Monday, June 20, 2011

The Consistent Keynesian Story

Brad DeLong highlights a particular portion of Krugman's piece on Keynes:

"What did Keynes really intend to be the key message of the General Theory?... [I]t’s surely not the most important thing.... What matters is what we make of Keynes, not what he really meant.
I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability.... Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed....

So who’s right about how to read the General Theory? Keynes himself weighed in, in his 1937 QJE article, and in effect declared himself a Chapter12er. But so what? Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can..."

A lot of people claim that there's this massive contrast between the early Keynes and the late Keynes. I think that's vastly overblown. Yes, there are a few ideas that the late Keynes provides us that the early Keynes hadn't thought of yet. But as early as the early 1920s you could see the germ of all the later arguments - all of them. And nothing was especially contradictory, so much as immature.

Now Krugman is suggesting there's some divide in the General Theory itself!

I really don't think there's any reason to choose here.

Why can the economy operate below full employment? Because investment demand isn't guaranteed to adjust to full employment. Why doesn't investment demand always adjust? Because investment demand is limited by the interest rate which - rather than being determined in the loanable funds market - is determined entirely by the demand for money or liquidity. The low expectations that Krugman refers to from Chapter 12 lower the expected stream of benefits from an investment. When those expectations are reduced, the marginal efficiency of capital - the discount rate at which an investment breaks even - is also reduced. Financial panics that reduce expectations also increase money demand. So the MEC consistent with full employment is getting lower at the same time that the demand for money is getting higher, and there is no guarantee that the interest rate provides a level of investment that is consistent with full employment.

We have a new equilibrium. It is not a unique equilibrium. There are many, including many that are below full employment.

Chapter 12 and Book 1 don't conflict. You need Chapter 12 to explain why Book 1 says that we're not guaranteed to sit at full employment. And furthermore, you need a liquidity preference theory of the interest rate to understand any of this or to make sense of the behavior of interest rates and employment over the last two years.


  1. Daniel - Krugman's making a pretty standard well-accepted argument. 'Chapter 12' Keynesians like Minsky and Shackle emphasise the impact of radical uncertainty and financial markets on investment expenditure. Shackle is very explicit that investment decisions are simply not sensitive enough to interest rates and that radical uncertainty dominates small changes in rates.

    Most Post-Keynesians are Chapter 12-ers and Keynes himself explicitly endorses this reading in the above-mentioned 1937 QJE article. Most models of this type are disequilibrium models - Minsky's approach being an example and Steve Keen's work being a more recent example. They are disequilibrium in the sense that the model is dynamic and equilibrium is never achieved. I'd even say that Minsky's work which incorporates financial markets into the Chapter 12 reading doesn't make sense in an equilibrium setting. The best source for this is Minsky's book 'John Maynard Keynes' which is his interpretation of the General Theory.

    As a market practitioner, I find Minsky's views persuasive and therefore to the extent that I am a Keynesian, I am a Chapter 12-er. Not saying that the Book 1-er position is right or wrong but at the very least, there are some fundamental differences between the two positions.

    P.S. Nice blog.

  2. Here's some more talk about Keynes (and Hayek) - you have to plop down to the second quoted segment to read it (do you think the author has read _The Road To Serfdom_?*):

    *And there's old Nozick again, standing in for all things libertarian.

  3. Imagine the time preference theory of interest were true, what implications does that have for investment demand and employment?

  4. Well do you mean just the time preference theory of interest were true?

    Most people agree on time preference questions. This is not in deep dispute, despite Keynes's own decision to break the mold and present an exclusively liquidity preference formulation (where the loanable funds market - i.e. questions of time preference - took the interest rate as given from the market for liquidity).

    Time preference alone obviously gives the standard, mainstream, marginalist, result.

    It also makes it harder to understand what's going on now.

  5. "Most people agree on time preference questions. This is not in deep dispute, despite Keynes's own decision to break the mold and present an exclusively liquidity preference formulation."

    This is my understanding of Keynesian theory. You hold a liquidity preference theory of interest, right? Where the interest rate is a price paid on the relinquishing of cash or liquidity. This makes it a "monetary" phenomenon, right - as opposed to a "real" phenomenon? In other words, the interest rate is determined solely by the interplay of cash balances and money transfers?

    "Time preference alone obviously gives the standard, mainstream, marginalist, result."

    Well, it does and it doesn't. Time preference theory explains the supply of loanable funds in the neoclassical framework, but not the demand. The demand for loanable funds is usually connected with the marginal efficiency of capital - and so the neoclassical theory of the interest rate becomes a "productivity" theory of the interest rate.

    I was asking you to imagine if the interest rate were a product of time preference on both accounts. Rothbard explains the Austrian position better than I can.

  6. "That no single purpose must be allowed in peace to have absolute preference over all others applies even to the one aim which everybody now agrees comes in the front rank: the conquest of unemployment. There can be no doubt that this must be the goal of our greatest endeavour; even so, it does not mean that such an aim should be allowed to dominate us to the exclusion of everything else, that, as the glib phrase runs, it must be accomplished 'at any price'. It is, in fact, in this field that the fascination of vague but popular phrases like 'full employment' may well lead to extremely short-sighted measures, and where the categorical and irresponsible 'it must be done at all cost' of the single-minded idealist is likely to do the greatest harm." - F.A. Hayek, _The Road To Serfdom_ pg. 211-212

  7. Mattheus -
    Keynes held a purely liquidity preference theory of interest and he reiterated that in 1937.

    No Keynesian since then that I am aware of has a purely liquidity preference theory of interest. They have a Hicksian perspective, which incorporates both liquidity preference and time preference.

    So - if one likes one can feel free to dismiss Keynes, and I can feel free to praise him for charting new territory with liquidity preference. In the end, though, I doubt any Keynesian you'll ever come across is in any way hostile to time preference.

  8. Mattheus,

    There are lots of problems with removing productivity entirely from interest rate determination, which is what Rothbard tries to do. The reasonable position is to have both "productivity" (which is really demand from entrepreneurs based on expectation of later profit), and time-preference play a role. Hayek does this in a paper called "Time-Preference and Productivity: A Reconsideration". I mentioned this in my article disagreeing with Daniel on the MEC on the Cobden Centre site.

    I don't entirely agree with Keynes' theory even when augmented with time-preference. A bank account balance may pay interest, just as bonds do. A bank account may also come with services that are free to the user. In both cases there is a saver who is lending and earning interest. The difference is that the interest is paid in a different form. If it's less for the bank account than for bonds it's because of the costs to the bank, including the redemption uncertainty cost and cost of reserves needed to cover it.

    However, Daniel and Keynes are quite right that people hold balances in order to have liquidity, so saving isn't just motivated by time-preference.

  9. What's the basis for taking liquidity preference then? And how do the two co-operate to result in the interest rate?


All anonymous comments will be deleted. Consistent pseudonyms are fine.