, but monetary policy was the key. FDR, influenced by George Warren and Frank Pearson, two Cornell economists, grasped both the importance of stopping deflation and the role of the gold standard in producing and propagating deflation. So, despite the opposition of some of his closest advisers and the conventional wisdom of the international financial establishment, he followed the advice of Warren and Pearson and suspended the gold standard shortly after taking office, raising the gold price in stages from $20.67 an ounce to $35 an ounce. Almost at once, a recovery started, the fastest recovery over any 4-month period (from April through July 1933) in American history.

Had Roosevelt left well enough alone, the Great Depression might have been over within another year, or two at the most, but FDR could not keep himself from trying another hare-brained scheme, and forced the National Industrial Recovery Act through Congress in July 1933. Real and money wages jumped by 20% overnight; government sponsored cartels perversely cut back output to raise prices. As a result, the recovery slowed to a crawl, not picking up speed again till 1935 when the NRA was ruled unconstitutional by the Supreme Court. Thus, whatever recovery there was under FDR owed at least as much to monetary policy as to fiscal policy. Remember also that World War II was a period of rapid inflation and monetary expansion along with an increase in government spending for the war. In addition, the relapse into depression in 1937-38 was at least as much the result of monetary as of fiscal tightening.

I would never say forget about Keynes or Hayek, but really the true master– the man whom Keynes called his “grandparent in the paths of errancy” — was Ralph G. Hawtrey.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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