The evidence for Keynesian economics

by Russ Roberts on October 11, 2011

in Stimulus, Uncategorized

Paul Krugman explains why he believes (his verb) in Keynesian economics.

A correspondent asks a good question: what evidence makes me believe that Keynesian economics is broadly right, given the relative absence of experience with large fiscal stimulus programs?

I’d answer that question with several points.

First, we’re talking about a model, not just a prediction about the impact of spending increases. So you can ask about the ancillary predictions of that model as opposed to rival models. Anti-Keynesians assured us that budget deficits would send interest rates soaring; Keynesian analysis said they’d stay low as long as the economy remained far from full employment. Guess who was right?

Krugman is a superb polemicist. He takes a single argument of anti-Keynesians and uses it to show us that Keynesian claims beyond the effects of stimulus spending are probably right. Does Krugman really believe that you can’t have high interest rates when there is high unemployment. The stagflation of the 1970s when there was high unemployment with high interest rates is one reason Keynesian went into disrepute.

Also, there are some features of the approach that can be tested separately. Keynesianism isn’t just about sticky prices, but it does generally assume sticky prices — and there is overwhelming evidence, from a variety of sources, that prices are indeed sticky.

This is an even better piece of polemicism than the first one. Keynesian models assume sticky prices, prices are sticky, therefore? Therefore what? Therefore Keynesian models have somewhat realistic assumptions. That isn’t the most convincing selling point.

Also also: there’s plenty of evidence that monetary policy can move output and employment — and it’s very hard to devise a model in which that is true that doesn’t also say that fiscal policy can be effective, especially when you’re up against the zero lower bound.

Yes, there is plenty of evidence that monetary policy can have real effects. So why isn’t there plenty of evidence of fiscal policy having real effects? He has to say that in the models (whose? which ones? All of them?) that presume monetary policy works, so does fiscal policy.

So his first point is that the model works well–it has correct implications in general, its assumptions (well one of them anyway) are realistic and if monetary policy works, fiscal policy should too.

Second, while we don’t have a lot of postwar experience with fiscal stimulus, we do have a lot of experience with anti-stimulus, that is, austerity — and that turns out to be reliably contractionary. Again, it’s hard to think of a model in which austerity is contractionary but stimulus isn’t expansionary.

Finally, there is evidence from fiscal expansions in the 1930s, which actually did lead to economic expansion too.

Mainly I’d stress the first point. We have a model of the way the world works, and the world does indeed seem to work that way. And an implication of that model is that fiscal stimulus will work under conditions like those we face now. If interest rates had soared, if the rise in base money had led to rising GDP and/or soaring prices despite the zero lower bound, I would have sat down to reconsider what I thought I knew about macroeconomics. In fact, however, my preferred model has passed the test of events with flying colors, while the other guys’ models have been totally wrong.

If I were defending Keynesian economics I guess I’d go with the first point, too. Because the empirical evidence he cites in his second point is very mixed. Krugman cites the studies that supports his view (as we all tend to do.) He leaves out the post-WW II expansion that followed huge cuts in government spending where the Keynesian predictions were totally wrong. He leaves out the stagflation of the 1970s. He leaves out all the studies that find a small multiplier (Barro and Redick, Ramey (who will be a guest on EconTalk in the next two weeks) and work by Alesina that shows that contractions in government spending (the austerity Krugman refers to) actually encourage economic growth.

The evidence for the Keynesian worldview is very mixed. Most economists come down in favor or against it because of their prior ideological beliefs. Krugman is a Keynesian because he wants bigger government. I’m an anti-Keynesian because I want smaller government. Both of us can find evidence for our worldviews. Whose evidence is better? I’m not sure it’s a meaningful question. My empirical points about Keynesianism won’t convince Krugman. His point don’t convince me. I am not saying that we will never get any kind of decisive evidence on the question. I’m saying it sure isn’t here now.

UPDATE: Krugman defends himself here.


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