Tuesday, June 1, 2010

Some Posts on Keynesian Political Economy

Tyler Cowen give his take on fiscal and monetary policy, and if readers of F&OST can make heads or tails of it, feel free to explain it to me. He starts by quoting Matt Yglesias as presenting a standard Keynesian position... so... bad start (while Yglesias's point isn't all that bad, citing him for this sort of thing is a big no-no in my book). What bothered me most is that he didn't even really seem to understand or make the Keynesian case for fiscal stimulus before declaring that he was skeptical. He cited two points: (1.) intertemporal substitution that was possible (ie - smoothing the business cycle), and (2.) uncertainty about the future. Both are fine and consistent justifications for fiscal policy, but he doesn't even address fundamental Keynesian understandings of the determination of full-employment when he talks about fiscal policy.

Brad DeLong seems to note this two when he writes that Cowen's "inner Keynes is missing". DeLong focuses on the uncertainty point first and shows (somewhat stylistically) that it doesn't fully explain the general glut situation that we're dealing with. He then goes on to the question of business cycle smoothing and is incredulous at Cowen's equivocation:

It's not just that a greater amount of government investment meets the benefit-cost test when the government can borrow at 1.83% in inflation-proof bonds for thirty years, a whole bunch of tax postponements do as well. And so do a whole bunch of expanded social welfare programs. And so do a whole bunch of government issues of debt which are then invested in risky private ventures. So I don't see how Tyler then gets to:
"But even if that fiscal policy is a good idea..."

Where does the "but even" come from? I see no "but even" earlier in the market: the cost of borrowing for the government has fallen--the market value today of future cash tax flow earmarked for debt repayment has gone way, way up--therefore we should dedicate more future cash flow to debt repayment by borrowing more. There is no "but even." Expansionary fiscal policy is a good idea.

I'd agree with DeLong's assessment of Cowen (not to mention his assessment of government borrowing) on this count. Cowen seems to fall back on the "well smart people in government aren't pushing fiscal policy right now so there must be a good reason not to push fiscal policy right now and how dare economists like DeLong second-guess that" argument. He offers no good reason why he or anyone else is fine with monetary policy but not fiscal policy. In fact you rarely hear this trade-off ever made. Scott Sumner constantly asserts the same thing, and does a great job explaining why he supports monetary policy but a terrible job (1.) addressing the critics of reliance on any more monetary policy, and (2.) explaining why fiscal policy wouldn't work.

Then Cowen gets even more unintelligible when he starts imputing rationalizations to Keynesians:
"Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery. The Keynesians have no good theory of why their advice isn't being followed, except perhaps that the Democrats are struck with some kind of "Republican stupidity" virus. (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.) The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left... In general you should be suspicious of explanations which take the form of "if only the good people would all band together and get tough."
Excuse me? In what universe does the government's choice of what to do or not do have anything to do with the validity of an argument about fiscal policy, monetary policy, or anything else? Some Keynesian bloggers may put out their "if only..." hopes, but that says nothing about the validity of their argument. And many don't put out these hopes - many understand why it's so hard to get governments to implement these policies. As Mark Thoma highlights, a lot of it is politics, plain and simple. No need to appeal to "stupidity".

While I wouldn't appeal to stupidity first (I would appeal to the incentives that politicians face), relative ignorance of economics is pretty clear on Capitol Hill too. Obama understands more than most do, but he regularly appeals to his own brand of populism when he addresses the economy. Democrats who appeal to fiscal policy rarely go any farther than Cowen's own point about intertemporal substitution (ie - they don't understand the fundamental justification). And need I say more than "have you ever heard Ron Paul explain monetary policy or Dennis Kucinich explain capital markets?". Ignorance is not what I would initially appeal to because Congress realizes that there are better informed people out there than them, they call these people as witnesses and get them to help write bills, and they rely on them to a certain extent. But we shouldn't ever be afraid to say that the government operates under a certain degree of ignorance.

And speaking of Keynesian policy, Jonathan Catalan smacks down Robert Murphy on his opportunistic economic history, and cites yours truly (although I can't help but expect Murphy to read this and think "who the hell is this Daniel Kuehn?". Jonathan brings up the point of the liquidity trap:

"However, with no liquidity trap in the Depression of 1920–21, one cannot make the argument that that recession proves Keynesian fiscal policy wrong. Strictly speaking, Keynesians argue for strong fiscal policy only during liquidity traps, or where there is a lack of private investment. This was clearly not the case during the early 1920s, and so in the broadest sense Keynesians have not necessarily been proved wrong."

I would modify this point somewhat. "Liquidity traps" actually play a very minor role in the General Theory. When Keynes first mentions them, it is very speculative and he wonders whether a liquidity trap is even possible - but he holds out the possibility when he is discussing liquidity preference. Even through to the concluding notes, Keynes emphasizes the role of the interest rate in recovery - so he's not relying at all on the liquidity trap as a reason for switching from monetary to fiscal policy (the way it's treated today by guys like Krugman). J.R. Hicks (who himself was inspired by Mises and Hayek, in addition to Keynes) is responsible for fleshing out the liquidity trap in a more formal way, and giving it the attention that Keynes never did. Here's my take - Keynesian theory jutsifies fiscal stimulus in situations where there is a shortfall in aggregate demand below a full employment level of output. This demand shortfall can be either due to a lack of private investment, as Jonathan says (that's how it usually starts), or due to a lack of consumption. Monetary policy can help in these cases as well. However, when you're in a liquidity trap monetary policy turns into pushing on a string. Money demand is elastic, and monetary policy becomes considerably less useful. The U.S. has only been in a liquidity trap in the 1930s and today (we brushed up against one in 2001). It's not a common occurence, but when it does occur it just means that you have one less tool in the toolbox. When downturns are caused by supply shocks, bubble liquidations (like 1920-21), etc, and there is no depression of aggregate demand, there is no justification for fiscal policy. Monetary policy can help lance the bubble and ensure that money supply doesn't fall too low in the panic resulting from the popped bubble (a la Benjamin Strong or Paul Volcker). That's my view of things, at least.


  1. I'm not sure, but in The General Theory Keynes doesn't refer to the liquidity trap in the sense of reaching a lower bound on interest rates. At least, I haven't come across it (maybe he does). I thought that this particular concept was developed in the 1950s, or at least after The General Theory?

  2. I'll read this post when I have more time to comment.

  3. Just one question: Is there any understanding, in the Keynesian literature, on monetary factors that cause a liquidity trap? Or is it just assumed that animal spirits are causing people to stop borrowing entirely?

  4. As far as I'm aware, the liquidity trap is a money demand issue. It's caused by liquidity preference at extremely low interest rates (see our discussion in the other post of liquidity preference).

    Versions of the liquidity trap that focus on lower bounds to the interest rate sometimes talk about a negative interest rate that would clear the market for laonable funds. This isn't "animal spirits" necessarily - it's just caused by an insensitivity of investment to the interest rate.


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