Friday, July 15, 2011

My Response to Russ

Russ Roberts emailed me that: "I criticized your comment to my post on Keynes and Reality. You'll see it in the post Keynes and Reality-2. If you'd like to respond, i'm happy to post it in the post itself rather than in the comments or in a separate post."

My response (edited a little bit from what I initially sent): "Russ –As you mention in the post, the comment of mine that you selected is the most tautological one I posted, so it deserves more fleshing out. I think I did that in other comments, but it’s worth mentioning some points here.

Why do Keynesians think aggregate demand can be weak? A lot of people claim we just resort to handwaving and ignore this, but if people are honest with themselves they know that’s not true. We usually cite problems of (1.) excess demand for liquidity due to uncertainty about economic conditions, (2.) an undersupply of government bonds and liquid assets, (3.) a drop in investment demand (animal spirits), usually due to a financial crisis, (4.) low consumer demand due to stagnant wages or lack of access to consumer credit, (5.) deflation which makes investment less attractive, (6.) weak foreign demand due to an overvalued currency, etc. There are lots of other things that are commonly pointed to as potential problems, but those are the main ones. Were any of these six a major problem in the immediate post-war period? Not that I can think of, and we haven’t even gotten into the ever-controversial “liquidity trap”. The first two are crucial and often discussed by Krugman, DeLong, and others but rarely discussed by libertarian opponents besides some monetary disequilibrium theorists like Scott Sumner and perhaps Steve Horwitz. Those two especially are what was addressed by spending on the second world war.

So no, if I had no clue who Samuelson was or that he made these predictions, the post-war period wouldn’t surprise me at all or challenge anything I know about what Keynesians think influences effective demand.

Which of course begs the question – what was Samuelson thinking? I don’t know all the details and I’ve also been frustrated at how inaccessible that chapter is (if anyone knows of an electronic copy I’m very interested), but part of it was that he was basing his expectations on the empirical example provided by the sharp cut in spending by Wilson immediately after the first world war, which was soon followed by a deep depression from 1920-1921. Samuelson wasn’t the only one to use the example of this depression. Irving Fisher mentions it a lot in his forecasts, a report by the Bank of International Settlements forecasting the post-WWII economy mentions the 1920-1921 prominently, and Herbert Hoover himself would mention it at the beginning of the Depression. We forget about it, but it was very prominent in people’s minds at this time.

The standard interpretation of the 1920-1921 depression was that it was caused by the sharp drop in military spending. We actually know better now, thanks to research by Christina Romer, Peter Temin, J.R. Vernon, S.N. Broadberry and others. They all concluded that despite following closely after a drop in demand, 1920-1921 was actually caused by a series of supply shocks and high discount rates imposed by the Fed to end the wartime inflation (much like Volcker‘s Fed in the early 1980s). So it offers a poor example of what to expect when the government removes demand from the economy. Many things could happen in response to that, and what ultimately happens depends on investment demand and consumer demand, both of which had every reason to be strong after WWII. I am somewhat familiar with the details of the 1920-1921 depression and trying to get more familiar. I have an article in the most recent volume of the Review of Austrian Economics on the subject, and another article under review at the Cambridge Journal of Economics, if anyone is interested in reading more.

I’ve never read a passage in Keynes that says “if the government doesn’t spend the private sector won’t or can’t”. I’m not going to think very much of this alleged silver bullet with Samuelson until I do come across Keynes or any Keynesian making a defensible claim to that effect."


Russ also writes me this afternoon: "If you cannot confirm or reject your predictions, your theory is not testable--it is merely a structure for thinking. You are dangerously close to saying that about Keynesianism..."

I have some thoughts on this, but don't have time to explain them in too much depth right now. It's certainly something I've talked about before. I'm pretty flexible in my answer depending on how he wants to define "confirm or reject your predictions". I'm happy to say "we can do that" given certain definitions, and happy to say "we can't do that and it's a structure for thinking along with every other theory" given other definitions. Anyone else have thoughts on this point?

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