Keynesian economics

by Russ Roberts on September 24, 2009

in Complexity & Emergence

Richard Posner has read Keynes’s General Theory so you don’t have to. He does a superb job of summarizing (HT: Greg Mankiw) what Keynes actually said. Other than pointing out the opaqueness of the work, Posner says little against it. The title of the piece is “How I Became a Keynesian” so I guess he found the arguments compelling.

Part of Keynes is compelling, the part about animal spirits, the idea that people get worried about the future, that the riskiness of the future is hard to quantify, and that this leads to people reining in plans for consumption and investment, leading to hoarding and reduced demand for all kinds of goods.

What is not so compelling is the conclusion that this can be rectified and improved on by the government taking up the slack, regardless of the reason. What is not so compelling is the idea that consumption creates growth. Consumption might create production (it depends) but consumption is not growth except in the very immediate term. (I almost said the short run, but you say the short run in a piece on Keynes and you can hear the mocking chorus that in the long run we’re all dead. If the long-run is five years, it’s not true. If it’s 50, our children are alive and we care about them).

Also missing from the Keynesian story is the role of money creation and where the animal spirits of caution come from. They aren’t spontaneous, certainly not in today’s world, a world where Posner want to apply Keynes’s insights. People are cautious right now in reaction to past recklessness. The Fed and the policy-makers are trying to keep the party going with massive increases in money reserves, cash-for-clunkers, home owner subsidies to people whose mortgages are underwater, and the so-called stimulus package which is stimulating the incomes of some people, financed out of future taxes on the rest of us.

But as Hayek would point out, the party needs to stop. We need to clean up the mess. It’s not an easy mess to clean up but to pretend that we can clean it up by pretending it didn’t happen seems to me to be a form of free lunch fantasy.

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Anonymous September 24, 2009 at 2:29 pm

I think the reason why a lot of people don’t take the next step with Keynes is that they don’t consider the unique circumstances of fiscal policy in a liquidity trap. They attack stimulus as if it was proposed in non-liquidity trap conditions and try to make the claim that that attack is valid against Keynesian arguments for stimulus under liquidity trap conditions.

Great points on Posner though. I found the article fascinating when I read it yesterday. What was most incredible to me is that someone of Posner’s stature hadn’t read the General Theory until THIS YEAR. I couldn’t believe it. I’ve written off a lot of Krugman’s “Dark Age of Macroeconomics” talk as hyperbole… but you really start to wonder about “lost knowledge” when someone that prominent hadn’t even read the book.

Anonymous September 24, 2009 at 10:39 pm

That you’ve written off Paul Krugman is a good first step. Next reading assignment – Milton Friedman.

Anonymous September 25, 2009 at 10:53 am

I’ve actually read Friedman books but never read a book by Krugman (portions). You’ll hear few complaints from me about Friedman. I’ve written Krugman off many times before! Not a first :) The important thing is I restrict it to specific statements of his, not the guy himself.

Jonathan September 24, 2009 at 2:38 pm

Good post, appreciate the insight. I read Mankiw’s NYT piece where he writes that Keynes’s book is the best one to read right now, but I’d suggest with the rapid expansion of government, perhaps the Constitution of Liberty deserves a second look by all. Feels like there’s quite a bit of coercion going on…

Anonymous September 24, 2009 at 3:22 pm

Warning warning to all educated participants, street level comment below.

“Part of Keynes is compelling, the part about animal spirits, the idea that people get worried about the future, that the riskiness of the future is hard to quantify, and that this leads to people reining in plans for consumption and investment, leading to hoarding and reduced demand for all kinds of goods.

What is not so compelling is the conclusion that this can be rectified and improved on by the government taking up the slack, regardless of the reason. What is not so compelling is the idea that consumption creates growth.”

I realize that I have excerpted just one small portion of the above, but when I read it I could not help but flash back to a day about 16 years ago when I was doing commission sales in Cultured Marble for an acquaintance.

We were traveling in the suburbs of Houston and seeing area after area of new home construction, thousands of new homes. We were also both aware that there were many more thousands of older homes in Houston, most occupied, some not.

My acquaintance made the comment that he couldn’t understand how this new building could be possible and asked, “where are the new buyers going to come from?” (Yes, of course it was all pre-catastrophe).

Just on the basis of logic I pointed out that with a population of 4 plus million the numbers of people seeking new homes are astounding. Consider that all those older homes occupied are done so by settled people probably reaching that conservative age mentioned above where people began to hoard, save, and perhaps consume less, but with 4 million people thus housed, we could assume (and not be too far off) that approximately 35 to 40 percent are coupled and producing at least an average of replacement babies, 2 children to each couple. Each year new couples, new children over the next few years. I also believe, but have no stats for that the replacement birth rate is low at least for this area.

So, just doing mental math we could again make an assumption that on any given year in Houston approximately 50 thousand babies are born. I am freely admitting my numbers are just WAGs (wild ass guesses to those who don’t know) but still they are most likely close.

If there are 50 thousand babies born in Houston each year INPUT, then we have to realize that also there will be 50 thousand new adults emerging from the OUTPUT end. New adults, new couplings, new children, year after year after year, added to the new immigration from the south.

50 thousand, again is a WAG, but that is a small city that needs to be built somewhere every single year and as typically most children do not move that far from their parents, that new city is being built around and in Houston.

Even factoring in the death rate, which empties older homes, a lot of those older homes are not going to be habitable or desirable to the new adult couples, so they will be torn down and a new one built in its place. That means the new demand substantially exceeds the availability year after year after year.

I have just addressed new homes so far, but each of these new adult couples are going to buy a vehicle if they don’t already have one, year after year. They will need foodstuffs, which means new grocery stores going up, year after year. They will need clothing, that means new clothing stores going up year after year.

Each new generation will require all and more of that which their older relations are cutting back on, growth is is unavoidable without direct deliberate interference by government.

My point is that while some are hoarding, saving, and cutting back on consumption, we don’t need government to come in and fix the part that says new or more consumption has to be generated. We do that very well on our own.

Our way is natural, steady, and reliable. It may not show the immediate results that produces huge yatchs, luxurious mansions, fabulous wealth, but it does show growth that will sustain us all as long as nothing gets in the way and screws it up, as only government can do.

I guess I am not a Keynesian.

John Dewey September 24, 2009 at 6:13 pm

growth is is unavoidable without direct deliberate interference by government.

Agreed. But regions cannot escape sins of their past. Growth will continue to favor Sun Belt cities, which have more population still in child-bearing years:

Metro area ——— median age

Houston ———— 32.4
Dallas ————– 32.7
Phoenix ———— 32.9
Los Angeles ——– 33.4
Atlanta ———— 33.6
Chicago ———– 34.6
New York ———- 35.9
Washington ——– 36.3
Detroit ———— 36.8
St Louis ———– 37.2
Philadelphia ——– 37.5
Boston ———— 38.0
Cleveland ——— 38.5
Pittsburgh ——— 41.4

In which of those cities has government been most active in interfering with commerce and industry the past few decades?

Anonymous September 24, 2009 at 7:41 pm

Sir,

You were just cryptic enough that I confess that I do not understand a point. I don’t understand the reference to regional sins of the past.

And, as the difference between Houston and Los Angeles above is only one point, yet I know that government is more interfereing in LA than in Houston, I do not understand that point either.

You gotta remember that I am not sophisticated, I like it spelled out.

Thanks

John Dewey September 24, 2009 at 8:05 pm

It’s not anything sophisticated at all.

First, I think Los Angeles is an outlier due to immigration. I don’t have demographic data at hand right now, but I’d bet that Hispanics make up a very large part of the Southern California child-bearing population.

As the rust belt has proven unkind to business, its factories and corporate headquarters have shrunk and disappeared. For the blue collar workforce, it has been the younger workers – the ones without seniority, the ones without home equity to tap, and the ones far from retirement age – who were forced to move.

By contrast, most of the sun belt has remained attractive to business. Younger workers in the South and Southwest stayed at home, and were joined by younger workers from the rustbelt.

So where are the children being born? What climate are tomorrow’s entrepreneurs and leaders growing up in? The sun belt, of course.

What strategy has the rust belt turned to in battling the sun belt? Level the playing field: raise national minimum wage; enact national pro-labor laws; force sun belt employers to provide outrageous insurance benefits which have already bankrupt the rust belt.

I don’t expect the blue states to win with that strategy.

John Dewey September 24, 2009 at 8:21 pm

One more thing: New York’s median age above looks younger because the dataset I used had separate MSA’s for Newark (median age 37.2) and Nassau-Suffolk (median age 38.5).

Anonymous September 24, 2009 at 9:20 pm

Thanks, I understand your point now.

But, my point about growth was not just directed at more kids, but the demand for consumer goods that increasing number will produce, that is the growth that drives the economy, in my rather humble viewpoint. And, having kids in increasing numbers is something the government can just get out of the way of, the demand and increase in the economy will follow, and this will happen across regions if the government stays out of the way. Businesses will take advantage of the labor pool in the rust belt, maybe not large manufacturing but there is more to manufacturing than making steel and autos, again in my rather humble opinion.

It just struck me that the Keynesians would do best by just getting out of the way and letting the natural course of events happen.

Will September 24, 2009 at 3:23 pm

Interesting… I find it odd that Posner cites the recent historical work about Keynes. Mankiw’s WSJ review of that book indicated that the economic bent of the book was deeply amateur, which is not surprising. Skidelsky is a historian, not an economist.

Anonymous September 24, 2009 at 3:31 pm

so why would the govt be bereft of any animal spirits?. guess,it would be intelligent dead-in-the-long run keynesy boy who woll be advising the govment

Pingry September 24, 2009 at 5:19 pm

“The Fed and the policy-makers are trying to keep the party going….”

Ummm…no, the Federal Reserve consists of real economists who eschew naive Austrian macro. They’re not “trying to keep the party going,” but rather trying to support a very weak invisible hand by setting the conditions to get the economy back to NAIRU. It’s entirely irresponsible to follow the Austrian prescription of cheering for a recession to liquidate malinvestment so that resources can be used for the next expansion.

This fallacy stems from the amateurish belief that the invisible hand works to eliminate malinvestment and other foolish decisions, consequently freeing up these scarce resources, only when the economy suffers some downturn from insufficient aggregate demand.

And predictably you follow up with:

“But as Hayek would point out, the party needs to stop. We need to clean up the mess. It’s not an easy mess to clean up but to pretend that we can clean it up by pretending it didn’t happen seems to me to be a form of free lunch fantasy.”

Yes, the party does need to stop, but Hayek, Mises and others were wrong to believe that a recession is necessary for it to stop. In fact, Keynes was far more concerned with the welfare of innocent people suffering (despite no separation of nominal and real magnitudes in the General Theory, he understood the nominal veil) when he talked about all of us being dead in the long-run. What did Hayek and Mises want? Not to interfere with the recession because it would leave its cleansing work undone, despite the fact that millions of workers and machines remain idle.

The party can stop at NAIRU so that innocent people (The Austrians have no explanation why non-bubble industries and other innocent people, like, say, recent college graduates get screwed over) don’t have to absorb most of the spillovers. Because, of course, that is what happens in most recessions: The spillovers from wage and price inflexibility are borne mostly by innocent people.

There is no changing of the structure of production. Bad investments and decisions can be taken care of at full employment, and recessions are never needed for anything. Indeed, recessions are a flaw in the capitalist system, and anyone who believes otherwise is both unethical and foolish.

As I have said before, the best situation is one in which we strive for perfect price stability at the macro level and perfect price flexibility at the micro level, both within the context of a free and open market system which operates as near as possible to the NAIRU so that the invisible hand can work its magic (that is, bad investment and other poor decisions can be taken care of) without worrying about the devastating effects of cyclical unemployment.

Finally, did not Friedman deal a devastating blow to Austrian Business Cycle Theory with the plucking model?

So, no Russ, nobody is “pretending it didn’t happen” nor is it a “free lunch fantasy.” We know what happened, and it’s very expensive to correct, but under no circumstances does it warrant an even greater downturn, or any downturn for that matter, to “clean up the mess.”

Anonymous September 24, 2009 at 6:24 pm

If some people are employed in unproductive places, how can we correct the situation without having them become unemployed for a period of time?

Pingry September 24, 2009 at 6:58 pm

There’s no doubt some people would be unemployed for some time, only to be allocated to a new use. But this need not entail a recession and cyclical unemployment endured by the wider economy.

If we could stay at NAIRU all the time, then the resources associated with the subprime mess (finance, real estate, etc.) could become unemployed for a given time and find new positions as there would be no insufficient aggregate demand. That is, their greedy and amatuerish bubble would affect only them, without spillovers to innocent people in other industries and elsewhere in the economy (A recession with cyclical unemployment).

Admittedly, this hypothetical argument, of course, makes an assumption that it doesn’t apply to healthy firms and resources in the same industry (unlike, say, unrelated industries) who may experience spillovers associated with massive counterparty risk because, despite not playing in the subprime feeding frenzy, the financial system is, by its very nature, very illiquid.

In the real world, we must settle for second best because we can never everywhere and always be at NAIRU, but I don’t think it’s such a radical proposition to have a countercyclical policy approach to get us back to NAIRU, and have the necessary resource allocation occur at NAIRU, not in a recessionary Okun gap.

Most of the silly arguments I hear about needing a recession to liquidate the malinvestment is based on a misunderstanding of the nominal veil (which is why explicit inflation targeting is an appropriate monetary policy strategy to those who do) and the belief that the invisible hand is stronger in a recession than at full employment (there is no lengthening of the structure of production), when, I strongly believe that the evidence is just the opposite.

Indeed, there are circumstances like our current crisis and recession in which I think the invisible hand would be crippled.

John Dewey September 24, 2009 at 7:28 pm

“the belief that the invisible hand is stronger in a recession than at full employment”

I don’t know about banking and finance. In the airline industry, I’ve observed that executives can more easily shrink capacity when they can blame misfortune on economic conditions rather than their own ineptitude.

“there are circumstances like our current crisis and recession in which I think the invisible hand would be crippled.”

Again, my experience in the airline industry leads me to believe that healthier firms wilol take advantage of exactly such an opportunity as this. When passengers return to 2007 levels, it will be the same young companies using their cashflow to gain share, just as they did in 2004-2007.

Why would other industries be different?

andy September 24, 2009 at 6:59 pm

It’s funny how calling a belief ‘amateurish’ is an acceptable argument…

The plucking model doesn’t seem to deal a blow to austrian economics: http://www.auburn.edu/~garriro/fm1pluck.htm

“What did Hayek and Mises want? Not to interfere with the recession because it would leave its cleansing work undone, despite the fact that millions of workers and machines remain idle.”

Not to interfere with the recession so that the unemployment would be short, instead of 10 year depression as in the 30′s.

“The party can stop at NAIRU so that innocent people (The Austrians have no explanation why non-bubble industries and other innocent people, like, say, recent college graduates get screwed over)”

‘re you sure? I don’t think there is any hard-rock science necessary to explain why ‘innocent people’ have problems, and considering deflation and indebted population…

“Bad investments and decisions can be taken care of at full employment, and recessions are never needed for anything.”

Accidentally the austrians believe roughly the same – the unemployment needn’t be too high if you allow * markets to operate *, if you don’t have *sticky prices*. Just wonder what has macro to do with all this…

Anonymous September 24, 2009 at 9:13 pm

You are using the wrong definition of ‘necessary’. In this case, it means “unavoidable”.

Bret September 24, 2009 at 6:20 pm

Russ Roberts wrote: “We need to clean up the mess.

Who exactly is “We”? The government? Economics professors? Readers of Cafe Hayek? Who?

Justin P September 24, 2009 at 6:52 pm

I don’t agree with much of what Keynes said. General Theory is not a good read. It’s very boorish, IMO.

Anonymous September 27, 2009 at 5:40 pm

I firmly believe that the monetary and fiscal policies that the world is embarking on have created liquidity induced securities speculation (all over again) and have engendered inefficient resource allocation. You can’t erase trillions in bad loans and poor capital investment decisions just by throwing around some “stimulus” funds and lowering interest rates to 0%.

http://www.beyondthemargin.net/2009/09/keynesian-economics.html

John Dewey September 25, 2009 at 1:13 am

“Businesses will take advantage of the labor pool in the rust belt”

Well, I agree with that. But I don’t expect that labor pool in the rust belt to grow. Or at least not grow very fast. As I see it, the business-friendly south and non-coastal west will continue drawing talent away from the rust belt.

How many young Texas and Tulane and Auburn grads do you think are making careers in Ohio and Michigan and Indiana? I’ve worked and golfed in Texas and Tennessee with many bright kids from the Midwest. I know that’s anecdotal evidence, but it’s been happening for at least 25 years.

Anonymous September 25, 2009 at 11:35 am

Why do I get the feeling that we are disagreeing when we don’t seem to be?

If you agree with the sentence you pulled, then consider that if it is probable, then growth there will inevitably occur for the simple reason that people with steady means of income will most likely began to buy the things they did without while out of work. That will inevitably attract more of all the side services, food, clothing, etc. that will now be in demand again. And, people child bearing years will feel more comfortable about bringing a child into the world.

I can agree that growth might be slower than in the sun belt, it may take longer for the effects to be felt, but it will happen if my thought was accurate.

I think we agree on the main point, and that is it will all work out better if the government can be made to leave things alone, and to clear out all the old foolish rules and regulations that contributed so much to the problem in the first place.

John Dewey September 25, 2009 at 1:19 pm

Oh, but we agree, vidyohs. You made the point very well that growth is inevitable as long as government stays out of the way. I was just adding that government can get in the way in many ways other than through Obama-type central planning. Business-unfriendly state laws, such as forced unionization laws, have seriously harmed the growth capability of the rust belt.

The point I was trying to make with median age comparisons is that the business-unfriendly climate of the rust belt has chased away much of the generation which would have fueled the normal growth of that region. After the grandchildren of the aging rust belt factory workers grow up in the Sun Belt, they will likely stay in the Sun Belt as adults.

I’m not disagreeing with your points at all, vidyohs. I’m just trying to show how the normal growth you refer to will be very uneven across the nation.

Anonymous September 26, 2009 at 3:36 am

Yes, we can agree on that. Thank you.

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