Democracy in Deficit: Hayek Edition

Often you'll hear the argument that whether Keynes was right or wrong, he opened the flood-gates to politicians who destroyed fiscal sanity in his name. Buchanan makes this argument in Democracy in Deficit, and recently it's been repeated by Peter Boettke and Don Boudreaux.

It's an absurdly weak line of reasoning, and I want to illustrate why by using the same logic with Hayek - not because I think it's a legitimate case against Hayek (unlike Boettke and Boudreaux with Keynes, I personally think Hayek is an extremely high-caliber economist) but to illustrate how ridiculous the argument sounds:

So let's start by simply assuming that Hayek's great - that paying attention to Hayek will not lead a government astray and will not pile up an unmanageable debt. Hayek, on his own, is fine. But that's not really important. What's important is what Hayek and Hayekian economics gives politicians the license to do. Many politicians over the years have said that they are inspired by Hayek. Thatcher and Reagan are obvious politicians that fit this - both are symbolic of their era and of course have many allied politicians who felt the same way about him. More recently Paul Ryan has listed Hayek as a major influence, and has quoted him (here and here), including at CPAC - a major Republican Party venue. The same goes for Senator Rand Paul, and obviously his father as well. When was the last time Keynes was listed as a top intellectual influence for a President or for a Prime Minister? When was the last time Keynes was promoted at a Democratic Party function? I'm not sure if it's ever happened. You also have Hayek trumpeted by Glenn Beck and promoted on his show. My assertion - which I don't think any honest person looking at the evidence can reject - is that if you think Keynes has set a tone for any set of politicians (whether they are faithful to him or not), then Hayek has obviously set an even more substantial tone for another major set of Republican politicians (whether they are faithful to him or not). Anyone who wants to claim that Keynes gave politicians a license to do what they do has to admit that Hayek, as a major inspiration for a large swath of conservative politicians, has given at least as much license and therefore ought to be judged by the same standards that Buchanan, Boudreaux, and Boettke judge Keynes by in this regard.

So what can we lay at Hayek's feet for the license he gave politicians? Massive military buildups. Large and growing deficits during recessions as well as boom years. A complete lack of will to deal with entitlements or propose a long-term budget solution.

No one who lays these things at Keynes's feet can neglect laying them at Hayek's feet as well. If anything the case is stronger. Ron Suskind's recent book on Obama reveals to us that the president was vehemently opposed to the major Keynesian voices on his economic team. This is Obama - the guy that actually did stomach a modest stimulus two and a half years ago. If this guy has been given license by Keynes, then certainly we can put the Reagan legacy and virtually all post-Reagan Republicans at Hayek's feet.

*****

I propose something different: we stop honoring this argument as legitimate or logical. I appreciate James Buchanan a great deal. I've said here before I was thoroughly impressed when I was first assigned to read him as an undergraduate. I still am. But James Buchanan did a very poor job thinking about the legacy of Keynes, and unfortunately his arguments have been reproduced widely.

Krugman has made a similar argument about Hayek to what I make above. The difference between Krugman and myself is that he thinks it's actually a legitimate argument against Hayek and I don't. Boettke and Boudreaux seem to understand the problems with this line of argument when it comes out of Krugman's mouth. But when it comes out of Buchanan's mouth about Keynes and when they repeat it themselves, they are completely oblivious to how illogical they sound. Foolishness gets passed off as wisdom. This argument really has to stop. I'm getting to the point where I am having a hard time taking people seriously who make this argument.

If you have a problem with politicians - criticize politicians. Don't bring the bone you have to pick with Keynes into it unless there's a much clearer connection than this one.

Bastiat again, a little more formally, and then implications for stimulus

1. Bastiat

Bob Murphy has a good post up on my conversation with him on Bastiat. You can read him for context, but what it boils down to is that he and I started parsing out the costs and benefits and we got to a point where he thinks I'm going back on an earlier assumption. In one way I was - and I didn't mean to because I still maintain my earlier assumptions about crowding out. But in a more accurate sense, saying "Daniel's going back on an earlier assumption" is too generous for me because my conversation with him in the comments was simply wrong. So let me clean this up a little bit.

We have a Keynesian economy where 0 < MPC < 1, Y=E, there is some autonomous spending, and there is some investment expenditure unrelated to Y or E, which we'll call "S" (for Bastiat's "shoe spending"). This should bring to mind some familiar dynamics, and it's presented in the first panel of the figure below. Vertical lines mark C and Y=E.

Then, disaster strikes. Underneath that first panel we have a new autonomous component of expenditures, R (for "repairs"). R is done by the same people that do S, and so S declines in response to an increased spending on R.

Now, the $787 billion question is "how does S respond to the introduction of R?". Bastiat's position is that it is completely displaced. Bob Murphy showed us where Bastiat wrote that in this post, which was one of the few enlightening Bastiat posts I've read recently (Do you see a pattern here? Read Bob Murphy!). Keynesians disagree with this, and I disagree with this - under certain conditions. This is the point I botched in the conversation with Bob. On the one hand I assumed a multiplier effect, but on the other hand I said it was completely crowded out (Bob could have pointed out that this was contradictory which means I was dumb, but he gracefully assumed I am not dumb and just agree with him).

Right now we think that a lot of money is being kept liquid, so that new spending doesn't necessarily crowd out old spending. Seems reasonable (to me). So spending on S doesn't completely disappear in the second panel, but it is curtailed. The addition of R2 to S2 and C brings the new Y=E up above the old Y=E: higher GDP due to spending on R at a time when there isn't perfect crowding out. Voila.



Now, I still am maintaining that a net benefit for the economy seems very unlikely, although I have just demonstrated I think there is a gross benefit in the form of an increase in GDP and employment. The reason for this is that there's still a lot of crowding out, so only a small portion of the increase in Y=E (see the horizontal axis) associated with an increase in R (see the vertical axis) is an actual increase - the rest is just a displacement of Y=E attributable to spending on S1.

Hold on a second - what was that? Why does Daniel think so much crowding out is happening? Don't he and Krugman and DeLong and all those other kooks think there are all sorts of free lunches all over the place?

Well you have to think about exactly what is being proposed here. The presumption is homeowners and shopowners are rebuilding, right? They don't have much of a choice but to divert a lot of their spending towards repairs. Doesn't this contradict what I say about the stimulus? No, it doesn't. Why?

2. The Stimulus

The key here is to remember what Keynesians actually propose, which is why the other day I wrote "The boilerplate Keynesian position is to increase spending and lower taxes during a downturn. So there is no proposal of taking money from anybody. The point is to create money or other safe, liquid assets (like, say, Treasury debt) for which there is an excess demand". One commenter said it was "stupid". Another called me a "loon". But the point of this is crucial.

If you really want to analogize cleaning up after a disaster to economic policy, it would have to be analogized to a situation where the government pays for a $787 billion stimulus by levying a $787 billion tax on investors. That would be a real broken window situation. You might have something like I demonstrated in panel 2 of the figure above: a modest increase in output due to the fact that perhaps some of those taxes would be paid out of hoards rather than investments. After all, the government's liquidity preference is essentially zero and investors' liquidity preference is some positive figure. So you might get some growth from that. But not really much of any. That's why Obama didn't demand a $787 billion tax increase with the ARRA bill. That's why Krugman wasn't clamoring for a $787 billion tax increase. That's why I - unlike Krugman or Obama - didn't want to repeal the Bush tax cuts.

So for the reasons Bastiat laid out, paying for window repair with money budgeted for buying shoes is not going to increase growth. A Keynesian might quibble that if the shopkeeper had a non-zero level of liquidity preference you might get a little growth (because not all of his shoe spending would be displaced), but I'd maintain that once you take the loss of wealth into account, you're still likely to end up with a net loss in economic welfare, despite the increase in GDP. Same goes if you tax the shopkeeper and then pass a stimulus package with that tax money.

Of course, tax money and money budgeted for buying shoes isn't the only way to fund these things. Enter, the bond market.

This is what really sets the stimulus apart from any of this discussion about Bastiat. This is why I can say that with a few quibbles I agree with Bastiat, but that I also agree with Krugman and Keynes (and that Bastiat doesn't really contradict Keynes in a lot of the ways people seem to think that he does).

Let's think of the loanable funds market, which I find to be a much better way to think about the origins of the IS curve in the IS-LM model than the modern tendency to derive it from the national income equation.

A lot of Keynesians (maybe not all?) think that the loanable funds market is not clearing because of the zero lower bound on interest rates. There's a lot of bitching and moaning on this point, but let's take that as given for the sake of illustrating why regardless of what you think of the zero-lower bound it's still very different from Bastiat's shopkeeper. In the figure below, Id is investment demand, Ss is savings supply (loanable funds supply), and the market clearing equilibrium point is below the zero lower bound. Since that's inaccessible, the actual equilibrium point is of course the point where the Id curve intersects the x-axis. What happens when government borrows in this market? It depends on how much they borrow, of course.



If they borrow at G1 and hit the market clearing equilibrium exactly, there is no crowding out, because at this price you still have the same amount of investment demanded that you did before. If the government borrows more than that (say, at G2), then you start to crowd out investment. Notice this is very different from supporting stimulus with taxes (which still have a very large opportunity cost) or confiscation, or anything else like that.

This is why the Bastiat talk sounds like such a non-sequitor to Keynesians. Bastiat doesn't sound wrong to us - he sounds irrelevant. When you quote Bastiat to talk about the stimulus we hear "you shouldn't tax people to spend on stimulus", to which our response is "duh". When you quote Bastiat to talk about the GDP response to disasters, we say "well actually what's kind of cool is that you could get something of a bump in GDP because people are hoarding more than usual right now, but disasters still suck".

I feel like these two conversations collide a lot which leads to a lot of the confusion. I think I've clarified my/our position a little bit here.

3. Multipliers

Multipliers depend crucially on the extent of crowding out. That depends on (1.) how spending is financed, and (2.) the macroeconomic facts on the ground. Bob talks about a 1.84 multiplier. Fine. That's a 1.84 amplification of whatever spending you increase, but it's also a 1.84 amplification of whatever spending you reduce (paradox of thrift, anyone?). So the empirically measured multiplier from a debt-funded stimulus, a tax-funded stimulus, and a spending-replacement stimulus (i.e. - cut the Dept. of Education and the Pentagon's budget to build bridges) are all going to be different because there's different levels of crowding out associated with each. What I should have said to Bob Murphy was that we need to take:

1. Minus the $1 billion in damages
2. Plus the $1 billion in repairs
3. Plus the $840 million in the multiplier from the repairs
4. Minus the $X million in reduced shoe purchases
5. Minus the $(X)*(0.84) million in reduced shoe purchase multiplier

Bastiat thinks X = 1,000. I think X < 1,000 but still pretty big. And ultimately, you still have the $1 billion loss of wealth, so I don't see how any of this is likely to result in a net benefit (although it will result in a gross benefit to output.

Now - if instead the government funded $1 billion in repairs through deficit spending, then we'd be looking at some net benefits. But that would be a completely different story from what Bastiat tells - and we don't have to wait for a broken window to fund $1 billion in spending through deficits.

Thinking through Chapter 3 of the General Theory

Bob Murphy is seeking some insights on Chapter 3 of the General Theory, and I thought I'd give it a shot. I haven't read the book carefully through for several years now, although certain chapters I've given multiple careful reads since. Chapter 3 is not one of them. It's worth noting - before jumping into this - that Keynes himself says that his exposition of the theory of effective demand at this stage, before introducing subsequent theory, "may not be fully intelligible".

Question 1: What is the unit of aggregate supply price and aggregate demand? In money?

As far as I can tell it's in money. The question, of course, is whether it's in current money or some constant value of money. For Keynes, money is not some numeraire. There is a reason for its value at any given point in time, and the value of money at any point in time, and the change in the value of money relative to expectations has consequences. So I would guess (and Keynes seems to give no reason not to suppose) that it is current money. He doesn't seem to make it explicit either way, but that's how I read it. Later in the chapter he talks about how the analysis of wage units can be done either in "money wages" or real wages.

Question 2: Is the aggregate supply price referring to the unit price, or the total proceeds?

This he does make explicit. The aggregate supply price is the total proceeds of the output associated with a given employment level, N. This is, of course, confusing. That's not a "price". But Keynes lays out his definition, and it is what it is. He says in the text that "the aggregate supply price of the output of a given amount of employment is the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment." Murphy quotes this portion, and it's true it's not entirely clear from this sentence whether he's talking about total proceeds or unit price (i.e. - he could be refering to the unit price consistent with a total outpu that will make it with the while of the entrepreneurs). But the footnote to this sentence clarifies: "Not to be confused (vida infra) with the supply price of a unit of output in the ordinary sense of this term". This is still odd. We don't talk about the total proceeds of output much. However, I think it becomes clearer later, and it makes more sense when we think in terms of the quantity theory of money. The other clue is that the demand function - which equilibrates with supply and therefore must be measured in the same units for both variables - is clearly the entrepreneurial proceeds (not profits - which are proceeds minus factor costs). In the first paragraph he also calls the "proceeds" the "aggregate income (i.e. factor cost plus profit)". So I think it's quite definitely the total rather than unit proceeds.

Question 3: Related to this, are the functions Z=φ(N) and D=f(N) upward sloping? (And what is the Y axis here–money?) So Keynes is saying that in the general case, D starts above Z, but has a lower slope, so that when N is really low, D is above Z, but eventually they intersect as N increases?

Yes, I think so. This stands to reason. If Z and D are the total proceeds rather than unit price, then Z=φ(N)=pQs, and D=f(N)=pQd. We know that Qs is increasing in p and Qd is decreasing in p by the basic law of supply and demand, so at Z=D (or, equivalently, Qs = Qd) Z is steeper than D. Is that a unique equilibrium? We don't know. We take local equilibria and don't usually ask any more questions, unless circumstances or research interests compel us to ask questions. Multiple equilibria aren't relevant to the issue at hand, though.

The vertical axis, Z and D, is measured in money - presumably current money for the reasons I gave in response to the first question.

Consider the following data from a simple AD-AS graph which follows. After the AD-AS graph is the associated Z-D graph:

There's one major difference between my last graph here and the version that Keynes presents: my horizontal axis is in terms of the aggregate price level (i.e., the CPI) and Keynes's horizontal axis is in terms of N - employment.

Strange, isn't it? How did I get that on the horizontal axis? It's because we typically think of quantity as a function of price. So we talk about "quantity demanded" and "quantity supplied", but we never talk about "price demanded" or "price supplied". To get output (which we assume to be increasing with employment up to a level of diminishing returns at least) on the horizontal axis, all we need to do is sub Q for Qd and Qs in my data chart and sub pd and ps for p. You can see in this interchangability the origins of the Phillip's Curve*.

Question 4: Keynes says that when N is below the equilibrium point, then D is above Z, and so entrepreneurs have an incentive to hire more workers. But why? It sounds intuitive at first, but I’m not so sure it is. In particular, Keynes says that when N is such that D and Z intersect, the entrepreneurs profit has been maximized. But it seems to me the profit is zero at that point? (In a standard micro model, it’s fine for the producers to maximize profit at the point of zero-profit, because they’d earn negative profits at different levels of output. But that’s not what happens here. If N went below the intersection point, then wouldn’t aggregate profits go up?).

Entrepreneurs have an incentive to hire more workers for the same reason that they have an incentive to hire (i.e. - produce more output) when Q is below equilibrium in the supply and demand model: some entrepreneur is earning a marginal revenue that exceeds his marginal cost. What happens when N is below equilibrium? At that point Z, which is the minimum aggregate proceeds required to engage the employment of N units of labor, is lower than the expected proceeds of that labor. Profits are positive, as Bob notes. What do entrepreneurs do when they see positive profits? They enter the market. As Keynes writes "if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D". This is the basic market equilibrium of setting marginal revenue equal to marginal cost. Keynes does something you usually don't see, which is to present it in terms of the total proceeds from the market (i.e. price times quantity), because this is the relevant functional relationship in macroeconoimcs, where we look into the aggregate properties of human action.

Question 5: Later on, when discussing the implications of the classical view, where D=Z at all levels of N, Keynes says “the forces of competition between entrepreneurs may be expected to push [N] to this maximum value.” But why? If Z and D overlap each other for all N, and Keynes has earlier argued that at the intersection point, aggregate profits are maximized, then why would entrepreneurs have an incentive to move N one way or the other, if Say’s Law holds?

This part is confusing to me. If you read it all together, I'm not sure he's saying that the functions are identical - I think he's saying that for any given N, the D=f(N) curve shifts to be equal to Z=φ(N). Paying factors of production Z total proceeds creates the same amount of demand in the market, so demand increases in response. An increase in demand is a shift of the effective demand curve itself, not a shift along it. This seems to make the most sense to me after reading Keynes talk about demand "accomodating itself to the aggregate supply price", and "the proceeds D assume a value equal to aggregate supply price Z". That implies to me a change in demand, not an identical function.

If all values of N are admissable equilibrium, then Bob rightly asks on what basis would entrepreneurs move to a high value of N under Keynes's rendition of classical economics? We know entrepreneurs produce output until profits are driven to zero. What would require them to maximize N? If profits are zero, then income is made up of two components: factor costs of employment and what Keynes calls the "user cost". If we maximize the factor cost of employment (i.e., the wage bill) we have to minimize this "user cost". What is "user cost"? Keynes defines it as "the amounts which he [the entrepreneur] pays out to other entrepreneurs for what has has to purchase from them together with the sacrifice which he incurs by employing the equipment instead of leaving it idle" (emphasis mine).

People find private value in leaving things idle - in keeping capital or money ready at hand. This, more than anything else, is the point of the General Theory. The most valuable thing to keep idle, of course, is money. We only keep anything else idle because we think it may serve some purpose similar to what we turn to money for: either because we think it will store value, or because we think it can act as a medium of exchange.

Keynes argues that no classical economist really thought through the implications of leaving things idle. By ignoring it, they implicitly assumed that user cost would be minimized and that's what drives N up to the limits imposed on it by an inelastic supply curve and the marginal disutility of labor. Many classics touched on what would become known as "hydraulic Keynesianism". If you have a leak in the circular flow, your income level would go down. The mercantilists and Malthus got that far but were later pushed off the stage by classical economists who somewhat unfairly identified mercantilism with the protectionist ideas of kings and merchants. But this isn't really sufficient. This is what I've called the "whack-a-mole" theory of general gluts. Saying "demanding idle cash lowers income" doesn't do the trick because of the real balance effect. As the price level increases, the cash becomes more valuable and everything else becomes less valuable. As long as prices eventually adjust everything is fine. There's no reason for anything to change other than the price of money (i.e. the inverse of the price level). There's no reason for any relative price adjustments, in other words, and therefore no reason for a change in the employment rate.

However, if variations in the value of money (presumably driven by the demand for money) can influence Keynes's "user cost" of capital - if leaving capital idle can earn a return - then there is no reason to expect a rebalancing. We have the raw ingredients for a theory of a stable underemployment equilibrium.

So Bob's fifth question is by far the toughest (I wrote most of this last night and then had to sleep on my response to the fifth question), but I think the clearest way to think about it is (1.) Keynes thinks the classics ignore user cost or the cost of not leaving things idle, (2.) the implication of this is entrepreneurial competition maximizing N, (3.) In Z-D terms, this means that increasing N provides the additional demand to employ that N, and the D schedule is driven up the Z schedule to the point where Z is inelastic.

That's my reaction - any thoughts? Later in the chapter Keynes provides a great synopsis of the General Theory, which I think helps clarify what is going on early in his discussion of the classics and "user cost". I haven't read Chapter 6 again, yet, but that also goes into more detail on user cost.

* This was actually an accident. In writing the post, I realized "that shouldn't be on the horizontal axis!" and had to think through why it came out that way. So it's a diversion, but an interesting diversion I thought. The point is in (1.) deriving a Z and D function where the D function isn't as steep at equilibrium as the Z function, and (2.) demonstrating why it follows necessarily from the definition of Z and D as the total proceeds of the output.

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.

LK on Keynes's German Foreword

I was too busy to repost this morning, but I would be remiss if I didn't bring people's attention to LK's post on the German Foreword. Of course this is something I've written on in the past too. This is something I would like to revisit again in the future - there's a ton of implicit German intellectual history in that foreword that gets obscured by the low quality analysis and simple demagoguery surrounding it.

LK makes an explicit comparison to some of the less savory things Mises has said about fascism. After providing the material, he writes: "If anyone is a candidate for having (in Rothbard’s words) a “strong fascist bent,” then it would be Mises, not Keynes."

I would put it this way - as far as I can tell, neither Keynes nor Mises were anywhere remotely in the neighborhood of sympathizing with fascism. However, I would say that if we found out that one of the two of them was a closet fascist or collaborated with fascists to reach other ends, I would be much less surprised to find out that it was Mises. The fact is, neither men were fascists - and that should be the take away. But Mises skirted the boundary in ways that Keynes never did. There is a pretty bold line between libertarianism and fascism. Libertarians are liberals, after all - and fascists are not. But insofar as libertarians tell a society they cannot make certain decisions for themselves and insofar as libertarians weaken the basic liberal institutions of representative democracy, they can make that bold line between liberalism and illiberalism fairly porous. This is a small, small minority, of course. I'm sure you all can think of one well known example of what I'm talking about. That's the sort of thing that worries me about libertarianism. But Mises the man was unequivocally a liberal - as was Keynes the man.

UPDATE: I want to be clear - just because I offered how I would have phrased it, and just because that emphasized that I don't think either are fascists - I didn't mean that to imply that LK thinks Mises was a fascist. He clearly doesn't.

Clarification on the marginal efficiency of capital

Gene Callahan laments a poster who writes of Keynes "I admit that I’m commenting as someone who’s not intimately familiar with Keynes’ work...". He responds "My interpretation: "not intimately familiar" can be translated as "I have not read a single word of Keynes's." So why does he have any opinion on it at all?". Gene specifically avoids naming the blog where he read this (perhaps he's embarassed he visits it?) but I have no such restraint. He read it on Cafe Hayek in the post about Smith and Keynes's shared birthday that Jonathan pointed us to.

That wasn't the only person on that blog post that seems to have some degree of unfamiliarity with Keynes - but at least he admitted it. Don Boudreaux himself wrote in the comments:

"I’m sorry, but I do believe that on matters of economics Keynes was indeed a simpleton. I offer here but one quotation, from page 220 of The General Theory, as evidence of Keynes’s simple-mindedness on matters of economics: “I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation.”

Keynes here argues that capital can be made non-scarce (and, as he puts it in the preceding paragraph, that one key to making it non-scarce is “that State action enters in as a balancing factor to provide that the growth of capital equipment shall be such as to approach saturation-point….”). These are the words of an economic simpleton – a simpleton about the nature of capital, about the nature of scarcity and human wants, and about the nature of the state and “State action.”" [emphasis is mine]

Let's nip this one in the bud, shall we? Because this is a line that has been adopted by much more dangerous people than Don Boudreaux: people who wield video cameras and youtube channels.

If capital were non-scarce we would expect its price to be very low, right? If it were truly infinite, the price would be zero. Marginal productivity would go right down with it for the normal reasons. That's the diamond/water paradox for you - water is cheap because it is (relatively) non-scarce (and of course where it is scarce it's not cheap!). As far as I can tell, this is what Don thinks is going on here when he quotes Keynes as saying that we can drive the marginal efficiency of capital down to zero within a generation.

Don Boudreaux is wrong.

I don't know why these things even pass the smell test for people, but apparently they do. Does Keynes come across as a utopian? He doesn't come across as a utopian because he's not a utopian.

The marginal efficiency of capital is not the same thing as the marginal cost of capital or the marginal productivity of capital. Keynes defined the marginal efficiency of capital as the discount rate at which the price of capital was just equal to the present value of the stream of benefits proceeding from that capital. So the marginal efficiency of capital could be zero at a time when the marginal cost and the marginal benefit of capital were both very, very high (but equal). A high marginal cost and marginal benefit of capital, of course, means that capital is scarce. A lower marginal efficiency of capital is associated with more capital, to be sure - because a lower discount rate means more investment becomes viable, driving down the marginal benefit of capital. So certainly a more capital-rich future is part of the Keynesian vision. But "non-scarcity"? Of course not. He never says that anywhere, and the marginal efficiency of capital is not the marginal cost or the marginal productivity of capital. The point is this - since the level of investment is determined by the interest rate (through the marginal efficiency of capital - what investments are viable at what interest rates), capital owners commanded a return simply by virtue of the scarcity of capital (or - put another way - by virtue of artificially high interest rates). A low interest rate and potentially even a zero marginal efficiency of capital was Keynes's way of separating out the rentier from the entrepreneur.

And in Keynes's vision there were entrepreneurs. Why? Because capital is still scarce and the expertise of the entrepreneur was still needed.

Hmmm...

Jack Kevorkian dies on Friday and by Monday the rentier makes a comeback.

Coincidence?

We report - you decide.

Happy Birthday Smith and Keynes

Jonathan reminds me that it is John Maynard Keynes and Adam Smith's joint birthday today! The two are ranked together in the highest echelons of economic science for good reason. To a large extent (and admittedly simplifying many other great economists) they provide bookends to an interlude in economics where one simply fact was often forgotten: we do not sit comfortably and automatically on a production possibilities frontier. Smith destroyed the poor arguments of British protectionists by discussing how the division of labor and mutually beneficial exchange could make us more wealthy with the same inputs. After Smith, the Ricardians and the classical economists slipped the discipline into a world of diminishing returns - not because it was necessarily realistic, but for the sake of tractability. Themes of increasing returns, innovation, and spillovers from specialization were underemphasized (although thankfully the gains from trade were still maintained as a theme in classical economics). There were innovations in this Ricardian interlude - the marginal revolution being the chief among them. And while Walras made important contributions in this respect, his general equilibrium system continued the tradition of a perfectly calibrated, balanced systems where general gluts were inconceivable. At the Walrasian auction block, everything was sold and everyone was employed. Keynes revived the tradition of Smith in a subtle way. Smith studied the economy as it really existed and uncovered the key to rapid economic growth and innovation beyond a production possibilities frontier. Keynes filled in the other side of the equation and explained how the complex emergent system of Smith could discoordinate and collapse at regular intervals. The key was the relationship between money, the interest rate, and investment levels. The economics of Ricardo, Walras, and the classics was both Panglossian and stagnant. Smithian economics dispells the stagnation of the classics, while Keynesian economics unravels the Panglossian myth.

It is fitting that two of the greatest economists we have and two of the greatest champions of liberalism share a birthday.

The best piece I've read on Keynes in a while

Deirdre McCloskey, Keynes was a Sophist, and a Good Thing Too.

One critique I have is that McCloskey doesn't seem to allow for the prospect of Sophist mathematical theory or a Sophist econometrics - scientific theoretical and empirical work that understands the contingency of human knowledge and that understands that science is a search for useful knowledge rather than "truth". I think she presents Keynes well - he shares her skepticism. But I still think it's a mistake.

Papola on DeLong on Hayek

I'm posting this against my better judgement... every time I touch on anything out of Papola the discussion seems to degenerate at a faster than average rate into pointlessness. But this introduces somewhat new material, so what the hell.

The issue at hand is a 1998 review by Brad DeLong of a book by James Scott about the problems with central planning particularly as they relate to the importance of local knowledge, which Papola mentions in this post. The local knowledge point is one that lots of people have made but of course one very famous person who made this point was Hayek, and DeLong recognizes this. Indeed in the review DeLong takes Scott to task for not mentioning Hayek more in the book. If you want a treatment of the role of very local information in social decision making and allocation, the best place to start is certainly Hayek. Papola follows this link with the statement "I think he [DeLong] was less Keynesian then than now."

I don't understand what makes people like Papola tick. I don't understand this tendency where people imagine that there has to be stark battle lines drawn in intellectual life. DeLong is Hayekian in this 1998 review so he clearly can't be Keynesian, according to Papola. What exactly does Papola think we all think? Does he think that Keynesians are generally opposed to a Hayekian outlook on the economy? I suppose he might actually think that, and I just don't understand it. Do I (and does DeLong) disagree with Hayek? Sure, on certain things. Certainly a few policy areas. Probably some methodological points. A world where there is no disagreement with Hayek is as bizarre as Papola's world where there is no agreement. And in order to generate a stark contrast between "Hayekian" ideas and "Keynesian" ideas Papola has to erect this version of Keynes that is purged of the price mechanism, purged of market efficiency, purged of free market orientation, purged of liberalism, and purged of any disaggregated conception of economics.

In other words, to get "Keynesian" and "Hayekian" to be concepts that repel in his mind, Papola reinvents Keynesianism.

I don't know - maybe life really is this stark and oppositional. I sure hope not. I don't think so. I'd like to keep my Hayek and my Keynes. The first video was pretty good (weak in expositing the point of Keynesianism, but good) because it focused on a very real point where saying you're both Hayekian and Keynesian is a lot harder: the macroeconomics of the business cycle and macroeconomic policy. The broader scope of the second video is precisely what revealed the true paucity of Papola's vision of this "fight" (what an utterly bizarre word to describe the relationship of the thought of these two tremendous thinkers). As I've said elsewhere - I'm positively disposed towards Hayek and positively disposed towards Keynes, but when you present a narrative where I'm turned off by the "Keynes" voice and find myself in agreement with the "Hayek" voice, something is very wrong.

Kumbaya, "can't we all just get along", yadda yadda yadda. I don't mean to be too pie in the sky, but I don't want to invent reasons to fight either.

Some Keynes links

- Giovanni Dosi talks about the confluence between Schumpeter and Keynes at the Institute for New Economic Thinking website. I think this is very important. Some people see Keynes as saying "saving is bad and spending is good". I think that's a strange way to look at it. I see Keynes as saying "investment is good and investment doesn't always match up with savings". The latter perspective, which stresses animal spirits, etc. - this sort of view of Keynes that is more common at the Institute for New Economic Thinking - is quite commensurate with a Schumpterian entrepreneurial view of the economy.

- Brad DeLong defends Keynes against Jacques Rueff booster Benn Steil.

- Dominique Strauss-Kahn is in the news for things besides his economics, but his vision for the IMF has been similar to that of Keynes. He has pushed for the broader Keynesian vision of the IMF in the past, which was vetoed at the Bretton Woods conference. Strauss-Kahn is out of the picture, and that is a good thing. But that's not going to stop people from making this point about the role of the IMF. I don't think we've heard the end of plans for the SDRs that more closely mirror Keynes's original vision of the bancor.

- Finally, I recently came across a collection of John Maynard Keynes's Newton related papers. It's mostly letters, invoices, etc. associated with his efforts to collect Newton's papers in the 1940s. There's some really fascinating stuff in here.

And a quiz - who called Keynes a "well-known bourgeois and implacable enemy of Bolshevism"?

Keynes and the Nazis

Tyler Cowen joins a growing list of people who are citing the German preface to the General Theory to argue that Keynes had at least some sympathy with totalitarianism.

It's absurd. It's wrong. It's a complete misreading of the preface.

This is the passage that I think gets to the heart of what Keynes was trying to do in the preface: "But could I hope to overcome the economic agnosticism of Germany? Could I convince German economists that methods of formal analysis constitute an important contribution to the interpretation of contemporary events and to the shaping of contemporary policy? It is, after all, a feature of German character to find satisfaction in a theory. How hungry and thirsty German economists must feel having lived all these years without one!"

Most of the preface involves Keynes tracing out the history of economic thought in Germany, through the German Historical School which rejected Ricardianism for the simple reason that German institutions didn't always coincide with Ricardian assumptions. Predictably, a school of thought grounded in institutional and historical analysis emerged instead. Keynes thought this was unfortunate, and that there was a role for "formal analysis". He thought his theory could provide that role, because he thought his theory was sufficiently general to be useful for economists living with less-than-Ricardian political institutions (like totalitarianism).

The German preface is an intellectual history and a methodological argument directed at the German Historical School.

Period.

I go through the preface line by line here.

Here's a challenge - don't comment on this post without having read the preface from beginning to end.

Nick Rowe, Brad DeLong, and Me on Whack-A-Mole General Gluts and Money

The other day I took some issue with the idea that general gluts are just excess demand for [bonds, money, secure assets] and excess supply of goods and services. The idea isn't absurd, of course. If there happens to be no excess demand for money but there is an excess demand for bonds and surplus of goods and services, that will sure feel like a recession to workers and look like a recession in the data. In that sense I don't think Brad DeLong's version of the story is wrong per se. In all likelihood we've had many downturns characterized by this sort of general glut. But there's something ultimately unsatisfying about this approach when you're going through a downturn that just doesn't bounce back - when you have a stable underemployment equilibrium. Why would this "whack-a-mole" general glut not work itself out? Brad provides several great reasons why not: disrupted credit channels, the zero lower bound, etc. All of these reasons are very good reasons for why a whack-a-mole general glut would lock in for a while. And perhaps that's all there is to it.

But I have my doubts that that's all there is to it, and so does Nick Rowe. However, Nick takes a somewhat different approach from me an in a lot of ways, my approach to why the whack-a-mole theory is incomplete is closer to Brad.

Nick starts with a review of some quantity-constraint material which is very good to look over. He was the one that first alerted me to how important Janos Kornai's work on socialist economies was for understanding market economies - because of these quantity constraints (supply constrained under socialism, demand constrained under the market).

Then Nick gets into the monetary stuff:

"If there are n goods, including one called "money", we do not have one big market where all n goods are traded with n excess demands whose values must sum to zero. We might call that good "money", but it wouldn't be money. It might be the medium of account, with a price set at one; but it is not the medium of exchange. All goods are means of payment in a world where all goods can be traded against all goods in one big centralised market. You can pay for anything with anything. In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods. Each market has two excess demands. The value of the excess demand (supply) for the non-money good must equal the excess supply (demand) for money in that market. That's true for each individual (assuming no fat fingers) and must be true when we sum across individuals in a particular market. Summing across all n-1 markets, the sum of the values of the n-1 excess supplies of the non-money goods must equal the sum of the n-1 excess demands for money.

Walras' Law describes an economy with one market with n goods traded and n excess demands. In a monetary exchange economy there are n-1 markets with 2 goods traded and 2(n-1) excess demands.

OK. So can't we just re-state Walras' Law as saying that the sum of the values of the excess supplies (demands) for the n-1 non-money goods must equal the sum of the n-1 excess demands (supplies) for money?

The short answer is: "No, you can't". Or rather: "You can if you like, but it's a very different beast from the original Walras' Law, and is totally useless"."

I like to think in terms of a linear system, because when we worry about recessions we're worrying about slack, and with a linear system it's very easy to conceptualize exactly what the source of the slack is. So Nick talks about n-1 markets and n goods (one being money, which crucially has no market, and is instead traded in all markets). When he says "market" think of a linear system with a supply and demand schedule. So:

Qs=a+bP
Qd=c-dP

Putting this in equilibrium (Qs=Qd) and moving things around:

Q-bP=a
Q+dP=c

...and the solution is trivial. That system is a "market". There are n-1 goods out there and then Nick adds money which makes "n", but he says money isn't traded in a market, so that's n goods, n-1 prices, and 2(n-1) market relations (because you have a supply relation and a demand relation for each market). I think Nick is wrong here. Why? Let's go back to our system of equations - "money" gets a column because it's a good, right? Does it get a row? Nick implies no - because there are n-1 markets. But this seems wrong. It oughta get a vector of prices, right? That's what the "price level" is, after all - it's the inverse of the value of money. So while Nick tells us there are n-1 markets which have 2(n-1) market relations and n goods, and n-1 prices it seems to me there are n goods, n-1 prices, and the price level.

This, I think, is what Brad was thinking in this post where he took issue with my claim that the nature of the interest rate as one price operating in two markets implied an overidentification. Brad wrote: "In the language that Dan is talking, I think that the right thing to say is that if the price level is sticky then the Walrasian system is over-identified. If the price level is flexible then the Walrasian system is just identified--the thing that is supposed to move in order to eliminate the excess demand for financial assets is the price level, and it does not, or it does not move fast enough."

This thinking from Brad seems very close to what Nick is saying to me: n goods (including money), n-1 markets, and one "price level" producing a perfectly identified system. In this system, you need sticky prices to get slack, Brad is right on that.

But the problem is, we don't live in this system. And you know who drove this home for me? Brad DeLong.

Everything comes down to money and the interest rate, and everything comes back to Keynes. In this post, Brad explains why the interest rate is really one price functioning in two markets: the bond market and the money market. People want loanable funds and people want liquidity. Let's bring this back to our system of linear equations where Brad is an out-of-the-closet Walrasian (who is open about the fact that the price level squares the system of linear equations) and Nick is a still-in-the-closet Walrasian (who still insists we have n goods and n-1 markets even though it's clear that that n-th good - money - is related to all the other goods through the price level). What does the interest rate do to this system of equations?

It overidentifies the system, introducing the very real potential for slack. Before we had n-1 goods, n-1 prices, and money for a total of 2(n-1)+1 columns. We had 2(n-1) market relations (supply and demand in each of the n-1 markets) and the price level for a total of 2(n-1)+1 rows. This is a well-identified system where we can have whack-a-mole general gluts but no reason to think those gluts won't be arbitraged away eventually (by adjustments in the price level, a la Brad's point, if nothing else). But Keynes points out that we are missing one row - one market relation. We are missing the money market or the market for liquidity - that market that Nick says doesn't exist. This is the liquidity preference theory of the interest rate - the interest rate is determined by the desire to stay liquid. The problem is that while we add this market relation as a row in our linear system, we don't add another column so that the system remains identified. Why? Because we already have the interest rate as a column - because the interest rate is the inverse of the price of bonds (which are presumably already there as one of our n-1 goods and n-1 prices).

This is a major problem. Now we have 2n rows and 2(n-1)+1 columns. That introduces slack. Now, where that slack shows up isn't entirely clear. Keynes said investment was made based on the investment level that would equalize the marginal efficiency of capital and the interest rate. So he thought a lot of the slack would show up in investment. It's not a bad approach - we do see the sharpest drops during recessions in investment. Keynes was a sharp guy. Hicks took a slightly different approach that was perhaps better suited to the new wave of national accounts measurement. In his model, he forced the loanable funds market to actually clear at the same interest rate as the money market. This means no slack in the loanable funds market, so the slack would be felt in the prices or quantities of goods and services. Hicks strikes me as being a little more presumptuous than Keynes in this respect, so I somewhat prefer Keynes - who left the question open.

Anyway - hopefully this clarifies where I agree and where I differ with Brad and Nick. I think Nick's system is relatively Walrasian once you think about the role of the price level. I think Brad's unashamedly Walrasian system ignores his own prior writing about the interest rate. And I think the interest rate is key: it is one price operating in two markets. You can arbitrage your way out of whack-a-mole gluts. You cannot arbitrage your way out of an overdetermined system. You have to hack the system - you have to get the interest rate to a level that is consistent with full employment.

UPDATE: And this, I should add, is why despite Brad's quite justifiable praise of Say, Bastiat, Mill, Bagehot, Fisher, and Friedman - there is a very good reason why Skidelsky calls Keynes "the master", and why I write so much about him on here.

*****

The blogosphere can get heated when people disagree with each other. Let me nip that in the bud. Nick and Brad are quite simply the best bloggers that I follow right now. Most of this stuff I ultimately, at some point picked up from them anyway!

Keynes and the "Socialization of Investment"

Cold War paranoia really screwed over the United States in many ways - it generated a lot of pathologies. One is that it's hard to talk seriously about anything that Marx wrote around a large portion of the population. I can deal with that - I can do without Marx on a day to day basis - but it's still unfortunate. It's harder, though, to talk about other people who called themselves "socialists" explicitly or who talked about "socialization". This stuff always gets tied back to Marxism in people's minds, and that's unfortunate.

If only Keynes knew about what would happen in the 1950s and 1960s back in 1936. He might have thought of something to replace "socialization of investment" with. Commenters on this post are getting interested in that, so I thought I'd share some from one of my favorite books of Keynes - The End of Laissez Faire (1926).

"I believe that in many cases the ideal size for the unit of control and organisation lies somewhere between the individual and the modern State. I suggest, therefore, that progress lies in the growth and the recognition of semi-autonomous bodies within the State - bodies whose criterion of action within their own field is solely the public good as they understand it, and from whose deliberations motives of private advantage are excluded, though some place it may still be necessary to leave, until the ambit of men's altruism grows wider, to the separate advantage of particular groups, classes, or faculties - bodies which in the ordinary course of affairs are mainly autonomous within their prescribed limitations, but are subject in the last resort to the sovereignty of the democracy expressed through Parliament.

I propose a return, it may be said, towards medieval conceptions of separate autonomies. But, in England at any rate, corporations are a mode of government which has never ceased to be important and is sympathetic to our institutions. It is easy to give examples, from what already exists, of separate autonomies which have attained or are approaching the mode I designate - the universities, the Bank of England, the Port of London Authority, even perhaps the railway companies. In Germany there are doubtless analogous instances.

But more interesting than these is the trend of joint stock institutions, when they have reached a certain age and size, to approximate to the status of public corporations rather than that of individualistic private enterprise. One of the most interesting and unnoticed developments of recent decades has been the tendency of big enterprise to socialise itself. A point arrives in the growth of a big institution - particularly a big railway or big public utility enterprise, but also a big bank or a big insurance company - at which the owners of the capital, i.e. its shareholders, are almost entirely dissociated from the management, with the result that the direct personal interest of the latter in the making of great profit becomes quite secondary. When this stage is reached, the general stability and reputation of the institution are the more considered by the management than the maximum of profit for the shareholders. The shareholders must be satisfied by conventionally adequate dividends; but once this is secured, the direct interest of the management often consists in avoiding criticism from the public and from the customers of the concern. This is particularly the case if their great size or semi-monopolistic position renders them conspicuous in the public eye and vulnerable to public attack. The extreme instance, perhaps, of this tendency in the case of an institution, theoretically the unrestricted property of private persons, is the Bank of England. It is almost true to say that there is no class of persons in the kingdom of whom the Governor of the Bank of England thinks less when he decides on his policy than of his shareholders. Their rights, in excess of their conventional dividend, have already sunk to the neighbourhood of zero. But the same thing is partly true of many other big institutions. They are, as time goes on, socialising themselves.

Not that this is unmixed gain. The same causes promote conservatism and a waning of enterprise. In fact, we already have in these cases many of the faults as well as the advantages of State Socialism. Nevertheless, we see here, I think, a natural line of evolution. The battle of Socialism against unlimited private profit is being won in detail hour by hour. In these particular fields - it remains acute elsewhere - this is no longer the pressing problem. There is, for instance, no so-called important political question so really unimportant, so irrelevant to the reorganisation of the economic life of Great Britain, as the nationalisation of the railways."

I love that last sentence especially, and it's one of those cases where you wish Keynes had lived longer than he did. He simply had no use for the wave of nationalizations that washed over Britain in the mid-20th century - the nationalizations that disturbed Hayek so much. I wish more of this had made its way into the General Theory. The need for the socialization is clear in both. The doubts about central planning and the state are there in both. But people still think of state socialism when they read those passages of the General Theory because we've been hard-wired to associate "socialization" with "socialism". How depressing is that? Keynes can't talk about any sort of social action without people thinking of socialism - even when he denigrates state socialism in the very same passage. Anyway - in addition to denigrating state socialism I wish he talked more about joint stock companies in the General Theory as well. It would have helped to clear a lot of things up. Keynes also regularly notes that different solutions are appropriate to different societies - I imagine he would say that lot of the public corporations he personally found appropriate for Britain in the 1930s might not be appropriate for America or even for Britain in the 2010's. The point is clear on the socialization of investment, though - he is least enthusiastic about state ownership, most enthusiastic about complete private ownership by joint-stock companies, and willing to contemplate public corporations. Needless to say, that's not socialism and I personally think it's a stretch to call it corporatism (but perhaps that could apply).

I'll end with a passage a little further down that has some externality thinking to it:

"We must aim at separating those services which are technically social from those which are technically individual. The most important Agenda of the State relate not to those activities which private individuals are already fulfilling, but to those functions which fall outside the sphere of the individual, to those decisions which are made by no one if the State does not make them. The important thing for government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all."

The Fight of the Century

John Papola and Russ Roberts' new Keynes v. Hayek video is up. It is very high quality and entertaining, like the last one. I have a few reservations about the content, though (also like the last one) - but it's still worth a watch.

First and foremost, is this really "the fight of the century"? The contrast between Keynes and Hayek just seems so artificial to me. I've always been a proponent of what's been called "Hayekian micro" and see no contradiction with Keynes on that front. In some ways, Hayekian micro is more consistent with Keynesianism than more traditional neoclassical micro. As for Hayekian macro, I've always thought there was something to that too (Keynes thought there was something to it as well), it just doesn't seem to provide a viable counter-argument to the liquidity preference theory of the interest rate, and therefore it doesn't displace Keynes. Keynes still provides the best view of the macroeconomy that we have, and I think Hayek provides a good treatment of a more specific process that probably also goes on. Of course, when we juxtapose Keynes and Hayek it's often a stand-in for the libertarian and non-libertarian strains of the classical liberal tradition. OK, fine. There is some conflict on that front. But they seem to be allies in the liberalism vs. fascism or liberalism vs. central planning fight. In economics itself their conflict doesn't really exist in any real way in micro (Keynes didn't weigh in there and there's nothing about Hayek's micro that contradicts Keynes), and their conflict in macro is fairly marginal compared to other macro fights (I know it doesn't seem this way from some corners of the blogosphere, but it really is).

Another issue with the video is that Keynes is referred to as "central planning", "top-down", "chessmen moved on a board at a whim", etc.. Oh please. If this is artistic license, then OK. As I said, I enjoyed the video and don't want readers here to get the impression that I'm disparaging it over what amounts to artistic license. The concern, though, is that people that are starting to get interested in these subjects and are relatively new to Keynes and Hayek are going to get a very skewed idea of Keynesianism.

A recurring problem in this video is that it distorts Keynesianism in much the same way that the first one did - namely, Keynesianism is reduced to "C+G+I=Y, so if we boost G we boost Y". This is exactly what you're supposed to learn that Keynes was not saying. John and Russ are confusing accounting identities with behavioral laws. They're confusing a static economy with a dynamic Keynesian economy. This is a very bad habit in economics. In the last video, we had the Austrian theory of the interest rate, but no Keynesian theory of the interest rate. In this video we have neither theory. So once again, John Papola gets hung up on this "you can spend on anything - it doesn't matter" issue. That sounds very strange if you think that Keynesianism is "if we boost G, we boost Y". It makes more sense when you realize it's about government note creation - Keynes's version of the helicopter drop.

Econometrics makes its way into this video as well, in some funny ways. First, I'm not sure why the Hayek character thinks that econometricians have a predisposition to Keynesianism. Any macroeconomic theory is going to have its cadre of econometricians and empirical evidence. Second, it's odd that Russ keeps making this claim about how unscientific this work is... we're still waiting for Russ's "Great Austerity Hoax" post about the Heritage analysis where two economists formerly affiliated with GMU use exactly the same models that stimulus advocates used!

Another thing that might be worth noting is that the Austrian inferiority complex comes out here, as in the last one. Hayek isn't recognized at the door again and gets a cavity search (the Hay-eksplosives line was great!), he loses in the end despite punching out Keynes, etc. This is all a little silly too. Hayek won a Nobel Prize. He's widely recognized as a towering figure in economics. He's not a marginal figure. Keynes is lionized too, of course - and for good reason. And he's not celebrated today despite being proven wrong. He's celebrated because most of what he predicted has been borne out by the data. We can note that you can squeeze Austrian theory into the data too if we are so inclined. Predictions about interest rates and inflation that Keynesians got right are a little embarassing for some Austrians, but you can make a case for them. But it's simply not true that Keynes has been knocked out here. John and Russ and many others want to ascribe Keynes's success to politicians - because apparently politicians love Keynes (you could have fooled me - I thought everyone's been trying to outdo each other on deficit reduction). Personally, I think it's more than a little condescending for John and Russ to keep repeating this sort of thing. Politicians get elected on promises to "rein in spending" - you don't see me going around saying that the only reason Hayek is having a revival is that politicians love him. I know that's condescending and I know that's simply not true, despite the apparent coincidence between what some politicians say and what Austrians say. That's not the reason why a large share of the profession is coming around to ideas they had rejected for decades in the case of Keynes or Hayek.

*****

So in summation, it's a great video. It's always tough to talk critically about this or the last one because I do think there's a degree of artistic license and I do thoroughly enjoy the videos. But you have to be careful with these as well. I think people could really enjoy this if they come at it knowing something about the economics of Keynes and the economics of Hayek. But for less informed viewers, a lot of these videos can be extremely misleading. And the "central planning" lines, etc. are very unfortunate - even from an artistic license perspective. It makes me less interested in taking part int he discussion if that's what "the other side" thinks of me, and I'm sure I'm not alone. If you want to fight with a central planner over the pretense of knowledge go find a central planner, and stop wasting your time with Keynesians.

*****

A few links that might be relevant:

- My first long post contrasting Keynesianism with consumptionism. My post taking Krugman to task for slipping into consumptionism. Taking Casey Mulligan to task for consumptionism (this is when I knew I was making an impression, because commenter Samuel Wonacott said he knew as soon as he read Mulligan's post that I would "jump all over it").

- This, I think, is an important post where I talk about why Keynesian "ditch digging" is more like Friedman's helicopter drop than it is like a public works program. This isn't to say public works are bad from a Keynesian perspective. We should just think of public works as "a helicopter drop where we get a bridge too" rather than "boosting G to boost Y". And this is just a fun post on helicopter drops.

- This is an old post on the prospect of a Keynesian-Austrian synthesis. Also here and here. I sketched out some of the math on this a couple weeks ago in response to a conversation at Coordination Problem where - again - commenters insisted on this false choice between Keynes and Hayek. I hope to finish that this fall. The posts above actually don't get into exactly what that entails - essentially I was working on an IS-LM models with a capital structure. Or, if you prefer, a capital structure model with a liquidity preference theory of the interest rate.

*****

What are people's thoughts on the video? I want to draw people's attention to my new comment policy - I'm not going to put up with drive-bys anymore.

UPDATE: One more point I meant to mention on the substantial WWII segment in the video. I think the episode is suggestive, and it's suggestive in clear favor of Keynes - but it's very hard to make much of it because as Hayek says in the video, it's just one datapoint. However, one of the things that bothers me about this talk about WWII is the idea that all wars are all waste. I am always stunned that people talking about WWII from a Bastiatian angle are so loathe to note that keeping fascists from dominating Europe was a very, very good thing. War is hell. It's not something to be excited about. It causes lower standard of living at home. It does all these things. But Nazis are more hellish, and I wish people would do less insinuating about how the draft tinkers with unemployment figures and be more explicit about the fact that those soldiers were fighting for a free world.

Jonathan on Keynes on Methodology

Jonathan has his first post up on The General Theory. I want to read it and respond to it more carefully later than I have time to now (on his blog... I always feel bad that instead of commenting on others' blogs I throw up my thoughts on here), but I did want to throw one question out there. Jonathan asks "Does Keynes ever elucidate on the methodology he applies to theory development in economics?" (with more details on motivation in his post). Nothing immediately comes to mind to me, but I would venture that he's a traditional positivist. Jonathan will find that the book is peppered with statements of the form "this seems reasonable but we will have to find out from experience whether it works this way in practice". When it came to wage cyclicality, Keynes offered a speculation in the General Theory, was proven wrong with data in 1938 and 1939 by Tarshis and Dunlop, and recanted in 1939 in light of the evidence. Anybody have any more specific thoughts on Keynes and methodology? Jonathan also mentions epistemology, and I would carefully segregate this from methodology for Keynes. Keynesian epistemology is best found in his Treatise on Probability (1921).

Keynes on Plans for Society

I was reading Keynes's 1926 review of Trotsky's book Where is Britain Going? and particularly liked this passage:

"Granted his assumptions, much of Trotsky's argument is, I think, unanswerable. Nothing can be sillier than to play at revolution if that is what he means. But what are his assumptions? He assumes that the moral and intellectual problems of the transformation of Society have been already solved--that a plan exists, and that nothing remains except to put it into operation. He assumes further that Society is divided into two parts the proletariat who are converted to the plan, and the rest who for purely selfish reasons oppose it. He does not understand that no plan could win until it had first convinced many people, and that, if there really were a plan, it would draw support from many different quarters. He is so much occupied with means that he forgets to tell us what it is all for. If we pressed him, I suppose he would mention Marx. And there we will leave him with an echo of his own words "together with theological literature, perhaps the most useless, and in any case the most boring form of verbal creation."

Trotsky's book must confirm us in our conviction of the uselessness, the empty-headedness of Force at the present stage of human affairs. Force would settle nothing no more in the Class War than in the Wars of Nations or in the Wars of Religion. An understanding of the historical process, to which Trotsky is so fond of appealing, declares not for, but against, Force at this juncture of things. We lack more than usual a coherent scheme of progress, a tangible ideal. All the political parties alike have their origins in past ideas and not in new ideas and none more conspicuously so than the Marxists. It is not necessary to debate the subtleties of what justifies a man in promoting his gospel by force; for no one has a gospel. The next move is with the head, and fists must wait."

First, as in the General Theory and the Tract on Monetary Reform Keynes comes out firmly against this idea that anybody has a viable blueprint or plan that they can just superimpose on society. In the General Theory especially he made repeated mention of the fact that we must take a gradual, experimental approach and be cognizant of the fact that different societies are going to accept different forms and extents of reform. This point, of course, gets back to my old complaint about rationalist vs. empirical outlooks, and my old complaint against social engineering mindsets.

I am also quite fond of the point against people who promote themselves through the use of force. The dismissal of this option reminds me of Christopher Hichens; the advocacy of force in the imposition of these master-plans should not lead us to a debate over the alleged plan. "It is not necessary to debate the subtelties of what justifies a man in promoting his gospel by force," in other words. By promoting his gospel by force, this man removes himself from the scope of reasoned discourse.

Finally, I love the line "we lack more than usual a coherent scheme of progress, a tangible ideal". It captures the mood of the interwar period very well, and I'm afraid it also captures our current mood.

This will be the narrative to defeat

Keynes, certainly the greatest economist of the 20th century and perhaps the greatest ever, has made an incredible comeback in the last several years. In many ways he never left. While very specific public policy prescriptions had fallen out of favor for a while, the impact he made on how economics is done and how we think about the economy lived on even through the people who thought they were displacing him. But even in addition to that framework for doing economics, the more specifically Keynesian ideas have had a resurgence for one important reason - the same reason that any scientific theory gains acceptance: it makes good sense theoretically and it fits the data.

A lot of people who are not on board, though, have been pushing back. It's notable that one of the major ways they push back is with a sort of sociological, historical counter-argument, rather than an analytical, scientific counter-argument. Peter Boettke writes:

"The main mechanism [for the rise of Keynesianism] is the shift in the nature of public administration due to the progressive era, which Vincent Ostrom examines in detail in his masterpiece in the field, The Intellectual Crisis of American Public Administration (1973). This shift in public administration changes the expectations of what public policy is to deliver to citizens, and more importantly for our purposes what is expected of the policy experts. Keynes' economics fit that demand better than the more traditional mainline of economic thinking, and the Keynesian avalanche occurred and transformed economics as a discipline and economic policy ever since. To challenge this hegemony, one must get at the root cause, which is that transformation of public administration."

Boettke is - and I don't think he would dispute this - a heterodox economist. But he's not the only one that's asserted things like this. Lee Ohanian has been on record saying things similar to this (although less blatant in saying "the politicos like it") as well. And you can look at the way the whole Tea Party movement reacts too - they don't care about economic science - they see the constellation of Keynesian ideas (even if they can't identify it as "Keynesian") as a politician-buttressing ideology. It's much like the reaction against evolution that some people have - often it isn't an analytic counter-argument at all. Instead, creationists provide a sort of botched, unconvincing "these are the political ramification of evolution" counter-argument.

And yet the narrative is remarkably persistent, despite the lack of a real argument. They categorize Keynesianism as political ploy rather than scientific theory, which relieve's them of the need to engage it as a scientific theory.

This frustrates me to no end, but ultimately this will be the narrative that needs to be defeated. It's not even a narrative that makes particular sense. Since when have politicians been elected on the slogan "I don't really care about your specific spending needs because Keynesianism doesn't go that specific, I'm just going to deficit spend on everything". Keynesianism makes horrible politics, which is part of the reason why Alex Tabarrok has questioned whether for that reason alone we need to consider alternatives (I provide thoughts on Tabarrok here) I disagree with some of the pessimism of guys like Tabarrok on "Keynesian politics", but I think his grasp of the situation is much stronger than Boettke's on this point.

Anyway, like I said - this is the narrative to beat. I plan on writing something about this in my Economic Thought class this fall - answering or starting to answer this question of "why did Keynes catch on in America?". I think it has very little to do with what Boettke has mentioned and a lot more to do with the fact that (1.) it's good science, and (2.) American economic thought extending back to the colonial period was predisposed to accept Keynes.

Brad DeLong, Ditch-Digging, and Helicopters

Brad DeLong graciously linked to my post extending/critiquing Steve Horwitz's jigsaw puzzle metaphor for the difference between Austrians and Keynesians, which I felt relied on critiquing a parody of Keynesianism.

It's fitting that Brad linked to it because I think he's one of the best guys out there for explaining that Keynesianism is not about the government being the spender of last resort - it's about the government acting to eliminate distortions in the interest rate. These distortions arise from the fact that the interest rate is really one price for (at least) two goods: credit (or loanable funds) and cash (or liquidity). For those of you that remember your linear algebra, this is the same as saying that we have more equations than we have unknowns. We have four equations (demand for loanable funds, supply of loanable funds, demand for cash, supply of cash) but only three unknowns (quantity of loanable funds, quantity of cash, and the interest rate). We call systems like this "over-identified", which means somewhere there is going to be slack. Keynes was ambiguous about where the slack would come up. Hicks forced the slack to express itself in output by making a model where both the loanable funds market and the cash market had to clear. Wherever you fall (and I'm personally agnostic between Keynes and Hicks), the point is it's this price distortion that causes all the trouble, and Keynesianism is about fixing broken interest rates.

For some reason, this message does not get across to people and Keynesianism instead gets treated like it's saying "Y=C+I+G so if you increase G you have to increase Y". This view reads Keynes writing about burying bank notes and digging ditches and assumes he's talking about make-work projects. This view reads Brad DeLong saying that anything that adds to the deficit passes the cost-benefit test and thinks he's saying we just need to add more demand and pump up G. This completely misses the point. Keynesian ditch-digging is not a make-work argument. Keynesian ditch-digging is a helicopter drop, not a make-work program. The first helicopter flew in June, 1936* - only a few months after Keynes published the General Theory. It's a shame, because if Keynes had come up with Friedman's "helicopter drop" analogy rather than a ditch-digging analogy it probably would have lead to a lot less confusion.

If you want to cling to a loanable funds theory of the interest rate, by all means do your best at defending that view. It's going to insure that you happily and naively live in an abstract world of full employment and supply creating its own demand. Good luck with that one. But if you choose to engage Keynesianism, make sure you take the time to understand the argument. It's not about make-work, and it's not about replacing what the private sector used to do. It's about correcting price distortions that are inherent in monetary economies.

* - In Nazi Germany, which is why the helicopter picture in the top-left has a swastika on it... I don't just randomly post Nazi military images on my blog - it ain't my fault they figured the helicopter out first.