Wednesday, July 3, 2013

Nick Rowe on Keynesian Questions

This is a very good post. It starts with two observations: (1.) Keynesianism isn't really about fiscal policy, and (2.) Keynesianism is highly correlated with fiscal policy views (certainly before New Keynesianism).

The question is, why?

The first observation is important in its own right. Going back to my extremely limited experiencing teaching macro to freshman, I would run through the Keynesian cross first without G (of course its in their textbooks with G in a fiscal policy section so it came in pretty quickly). But the first cut was nice to do that way precisely because I'm one of those sticklers on Nick's first observation. The important contribution is the theory of how the economy works, not the policy view. Plus in the General Theory he doesn't have G in his initial Keynesian cross analysis (in fact I'm not sure if it ever comes in explicitly). So call it my history of economic thought rebellion against modern textbooks.

Nick also gives two important reasons for why Keynes thinks that the division of expenditures between consumption and investment might not always be optimal - neither are particularly commonplace in casual internet conversation. If you're speaking to a Keynesian critic they'll usually cite "animal spirits" and say that Keynes basically handwaved at the whole question. Somewhat more sophisticated conversations will bring in Nick's "macro reason" - the problem of how Say's Law breaks down in a monetary economy. I have almost never seen anyone bring up the "micro reason". Nick doesn't cite to the General Theory but this comes from Chapter 16 in what I think is a too much neglected passage:
"AN act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

If saving consisted not merely in abstaining from present consumption but in placing simultaneously a specific order for future consumption, the effect might indeed be different. For in that case the expectation of some future yield from investment would be improved, and the resources released from preparing for present consumption could be turned over to preparing for the future consumption. Not that they necessarily would be, even in this case, on a scale equal to the amount of resources released; since the desired interval of delay might require a method of production so inconveniently “roundabout” as to have an efficiency well below the current rate of interest, with the result that the favourable effect on employment of the forward order for consumption would eventuate not at once but at some subsequent date, so that the immediate effect of the saving would still be adverse to employment. In any case, however, an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order. Thus, since the expectation of consumption is the only raison d'ĂȘtre of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has cet. par. a depressing effect on employment.

The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for “wealth” as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished."
This is exactly why when people tell you that Keynesians think that investment and capital are homogeneous they have no !&#$% idea what they are talking about and should not be taken seriously on the matter. It is one of the dumbest criticisms out there.

Monetary policy is of course also correlated with Keynesianism, but it's correlated with other ideas too, because monetary policy moves the investment/consumption mix. I think fiscal policy is correlated with Keynesianism for a different reason: because fiscal policy is considered, like investment, to be exogenous w.r.t. income. You can think of the exogeneity of investment in the Keynesian cross sense that investment is not a function of income but consumption is (this should be reminding you of the Landsburg discussion and some bad counter-examples that people came up with - specifically the problems Malcolm outlined in his comment that I shared as a post), or you can think of the exogeniety of investment in more neoclassical terms as a function of technical parameters in the production function, depreciation, time preference, etc.

However you choose to think of it, fiscal policy is an exogenous lever that gets income back on track - and when income is back on track then private preferences can get the distribution of expenditures back on track.

As a side note I think that a good appreciation of externalities means that there's lots of stuff we should be confident in the government spending on anyway (so why not make it counter-cyclical?). But this is more of a Pigovian point than a Keynesian point.

11 comments:

  1. Thanks Daniel!

    I have updated my post to link back to your post, because that passage in the GT was exactly the one I vaguely remembered reading, and that was in the back of my mind when I wrote my post.

    I don't remember reading much about G in the GT either. But my memory is no good.

    I'm not sure you are right that monetary policy affects the I/C mix (ratio). Even if you think of monetary policy as "setting interest rates", a cut in r will increase both C and I, directly as well as indirectly (via Y). Which one rises most, and so whether C/I rises or falls, depends on the elasticities (both interest and income).

    Remember the Investment accelerator -- I depends on Y (or expected future Y demanded) too.

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  2. "The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished."

    This is essentially an arguing that a "flight to quality" has taken place. So, new savings push up the value of existing capital rather than causing new investment. Is that what you mean?

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  3. If you are the producer of a consumer good and demand suddenly falls then you may (if you read economic blogs) conclude that one of the following is true

    1 liquidity preference has risen and demand for all goods has fallen
    2 demand for your good has fallen and moved to other consumer goods
    3 demand for all consumer goods has fallen as people wish to save more so they can increase consumption in the future.

    If you live in a world where the money supply is adjusted to meet changes in liquidity requirements (say NGDPT) then you know the reason is not 1. If its either 2 or 3 then your action is the same. You reduce qty produced and adjust price (depending upon shape of demand curve for your product and supply curve of your inputs).

    If you're the producer of a consumer good whose sales suddenly increase then the same logic applies. You just You increase qty produced and adjust price (depending upon shape of demand curve for your product and supply curve of your inputs).

    And if the reason for the change is 3 ? Then more money will be saved, this will make it more attractive to invest. People looking at where to invest will see consumer good prices diminishing and investment goods prices increasing (at least relative to consumer goods0 and invest in the appropriate area.

    So: as long as we have a monetary policy that adjusts for changes in the desire for liquidity the price mechanism will guide the economy no matter what changes in tastes for different goods or time preference are driving it.

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    Replies
    1. Ngdp targeting is about #3 not #1. If we want to eliminate all excess demand for money and excess supply of it then targeting MV=PT rather than MV=PQ is the way to go about it. Targeting MQ is all about the output gap, not demand for money.

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    2. Do you think so ?

      The way I have been looking at it is that if the value of money can be held constant (which is what my #1 is about - adjusting the supply of money to meet the demand) then #3 will take place thru market forces.

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    3. The equation MV=PY (or MV=PQ) deals with transactions that are counted for GDP. M is all money. P is the price level of GDP income and Y is real income. V is not the rate that money changes hands. Transactions of money that take place to buy or sell assets are not counted in V. So, if I sell you a used car then that doesn't increase V in this equation, but if I sell you a new car then it does.

      The result of this is that this V doesn't have a fixed relationship with the demand for money. The normal rationalization is that if a person holds more of their money rather than spending it then V decreases. That means that the realized demand for money is the inverse of V. But, that only works if the the V here is actual velocity, which the V in MV=PY is not. For example, I could have a high demand for money and therefore sell some of the capital goods I own to obtain more money. But, that isn't counted in MV=PQ, because those goods aren't part of GDP. All that counts for that is my spending on GDP goods, and if that increases during the same period then according to MV=PY my demand for money has fallen.

      So, it only makes sense to talk about demand for money when using the total quantity equation, the one which includes all transactions: MV=PT. Targeting PY as Sumner & co propose isn't really adjusting the quantity of money to demand for it. It may be in some cases, but that's an empirical question that would be difficult to answer.

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    4. If the aim of economic policy is to keep real output at its optimum level then it seems logical that demand for money will be measured in relation to spending on real output. The aim is to keep the value of money constant in relation to these goods.

      I agree that it may be a weakness in the case for NGDPT that it ignores other signals that V may be increasing such as increasing transaction volume and prices of assets. I think that many supporters of NGDPT are supporters of EMH and think that if you take care of AD everything else will fall into place.

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    5. "If the aim of economic policy is to keep real output at its optimum level then it seems logical that demand for money will be measured in relation to spending on real output."

      To make sense "Demand for money" must be measured like any other sort of demand in economics. For example, we don't say that the demand for cars is the demand to buy cars with income though not with capital. Demand shouldn't be redefined to mean something special and different. It may be that adjusting the quantity of money so that PY is a constant is a good policy, but it's still not satisfying the demand for money.

      "I think that many supporters of NGDPT are supporters of EMH and think that if you take care of AD everything else will fall into place."

      That's certainly what Sumner thinks. I don't agree, I think things are more complicated than that.

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  4. The paragraphs cited are the basis of the (largely neglected) work of Leijonhufvud, Clower and others, labeled (wrongly, in my view) as "disequilibrium theory". This theories lead naturally to fiscal policy as the right signal to fix the coordination failure between saving and investment. So yes, GT has a lot to do with fiscal policy after all.
    Pablo Mira

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  5. In that one passage of GT we see what distinguishes Keynes from virtually anyone today-at least in the Neoclassical school. In my experience the idea that savings aren't automatically and necessarily future consumption is such an counterintuitive idea it's not even seen as something you discuss in politic company. Yet it has a lot of consequences.

    For one thing it calls into question the very philosophical premise of a 'progressive consumption tax.'

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  6. Mike: "In my experience the idea that savings aren't automatically and necessarily future consumption is such an counterintuitive idea it's not even seen as something you discuss in politic company."

    It's an idea we discuss a lot in basic macro courses. It underlies the "Paradox of Thrift". Whether it's right or not is open to debate. It depends. It depends in particular on monetary policy.

    Pablo: I agree that "disequilibrium theory" is unjustly neglected. I was lucky enough to be of exactly the right age to learn it at grad school (from Peter Howitt), just before it was abandoned. I don't think I would agree with you though that this approach leads naturally to fiscal policy.

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